Awhile back, I wrote about Flagstone Re
How do reinsurers make money?
First things first: How exactly do reinsurers make money? In a nutshell, reinsurers insure insurers. (Say that five times fast.) When insurance companies want to cut back on certain risk exposures, they turn to reinsurers to get rid of some of that risk.
Reinsurers hope to make money in two ways. First of all, if a reinsurer pays out less than $1 in claims for every $1 in policies, it earns underwriting income. On top of that, insurers get to invest cash from policyholders' premiums (float) into stocks and bonds and keep the investment income.
This float is what makes insurance such a tantalizing business. Suppose insurer A has $3 in float for every $1 in equity. Combined, this would equal roughly $4 in investments (3+1) for every $1 in equity. If float was invested in bonds yielding 5%, then even if the insurer only broke even on underwriting ($0 underwriting income, 100% combined ratio), the company would still get a 20% pre-tax annualized return on equity just from investment income.
However, what if a reinsurer could combine its float-generating ability with above-average investment prowess? Berkshire Hathaway's
Greenlight's got next?
Although Berkshire has some truly unique characteristics and a collection of businesses that would be impossible to replicate, I can't help but wonder if Greenlight Re could attempt to follow in its footsteps.
Greenlight Re's prospectus states that 96% of its investments in securities are invested in a long-short portfolio of public equity managed by David Einhorn, the chairman of Greenlight Capital.
This is unique because reinsurers tend to allocate most of their portfolios to safe and liquid investment-grade bonds, reserving only a small portion for other asset classes. In 2005 and 2006, Greenlight Re's investment returns were 14% and 24% -- much, much higher than a reinsurer's typical 6% to 8% return from fixed-income investments.
Obviously, the investment strategy is also riskier, as the negative 4.2% return (partly thanks to a soured bet on subprime lender New Century) through March 31 demonstrates. However, in the long term, which is what Fools truly care about, David Einhorn has a pretty amazing track record. According to a Bloomberg article, Einhorn's funds had returned 29% annually since 1996. If Einhorn is able to earn even half of that return for Greenlight Re's portfolio, it would be a major home run.
Valuation
Greenlight shares, partly thanks to the Einhorn premium, trade at $23 per share, or 21% above the $19 IPO price. Thus, shares trade at a 66% or so premium to book value -- a bit on the high side compared to fellow reinsurers RenaissanceRe
Risks
Investors eyeing Greenlight Re should also be aware that the company's nontraditional investment strategy could result in a substantial amount of risk. If Greenlight's reinsurance and investment bets go bad at the same time, then shareholders might take an irreparable hit, especially if the company becomes overly leveraged.
However, I think the company will end up being managed more in the vein of Berkshire, as a reinsurer with a conservative balance sheet and risk exposures -- after all, compensation is based on profitability, not volume, and David Einhorn owns 17% of the company's shares.
Final thoughts
For Greenlight, I'm sitting on the sidelines and crossing my fingers that I'll be able to pay a smaller premium to book value in the future. Because reinsurers are quite volatile and the sector goes in and out of fashion very rapidly, I'm pretty sure that at some point I'll get my chance.
Related Foolishness:
Berkshire Hathaway is a Motley Fool Inside Value recommendation. Try out an all-access 30-day trial to the market-beating service at no cost. Berkshire is also a Stock Advisor pick.
Fool contributor Emil Lee is an analyst and a disciple of value investing. He doesn't own shares in any of the companies mentioned above. Emil appreciates your comments, concerns, and complaints. The Motley Fool has a disclosure policy.
