The great thing about the insurance industry is that most people find insurance as exciting as a visit to the local dentist. As a result, there are tons of insurance companies and not many investors looking at them, compared to, say, Google or Yahoo. Thus, even though I'm not excited about property and casualty insurers as a whole (combined ratios are at historical lows), I'm still able to find some stocks that might be interesting.
Cheap is in the eye of the beholder. I like to look for an insurer that trades at a low multiple-to-book value, has a high earnings yield, and has high returns on equity. Before we get into the good stuff, here's a quick refresher on those metrics.
Book value is total assets minus total liabilities. If an insurer has $100 in assets and $50 in liabilities, it has a $50 book value. If I can buy that insurer for $25 bucks, then I could theoretically liquidate that insurer by letting its contracts run off and pocket the $25 profit for a 100% return (assuming I don't have to incur huge expenses to liquidate the company). Thus, book value can be considered a margin of safety.
If you invert the P/E ratio, you get the earnings yield, thus a P/E of 10 becomes a 10% earnings yield. Obviously, it's better to have a higher earnings yield than a lower one.
Return on Equity
Book value equals equity. When you buy shares of an insurer, technically, as a stockholder, you are only entitled to the equity -- the rest belongs to the policyholders (float) or creditors (debt). Thus, net income -- which is profit after paying policyholders, operational expenses, and creditors -- belongs to shareholders. This net income can either be returned to shareholders via buybacks or dividends, or reinvested into the business, which increases equity. Thus, we're concerned here with how much income trickles down to stockholders, or return on equity.
When buying an insurance company, investors need to decide what multiple of book value and earnings they're willing to pay. If I do a quick Yahoo screen for property and casualty insurers trading at less than 20 times earnings with a low price-to-book multiple, a number of interesting opportunities pop out.
Property and casualty insurer Cincinnati Financial
Cincinnati Financial also creates shareholder value through its stock picking prowess. As of the latest quarter, the company's equity portfolio (Cincinnati is one of the few insurers that has more of its investment portfolio in equities than fixed income) had a cost basis of $2.3 billion and a market value of $7 billion -- meaning its stock holdings have more than tripled in value. For example, the company bought $283 million worth of Fifth Third Bancorp
Mercer Insurance Group
Mercer Insurance Group
The most compelling thing about Mercer is that the company is underleveraged. In 2005, Mercer's earned premiums-to-equity ratio was only 75%. In contrast, Markel
Finally, a household name. As you are probably aware, Progressive
Currently, Progressive Direct accounts for 30% of its total earned premiums and should be a healthy grower. Because direct-to-consumer sellers don't have to give independent agents a cut, they often have a cost advantage over their non-direct brethren. According to a presentation by 21st Century, direct-to-consumer auto insurers have captured 4.6% market share since 1999, whereas the independent channel captured 1.6% over this time period (each percent of the $160 billion in annual auto insurance premiums is worth $1.6 billion).
In the independent agency channel, Progressive is also a low-cost provider, thanks to its scale efficiency as the third-largest writer of auto insurance. Although Progressive's aggregate expense ratio was higher than pure direct insurers USAA, GEICO, and 21st Century, Progressive's costs were lower than State Farm, Allstate
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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 and appreciates your comments, concerns, and complaints. The Motley Fool has a disclosure policy.