For balance sheet-oriented investors with expertise in the insurance industry, opportunities for alpha creation abound.
At Prospector, our three portfolio managers (as well as one analyst) each have over 20 years’ experience analyzing and working at insurance companies. This experience includes managing insurers’ investment portfolios and even serving on boards. With over 100 years of cumulative experience, it goes without saying that insurance is an area that we feel very comfortable analyzing and investing in. We also do many face-to-face meetings with these companies’ management teams, and are regulars at most of the sector-specific, annual gatherings.
Sometimes when comparing two property-casualty insurance companies, our experience helps identify investment opportunities that other firms may be missing. For example, we often describe insurance accounting as a self-graded exam. This is because insurers take in premiums well before their cost of goods sold is known, but have to set up a reserve for future losses when they take in the premiums. So, this often creates situations where two companies could appear the same based on valuation, but one has been aggressive on establishing the liabilities for future losses (i.e. setting aside too little for reserve) and is therefore over-stating earnings and shareholders equity. At some point, the chickens come home to roost, and the under-reserved companies will have to take a hit to reserves as the paid claims start coming in much higher than their initial estimates.
We perform this analysis by “going beyond GAAP” in terms of analyzing regulatory statements and determining how conservatively a company is valuing their reserves. Because we have “black belts” in insurance accounting, and know our way around statutory statements, we can make better educated guesses as to who is under, or over-reserved. This is a piece of the analysis where we spend significant amounts of time.
This analysis, together with our knowledge of valuations for historical transactions within the sector, helps us to determine our own private market value for an insurance company. For example, in the past we have owned several Bermuda-based reinsurance companies. Looking at these companies’ well-thought-out actions and how their stocks were being valued by the market, they looked like attractive investment opportunities.
Our analysis indicated that one of these Bermuda-based reinsurers in particular was trading at a material discount to its book value. We believed in the integrity of their loss reserves, and we were comfortable with the conservative nature of the assets on their balance sheet. The company’s assets were fixed income securities with a very short duration. In general, we pay close attention to not only the quality of the assets that reinsurers hold, but also the duration of those assets. Shorter duration assets can prove beneficial in an environment where inflation is rising and/or the Federal Reserve is raising rates.
In other words, we typically like to see reinsurers’ fixed income portfolios’ duration on the shorter side, and the credit to be clean. These reinsurers do write substantial property limits on a global basis. When the ground shakes or the wind blows, they can have exposure. This makes it all the more important for them to have their assets conservatively invested so that if they need to pay claims, the funds are on hand. Additionally, this company was aggressively buying back stock – often at prices below book value. We tend to be attracted to companies that are actively managing their capital – especially when it is accretive to book value per share.
After conducting our in-depth analysis, we established a position in the company. This proved particularly profitable when it was later acquired by a larger competitor who took note of the strong assets and conservative accounting practices, which were being undervalued by the market.
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