"Over time, most insurers experience a substantial
underwriting loss, which makes their economics far different from
Identifying the right company and having the intestinal fortitude
to hold the stock over an extended period of time can lead to
retirement prosperity. Well-managed insurance companies, with
long-term growth potential, are perfect candidates so long as
they are purchased at the right price. Imagine the effect on
's or Benjamin Graham's overall net worth without Geico Inc. The
same goes for
without his Fairfax insurance operations.
Great insurance companies differentiate themselves from mediocre
ones by their ability to achieve consistent underwriting profits.
They do so by employing discipline in their underwriting as well
as utilizing skilled management teams which improve the operating
efficiencies of their day-to-day operations.
Occasionally an investor can learn a great deal about a company
and the quality of their management team by merely listening to
their conference calls. Such is the case with tiny Florida
insurer, Federated National Holding Company (
), which happens to be my largest stock holding. I originally
profiled the buying opportunity back in 2011, when the company
was trading at less than 35% of its tangible book value and was
in the midst of returning to profitability. At the time, the
stock was trading under $2.50 per share with at tangible book
value in excess of $7. See
. At that time, the article ticker symbol of the company was
TCHC; the company name was changed to Federated National Holding
) a few months later.
During a recent conference call, CEO Michael Braun discussed the
four pillars of a successful insurance company: disciplined
underwriting, risk management, expense control and product
distribution. Those pillars, along with some other observations,
are the subject of today's discussion.
How Insurance Companies Record Earnings
Most insurance investors are privy to the fact that many
insurance companies earn the bulk of their profits by investing
the prepaid premiums which they receive (float). As Buffett
pointed out in the opening quote, the norm for insurance
companies is to write business at a rate below its true actuarial
break-even point in an attempt to maximize their prepaid premiums
which, in turn, are generally reinvested in conservative
In essence, many insurance companies are borrowing money from
their policy holders (in the form of poorly underwritten
premiums) and immediately reinvesting the proceeds into
higher-paying investment vehicles.
Say I accept thousands of poorly underwritten policies that will
result in a future loss of five cents for every dollar that I
have insured (the company's combined ratio is ultimately 105
although current results might belie the future losses). The
insurance company may still prosper as long as their investment
portfolio yields rates that are substantially higher than 5%. In
other words, the company is actually borrowing money from its
policy holders with a 5% interest rate attached which must be
paid out at some period in the future. Such a practice may be
considered quite sensible if the insurance company is able to
reinvest the float and secure steady returns of 10%.
In the above fictitious example, the insurance company has a 5%
cost of capital and a 10% yield which results in a spread of
100%, pretax. During periods of high yields on conservative
fixed-income vehicles, companies which operate with steady
underwriting losses can still prosper as long as their cost of
capital remains substantially under the safe yields of their
The problem with such a strategy is two-fold: first of all, when
fixed-income yields are excessively high so is the likelihood of
inflation; secondly, during periods of relative deflation (such
as we are experiencing now) fixed-income yields are excessively
low and resets tend to diminish paltry bond yields even further.
Subsequently, companies which perpetually write policies with
combined ratios in excess of 100 begin to experience squeezes in
their profitability. Further, they tend to purchase lower-grade
securities in an attempt to increase yield or engage in
proprietary trading in an attempt to earn profits in excess of
their cost of capital.
The aforementioned companies may appear to be quite profitable on
a short-term basis but many times the actuarial value of their
reserves are substantially understated; furthermore, such
companies frequently engage in risky investment behavior. In such
cases, their current earnings yields and their seemingly
impressive returns on equity are purely a mirage. As the weight
of the poorly underwritten policies invariably shows up on their
income statements and balance sheets, their earnings and book
value can decline for a period of years. The scenario I just
described was exactly the case for TCHC for multiple years prior
to their recent epiphany and return to proper underwriting
The Four Pillars of Insurance
The following is a brief description of the four pillars of
insurance investing which result in profitable operating results.
If an investor wishes to hold on to an insurance stock for an
extended period, he or she had better be quite certain that the
company will steadily write business with a combined ratio of
under 100. Great long-term insurance investments are a function
of two simple points: 1) profitable underwriting and 2)
conservative and competent investment of the float and the equity
of the company. The four pillars deal with the operational aspect
of the insurance business.
1) Disciplined Underwriting
Poor underwriting not only results in poor operational results in
the long term, it also results in excessive costs for purchasing
reinsurance. Exactly the opposite is true when policies are
highly scrutinized and poor risk policies are not accepted.
Reinsurance companies begin to knock on your door and fight for
your business when you write profitable business and refuse to
purchase risky policies which can damage their profitability as
well. Utilizing competent actuaries and insisting upon proper
pre-purchase inspections are paramount to long-term success.
2) Risk Management
Skilled managers take into consideration all facets of risk which
could affect the liquidity as well as the profitability of an
insurance company. Such duties involve purchasing the correct
amount of reinsurance to cover "black swan" events as well as
common occurrences. Proper diversification of coverage is
imperative so an extraordinary regional event does not put the
company in financial peril.
The management team must also be certain that the investment
teams are not engaging in high-risk behavior when deploying the
company's float and equity. Ask Hank Greenberg and Jaime Dimon
about the importance of monitoring the investment agents of the
company to ensure that they are equipped with a proper concept of
3) Expense Control
Well-managed insurance companies are streamlined and are not
laden with high fixed costs. Variable and product acquisition
costs are inevitable but companies which operate on tight budgets
and consolidate their operations are frequently able to provide
the same coverage as a competitor with a lower cost structure.
Geico Inc. was the original low-cost provider of automotive
insurance by effectively eliminating the commission cost of the
agents. Through the years other companies have adopted similar
business models and cut in extensively to Geico's competitive
advantage. Geico's moat has now become more a function of its
effective advertising campaigns rather than its low-cost
structure. Again, the credit goes out to the Geico management for
maintaining its operational efficiencies quarter after quarter.
Expense control is also largely a function of customer service
and the ability to retain one's clients for extended periods.
Policy acquisition costs are extremely expensive in the insurance
business. The cost of insurance leads is expensive whether they
are attained through advertising, canvassing, direct mailing or
cold calling. It is imperative to long-term profits that the
business handles claims promptly and have well-trained
administrative and support teams to help retain satisfied
Of course from a Philip Fisher perspective, the company must also
operate as an effective sales organization if they are to grow
their sales and continue to prosper. The key for management is to
do so in a cost-effective manner.
4) Product Distribution
Outstanding insurance companies are masters of increasing their
product distribution. Sales growth is largely a function of
increased geographic distribution. McDonald's would have never
become a behemoth if they had limited their sales to California,
and Geico would be just another small niche insurance company if
they still sold only to government employees.
Most investors punch their ticket to financial freedom by making
a few great investments in their lifetime and grinding out small,
steady gains in the rest of their portfolios. That certainly was
the case for Benjamin Graham; without his extraordinary gains in
Geico he would have never achieved the financial security that
allowed him to live as he pleased after shuttering Graham-Newman.
Any type of business can qualify as the one opportunity which
might put an investor over-the-hump. However, the very nature of
insurance investing and the ability to make sizable profits off
the float of the company as well as its equity is the reason that
Buffett became so infatuated with Geico at such a tender age.
That said, the key to a great investment is not only the dynamics
of the company but also the price at which a person is able to
acquire his or her shares.
In a small sense, I discovered my own little Geico in Federated
National Holding Company, a little over a year and a half ago.
Since I bought in at around 35% of the company's book value, they
have not recorded a losing quarter. Further, they reinstated
their dividend and have raised it recently to 0.03 a share per
quarter. The company is now growing like a weed and has increased
their tangible book value from $7.05 per share at the time of my
purchase to its current value of $8.60 per share.
I hold no delusions that the little company will become the next
Geico, but I am quite confident that they can continue to grow
their book value at an above average rate for the next few years.
They are now writing thousands of new policies every quarter at
favorable pricing and they are growing the profitability of their
operating business at a rate which suggests that they are worth a
considerable amount more than their tangible book value. While
the company no longer holds the supreme margin of safety in the
form of its former 65% discount to tangible book value, it has
become a play on its rapidly improving return on equity. I have
no intention of selling my shares in the near future and I expect
FNHC will continue to provide me with adequate returns
considering its increased dividends and its dramatic growth in
revenues, book value and earnings per share.
Disclosure: Long FNHCAbout GuruFocus: GuruFocus.com tracks the
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