Insights from Prospector Partners, Sub Advisor to the LS Opportunity Fund.
Insurance is a distinctive product. The buyer (consumer or business) is paying premiums today to collect payment in the future for something that may or may not occur. The seller (insurance company) doesn’t know its cost of goods sold until well after the policy is sold and premiums are collected. Actuarial science plays a vital role within the industry. The better the data, the more accurately an insurance company can estimate a potential claim and its cost. A more accurate assessment of cost of goods sold yields a more accurate price for the customer and a more predictable profit margin for the insurance company. Regulators and ratings agencies assign capital requirements with these calculations in mind. Different types of insurance vary dramatically. There are significant differences between insurance for cars/homes versus businesses, mortality, investments, etc. The different lines of insurance each possess unique aspects such as:
- Predictability and variability of losses. How wide is the range of outcomes and how reliable is the data to predict outcomes?
- Duration of claims payments. How, and for how long, does the insurance company invest and hold the premiums before having to pay the claims?
- Required capital. How much leverage will regulators allow?
The inherent lack of certainty in estimated claims at policy inception yields a “cyclical” business. Companies are always needing to adjust prospective pricing based on realization of actual claim payments made over time. Different lines of insurance tend to have their own cycles.
The team at Prospector Partners have followed the insurance industry for decades. While Insurance is but one subsector of the broader industry category known as Financials, this subsector title is too broad a description for all of the different underlying business models within the space. We would further categorize the industry into these segments: (1) Property-Casualty, personal lines; (2) Property-Casualty, commercial lines; (3) Property-Casualty, reinsurance; (4) Life insurance; (5) Insurance, distribution; (6) Insurance, credit, title, mortgage. Our team tends to focus on analyzing and investing in companies within the first five of these groupings, each of which we will discuss individually.
Property-Casualty Insurance for Personal Lines
When consumers purchase insurance for cars and homes (or rental homes), the concept is relatively easy to understand. These policies are typically mandated by law and there is much standardization for policy terms, conditions, and limits of coverage. Actuarial data on historical loss trends is material and deemed to be quite reliable for extrapolation. Claims are typically settled in a relatively short period of time. Carried reserves for claims on the balance sheet do not tend to develop with material deviations over time, given the aforementioned characteristics. The relatively short period of time between premiums received and claim payments yields a more conservative and shorter duration investment portfolio, which tends to be highly liquid and highly rated. Regulators and rating agencies appreciate these attributes and assign relatively lighter capital requirements to personal lines businesses. This segment of property-casualty insurance is perhaps the most commoditized; differentiation between companies derives from distribution, cost advantages, and brand, amongst other attributes.
Our team likes this sector; we like the reliability of loss estimates and find it easier to trust the carried reserves on the balance sheet (the largest liability on any insurance company’s balance sheet), particularly given our internal reserve analysis which you can read more about in this separate research piece. The companies in this sector also tend to purchase much reinsurance to limit “tail risk” (i.e. aggregation of losses from natural disasters such as earthquakes and hurricanes), which again, instills trust in the balance sheet. These companies can write business with greater leverage (premiums/capital), so every point of underwriting margin generates relatively greater return on capital.
Property-Casualty Insurance for Commercial Lines
Businesses purchase insurance for vehicles, property, liability, and employees, among others. Workers’ compensation insurance is mandated by law, but most other coverages are purchased regardless. Actuarial data on historical loss trends is prevalent, but less reliable for extrapolation, for the following reasons:
- Coverages tend to be relatively less standardized (particularly as size of business increases)
- Deviation amongst businesses and exposures (i.e. widget manufacturers versus oil drillers versus banks, etc.)
- History of coverage (i.e., cyber insurance is a relatively new product)
Our team has a favorable opinion of this sector, but we are relatively selective and opportunistic. We are generally more skeptical about carried reserves, and tend to discount even our own reserve analysis, respecting the limitations of the exercise and variations in product, customer, etc. The companies in this sector also tend to purchase reinsurance for hurricanes and earthquakes, but tail risk remains from large “surprise” losses (legacy litigation, terrorist attacks, pandemics, et al). The relative unpredictability in claims and reserves yields a business cycle with greater variance.
We tend to prefer investing in “Main Street” business insurance providers. In general, the smaller the business insured, the greater standardization amongst terms/coverages/pricing and the lesser tail risk for unknown catastrophes. Policies purchased also tend to be for only the most basic of coverages (property/liability/workers compensation) and provide lower limits of coverage. In some cases, one could argue that Main Street business insurance can be somewhat similar to personal lines insurance.
Property-Casualty Reinsurance
Reinsurance is essentially insurance for insurers. Reinsurance allows insurance companies to mitigate and manage known (and unknown) exposures by “ceding” premiums and expected claims/losses to reinsurance companies.
Reinsurers are a step removed from the underlying risks. For example, an insurance company sells thousands of policies covering thousands of individuals and businesses, then purchases reinsurance for that basket of exposures. Reinsurers do not price individual policies for individuals and businesses — they price the portfolios of policies. Reinsurers must understand their insurance company clients as well as the risks assumed. Therefore, reinsurers have less granularity and visibility into the exposures they underwrite and the reserves they set aside to cover those ultimate claim payments.
Our previous discussion of personal and commercial lines “primary” insurance companies is constructive to understand why investing in reinsurance companies carries greater uncertainties. Reinsurance companies have inherent disadvantages to setting reserves— they are a step removed from the underlying risks (the ultimate persons and businesses insured) and are trusting of, and at the mercy of, the data provided to them by their insurance company clientele when providing coverage. Reinsurers have all of the challenges of a primary insurance company in addition to this limitation. Therefore, regulators and ratings agencies consider these attributes and assign meaningful capital requirements for reinsurance companies, which significantly limits leverage in the business. Reinsurers have to price business for larger underwriting margins to compensate for this disadvantage. All of these factors contribute to a business cycle with much more variability and volatility. Unsurprisingly, stock valuations assigned to reinsurers tend to be lower than that of primary insurance companies.
Our team invests opportunistically in this sector. We invest with a healthy skepticism of reserves given the characteristics of the business. We tend to increase our allocation to the group after a period of significant losses, reserve surprises, and/or prospective profitability concerns, as these periods usually lead to valuation dislocations and improved industry pricing.
Life Insurance
The economics of life insurance are very different than the economics of property-casualty insurance. Property-casualty insurers do not know their cost of goods sold until much time has passed post inception of the policy. These companies must be cautious in investing premiums collected, given the unpredictable nature of claim payment amounts and duration, which could be 3–5 years or more. Therefore, property-casualty insurers take the majority of their risk on the liability side of the balance sheet and maintain a conservative asset mix. Conversely, life insurance companies have very reliable actuarial data to predict and price for mortality, with little actuarial differentiation between estimated and actual claim payments. Additionally, life insurance companies tend to hold the collected premiums for a very long time (10+ years) before having to make a claim payment. Therefore, life insurers take the majority of their risk on the asset side of the balance sheet. Regulators and rating agencies have a positive view of these attributes and allow life insurance companies to operate with greater leverage than property-casualty companies.
Life insurance companies sell a wide range of products, from the relatively simple (e.g. term life insurance — pay premiums every year for X number of years, and should you die, you collect) to the relatively complicated (e.g. annuities — products combining death benefits, investment returns, and a variety of bells and whistles to meet individual financial and estate planning needs). Products are fairly commoditized, with differentiation possible from distribution, cost advantages, and brand, amongst other attributes. In general, life insurers focused on simpler products tend to have captive distribution, cost advantages, and lower capital requirements. Additionally, these products are fairly straight-forward from an accounting perspective. Life insurers with broad-based product offerings that include relatively more complicated products tend to use multi-channel (including 3rd party) distribution, have no perceivable cost advantages, and have relatively higher capital requirements. The more complicated products embed many long-term accounting assumptions, with a list of rules and principles that would make the best accountant’s head spin!
Our team prefers investing in the “simple” bucket. These companies typically generate underwriting margin (claims and expenses less than premiums collected) which lessens the required investment return to achieve targeted financial objectives. In other words, these companies don’t have to stretch for yield. These companies’ product portfolios also carry less reserve and accounting variability. Reported GAAP results typically approximate adjusted results, and free cash low (i.e. cash generated available for dividends and/or share repurchases) tends to represent a high percentage of reported earnings.
Insurance Distribution
Insurance is generally sold “direct” by insurance companies’ paid employees or sold via agents/brokers also known as third party distributors. The economics of an agent/broker are very attractive. They charge a commission/fee for their services (typically a percentage of the premiums) and do not assume underwriting risk — they are only middlemen in the insurance placement and sale. Insurance industry premiums are correlated to economic and population growth, and agent/broker client retentions are typically >90%. These factors yield steady, predictable revenues and margins, with only modest capital needs.
There are thousands of agents/brokers in the U.S. The attractive economics of the business, combined with readily available credit, have fostered a robust M&A environment in recent years. This consolidation has left public investors with fewer options to invest. However, publicly traded agents/brokers remain active buyers of private properties, adding another layer of growth to the long-term business model.
There is some cyclicality in the business. Insurance industry premiums reflect exposure (economic activity) and price (actuarially determined). When economic growth accelerates, the exposure piece of the premium equation increases, which tends to increase commissions and fees for the agents/brokers. The converse is also true. When property-casualty prices are increasing (to offset increases in claims/reserves), the price piece of the premium equation contributes similarly to the revenue model. The converse is also true. We like the business model and the attractive margins and compound growth many of these companies produce.
Prospector Partners is not affiliated with Ultimus Fund Distributors, LLC.
