Lancashire Group (ISIN BMG5361W1047) – The UK equivalent of Buffett’s National Indemnity ?

While I was writing this post which I do normally over 1-2 weeks, the excellent WertArt Capital blog has released a very good post on Lancashire a few days ago. I higly recommend to read the post as it contains a lot of usefull information.

This saves me a lot of time and I only need to summarize the highlights:

– Lancashire is a specialist insurance company which insures mostly short tail “Excess loss” type of risks. It was founded by Richard Brindle, an experienced underwriter

– Since founding & IPO in 2009, the company has shown an amazing track record. No loss year, 59% average combined ratio and 19,5% ROE is simply fantastic.
– the company has a very disciplined underwriting focused business model, investment returns are negligible
– focus in on capital allocation and efficiency. If rates are not good, Lancashire returns capital to shareholders
good alignment of management and shareholders (majority of bonus depends if ROE hurdle of 13% + risk free is hit)
– The company looks cheap at ~8,5x P/E and 1,3 x P/B

For non-insurance experts a few quick explanations of insurance terms:

“Short tail” insurance business:

“Short tail” means that one is only insuring stuff where you pretty quickly see if there is a loss or not. For instance a “plane crash” insurance will be good for 1 year and if a plane crashes, the insurer will pay. After that 1 year there are no obligations for the insurer.

“Long tail” in contrast is an insurance policy which again covers a calendar year but where the damage can come up much later. A good example is D&O (director and officers) insurance. Often, when a big company goes bankrupt, some fraud etc. was involved at management level. Until a jury finally makes a verdict, many years can pass by but still the insurance company which has underwritten the policy remains liable. A good example is for instance the recent Deutsch Bank /Kirch trial where insurers will have to pay 500 mn EUR for something that happened 12 years ago.

Long tail has the advantage that the “float” can be invested long-term and illiquid, on the other hand the risk if a significant miss-pricing is much higher.

Excess Loss contracts

Excess loss contracts are contracts where the insurer only pays above a normally quite high threshold. This means that in normal cases, one does not need to pay but as a result premiums are lower than with normal contracts or “lower attachment points”. These kind of contracts are also often called “catastrophe risk” or “Cat Risk”. If such an event hits, then the hit will be big. Lancashire initially expected to make a loss 1 out of 5 years but up to now they had no loosing year. A company which has many excess loss contracts will report very good results in some years but very very bad in others.

What is the connection to Warren Buffett ?

Lancashire and Co. are relatively similar to Buffet’s National Indemnity Insurance, maybe the most overlooked part of his insurance empire after GEICO and Berkshire/General Re. Buffet has commented several times on National Indemnity and the competitive advantages of this company. The major competitive advantage of this business according to him was the ability NOT to write business if premiums are too low. The problem with this approach is of course that if you write less business, cost will be higher and the all important “Combined Ratio” (costs+claims divided by premium) will go up and investors will get nervous.

I wrote down this quote from last’s year Berkshire AGM from Buffett:

“I prefer the underwriters playing golf all day instead of underwriting risks at the wrong price. I don’t care of combined ratios grow well above 100% in such years.” For normal Insurance companies this is almost impossible to achieve as investors want to see increasing sales and profits any year and so most Insurance companies will underwrite no matter what the price is just to maintain the premium.

On the web I found similar quotes from him on the National Indemnity (NICO) which the bought in the 80ties:

Nevertheless, for almost all of the past 38 years, NICO has been a star performer. Indeed, had we not made this acquisition, Berkshire would be lucky to be worth half of what it is today.

What we’ve had going for us is a managerial mindset that most insurers find impossible to replicate.

and:

Most American businesses harbor an “institutional imperative” that rejects extended decreases in volume. What CEO wants to report to his shareholders that not only did business contract last year but that it will continue to drop? In insurance, the urge to keep writing business is also intensified because the consequences of foolishly-priced policies may not become apparent for some time. If an insurer is optimistic in its reserving, reported earnings will be overstated, and years may pass before true loss costs are revealed (a form of self-deception that nearly destroyed GEICO in the early 1970s).

Additionally, Buffett is already participating in the London/Lloyd’s market via another structure. Last year, he underwrote a socalled “side car” deal with Aon. The deal is still controversial but indicates a change of how things are being done at Lloyds. Funnily enough, Lancashire CEO Richard Brindle called the Buffet/Aon deal “foolish” in an interview last year.

Why is the company cheap ?

1. In general, all the socalled “London market” insurers are cheap. Let’s look at the “London” peer group:

Name Est Price/Book Current Yr P/E P/E FY1 Current Div. Yld (%)
         
LANCASHIRE HOLDINGS LTD 1,24 8,76 8,77 8,26
HISCOX LTD 1,62 10,47 13,48 8,21
BRIT PLC 1,23 #N/A N/A 8,59 #N/A N/A
BEAZLEY PLC 1,55 8,11 9,55 10,00
AMLIN PLC 1,36 7,94 11,13 6,07

Compared to those London players, all European P&C Insurance peers trade on average at~ 2,2 x book and 12 x earnings. So why are the London insurers so cheap ? In my opinion, the answer lies in the cyclicality of the business similar to Admiral. The “London market” is even more cyclical as it is primarily an institutional price driven market. The London market specialises in large and complex risks with “natural catastrophe” exposure. Despite the headline news, in the last years there were very few NatCat events which really led to large insured losses. In those times, profit margin increase and there is big pressure to lower premium. As companies accumulate capital, the appetite for risk increases, which further lowers premiums. This works as long as either a large NatCat event happens or capital markets crash and the insurers then have to raise premiums in order to restore their capital levels.

2. Management and strategy change

Lancashire so far has shown excellent underwriting discipline and outstanding an outstanding ability to allocate capital. However in the last few months a couple of things have changed:

a) The founder & CEO has “retired” in April at an age of 54. I haven’t found out why. Since 2005 I would guess that he has earned 50+ mn GBP, maybe he thought that this is enough ? At least he got an extra 10 mn package according to this article. He has been selling shares before his retirement.

b) In a change of strategy, Lancashire bought at the end of 2013 a Lloyd’s syndicate called Cathedral for ~200 mn GBP. Although the Lloyd’s business is not necessarily bad business, it is clearly a change. Lloyd’s underwriting is often reinsurance in contrast to Lancashire’s direct insurance. In their previous reports they claimed that their strategy of insuring directly was a competitive advantage. The Lloyd’s market on the other side is mostly reinsurance and more vulnerable.

c) Finally, after having been invested in short-term no-risk bonds since their IPO, they suddenly disclosed beginning at year-end 2013 that they now invest also into stocks and “Low volatility” hedge funds. Most likely not a good idea at this point.

For me, the cyclicality of the business itself would be no problem. But the combination of Management change and strategy change is very hard to swallow. I would happily invest if there would be EITHER a management change OR a strategy change but not both.

Summary:

To quote Donald Rumsfeld, those two changes lead Lancashire into the “unknown unknowns” territory. Sure, the new CEO is at Lancashire since 2007 and an underwriter, but overall I am not sure if the superior capabilities of the forme CEO have been “institutionalized” in the 8+ years of company history. Having three platforms instead of one sounds great, but it can also mean a loss of focus. So at the moment, Lancashire for me is not a “buy” as I do not have a clear idea how and if they can replicate their past results. T

However in general, the business model is attractive and the “London Insurers” could become interesting, especially if the market softens further so I will try to look into the others at some point in time.

Edit: I have just seen via the “Corner of Berkshire and Fairfax” board a link to an “Insurance Insider” article which states that the former CEO has completely sold out and is expected to launch a new company. A reason more not to rely on past results as this business is very dependent on the persons and the old CEO wil be a pretty tough competitor if he starts over again.

10 comments

  • FYI, Lancashire just posted an updated Investor Presentation to their website this weekend

    http://www.lancashiregroup.com/~/media/Files/L/Lancashire-Group/Attachments/presentations/2014/q2-investor-presentation-2014-final.pdf

    They have some good information in the presentation relevant to your concerns about strategy change and whether or not they are taking on more risk in a soft market

  • Hello,
    I think that Brindle would not start an insurance company in the middle of a “soft market”, that is nonsense. Brindle knows this and it was not luck that Lancashire was founded 8 years ago.
    On the reinsurance I think you miss the point that Lancashire is buying reinsurance itself because rates are so low so their risks are diminishing.
    On the investment side they are pretty conservative and hedge funds are not all of the same, some could be really safe.
    Brindle was not on the day-to-day operations since at least a year, or so told me the management. Current CEO was in charge of underwriting risk so he should know well the job. Anyway even if Brindle owned shares in the company his chunk was not a majority or a big part like Buffett’s Berkshire or Watsa’s Fairfax, it makes a great difference.
    In my opinion the insurance sector does not offer enterprises with competitive advantages and everything comes down to discipline, if they have it they will do very well if they do not keep it that would be bad.
    Cathedral gives Lancashire the opportunity of the Lloyd’s sindicates ( let’s not forget that Brindle came from lloyd’s) and Kinesis is only a vehicle to use external capital with very low risk for Lancashire.
    Some markets are already hardening, let’s not forget that 2 big airplanes just fell down in Ukraine and Africa and unfortunately market become hard after tragic events, Lancashire is involved in aviation.
    As for the case of an investment, I believe that it is very difficult to find a company with a durable moat in the insurance sector if they exist but this one looks very good and with a solid balance sheet, I also find it very “robust” in case the stock market takes a dive.

    • Marco,

      one comment: Lancashire on average had around 40% of their inbound business as reinsurance and ceded themselves around 20% to reinsurers. If you look at the most recent numbers they now cede less to reinsurers (only 10% in Q2), this means that they seem to keep more risks. For me it looks like that they fall into they same trap as normal insurers: in order to make their hurdle they take more risk at a lower price.

      And allow me one sarcastic comment “Safe hedge funds” to me sounds like “famous last words”……

      Clearly, Lancashire could turn out to have a really good year again, but for me it is too risky at the moment.

      mmi

      • Mmi,
        I do have many concerns as you do, and in fact they are the same, the real question comes to the fact if they keep their discipline or not since the soft market is a reality for everyone in the sector, eventually it will change but we do not know when. In my opinion they are still on the disciplined side but I agree with you that keeping on that side is difficult particularly when the soft market seems to be prolonged. If you believe that they will be disciplined in the future then it is a good long term investment

      • MMI, I believe you are mistaken as far as what Lancashire is doing with their reinsurance. Lancashire ceded less in Q2 but that appears to be just normal seasonal variation. The percentage ceded in Q2 2014 was similar in Q2 2013. Lancashire ceded over 30% in Q1, and the percentage YTD is around 20%, not that dissimilar from last year. I think it is just a timing question of when the various reinsurance policies are renewed

  • Which insurer or reinsurer doesn’t say, “not to write business if premiums are too low”? Other prominent examples include Munich Re and Alleghany. You remember your link in February? Personally I ignore such statements and look at the ratios.

    Largely due to the low cost-of-capital environment in recent years, several new companies are crowding in the insurance market, many based in Bermuda and even subsidiaries of hedge funds like Third Point (IPO 2013). In the late 80s Barbados and Bermuda signed a treaty with the United States exempting all premiums paid by American companies to insurers in Barbados from American taxes.

    In individual cases, I would pay attention to signs of loose lending. In 1999, I read a book about Lloyd’s and a dacade later Shelp’s book about AIG. I ain’t sure if I had seen it in a timely manner, even if I would have been interested. Insurance is a highly complex business and there are quite a few ways to improve the figures, but this should not exclude any investment.

    • Darius,

      Lancashire is one of the few Insurance companies which had actually “walked the talk”. They returned already more than double the money that shareholders have put into them in 2005 plus you could clearly see that they didn’t aim for topline growth.

      If they manage too do so going forward is another question.

      mmi

  • I am very happy to see Lancashire being discussed. I presented Lancashire as an investment idea at Vitaliy Katsenelson’s ValueX Vail conference in June. With the conditions in the industry and Brindle leaving, there is obviously much to be concerned about, but Lancashire remains my largest holding. I had just a couple of thoughts in response to your concerns about a strategy change.

    While Lancashire does now own some equities, equities were less than 1% of the total investment portfolio at June 30. Hedge Funds were less than 4% of the portfolio. Lancashire still has the most conservative investment portfolio of any insurance company I have seen.

    I don’t see the Cathedral acquisition as a strategy change. Reinsurance tends to be more commodity like than primary insurance, but it is much more important to consider the types of risk being covered than the reinsurance vs. primary insurance label.
    I don’t really think that the Cathedral business is all that different than the rest of the Lancashire book of business. Their business is very specialized. Much of it is reinsuring small U.S. based mutual insurers, and a very large part of the Cathedral business has been with them for more than 10 years. This does not look like a commodity business at all. Lancashire has always been both a primary insurer and a reinsurer. The Cathedral acquisition changes the mix some, but not a great deal.

    • Dear Greg,

      thank you very much for your detailed comments. I haven’t seen your presentation but I have looked it up, it is really really good.

      http://de.scribd.com/doc/231578937/Greg-Porter-Lancashire-Holdings-Limited-ValueX-2014-Presentation-Final

      Allow me to comment some points you made:

      -investments: Yes, they still have a conservative portfolio, but still shifting 4% (or ~10% of equity) of the portfolio to risky assets within 6 months or so is still an issue. I am afraid that they try to do the same thing as traditional insurers: Trying to increase their results by increasing investment risk. At their current run rate, hitting the 13% ROE hurdle for bonuses is not easy and every CFO is tempted to spice up ROE with investments

      – reinsurance: I tend to disagree here. Reinsurance is wholesale business compared to direct business. One easy way to spot this is the development of acquisition cost. The more reinsurance they do the higher the acquisition cost of this business becomes. Higher acquisition cost means lower margin for error in the underwriting book. Aquisition cost has been going up for Lancashire even without Cathedral for quite some time.

      – I think that Lancashire was also lucky since their IPO. Their own estimate was that they make a loss every 5 years. They didn’t make a loss in 8 years but that doesn’t mean that they were so brilliant. CatRisk underwriting over such a short term is subject to a lot of randomness, so projecting past loss ratios as a simple average understates the tail risk in the book in my opinion. Loss ratios of 100% are easily possible. This is not Admiral

      – finally, I consider Alchimy, the former PE owner as a smart seller. So you should assume that Lancashire did not make a bargain purchase as it was the result of a competitive auction.

      For me, the biggest risk with Lancashire is the following: I

      It is a young company and so far life was good. They made great returns and everyone got nice bonuses. However they did not experience bad times yet and in this business they will come for sure. Imagine one or two years of no profits and no bonuses. And then across the door, Brindle is starting a new company. This will be a hard test if Lancashire already has some corporate DNA.

      It iwll be interesting to see even this year what wil hapen if they don’t hit the hurdle of 13% ROE. Will they lower the hurdle ?.If yes, this would be another reason not to invest.

      Maybe I am too pesimistic here, but at the moment, Lancashire is not an investment for me.

      mmi

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