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

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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.

Admiral Plc (ISIN GB00B02J6398) – Short candidate or “Outsider” company with a Moat ?

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Disclosure: The author might have bought the stock well in advance of publishing the post. In this special case, the idea has been presented already some weeks ago to a group of value investors.

Introduction

Admiral is a UK based P&C insurance company. A brief look into Admiral’s multiples would single it out as a potential short candidate (~15 GBP/share):

P/B 8,0
P/S 4,5
P/E ~14,5
Div. yield 3,7%

Especially P/B and P/S look overvalued if compared to other P&C companies. The average multiple for European P&C companies is ~2,1 for P/B, 1,6 for P/S and 11,6 P/E. So the company looks wildly overvalued.

Admiral – “The UK Geico” ?

Admiral is definitely no stranger for value investors. Metropolis Capital, a value investing shop with a good reputation presented Admiral as their pick for the London Value Investor conference some weeks ago.

The pitch is relatively simple: Admiral is the UK version of GEICO, the famous low cost direct insurer owned by Warren Buffet. Just look at the cost ratios of Admiral compared to its 4 main competitors:

Cost ratio P&C 2013
Aviva 32,8%
RSA 32,6%
Direct Line 22,3%
Esure 23,8%
Admiral 19,9%

Clearly, the cost advantage against “traditional” companies like Aviva and RSA comes from the fact that they don’t have to pay insurance agents. But even compared to the direct competitors, Admiral seems to have a cost advantage. Among other things, Admiral is the only FTSE100 company located in Wales which implies quite “reasonable” salaries.

However there is a big difference compared to GEICO:

GEICO’s business model as we all know, combines low cost / direct with investing the “float” Buffet style, so every premium dollar earned is kept and invested as profitable as possible, preferably in stocks. In principle, this is the strategy of all insurance companies, but very few are able to get “Buffet like” returns.

So I have compiled 3 statistics which show that Admiral “ticks” differently:

2013 Ratio Financial income /total profit Net retained premium “Other” in % of profit
RSA 116,4% 93,6% 0,0%
Aviva 72,9% 88,2% 0,0%
Direct Line 35,2% 101,6% 36,3%
Esure 11,3% 91,4% 40,1%
Admiral 3,3% 25,0% 85,0%

A quick explanation of those ratios: The net profit of an Insurance company is the result of 3 major components:
a) Underwriting result
b) investment result
c) “other” stuff

The first column in the table above shows what percentage of the total result in 2013 can be attributed to the investment result. RSA for instance actually makes a loss in insurance, so more than 100% of their profit comes from the investment portfolio. Admiral, on the other end, attributes only 3% of the total profit to investments. So what’s going on here ? Do they manage their investments so badly ?

The second column explains this “conundrum”: All the other players keep more or less all the insurance premiums they are collecting. Admiral, on the other hand only keeps 25% of incoming insurance premiums, the other 75% get “ceded” to Reinsurers.

Finally, the third column shows, that Admira is actually earning most of its money with “other” stuff whatever that means. To solve the puzzle, one has to look back into history of Admiral: Admiral was founded by a Lloyds syndicate to act as a kind of “Underwriting agency” in order to generate premium for the syndicate. So from the start, Admiral had a very lean structure, selling only direct etc. At some point in time they decided that the syndicate was too expensive and that they actually want to issue the policies themselves. Nevertheless, they kept their lean set up and lined up reinsurers to shoulder the majority of the risk.

Most people familiar with Insurance would say that the concept of Admiral doesn’t make sense. Why should you give up profits both, on the insureance side as well as in investments by passing 75% ? The answer is relatively simple: Capital efficency. Most insurance companies are notouriously capital inefficient. Long term ROEs for most major players are below 10% p.a. despite often significant leverage through subordinated debt. The main reason for this is the fact, that in many jurisdictions, the “GEICO” model requires to hold a large amount of capital to buffer capital market movements. Unless you are Warren Buffet, the returns on those investments are often below average so as a result, ROEs are bad. Plus the fact that growth often requires a lot of upfront capital as well.

For Admiral, the big structural problem of course is the following: If I pass most of my premiums and cash to reinsurers, how do I then earn money ? This is where the “other” column from my table above comes into play. Due to this business model, Admrial very early concentrated on making additional money by selling “ancillary” stuff.

This is what Admiral writes in its latest annual report (by the way: all annual reports since 2003 are highly recommended for clarity and insight !!!):

Other Revenue
Admiral generates Other revenue from a portfolio of insurance products that complement the core car insurance product, and also fees generated over the life of the policy. The most material contributors to net
Other revenue are:
> Profit earned from motor policy upgrade products underwritten by Admiral, including breakdown, car hire and personal injury covers
> Profit from other insurance products, not underwritten by Admiral
> Vehicle Commission (see page 25)
> Fees – a dministration fees and referral income (see page 25)
> Instalment income – interest charged to customers paying for cover in instalments

This additional income is extremely high margin with almost no capital requirement and drives the profitability of the company.

The result

This low capital requirement leads to ROE’s which are compared to its peers “from outer space”:

Name ROE FY ROE 5Y
     
Average 16% 17%
ADMIRAL GROUP PLC 59% 59%
TOPDANMARK A/S 26% 31%
TRYG A/S 19% 21%
LANCASHIRE HOLDINGS LTD 15% 17%
BEAZLEY PLC 21% 16%
GJENSIDIGE FORSIKRING ASA 16% 15%
SAMPO OYJ-A SHS 14% 14%
GRUPO CATALANA OCCIDENTE SA 13% 14%
EULER HERMES SA 13% 13%
ZURICH INSURANCE GROUP AG 12% 12%
ALLIANZ SE-REG 11% 12%
AMLIN PLC 19% 10%
MAPFRE SA 9% 9%
XL GROUP PLC 9% 9%
RSA INSURANCE GROUP PLC -11% 5%

Other unique aspects of Admiral’s business model

Comparison sites

Admiral runs in addition to its insurance operation, its own insurance comparison sites (e.g. Confused.com in the UK). Although those comparison sites themselves only contribute less then 10% of total profit, it gives Admiral a strategic advantage: Via their comparison site they can monitor in real time what competitors are doing and how they are pricing stuff. Other comparison sites also sell this kind of data but usually with a significant time delay. So running its own comparison site is clearly an advantage against a “normal” onilne insurer.

Capital allocation

With regard to capital allocation, again look at this statement from the 2013 annual report:

Admiral believes that having excess cash in a company can lead to poor decision-making. So we are committed to returning surplus capital to shareholders. We believe that keeping management hungry for cash keeps them focused on the most important aspects of the business. We do not starve our businesses but neither do we allow them the luxury of trying to decide what to do with excess capital.

Charly Munger would say at this point “I Have nothing more to add”. This is how it should be done but rarely found especially in the Insurance industry.

Managment & Shareholders:

The current CEO, Henry Engelhardt founded the company on behalf of the Lloyds Syndicate in 1991. He still holds ~12,8% of the company.

Co-founder David Stevens owns around 3,8%. Both founders only pay themselves ~400 k GBP per year salaries and no bonuses. The only exception is the CFO, who is relatively new. He earns around 1 mn GBP including a bonus and doesn’t have a lot of shares. There are quite some interviews available on Youtube with the CEO, among them this one is especially interesting:

Largest outside shareholder is MunichRe with 10%, who is also providing the majority of the reinsurance capacity. Other noteworthy shareholders are PowerCorp from Canada and Odey, the UK Hedge fund with a -0.79% short position. All Admiral employees are shareholders and there is a program for employes to purchase shares.

Stock price

Since going public, Admiral has performed very well:

Including dividends, Admiral returned 25,5% p.a. since their IPO against ~8% p.a. for the FTSE 100. Since 2004, EPS trippled and dividends per share increased by a factor of five. Interestingly, Admiral never traded at a level which one would asociate normally with such a growth stock, at the peak, the share had a P/E of 22 in 2006. I think this has to do with the general discomfort that many investors have with financial stocks.

Challenges for Admiral

Some of the additonal income sources for Admiral are clearly under regulatory thread. Referral fees, bundling etc. are currently investigated by UK regulators (see here and here) but especially Admiral seems to be quite creative on how to find different ways to earn fees.

Another and maybe the biggest strategic issue is that in theory comparison sites could start to sell additional products as well as we can see in the car rental market. However Admiral has the big advantage as they cover both, the comparison area and the insurance “sales funnel”.

I also think that for the comparison sites, it is not that easy to sell additional insurance products. Insurance policies are less standardized than rental cars, with very individual pricing so it is harder for a comparison site to actually close the deal intead of passing the client on to the insurer for a fee. Clearly comparison sites will try to get into this game as well but again, Admiral is the best positioned insurer.

Finally, the UK car insurance business shows almost a “brutal” cyclicality, for instance in 2013 premiums for the whole market dropped ~20%. Nevertheless, Admiral has shown that they are profitable over the cycle.

Opportunities

Admiral is currently trying to expand its business model into 4 other countries: Spain, France, Italy and the US. An earlier attempt in Germany failed a couple of years ago, mainly because the German market renews policies only once a year and Admiral was not able to really use its strengths (dynamic offers and pricing) on that basis.

If they succeed in any one of those markets similar to the UK, then there would be significant upside in the stock. If they suceed in 2 or more, Admiral could become a multibagger. If they don’t succeed at all, one could imagine that they might take additional market share in the UL, but then the upside is limited.

Although the subs are growing strongly, they still made a loss in 2013. Car insurance is however to a certain extent a scale business. You need a certain scale to become profitable. Clearly, just buying a competitor (and paying a lot of goodwill) would look better in the short term. Building up your own operations takes longer, but if you do it right, the value generation is significantly better than via M&A.

SUMMARY: Bringing it all together

Personally, I think Admiral has a very unique “outsider” business model. Reinsuring most of their business allows them to focus on the core product, car insurance underwriting and ancilliary services. They don’t have the complexity of traditional insurers with complex investments, expensive investment management and “asset liability management” departments etc. etc.

This keeps structural complexity low, lowers cost and allows them to scale up business much quicker than any “traditional” model and with very low capital intensity. Traditional insurance companies have always the option to realize investment profits in order to make results look good in the short term. In the long term, this often leads to a detoriation of the core business. Admiral doesn’t have this luxury. Additionally it insulates Admiral mostly from capital market volatility and enables them to move aggresively if other insurers are nursing their investment losses. Additionally, they don’t need to sell complicated subordinated debt etc.

Overall, I think the likelihood that someone succesfully copies Admirals business model is low, because for any Insurance executive, it is extremely counterintuitive to give premium away. Any insurance CEO would rather sell his grandmother than increase the reinsurance share and give away investment money. GEICO for instance in my opinion is not a “real” outsider company. It is a traditional insurer with a focused direct sales force. Admiral is really a very different animal.

Clearly, the thread of Google & Co is real, but on the other hand, Google & Co hesitate to to move into regulated areas. However if they would want to seriously move into this business, I would think that Admiral could be an interesting acquisition target for cash rich Google & Co.

Against the traditional competition, in my opinion Admiral has a 10 year headstart in understanding how to sell insurence and especially “others” over the internet. I think they will chuckle when they read how for instance AXA tries to become “digital” as they were already selling 70% of their policies over the internet in 2003.

I would go so far as calling the combined business model a “moat”. Yes, it is maybe not that difficult to start an online insurer and does not fit into the classical moat categories, but to scale up quickly and get the whole package right, this is another story and in my opinion very very unlikely. Even the direct clones like Esure only go “Half way” by keeping all the premiums and exposing themselves to capital market volatility.

I also think that this is still a “value investment” despite the optically expensive multiples. In my opinion, the value lies in the business model plus the headstart in online insurance. To put it into s short thesis: This is a high quality company at a “Normal company price tag” and an “above average” growth opportunity due to the cost advanatges.

For the portfolio, I had bought already a “half position” in April at 13,80 GBP per share as I have briefly mentioned in the April post. I know this is a little unfair but I just didn’t have time to finish the write up.

P.S. There will be an extra post for this, but I have sold the rest of my April SA position in order to keep the exposure to the financial sector (~20% of the protfolio including the bonds) constant