Tuesday, December 4, 2007

Valuing an Insurance Company – using Cash & Investments per share

Bruce Berkowitz & the Fairholme Fund have a great track record & I thought it would be worth discussing Bruce’s approach to valuing insurance companies.

Here is an excerpt from an interview with Businessweek in (October 2000), Bruce talked about his approach to valuing Markel Corporation(MKL).

"Look, the key concept for insurance companies is to take a look at the investments per share. And you can find companies where the investments per share are significantly higher than the stock price. Markel has roughly $400 per share of investments. If they can break even on their underwriting and only make a 5% after-tax investment return, that's $20 per share. Not bad for a company at $140 per share (in market price).
So the trick is to have that investment leverage and at the same time break even or make an underwriting profit. And it's hard for people to see it. These are not easy companies to understand."

Calculating the cash and investments a company has per share and determining what return they are likely to achieve is an excellent way to value an insurance company.
At the time Markel Corp had shareholders equity of around $94 per share, the price to book value was around 1.5x. With cash and invested assets of over $400 they had a 4:1 leverage. So using a 5% return after tax would be equivalent to a 20% return on equity & growth in book value.

Bruce Berkowitz also discussed a number of important issues that really go beyond the financials. He described Markel’s approach to underwriting as very disciplined & he knew Markel had honest and capable managers and had a great track record of growing their book value at 20% + compounded since the mid-80s.

Lets see how the investment thesis panned out?

By December, 2006 book value had grown to $230 per share which was a 15% compounded growth return from $94. Nevertheless, by December 2006 investors re-rated Markel’s price to book value to 2x and shares rose to $480 from $140. That’s a shareholder return of over 20%. So investors put a quality premium on Markel for its consistency and long term record of 20% +book value growth.


Bruce Berkowitz used a big margin of safety and even though his investment thesis was not exact (no thesis ever is!) it still gave a very favourable outcome. Hurricane Katrina & reserving issues with various acquisitions did conspire to limit the book value growth rate. However, Markel’s book value growth over 20 years remains at an excellent 23% so it is worth being wary looking at 5 year time frames as book value growth is lumpy in the insurance business.

Disclosure: I own shares of Markel (MKL) & Fairholme Fund (FAIRX)

No comments: