To proclaim a competitive advantage for any member of the insurance industry is ambitious. Lancashire has outperformed its peers over an extended period of time and seems to be one of the few exceptions in the industry, where dependence on investment income is very low due to a very profitable underwriting. A soft insurance market and uncertainties with regard to both the recent departure of the long term CEO and a recent acquisition have been putting pressure on the share price. From my perspective, this provides an attractive investment opportunity in a high quality insurance company.
Lancashire is a Bermuda based specialty insurer, providing insurance for the aviation, energy, marine, property and terrorism/political risk markets. The company was founded in 2005. The table below provides an overview of the most relevant performance measures:
Management’s focus is not on top line growth, but on underwriting profits in attractive niches of the insurance market and growth in book value. Management’s aim is to provide its shareholders with an ROE of 13% in excess of a risk-free rate over the insurance cycle.
With an average combined ratio of 59.2% since inception Lancashire has set itself apart from the normal insurance company as it is not selling a commodity product as most competitors do. Rather Lancashire is insuring risks that require extensive knowledge and experience to price policies and administer claims. The company has experienced underwriters who are trusted by clients and brokers having long term relationships with them and who are able to be smart about risk selection. Given this skillset, Lancashire has been able to sustain a competitive advantage and thus high profitability.
As more than 85% of profits come from the insurance business, they do not have to rely on investment return as most competitors do. This is quite useful for the following reasons:
First, there is no need to increase the company’s float by writing as much business as regulators allow. Instead, Lancashire can focus on the relatively profitable contracts.
Second, there is no need to leverage the investment portfolio to generate adequate returns. Comparing return on assets with return on equity in the table above you can see that financial leverage is relatively low. In addition, debt makes only up roughly 10% of total assets.
Third, there is no need to take high investment risks. The company’s investment portfolio almost exclusively consists of highly rated fixed income. – Edit: However, they recently decided to establish a 3.7% portfolio position in different low volatility hedge funds. While they did not explicitly disclose what kind of strategies (e.g.market neutral) these funds follow, the allocation to these types of alternative assets seems to increase the investment risk and might have a negative effect on investment income in turbulent markets. –
Fourth, interest rate risk can be mitigated as there is no need to invest in long term bonds (with high interest rate sensitivity). As of December 31, 2013, the duration for the overall portfolio including the use of derivatives was only 0.8.
In addition, they have established a 3.7% portfolio position in a number of hedge funds which are specialized in trading volatility.
Lancashire’s insurance operations
Lancashire primarily writes insurance with a focus on short-tail specialty risks where losses are usually known within, or shortly after, the policy period. This makes the process of reserve setting easier than in some complex casualty businesses where claims trends may be slow to materialise. The majority of the company’s business are excess of loss contracts.
This means that However, each policy has a defined limit of liability arising from one event. Once that limit has been reached, there is no further exposure to additional losses from that policy for the same event. In addition, the claims count on the types of insurance and reinsurance that Lancashire writes, which are low frequency and high severity in nature, is generally low.
The company’s four principal classes are property (49% of gross written premiums in 2013), energy (31%), marine (9%) and aviation (7%). Their insurance book is diversified over different regions and risks exposed to both natural and man-made catastrophes. In the property segment Lancashire insures mostly risks from natural catastrophes, political risks (e.g. confiscation, nationalisation) and risks from terrorism. The energy segment mostly covers the insurance of offshore drilling. The marine segment provides insurance for physical damage, loss of vessels from war, piracy or terrorist attack. The aviation segment provides coverage for third-party liability, excluding own passenger liability, resulting from acts of war or hijack of aircraft. In addition, the segment provides cover for satellite launches and satellites in-orbit.
The table below provides an overview of the development of Lancashire’s estimated insurance liabilities since inception:
Looking at the development of the estimates of ultimate liabilities indicates that management has been relatively conservative. For all periods (except for 2012) the estimates of ultimate liabilities had a tendency to decline in value over the years.
Setup of Kinesis Capital Management
Besides its direct insurance business, Lancashire is also a reinsurer. Approx. 40% of the business is made up of reinsurance. At the same time, Lancashire is both a buyer and seller of reinsurance. Increasing reinsurer capital levels and large supply of capital from alternative capital investors is pushing risk margins lower on reinsurance renewals in general. Based on this report, margins in some programs today stand at levels not seen for a generation. The current weak pricing in the market is therefore both an opportunity and an obstacle to Lancashire. On the one hand, the company has currently bought the biggest amount of reinsurance cover in its history to capitalize on the low pricing and to give part of the insurance risk to someone else. On the other hand, the company faces obstacles to increase its insurance book given the low margins achievable. However, Lancashire seems to have more pricing power than other insurance businesses given its niche lines of business which are less commodity like. In addition, to profit from the current supply of capital from alternative resources, the company recently set up a subsidiary to manage third capital. Kinesis will manage third-party capital on behalf of Lancashire, by leveraging its existing relationship network and underwriting knowledge in the property catastrophe and specialty lines. The business is capital light as there is no need for additional capital besides a 10% equity interest in the vehicle. As a consequence, return on capital for the whole company can be elevated relatively easily the more capital will be employed. Kinesis will receive a profit share and management fees from the investors. Based on the company’s information, there is no other meaningful seller of multi-class collateralised capacity in Lancashire’s area of expertise. The new business started at the beginning of 2014 and has so far deployed roughly USD 300 m.
Lancashire acquired Cathedral in 2013 being the first acquisition since inception. Cathedral has two syndicates under management at Lloyd’s. Syndicate 2010 has 42.2 per cent of its capacity provided by third-party capital (Lloyd’s Names) who pay a fee, profit commission and their share of the costs. The remainder is underwritten on the Cathedral balance sheet. Syndicate 3010 is wholly underwritten for the Cathedral balance sheet, and provides the logical platform to build out additional business in future. The segments where Cathedral is active are similar to Lancashire’s. However, management regards the way that Cathedral underwrites its business as different, and therefore complementary, to Lancashire’s model of writing larger direct and reinsurance risks in the non-Lloyd’s environment. The Cathedral approach is based on greater populations of risk in portfolios of more modest individual line sizes. The rationale for the acquisition was that while Cathedral will continue to trade independently, Cathedral will profit from Lancashire’s more robust balance sheet (better opportunity to leverage exposure, should opportunities present themselves), the addition of proven underwriters, the geographic expansion in attractive markets where Lancashire is not doing business and the access to Lloyd’s worldwide licencing and rating. In addition, management expects to improve Cathedral’s capital structure and efficiency, making the acquisition accretive to ROE. Cathedral had gross premiums written of USD 288.2 m and a combined ratio of 77.3% in 2013.
Opportunistic management of capital
Management follows a shareholder friendly approach regarding the allocation of capital.
In a soft market as it is the case now, when there is no opportunity to reinvest excess cash to earn attractive returns, they return that cash to shareholders. Management has stated that they repurchase shares, when the share price is around 1.2x book value. If the share trades at a larger premium to book value the company will pay out special dividends. Over the last five years the average dividend yield has been more than 10%.
In a hard market management makes use of the option to raise equity or debt to profit from high underwriting margins.
Major risks and uncertainties
In April 2014 the founder and CEO of Lancashire left the company and sold all his shares. It is pretty unclear why he made this decision. Given the development in 2013 with Kenesis and the Cathedral acquisition there might have been some disagreements regarding the future strategy. However, in this interview the new CEO Alex Maloney made clear that there will not be any changes in the company’s business model and management style. I think it is positive that Alex Maloney and a large part of the management team have been with the company for a long time. Nevertheless, this remains an uncertainty and might be one of the reasons for the weak performance of the share price over the last couple of months.
The integration of Cathedral is a major task for the company given that it will increase Lancashire’s premium level by 40% to 50% and that it has been the first acquisition since the company’s inception. Reading through the latest annual report it also seems that Cathedral’s solvency is lower than Lancashire’s. Though there is a risk with every acquisition, management did a good job in explaining the advantages of Cathedral’s addition to the group, which I think will lead to additional value for shareholders over time.
At the moment Lancashire is facing a very soft insurance market. Management states the following about the market condition in the report for the first half of 2014:
“There can be no doubt that the additional capital in our industry, not just new capital but also the undistributed retained earnings of many of our peers, is driving competition on pricing, terms and conditions. Most of this competition is still responsible and leaves acceptable underwriting margins and volumes for those underwriters like Lancashire, Cathedral and Kinesis who have the ability, experience and track-record that clients and brokers rely on to lead and structure policies. However there are areas of the market where there are instances of indiscipline, and Lancashire is always prepared to let underpriced business go. There have been some industry loss developments from prior years and events, but the first half of 2014 itself has been relatively quiet in terms of major loss events, so there is no catalyst for pricing to move upward.
Lancashire’s strategy since day one has always been to write the most exposure in a hard market and the least in a soft one. There are now abundant reinsurance and retrocession opportunities that allow us to maintain our core insurance and reinsurance portfolios, whilst significantly reducing net exposures. From our peak exposures in April 2012, when losses had driven substantial market hardening, we have reduced exposures across the board. We will stick to our strategy in the knowledge that when an event comes, we are well prepared through all three of our platforms to take advantage of subsequent opportunity.
There is some discussion about whether pricing has reached a floor, and there have been signs of over-ambitiously priced programmes being rejected. But on the whole we think there is still pressure on pricing and, with business more scarce in the second half of the year, we wouldn’t be surprised to see some aggressive renewal targets. But we can mitigate the effects of up-front pricing impacts with very substantial savings on our own reinsurance and retrocession purchases, and for LICL and LUK we’ve also bought substantially more limit this year for both risk and cat covers. Cathedral has always been a buyer of extensive reinsurance but has also managed to improve retentions, breadth of cover and costs.”
There is a risk that a prolonged continuation of this soft market environment will lead to a lower premium level given Lancashire’s disciplined underwriting approach which might ultimately lead to lower earnings.
Catalysts for a hard market are a reduced supply of capital currently entering the insurance market or events leading to losses and therefore margin increases for contract renewals. The former could happen, when there are more attractive investment opportunities for alternative sources of capital than the insurance market (e.g. triggered by a rise in interest rates).The latter will happen at some point in time. This seems to be already the case in the aviation segment after the recent tragic events in Eastern Ukraine with MH17 and Libya.
There is always a risk, that a large event will wipe-out a substantial part of Lancashire’s shareholder equity. Management provides an estimate of the exposures to certain peak zone elemental losses, as a percentage of tangible capital, including long-term debt. As of June 30, 2014, these modelled assumptions for peak zone elemental losses have been reduced substantially compared to the end of 2013 due to the purchase of reinsurance:
Shares of Lancashire are currently trading with a P/B of 1.3x and a P/E of 8.6x based on 2013 earnings. The first half of 2014 was affected by the retirement package for the former CEO. Excluding this impact, net profit would have been roughly 20% higher for this period leading to a ROE of 7.6%. It is difficult to come up with an estimate for the whole year of 2014, but an ROE of 13% to 15% should be achievable in the absence of significant losses. Additional upside for earnings could appear over the next couple of years from the following sources:
– Increase in Kinesis assets under management
– Leveraging Cathedral’s business supported by Lancashire’s higher solvency
– A hard insurance market
– An increase in interest rates
From my perspective, the market is not giving any credit to a potential upside in earnings from recent corporate activities and a potential midterm improvement of the insurance market. If the market does not recover, Lancashire will continue to return cash to shareholders and to write premiums in selected market segments where opportunities exist. Therefore, I think that the downside is limited provided that Lancashire sticks to the disciplined underwriting approach.
Due to Lancashire’s highly profitable business model which includes a relatively solid balance sheet, the company’s share price should trade with a premium to book value. At the same time with an earnings yield of 11.5% Lancashire seems to be very attractively priced.
Lancashire offers a differentiated product in a commodity like industry. Management seems to be very capable of manoeuvring through the cycle. There are a number of catalysts for the stock price to appreciate, which the market seems to ignore. For instance, a rise in interest rates will not damage the investment portfolio significantly given its low duration. To the contrary, management could shift the portfolio in higher yielding securities. In addition, higher interest yields could translate into less supply of capital in the insurance market. From a portfolio perspective, the addition of Lancashire also provides some kind of hedge against a rising interest environment.
For the portfolio, I will establish a 3% position at the current price level.
The content contained on this site represents only the opinions of its author(s). I may hold a position in securities mentioned on this site. In no way should anything on this website be considered investment advice and should never be relied on in making an investment decision. As always please do your own research!