“Our financial goals are to earn consistent underwriting profits and superior investment returns to build shareholder value” – Markel 2013 Annual Report
Markel Corporation (NYSE:MKL) is an outstanding business currently in its 85th year of operations. It is an excellent insurance company with a history of underwriting profits. It is also a superb investment company with a history of above average investment returns. Markel had an outstanding year in 2013, basically doubling the size of its insurance business and investment portfolio in an acquisition that the market hasn’t seemed to fully value yet. I think the shares are priced not just fairly—but cheaply—at a valuation level where investors have the chance to partner with one of the great long term compounding machines of the past 3 decades and achieve investment results for a long period of time that will at least equal—and possibly exceed the comprehensive returns on equity and growth in book value that the business achieves.
I’ll discuss my opinions on Markel Corporation (NYSE:MKL), but first a quick overview of the fundamentals inherent to the Property and Casualty insurance industry, for those who need a quick primer. For those that don’t, feel free to skip ahead…
Insurance—Desirable Business Model Leads to Subpar Returns
Insurance companies have a unique feature that most businesses lack. Most businesses have one main source of capital to invest—namely the capital that the shareholders invested into the business. But Markel—and other insurance companies—have two:
- Shareholder Equity
- Reserves from Policyholders
Insurance companies have the added benefit of being able to accept money from customers (premiums) long in advance of the requirement to pay for the losses associated with that revenue (claims).
Of course, this concept is referred to as float—or the policyholders’ money that an insurance company gets to invest after receiving the premiums but before paying the claims.
Buffett made this concept famous, and he describes it often in his letters—here is his quick explanation in the most recent annual report:
“Property casualty insurers receive premiums upfront and pay claims later… This collect-now, pay-later model leaves P/C companies holding large sums—money we call “float”—that will eventually go to others. Meanwhile, insurers get to invest this float for their benefit. Though individual policies and claims come and go, the amount of float an insurer holds usually remains fairly stable in relation to premium volume.”
Although technically a liability, float is really an incredibly valuable asset—so much so that the industry at large is willing to lose money on underwriting in exchange for the access to this float. The concept is somewhat similar to a bank that collects deposits at a cost of say 3% and invests or lends those deposits out at say 6%–profiting from the 3% spread. Unlike banking however, it is possible for insurance companies to reduce their cost of float down to zero—or in rare cases even below zero cost. In other words, instead of having to pay 3% to gather funds, some insurance companies actually breakeven on their underwriting, meaning that this float is effectively “free”—like a bank that has no costs associated with gathering deposits.
Breaking even on the underwriting might not sound like a terrific situation, but it actually is quite valuable in the insurance business, as it effectively allows the business to use other peoples’ money to invest for its sole benefit. It’s effectively like taking on a partner who supplies your business with capital but asks for no equity stake nor charges you any interest—effectively this breakeven result creates an interest free loan for the insurance company.
In some rare situations, an insurance company not only breaks even on the underwriting, but actually makes consistent profits. This pleasant situation results in two possible streams of income:
- Underwriting profits
- Investment profits
The company in this rare situation actually gets paid to hold and invest their policyholders’ funds—like a bank that somehow charged depositors interest for the privilege of keeping their money at the bank.
Insurance—Competition Creates Mediocre Returns
Unfortunately for insurance companies, the nature of capitalism is such that this valuable business model combined with relatively low barriers-to-entry creates intense competition in the industry. Each insurance company understands how valuable this float is, and so they fiercely compete for a piece of the industry’s premium volume and the float that accompanies it.
This intense competition leads to companies being very willing to write business at a loss just to access this valuable float. These factors have led to very mediocre returns on equity over time for the industry as a whole.
“Unfortunately, the wish of all insurers to achieve this happy result creates intense competition, so vigorous in most years that it causes the P/C industry as a whole to operate a significant underwriting loss. This loss, in effect, is what the industry pays to hold its float. For example, State Farm, by far the country’s largest insurer and a well-managed company besides, incurred an underwriting loss in nine of the twelve years ending in 2012… Competitive dynamics almost guarantee that the insurance industry—despite the float income all companies enjoy—will continue its dismal record of earning subnormal returns as compared to other businesses.”
The P&C insurance industry has long operated at a combined ratio well over 100—meaning collectively insurance companies lose money on their underwriting. The combined ratio measures the total insurance costs (expenses and claims) as a percentage of premiums. A combined ratio of 100 is breakeven—meaning that the total expenses equaled premiums. Over 100 is an underwriting loss, below 100 signals an underwriting profit.
Moats in a No-Moat Industry
But some businesses—Berkshire Hathaway Inc. (NYSE:BRK.A) (NYSE:BRK.B) certainly being one—have carved out competitive advantages in this cyclical industry with commodity-like economics. Some businesses are able to consistently operate at an underwriting profit, which creates enormous value for shareholders over time. When combined with good investment skills, this combination can create an incredible compounding effect.
How do insurance companies create this advantage?
There are a few answers to that question, but one major factor is the willingness to walk away from business that will not result in profits. This is harder than it sounds, because it involves willingly lowering current revenue—something that most executives and almost all Wall Street analysts don’t like. But companies that are able to actually reduce their underwriting volume during soft markets are able to preserve their capital and their profitability. Every insurance company understands this, but few are willing to walk away from business. It is difficult for executives of insurance companies to willingly shrink their revenues when their competitors are growing theirs. It is also difficult for insurance employees—who are paid on commission in some cases—to willingly walk away from current business—even if it is the best thing to do for the long term interests of shareholders and employees.
However, a select few businesses have created incentive structures and an owners’ minded culture that allows them to be able to operate in such a profitable manner.
Berkshire obviously is one example of this—compounding shareholder value at 20% annually for half a century.
Markel Corporation (NYSE:MKL) is another example.
Introduction to Markel—A Value Compounding Machine
Markel was founded in 1930 and initially focused on insuring taxi cabs in Norfolk, Virgina. It was a family owned and operated business for decades until it went public in 1986, but even to this day it has largely maintained its culture as a family run business.