Investing In Insurance Companies: The Reserves Test

Investing In Insurance Companies: The Reserves Test
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Investing In Insurance Companies: The Reserves Test by David Merkel, CFA of alephblog

Here we go.  E-mail #1:

You truly have one of the great blogs out there!

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I was wondering, have you ever had to evaluate a company that had set up a captive insurance company to self insure? How did you get comfortable with it?

As an example, ZCL composites on the TSXV. I looked at them awhile back and disqualified it as I could not get comfortable with the environmental liability. They manufacture fuel storage tanks, so insurance is a large component of their cost of doing business.

If they did have a reputable outside insurer, you could at least count on the insurer for doing some audit work in their manufacturing and installation processes. But they have set up a captive, and self insure. 

So, how would you calculate whether they have enough reserves?

I threw the company in the too difficult pile and moved on, but it has irked me as I like them.

Good toss into the too difficult pile. Environmental liabilities are difficult even for actuaries inside the insurance companies  to analyze. Those of us outside have no chance.  I cannot validate reserves from outside, and particularly not on long-tail lines.  I will not invest in any insurer that has a large part of its underwriting in asbestos/environmental — it is too risky.

That aside, using a captive is a negative sign.  No one uses a captive, except to weaken reserving, taxation, or other rules.

Next e-mail:


I stumbled across Gainsco, Inc. (OTCMKTS:GANS), a very small nonstandard auto insurer (you may be familiar). It’s trading around 0.6x book value, seems to be well capitalized, and has had OK growth barring FY2012. It also has a pretty impressive 12.5% dividend yield.

I guess my questions are:

1) Would you expect this trade at such a discount to book because: its nonstandard insurance, it’s on the pink sheets (not regularly filing with the SEC), it’s too small, or some combination or other reason?

2) given that its nonstandard, I assume it’s riskier? What’s the best way to determine whether the company is adequately reserved/capitalized? 24.5% equity / assets seems pretty conservative, but I suppose if they’re not adequately reserved that could be meaningless.

Thanks so much, look forward to hearing from you.

I have run across Gainsco, Inc. (OTCMKTS:GANS) in the past, when they were bigger, and I avoided them.  Subprime insurers tend to lose money on underwriting over time.  There is a kind of cycle where a few make money for a few years, and then competition surges, and more money is lost than was previously made.  From the time I started as a buyside analyst of insurance stocks in 2003, until now, no subprime insurer has made money for a buy-and-hold investor.

Aside from that, Gainsco, Inc. (OTCMKTS:GANS) has gone dark.  You can see financials at their website, but do you trust them?  Aside from nonsponsored ADRs no good companies trade on the pink sheets.

Margin of safety — this does not meet my safety requirements.

Final E-mail:

Hi David,

I really enjoy your blog.  Have seen the recent news surrounding Amtrust Financial Services, Inc. (NASDAQ:AFSI) and short sellers?  I’d like to hear the thoughts of an actuary on the company and specifically the items that GeoInvesting points to.  To me, their financial structure appears extremely (perhaps, unnecessarily) complicated. 

Yes, and they fail my test of having conservative reserves.  They have had to strengthen reserves on prior year’s business for the past three years.  That is a bad sign, and would keep me away.  I think GeoInvesting is correct here, but this is not an endorsement of them generally.

It is very rare that an insurer should be valued near 2x book value.  Though I am rarely so bold, this one strikes me as a short sale, if you can get the borrow with confidence.

By David Merkel, CFA of alephblog


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David J. Merkel, CFA, FSA — 2010-present, I am working on setting up my own equity asset management shop, tentatively called Aleph Investments. It is possible that I might do a joint venture with someone else if we can do more together than separately. From 2008-2010, I was the Chief Economist and Director of Research of Finacorp Securities. I did a many things for Finacorp, mainly research and analysis on a wide variety of fixed income and equity securities, and trading strategies. Until 2007, I was a senior investment analyst at Hovde Capital, responsible for analysis and valuation of investment opportunities for the FIP funds, particularly of companies in the insurance industry. I also managed the internal profit sharing and charitable endowment monies of the firm. From 2003-2007, I was a leading commentator at the investment website Back in 2003, after several years of correspondence, James Cramer invited me to write for the site, and I wrote for RealMoney on equity and bond portfolio management, macroeconomics, derivatives, quantitative strategies, insurance issues, corporate governance, etc. My specialty is looking at the interlinkages in the markets in order to understand individual markets better. I no longer contribute to RealMoney; I scaled it back because my work duties have gotten larger, and I began this blog to develop a distinct voice with a wider distribution. After three-plus year of operation, I believe I have achieved that. Prior to joining Hovde in 2003, I managed corporate bonds for Dwight Asset Management. In 1998, I joined the Mount Washington Investment Group as the Mortgage Bond and Asset Liability manager after working with Provident Mutual, AIG and Pacific Standard Life. My background as a life actuary has given me a different perspective on investing. How do you earn money without taking undue risk? How do you convey ideas about investing while showing a proper level of uncertainty on the likelihood of success? How do the various markets fit together, telling us us a broader story than any single piece? These are the themes that I will deal with in this blog. I hold bachelor’s and master’s degrees from Johns Hopkins University. In my spare time, I take care of our eight children with my wonderful wife Ruth.

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