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!

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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