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End of the P/C insurance hard market - Is it time for investors to head for the hills? As the hard market slows we will begin to hear the drumbeat of the doomers - they will confidently tell you that it is time to sell your P/C insurance stocks. The drumbeat will likely get louder and louder over the next year. So with this post let’s explore the P/C insurance cycle to see what we can learn. The P/C insurance market is not rational Like financial markets, the P/C insurance market is not rational. How do we know it is not rational? Because it constantly cycles between hard to soft to hard to soft markets. The cycles are long. And they usually go to extremes. If the P/C insurance market was rational it would not cycle to the extent that it does. What causes the insurance cycle? Just like financial markets, what causes the insurance cycle is greed and fear. Greed = The end result is a soft market (product is sold at or below cost, generating low or negative returns). Fear = The end result is a hard market (product is sold above or well above cost, generating good or very good returns). Doesn’t this make P/C insurance a pretty shitty business? No. If all the players were rational then P/C insurance would be a shitty business - it would be impossible for anyone to make any money (outsized profits would quickly get competed way). The fact that many of the players are not rational is what makes P/C insurance such a great business. The rational actors are able to profit greatly from the folly of the irrational actors. Investors should welcome the insurance cycle. Having a good mental model can help Ben Graham provides investors with a great mental model (called Mr. Market) to help them understand and make money from investing in financial markets. Mr. Market (the stock market) often engages in irrational behaviour. Some days he is pessimistic, willing to sell his stocks at very low prices. Other days he is euphoric, willing to buy your stocks at very high prices. The prices he quotes often have nothing to do with the fundamentals of the business. The more extreme his behaviour (the higher the volatility) the better for you - the more you can profit. “Mr. Market is there to serve you, not to guide you. It is his pocketbook, not his wisdom, that you will find useful.” Warren Buffett - BRK 1987AR Is there a parallel for the P/C insurance market? Is there a good mental model we can use to help us understand the P/C insurance market cycle? Yes. Paul Ingrey and his P/C insurance clock. With his P/C insurance clock Paul explains how the insurance underwriting cycle works. It is a behavioural model - and is built on the simple assumption that P/C insurance companies will engage in irrational behaviour (like they always have in the past). PDF version of the clock https://www.archgroup.com/wp-content/uploads/00464-Ingrey-Underwriting-Cycle-Clock-FINAL.pdf Text version of the clock https://www.archgroup.com/the-underwriting-lifecycle/ The insurance cycle exists because of ‘stupidity.’ Paul Ingrey said he put the P/C insurance clock together to remind people of how stupid they are (at 37:30 of podcast linked below). The clock was built by Paul to explain to investors where the insurance market cycle is at (at a point in time). Who is Paul Ingrey? The podcast below is from 2018. It is a great introduction to Paul Ingrey - one of the greats in the P/C re/insurance world. No Change Without Fear With Paul Ingrey https://podcast.notunreasonable.com/126848/episodes/629958-no-change-without-fear-with-paul-ingrey Summary of podcast: “For reinsurance people, this interview is electric. “Paul Ingrey founded three of the most successful reinsurance companies of the last 40 years: Prudential Re (Everest Re), F&G Re (10% of staff became CEOs) and Arch Re (as we know it today). Thousands of people in the industry can trace their employment back to Paul's unique mix of discipline and charisma. “Being successful in insurance, like with many things, isn't complicated (write business in hard markets and not in soft markets) but it's devilishly hard to pull off. Paul is perhaps the original master of the cycle. “In the show we cover a complete modern history of insurance cycles, starting in the mid-60s, Paul's insurance cycle clock (see here), stories of the founding of each of the companies that would define his legacy and more.” Of note, Paul Ingrey served on the Board of Fairfax for about 2 years from 2001 to 2002. “…we welcome Paul Ingrey to the Board. Paul has had one of the best track records in the reinsurance business, having founded and run F&G Re (part of U.S. F&G, now St. Paul’s) for 14 years with a cumulative combined ratio of 91%. We look forward to Paul’s wise counsel in the years to come.” Prem’s shareholder letter - Fairfax 2000AR “Due to possible conflicts arising from his position as Chairman and CEO of Arch Reinsurance, Paul Ingrey retired from our Board during the year, but we hope to welcome him back when he retires again.” Prem’s shareholder letter - Fairfax 2002AR Volatility "Be fearful when others are greedy, and greedy when others are fearful." Warren Buffett Volatility in financial markets is a wonderful thing. It allows rational investors to make outsized returns over time. Volatility in P/C insurance markets is also a wonderful thing. It allows rational P/C insurance companies to make outsized returns over time. How to exploit volatility in the P/C insurance business Our chart below summarizes what is usually the best way to allocate capital through the insurance cycle. In a soft market (when margins are under pressure), be very disciplined with underwriting (minimal organic growth). The goal is to preserve capital. P/C insurance company valuations tend to be depressed in a soft market so this can be a good time to grow by acquisition (later in a soft market). In a hard market (when margins are expanding), get aggressive with underwriting new business (strong organic growth). The goal is to aggressively deploy capital. P/C insurance company valuations tend to be rich in a hard market so this is generally not a good time to grow by acquisition. What do many P/C insurance companies actually do? In a soft market many P/C insurance companies keep growing organically (some aggressively). Over time, this begins to impair their capital base (writing unprofitable business eventually sucks). This also means they do not have the money to grow by acquisition later in a soft market. At the beginning of a hard market they are capital constrained - so they have a limited ability to grow organically. But as the hard market plays out their capital base gets fixed and they attempt to grow by acquisition (paying high prices). This approach has a parallel in financial markets - it is like buying high and selling low. Except because of how pricing in P/C insurance works, you just don’t know that you are buying high in a soft market (or you don’t care - i.e. it becomes some else’s problem in the future). Yes, that is a very hard way to make money over time. The winners in P/C insurance are the contrarians Just like with investing, the winners in P/C insurance are the contrarians. It is the rational actors. The companies with great discipline. And a long term focus. Let’s go back to the question we asked at the start of this post. As we approach the end of the hard market, is it time for investors to head for the hills and sell their P/C insurance stocks? Soft markets are not to be feared. Well run P/C insurance companies welcome the insurance cycle. They don’t fear it. They exploit it. Soft markets sow the seeds of the next hard market. Well run P/C insurance companies will do well over the insurance cycle. Poorly run insurance companies underperform over the insurance cycle. So you need to figure out if you own one of the well run P/C insurance companies. But there is more… We need to broader out our analysis Our analysis above only discussed underwriting. But as everyone knows, all P/C insurance companies have two businesses: P/C insurance (underwriting) Investment management Now when it comes to investment management, almost all P/C insurance companies follow the same model - they put their investment portfolio primarily in bonds. And they match the average duration of the investment portfolio with the average duration of their insurance liabilities. The investment portfolio is put on autopilot. AND THE RETURNS ARE (USUALLY) NOT VOLATILE. Soft market? Hard market? The P/C insurance market cycle doesn’t matter for most P/C insurance companies when it comes to what they do with their investment portfolio. The genius of Warren Buffett Warren Buffett has always understood what it takes to have a well run P/C insurance business. Be very disciplined with underwriting in a soft market. Drive strong organic growth a hard market. Be very opportunistic with acquisitions. But what makes Buffett unique is what he did with the investment management part of the business. Buffett figured out that equities can deliver a much better return than bonds over time. I know, what a freaking genius. This benefits Berkshire Hathaway in two important ways: Investing in equities boosts the return of the investment portfolio (compared to what is earned by other P/C insurance companies). In a soft market capital that is not needed in the P/C insurance business can be shifted to equities. This allows BRK to maintain a high ROE even in a soft insurance market. And when the next hard market starts (years later), all the excess capital that has built up can be used to turbo-charge the growth of the P/C insurance business. Warren Buffett took the P/C insurance model to its logical conclusion: Exploit volatility (the insurance cycle) in the P/C insurance business. Exploit volatility (invest in equities) in the investment management business. Don’t just do it with insurance. Do it also with investment management. The result of this union has been magical for investors in Berkshire Hathaway. From 1965 to 2024 (59 years), the per share market value of Berkshire Hathaway has delivered a compound annual gain of 19.9%. What Buffett is doing is kind of like shooting fish in a barrel. But here is the crazy thing… Buffett isn’t secretive about what he is doing. For 59 years he has been educating investors (and competitors) on his business model. And Buffett is a great communicator… you would have to be an idiot to not understand him. We all know markets are wickedly efficient. If someone invents a better mousetrap… their advantage will not last long. Because competitors will copy what they are doing and this will in short order compete away and advantage that exists. So most P/C insurance companies are copying Buffett’s business model. Right? No. Actually almost no other P/C insurance company is copying Buffett. Honest. Its true. Why don’t all P/C insurance companies copy Warren Buffett’s model? Charlie Munger was asked this same question. And he had no answer (if I remember his response correctly). Which says something because Charlie was a pretty sharp guy and not shy to let you know what he was thinking. My guess is most P/C insurance companies don’t follow Buffett’s model for one simple reason: they are not running the business for the long term. Because they can’t. It can be explained: Volatility Wall Street hates volatility. It defines volatility as risk (which is absurd). Wall Street also is obsessed with the short term (and smooth results). And yes, Wall Street is that same manic-depressive called Mr. Market. It really is a delicious cocktail. And these are the basic building blocks that determine how almost all P/C insurance companies run their business. Wall Street is in control. So even though Buffett’s model is obviously the best one to use - if your goal is to maximize per share value creation for shareholders over the long term - well, pretty much no one uses it. Because they can’t. Crazy but true. The key is family control Buffett had this. Having control allowed Buffett to ignore Wall Street. Markel is going to be a great case study for my theory in the coming years. They were a family controlled organization… and when they were their returns for shareholders smoked. They are no longer a family controlled company…. and their returns for shareholders in recent years have started to stagnate. Of interest, who is Markel looking to for guidance to right their ship? Wall Street. Yikes! (Looks to me like they are letting the fox into the henhouse… but what do I know?). What about Fairfax Financial? This is where our story gets really interesting. Unlike Markel, Fairfax is still a family controlled company. Prem Watsa owns more than 9% of Fairfax and he has voting control of more than 40%. He also is in the process of grooming the next generation to continue the family’s stewardship of the company. Bottom line, Fairfax will remain a family controlled business in the coming decades. Let’s shift from theory to the real world. How has Fairfax fared over the past 10 years? We can split the past 10 years into the following: From 2014 to 2019, P/C insurance was in a soft market. From 2020 to 2024, P/C insurance was in a hard market. Let’s look at two key metrics for a P/C insurance company: net premiums written (NPW) and total investment portfolio In the soft market from 2014 to 2019: NPW increased from $6.1 to $13.3 billion, or a total of $7.2 billion. This was a 5-Year CAGR of 16.8%. Total investments increased from $26.2 to $39.0 billion, or a total of $12.8 billion. This was a 5-Year CAGR of 8.3%. Bottom line, Fairfax dramatically grew its P/C insurance business (and its investment portfolio) in a very soft P/C insurance market. How? By making many acquisitions (Brit, international and Allied World) at reasonable prices. In the hard market from 2019 to 2024: NPW increased from $13.3 to $25.3 billion, or a total of $12 billion. This was a 5-Year CAGR of 13.7%. Total investments increased from $39.0 to $67.4 billion, or a total of $28.4 billion. This was a 5-Year CAGR of 11.6%. Bottom line, Fairfax dramatically grew its P/C insurance business (and its investment portfolio) in a very hard P/C insurance market. How? By growing organically. How has Fairfax done over the past 10 years? NPW increased from $6.1 to $25.3 billion, or a total of $19.2 billion. This was a 10-Year CAGR of 15.3%. Total investments increased from $26.2 to $67.4 billion, or a total of $41.2 billion. This was a 10-Year CAGR of 9.9%. Bottom line, Fairfax dramatically grew its P/C insurance business (and its investment portfolio) in both soft and hard P/C insurance markets. Just what you would expect from a very well run P/C insurance company. Importantly, over the past 10 years, Fairfax has also improved the quality of its P/C insurance business. It is not just much bigger - it is also higher quality. What have we learned? Fairfax business model is unique in the P/C insurance industry. Family control appears to be a sustainable competitive advantage for the company. It allows the company to run the business (insurance and investments) for the long term. In terms of business model, Fairfax today looks like a much younger Berkshire Hathaway: Exploit volatility (the insurance cycle) in the P/C insurance business. Exploit volatility (invest in equities) in the investment management business. Fairfax has a high quality P/C insurance business: My guess is it currently has a ‘normalized’ combined ratio of about 94%, which is very good. At the same time, its investment management business is executing exceptionally well: My guess is Fairfax is currently generating a ‘normalized’ return on its investment portfolio of about 8%, which is outstanding. And when it comes to capital allocation, Fairfax has been best-in-class among P/C insurance companies over the past 5 years. As Stanley Druckenmiller would say, the management team at Fairfax has been on a ‘hot streak.’ Bottom line, Fairfax has never been better positioned an it is today to continue to drive per share value for long term shareholders. Regardless of where we are at in the insurance cycle.