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Good ORH write up from Mungerville -thought it deserved its own thread


Smazz
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Thanks again for this Mungerville - I appreciate your view points - Im sure others will also.

 

Mungervilles Post on ORH from the Bloomber on Pabrai thread:

(http://cornerofberkshireandfairfax.ca/forum/index.php?topic=441.30)

 

What gives me optimism is really pretty simple.  The underwriting is under control so a combined of 100% is achievable and has been achieved in recent years in an average market for reinsurance which I think is what we have in 2009 - not hard, but not as soft as 2008 at least in reinsurance.  This isn't the reason, I'm just getting that out of the way.  So, with that out of the way, imagine this is a mutual fund you are invested in. 

 

1.  Now imagine this mutual fund having a guaranteed minimum return of 8% after-tax buying at $40 per share just to start off with zero risk using none of the assets; 

 

2.  Then add some of the best investment managers in the business to that mutual fund to take the assets of say $1 dollar which you can buy for 90 cents (i.e. book value is $45 and price of stock is $40) and invest where they see fit - say undervalued stocks, MBS, junk bonds and you get the full return from that in a market that is semi-disfunctional;

 

So that's pretty damn good so far - an 8% head start after-tax, and assets for 90 cents on the dollar on top of that. 

 

3.  Now on top of this, let's say they get a little over-enthusiastic about the economic situation and misread a bit and buy stocks and other risk assets a little early and then the bear market resumes.  So you lose some of your assets, but because the wreaks havoc on the entire industry's already somewhat depleted capital base, a hard market for reinsurance occurs.  So you lost some assets, but now with a combined ratio of 90-95%, buying at $40 per share, you get an extra yield of 3-6% after tax added to that initial guaranteed yield of 8%.  So you are at 11-14% yield in this "dire" scenario.  On top of that you still have the assets invested in now very undervalued securities with the opportunity to buy more.

 

-------------------

 

My first point is the big kicker because that is one hell of a head-start.  ORH's equity capital or book value is $2.7 billion but... it owns $2.3 billion in muni bonds the great majority of which are guaranteed by Berkshire Hathaway which are pretty rare securities as Berkshire only guaranteed $15.6 billion of these in total - see p. 13 of Berkshire's 2008 annual report, 6th paragraph.  So, in my view there is zero credit risk there.  Furthermore, for those who care about mark-to-market volatility, they still owned $1.8B notional in CDS at year-end 2008 at Odysee so that will more than take care of any m-to-m volatility/credit risk or perceived credit risk in those munis as well as the 0.3 billion in convertible bonds ORH held at year end.  On top of that, they have 1.2 billion in US government bonds.  So they have a rock solid bond portfolio of 4 billion on book value of 2.7 billion which you can buy for 90 cents or $2.4 billion.  The $4 billion yields $280M pre-tax or $200M after-tax on your purchase price of $2.4 billion for the whole company.  That is a risk free 8% after-tax head start using float that costs them nothing.  So its like a mutual fund with a guaranteed 8% return, with no risk, tax sheltered because you already paid tax, and where you still have not started investing the net assets of yet.

 

The second point speaks to buying the net assets at 90 cents with great management investing the assets.  The third point is really important because if the markets turn down from here, and ORH loses book value because of its equity investments, we should almost be guaranteed a hard-market and expanding market share going forward as the competition will be on its knees and moreover the equity values will be wound up like springs being so low.  So we have a counterbalancing effect that is very significant.  And part of point #1 and point #3 talk to the two very important advantages of a well run P&C business: i) no cost no maturity investment leverage - who the hell can get that these days other than institutions supported by the government?, and ii) the countercyclical aspect built into the business - when investment returns get crushed, underwriting profit typically increases thereafter and for those that are ready, they can really expand their market share on top of that to get more float.

 

Take all that together and add a talented investment team and your worst-case scenario has to be an annual return of well north of 10% even in the worst economic and/or market environment.  8% is locked and loaded to start after all.  So that's the downside and that's how I like to think and that's pretty damn good for the downside.  So if that's the downside, what is the highly likely return?

 

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I am just a little concerned with the hope for a hard market "soon".  We've been thinking it is just around the corner for over 2 years now; I personally don't understand all the ramifications of the gvt's actions, TARP money, bail-outs & the like.  Propping up AIG means hurting the good companies like BRK & FFH.  How long will it last?

 

 

 

I like both these companies, but am not counting on any hardening of the market.  I worry when it has to become part of the equation to "make it work".

 

 

PS:  Obviously this is no ding on Mungerville's post, which is pretty good as usual.

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I am also not waiting for a hardening market because, since all things in life strive for equilibrium, with every insurer to go under, you will also have opportunities for revenue go tits up as well especially in this current environment.

 

What I do like, as Munger posted, ORH abiltity to do decent (as I see it)CR numbers in a not so great (not hard) market.

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Nice write-up, Mungerville. I am not sure, however, about "book going up almost guaranteed this year", like you said. ORH's combined ratio was 121.3% in 2001 and 117.6% in 2005. I think a big disaster in 2009 that drives up the combined ratio over 115% will be tough to overcome on the investment side. Perhaps you are considering disasters such as 9/11 and Katrina to be very rare, and almost guaranteed not to occur. I don't feel so sanguine myself.

 

I do like ORH a lot as a long-term investment though.

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Hard/Soft insurance markets have always been discussed in terms of the supply side i.e. funds available to the insurance companies. I have never seen a discussion in terms of the demand side. How does the demand for insurance vary with economic cycle? Is it fairly immune to economic cycle or would it be possible to have a sharp drop in demand in a depression type scenario? In this case would we not have a soft market if we assume that the supply remains constant or falls lower than the demand side?

 

Thanks

 

Vinod

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I think it was Shah that said the demand side for insurance will contract that will not help... I agree.  However, you hear a few comments muttering around now that the terms of the policies are getting better, so the effective premium may decline, but if you can the terms better you may be getting a better deal as your loss ratio will be lower.  These kinds of terms in contracts tend to persist as the cycle turns too so you will end up with a lower combined as premiums start to ramp (not that I can predict the future, but this is my understanding of what is likely... the 'when' is the killer though).

 

But I've been thinking a bit more on the supply side, and here are some helpful data points I think to understand what 'other' insurance companies will be looking at on the investment side:

 

1) Long T-Bond ETF --> TLT http://bigcharts.marketwatch.com/quickchart/quickchart.asp?symb=tlt&sid=0&o_symb=tlt&freq=1&time=19

-- Down ~15%

2) 7-10 Year T-Bond ETF --> IEF http://bigcharts.marketwatch.com/quickchart/quickchart.asp?symb=ief&sid=0&o_symb=ief&freq=1&time=19

-- Down ~3.3%

3) Long Muni ETF --> MLN http://bigcharts.marketwatch.com/quickchart/quickchart.asp?symb=mln&sid=0&o_symb=mln&freq=1&time=19

-- Up ~13%

4) Medium Muni ETF --> ITM http://bigcharts.marketwatch.com/quickchart/quickchart.asp?symb=itm&sid=0&o_symb=itm&freq=1&time=19

-- Up ~6%

5) US Stock Market ETF --> VTI http://bigcharts.marketwatch.com/quickchart/quickchart.asp?symb=vti&sid=0&o_symb=vti&freq=1&time=19

-- Down ~2.2%

6) US MBS ETF --> MBB http://bigcharts.marketwatch.com/quickchart/quickchart.asp?symb=mbb&sid=0&o_symb=mbb&freq=1&time=19

-- Up 1.75%

 

I'd say that net-net, the capital positions of most insurers will be flat to down at Q1 end.  The rallying has been massive, but cliff dive before it was just as big, and I think the Treasury market take down was bigger than I had realized.

 

Given the weighting of FFH/ORH's portfolio, I would imagine this quarter would be better than average for them.  Again, I"m not sure what will trigger a hard market, but with AIG winding down now I'm less inclined to believe that the irrationality will get much worse.

 

I like the prospects for these guys at less than book... ORH is a better deal right now in my opinion, but not by a huge amount in my eyes.

 

Ben - long both

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Yes, nothing is guaranteed annually.  If there are major disasters, and the combined goes to 115% and the stock market drops in half as well, book value will go down.  My point is that they have a 8-10% advantage or so annually in terms of book value growth coming from the investment side now that is significant, they are well capitalized and any pain like that will create a hard market.  So I welcome a book value decline this year where competitors also get hit hard - that would be the best scenario for long-term value creation.

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Ben, The muni chart makes me think that the FFH group of co's are likely to generate an ok at worst quarter on the investment side ,on the underwriting side I will leave  the conclusions to smarter individuals than myself however from what I have seen and heard so far there is little evidence of the mkt hardening at all ...yet. Clearly AIG has been gamed by their conterparties on the CDS transactions with perhaps tacit govt. approval who knows what is happening on the underwriting side however it is fraught with all sorts of unintended consequences imo. The largest insurance co. in the world is now owned by the federal govt. The CDS unwinds have led me to believe that the govt. is not running AIG to minimize their losses in AIG per se they are still fighting a depression is how I see it.

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Here is my take. Please feel free to point out my errors or overly optimistic assumptions:

 

1.) Underwriting: CR = 98 = $50 million

2.) Interest & Dividends = 5% x $7.9 billion = $380 million

3.) Operating Income = $430 million

4.) Net Gains on Investments = 4% x 7.9 billion = $316 million

5.) Interest Expense = $33 million

6.) Other Expense = $20 million

7.) Pre-tax Income = $693 million

8.) Tax Rate = 33% = $229 million

9.) Net Income after Taxes = $464 million = $7.70/share = 17% growth in BV

10.) Shares Outstanding = 60,243,000

11.) Book Value per Share (Dec 31) = $45.37

12.) Share Price (Apr 27) = $38.00

 

To be even more safe, let's knock growth in BV down from 17% to 15%. Looking out 5 years, the market will finally appreciate the ORH business model and will give it a book value multiple of 1.2. In 5 years this gives us a stock price = $109.51. With the stock trading today at $38 (0.85 x book) this would provide a compound annual return of just under 24%. Not too shabby. I believe the downside risk (stuff I have missed) is about the same as the upside potential (being too conservative). Also, given the (small) size of the company, I will limit my position to a max of 15% of my total portfolio.

 

Odyssey Re has the ability to pull $544.8 million in dividends in 2009 from Odyssey America (sub) if they so chose. I believe they plan to leave the cash with the sub and to utilize to grow their business as the markets harden in the future. Bottom line, this value is not built into the above analysis (i.e. they could pull this money up and buy back another 10 million shares to grow shareholder value). See p. 83 of ORH AR.

 

Regarding estimates, I am looking for a 5 year average and I am trying to be reasonably conservative:

1.) Underwriting = 98%. My guess is the market begins to harden in 2010 or 2011. This should give ORH a 5 year average CR of 98.

- Adverse Development: since 2001 ORH has had favourable = $868.4 million and unfavourable = $174.2 or net favourable development = $694.2 million. The issues regarding adverse development are really for accident years prior to 2001. Most importantly, since 2004 the cumulative development has been decreasing each year and was +$10.1 million in 2008. Bottom line, looks to me that the adverse development issues are largely behind us adn one could reasonably expect for positive development on a cumulative go forward basis. See p. 22 of ORH annual for more details.

2.) Interest & Dividends: From the Q4 conference call 'As a result of this portfolio restructuring, the yield on our overall portfolio at Dec 31, 2008, was projected to be 4.1% or 5% on a tax equivalent basis.' The yield in Q4 was only 2.75%!

3.) Net Gains on Investment: Since 1986, Hamblin Watsa Total Return on Avg Investments has been 9.8% (see p 142 of FFH Annual Report) and for the past 10 years I estimate it has been 9.1%. If we assume similar returns (to 9.1%) going forward and the current portfolio yield is 4.1% we could reasonably assume a Net Gain on Investments going forward of 5%. For this analysis I went with only 4%. Further, one could assume with with all the stock write downs in Q4 and the fact that most purchases have been made 50% (or more) off from recent market highs that the Total Return on Avg Investments should outperform over the next 5 years the performance of the past 10 years (i.e. a 10% total return is not a crazy number).

 

Other notes:

FFH Asia: ORH also owns 26% of FFH position in ICICI Lombard. It is carried on the books at $67 million. I think their share is worth perhaps twice that meaning BV is understated by perhaps $0.50 to $1.00. See p. 123 of ORH AR.

Balance Sheet: ORH has low amount of debt ($489 million) and no maturities are due before 2013.

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