Image Source: AIG
Competitive Structure of the Insurance Industry
Constituents in the insurance industry earn revenues primarily from insurance premiums, policy fees from life insurance/investment products, and income from investments. Operating expenses consist of policyholder benefits and claims incurred, interest credited to policyholders, commissions and other costs of servicing products, as well as general business expenses. An insurer’s profitability is dependent on its ability to price and manage risk on insurance and annuity products, to manage its portfolio of investments effectively, and to control costs through expense discipline.
The insurance industry is highly competitive, with rivals numbering in the thousands–including stock companies, specialty insurance organizations, life insurers, mutual companies, other underwriting firms, and banks. Though risk-acceptance criteria, product pricing, and service are some ways insurers can try to differentiate, we view the insurance industry as largely commoditized.
For one, most insurance products can easily be replicated by both existing peers and new entrants (at potentially value-destructive pricing), and sufficient financial strength (capital) is the only temporary barrier to entry. Though many are hugely profitable from an accounting standpoint, any outsize economic profit opportunities will likely be competed away over the long haul, as capital will inevitably chase such an opportunity. Diversification across product lines and geography offer some large insurers stability, but such a strategy also exposes them to a larger variety of more complex risks.
Generally speaking, insurers are inextricably tied to the vicissitudes of the global stock and debt markets, as underwriting profitability (as measured by the combined ratio) can fluctuate wildly through the course of the economic cycle–and particularly during adverse or catastrophic events that result in large losses. In our view, the key portion of an insurer’s income is generated from its investment portfolio, but these returns are largely out of the firm’s control.
Under difficult economic conditions, for example, the assets held in an insurer’s investment portfolio can experience rapid declines in value and performance–not only threatening the capital position of the company but also hurting consumer confidence in the sustainability of the insurer (subsequently slowing demand for its financial and insurance products)—a “not-so-virtuous” cycle.
An insurer is also heavily dependent on its credit ratings that are issued by the major rating agencies, and any downgrade may force it to post additional collateral payments (especially if complex derivative instruments are held on its books), potential hurting existing and future business. For example, during the Great Financial Crisis in 2008, Moody’s Investors (MCO) and Standard & Poor’s (SPGI) downgraded American International Group’s (AIG) credit ratings, forcing it to post billions in more collateral at a time it could ill-afford to, thereby driving a government response to save the company and arguably the global financial system at the time.
AIG remains a fraction of its former self and acts a reminder of the outsized risks and opaque books of some insurance companies.
Image Shown: Once a sprawling insurance giant, American International Group now acts as a cautionary tale as to what can happen to insurance entities that don’t manage their exposures well, and why the insurance sector has unique risks relative to general operating firms.
Insurance stocks, as a whole, also haven’t been able to keep pace with the broader equity market returns for some time now, as shown in the 15-year chart below, and we don’t see that changing anytime soon. We believe market participants will continue to prefer net cash rich, free cash flow generating companies with transparent business models tied to secular growth tailwinds such as those found in big cap tech and large cap growth. Insurance equities may advance in coming years, but we don’t think they will make for great long-term ideas, relatively speaking.
Image Shown: Shares of the SPDR S&P Insurance ETF (KIE) have trailed the performance of the S&P 500 (SPY) dramatically during the past 15 years. In general, we think there are better opportunities elsewhere, though we do like Berkshire Hathaway quite a bit.
As it relates to the Valuentum style of investing, no one insurer registers the coveted ratings of 9 or 10 on the Valuentum Buying Index (VBI) at this time, and we generally don’t emphasize the VBI as much with insurers as we do in other sectors. Quite simply, we’re just not huge fans of the insurance industry’s competitive structure, and we think members will benefit more from the application of the VBI in more attractive sectors.
That said, we do note that exposure to the insurance sector can sometimes provide diversification benefits to a broadly diversified investment portfolio, at times. In that respect, our favorite insurer and idea to gain exposure to the insurance sector is through insurance and industrial conglomerate Berkshire Hathaway (BRK.A) (BRK.B). We value Berkshire Hathaway’s B shares at $320 per share as of the latest update (the high end of our fair value estimate range is $384) and include it as an idea in the Best Ideas Newsletter portfolio.
To arrive at our $320 per share fair value estimate of Berkshire Hathaway’s B shares, we assign a 1.5x price-to-book (P/B) multiple per Class B book value per share of ~$213.40 at the end of the third quarter [BV per share: $481.1 billion/2.25 billion shares]. We assign a margin of safety band of 20% to arrive at the fair value estimate range for its B shares, as shown on its stock page. The fair value estimate is effective January 12, 2022.
Berkshire Hathaway Is Our Favorite Insurer
Image Shown: Valuentum’s best ideas are included in the Best Ideas Newsletter portfolio found in the Best Ideas Newsletter, generally on page 8 of each edition. Berkshire Hathaway (BRK.B) is included as an idea in the Best Ideas Newsletter portfolio, and shares have followed through on its technical breakout, a very positive sign. January 6, 2022.
On November 6, 2021, Berkshire Hathaway reported third-quarter 2021 earnings. We liked what we saw in its latest earnings update as most of its business segments reported strong results, save for some of its insurance businesses, which took a hit from major weather events and headwinds resulting from more drivers being on the road.
Berkshire Hathaway prefers to highlight its underlying financial performance via its operating earnings metric as compared to its GAAP net income metric due to the enormous impact changes in its investment portfolio can have on its financial statements. During the third quarter of 2021, Berkshire Hathaway’s operating earnings advanced 18% year-over-year. Berkshire Hathaway’s industrial and other business segments continued to stage a robust recovery from the worst of the coronavirus (‘COVID-19’) pandemic.
Image Shown: An overview of Berkshire Hathaway’s underlying financial performance, which improved on a year-over-year basis in the third quarter of this year. Image Source: Berkshire Hathaway – Third Quarter of 2021 Earnings Press Release
The conglomerate’s cash-pile has swelled higher in recent years, reaching $149.2 billion at the end of September 2021 (defined as cash, cash equivalents, and short-term investments in US Treasuries bills). Please note this does not include Berkshire Hathaway’s sizable ‘investments in fixed maturity securities,’ ‘investments in equity securities,’ or ‘equity method investments’ line items. The ~$149 billion figure is the amount of cash-like assets Berkshire Hathaway has just “sitting around” on the books earning a paltry yield in the current low interest rate environment.
With that kind of cash hoard, historically Berkshire Hathaway would be out looking for major deals. However, management does not view the current environment as conducive to acquisitions that could generate substantial shareholder value. In the view of Berkshire Hathaway, the proliferation of investment vehicles such as special purpose acquisition companies (‘SPACs’) has driven up valuations for potential takeout targets to arguably unreasonable levels. Due to its size, Berkshire Hathaway needs to find relatively large, undervalued companies as potential takeout targets to have a needle-moving effect on its business, a difficult task in the current environment.
Primarily for that reason, Berkshire Hathaway has opted to return cash to shareholders via share repurchases as the company remains a free cash flow generating powerhouse. The company does not pay a common dividend at this time and is unlikely to do so given the tax implications of that capital allocation decision (among other reasons).
During the first nine months of 2021, Berkshire Hathaway generated $22.4 billion in free cash flow (up from $19.7 billion in the same period the prior year) and spent $20.2 billion buying back its stock. That includes $7.6 billion worth of share repurchases during the third quarter of 2021, according to Berkshire Hathaway’s latest earnings press release. Berkshire Hathaway will likely continue buying back gobs of its stock going forward, activities that can be funded via its sizable free cash flows.
Image Shown: Berkshire Hathaway is a free cash flow generating powerhouse. Image Source: Berkshire Hathaway – 10-Q SEC filing covering the third quarter of 2021
Concluding Thoughts
Though we generally don’t like the structure and risks of the competitive insurance industry, we continue to be big fans of Berkshire Hathaway. The company’s various cost control measures (such as major workforce reductions at Precision Castparts, an aerospace supplier) that were enacted during 2020 in the face of the COVID-19 pandemic should steadily lead to meaningful cost structure improvements going forward as its businesses rebound (with an eye towards its industrial and retail operations).
Berkshire Hathaway’s free cash flow generating abilities continue to impress with ample room for upside given its improving outlook. Eventually investors will want to see some activity materialize on the acquisition front as that represents a core part of Berkshire Hathaway’s longer term growth strategy, even if the deal is relatively small. In the meantime, patient investors will be steadily rewarded via sizable share repurchases.
All things considered, we wouldn’t expect to add any pure-play insurer to the simulated Best Ideas Newsletter portfolio. We like Berkshire Hathaway as our insurance-related idea, but we continue to point to the area of large cap growth as our favorite area to consider ideas (as opposed to more pure-play insurance companies with ‘hidden’ risks and concentrated exposures).
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December 22, 2021: Valuentum’s President Brian Michael Nelson, CFA, explains why investors should not fear inflation, why government agencies such as the Fed and Treasury are prioritizing something other than price discovery, why the 10-year Treasury rate is a must-watch metric, and why Valuentum prefers the moaty constituents in large cap growth due to their net cash rich balance sheets, tremendous free cash flow generating potential, and secular growth tailwinds.
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