Arch Capital Group ACGL
June 15, 2004 - 9:48am EST by
gary9
2004 2005
Price: 39.25 EPS
Shares Out. (in M): 0 P/E
Market Cap (in $M): 2,780 P/FCF
Net Debt (in $M): 0 EBIT 0 0
TEV ($): 0 TEV/EBIT

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  • Property and Casualty

Description

Arch Capital Group is a Bermuda-based insurance and re-insurance company. You will not get much help valuing Arch Capital from sell-side analyst reports. However, the investment wisdom of Warren Buffett (as set forth in Berkshire’s annual letters over the years) offers many lessons on the value of insurance companies which, when applied to ACGL, reveal an incredible bargain.

Buffett’s basic measure of value for insurance companies, and one that’s easy to apply, is the concept of “net investment per share.”

We all know that insurance companies generate float – the net value of assets and liabilities on an insurer’s balance sheet that arise from the fact that premiums are collected up front and claims are paid at some point in the future. Float is essentially reserves plus all the insurance related receivables and payables – I’ll spare you the precise calculation.

According to Buffett, the cost of float is critical to the value of an insurer. Underwrite at a profit (premiums are greater than the sum of incurred losses and operating costs) and float is not only costless but better than free. Insureds are paying the insurance company to hold their cash and the value of the insurance company is greater for having written insurance. Underwrite at a loss (premiums are less than the sum of incurred losses and operating costs) and the float has a real cost. The float acts like debt – it has a yield and requires return of principal.

Measures like price-to-earnings and price-to-book value do not contain enough predictive information on which to make good investment decisions regarding insurance companies. There’s an old axiom among crusty insurance veterans - it goes something like, if someone gives you an insurance company for free, you paid too much. The point is that there’s far too much residual risk on the balance sheet and too much management discretion in setting reserves to simply assume that the stated book value or GAAP earnings for an insurance company properly captures its value. As investors, we’ve been blind-sided by far too many reserve charges and credit losses in the bond portfolio (or writedowns on equity investment portfolios) to assume that unadjusted book value is a meaningful measure.

Price-to-earnings is less meaningful than price-to-book value for insurance companies because insurance is not a growth business, is far too cyclical and earnings are subject to too much manipulation to be reliable. As a result, you should seldom used unadjusted price-to-earnings ratios as an investment tool. In insurance analysis, when I analysts turn to price-to-earnings multiples as a valuation tool because book values are too limiting, it’s time to exit insurance stocks.

For example, Arch Capital, which we’ll discuss below, has already released millions of dollars of reserves from the 2002 and 2003 underwriting years. By definition, the book value and earnings were understated because reserves were conservatively booked. Specifically, Arch is expected to earn $4.76 per share (a figure that is likely too low before reserve releases) this year and trades at 8.3x earnings. However, due to conservative underwriting standards, Arch has been able to release reserves of more than $40 million in 2003 and $8 million in 1Q04. Given the favorable claims trends, ACGL is likely to continue to release reserves and will likely do so at a greater rate than that experienced in 2003 and 1Q04. In 2004, ACGL will likely release close to $1 of reserves putting the stock at closer to 7x earnings. More importantly for this discussion, ACGL continues to set reserves at similar rates that are producing the current level of reserve releases. All this is to say that stated P/Es are difficult to use as a valuation tool.

As Buffett wrote in the 1998 and 1999 Berkshire Hathaway Annual Reports, “Growth of float is important – but its cost is what’s vital. In aggregate, we have posted a substantial underwriting profit, which means that we have been paid for holding a large and growing amount of money. This is the best of all worlds. Indeed, though our net float is recorded on our balance sheet as a liability, it has had more economic value to us than an equal amount of net worth would have had. As long as we can continue to achieve an underwriting profit, float will continue to outrank net worth in value.”

Buffett doesn’t make things much more simple than that. If an insurance company can underwrite profitably over time AND grow the float, then this float is actually MORE valuable than equity. Why? Simply because it earns an investment return, costs nothing in the way of dividends or interest payments and can behave like a very long-term liability. Underwriting at profit means that a significant portion of an insurance company’s liability structure has a zero cost of capital. This is explains the old axiom – “Rich families own banks, smart rich families own insurance companies.”

Buffett is showing us another way. Net investment per share. So long as we can find insurance companies with clean balance sheets, underwriting discipline and the ability to grow float, then we have a better way to value companies. Yes this requires some subjective analysis on our collective parts, but successful investing is replete with these subjective judgments.

Using Buffett’s methodology, I have stumbled upon an incredibly cheap insurance company - Arch Capital Group. Near as I can tell, it’s one of the best run insurance companies on the planet (with insurance titans like Paul Ingrey and others providing important leadership), has no legacy insurance liabilities pre-dating 2001and has some of the best underwriting talent anywhere. Unlike the other Bermuda based insurance companies created after the 9/11 tragedy, ACGL is a powerful mix of insurance and reinsurance lines and only has a minority of its business in property or catastrophe lines. These are all important conditions to use the net investment per share methodology. In fact, ACGL is the only insurance company created after September 11, 2001 that is trading at a sizable discount to its net investment per share – because investors have been misinformed using the P/E and P/BV ratios. While most of the new Bermuda based insurance companies are trading at modest discounts to slight premiums, ACGL is trading at a whopping 33% discount.

Let’s take a closer look at the ACGL balance sheet as of 3/31/04, after making the necessary adjustments to calculate float –

Assets (millions):

Investments $4,316
Net Working Capital and Other $25
Goodwill $36

Total Assets $4,377

Liabilities and Shareholder’s Equity
Float $2,120
Debt $246
Equity $2,011

Total Liabs and S/E $4,377

Given my fervent belief that ACGL has a superior business mix necessary to maximize long-term shareholder value and a real underwriting discipline rarely seen in insurance, we can make the following adjustments – valuing non-investment assets at zero and converting float to equity.

Assets (millions):

Investments $4,316

Total Assets $4,316

Liabilities and Shareholder’s Equity
Debt $246
Adjusted Equity $4,070

This adjusted equity (net investment per share) represents roughly $58 per fully diluted share (using a fully diluted share count of 71 million shares, which includes the converts and warrants).

But why should this analysis work? Arbitrage my friends. In ACGL you’re buying a $4.3 billion investment portfolio with a 2.3 year duration and a AA+ rating. Given that the stock is trading at a 33% discount to its net investment per share, you’re buying a $4.3 billion short duration bond portfolio for $2.9 billion. If my evaluation of management is right and they’re able to grow float at a minimal cost (underwrite at a profit), then the valuation discount must close.

In addition to that 33% gain potential, the investment portfolio itself is poised to grow by 13-15% per year due to ACGL’s growth in premiums and reinvestment of income. This above-market return on net investment per share can be further enhanced if ACGL takes advantage of rising rates with a less ultra-conservative investment posture in the future, as discussed below.

If you complete this calculation for other insurers, you’ll note that ACGL screens as particularly cheap especially versus other new Bermuda based insurers (AXS, MRH, ENH, etc…). While other older Bermuda based insurers screen as cheaper (PRE, RE, etc…), their focus on market share and their horrifically bad underwriting track records do not satisfy the conditions of generating consistent underwriting profits making valuation analysis significantly more difficult. The arbitrage opportunity is less certain. I’ve also back-tested the measure against easier to value monoline property-casualty insurance companies and found that stock prices tend to oscillate around net investment per share with long-term clean results.

Unfortunately, you’ll never read about this as a valuation tool from the sell-side. It requires analysis, understanding of how insurance companies work (not just pricing trends) and a judgment of management quality.

Several other key points to the ACGL investment story –
1. I believe that with more quarters of execution by the ACGL management team, the stock will come to reflect net investment per share or $62 per share. In the hands of a more aggressive portfolio investor, the value of ACGL is much higher than the current $62.
2. ACGL has a superior business mix versus the other new Bermuda based insurers. In 1Q04, ACGL generated roughly 38% of its net written premium from insurance lines versus the predominantly reinsurance lines of the other new Bermuda insurers. While reinsurance premium growth is slowing around the industry, ACGL’s insurance lines generated more than 50% growth versus 1Q03. Furthermore, less than 25% of net written premium comes from property and catastrophe lines where pricing is beginning to decline pressuring net written premium growth.
3. Here is a subtle point not fully grasped by Wall Street yet. Because ACGL has a higher proportion of its business coming from longer-tailed casualty lines, the business model is still growing into it’s equity base. For investors, this means that the investment portfolio will ultimately reach 3.0x its equity base versus the current 2.1x. As a result, net investment income will grow faster at ACGL than at other insurance companies causing stronger than anticipated book value growth and upward earnings revisions.
4. ACGL has a very short duration investment portfolio at only 2.3 years – implying that ACGL is giving up current earnings to protect book value. I can name short-tail dominated insurance firms with longer-duration investment portfolios. This has two future benefits for ACGL shareholders. First, the exposure of their equity base to rising rates is less than other insurers (ACGL loses about $1.50 in book value for a 100 bps rise in rates – most of this would be offset by what ACGL would earn in a single quarter so the event is manageable). Second, ACGL will be able to roll their investment portfolio into higher yielding investments more quickly than other insurers as rates rise and can additionally benefit from extending the duration of the portfolio to better match the term structure of their claims tail. Again this ties back into ACGL growing net investment income far faster than other insurers and current expectations.
5. This is one of the strongest management teams in all of insurance and certainly of the new Bermuda based insurers. Importantly for this discussion, the senior management has consistently generated underwriting profits wherever they’ve gone.
6. Like the other Bermuda insurers, ACGL is generating a 20% ROE while reserving conservatively. With sizable IBNR and a low paid-to-incurred ratio, ACGL will be releasing redundant reserves for years to come providing investors with superior book value growth.

Risks to the Investment Case –
1. ACGL fails to produce consistent underwriting profits rendering our $62 of net investment per share useless. As I noted above, this is a superior management team. Paul Ingrey, who is leading underwriting strategy, has a long history of producing superior results. In fact, as CEO of USF&G Re, he led a team that produced 14 consecutive years of underwriting profits during a long soft market cycle. The team at ACGL understands that risk has a price and they’re willing to walk away if prices are not adequate. They don’t take comfort in simply knowing that prices have risen a lot. Market share is an irrelevant concept to them.
2. The pricing cycle turns very negative. The pricing cycle is over. Actually it ended in 2002. At the end of the last real pricing cycle in the mid-1980’s, some of the most profitable business was written after pricing had peaked – from 1987-1990. In fact, many industry executives will tell you that the biggest mistake made at the end of the last cycle was not writing business aggressively enough after pricing was stable to declining. With investment returns low, industry balance sheets still reserve deficient and punitive bond rating firms, the risk of a deteriorating pricing environment is low. I suspect that high quality insurers with experienced management teams will continue to produce robust results.
3. Rising rates cause losses in the investment portfolio. As with the banks this is a specious argument. The reduction in value only matters if the insurers are forced to sell the investments. With a 2.3 year duration investment portfolio, ACGL is less exposed than virtually any other insurer.
4. Pressure from insiders/venture capitalists selling stock. Frankly I worry more about primary issuance of stock as that represents new capacity. I fully expect insider to continue selling but in reasonable amounts.

Catalyst

continued reserve releases; unappreciated above market-growth; higher investment income in rising rate environment
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