2014 Good Year for Insurance

My insurance holdings are all doing well in 2014. I am not a swing-for-the-fences type of guy. I'd much prefer staid consistent returns. And insurance companies give me that — for now. Insurance companies are strictly regulated in the US. An insurance company requires a license from state regulators in whatever state it wants to operate. The regulators set guidelines for drawing up the liabilities, i.e., the reserves. This is especially true for life insurance companies. People's life expectancies are very well understood, and when a company combines thousands of policies together, the result is a very predictable income and payment stream. Life insurance is also a commodity because there is little room for innovation. For these reasons, life insurance companies are in a competitive low-margin business. On the other hand, many trade considerably below book. Kansas City Life (KCLI) is a case in point. The company's 3 month and 9 month earnings so far this year are in line with last year. But this is just a 4% return on equity! This is a paltry return for a company with no top line growth.

I also own AIG. AIG specializes in both life and property and casualty (P&C). The company's third quarter results was pretty much inline with a year ago period. AIG is now in its first quarter without Benmosche as CEO since 2009, when he steered the company out of the financial disaster. AIG's return on equity is better than KCLI but its relative market to book value is about the same, as shown below. But AIG is a more dynamic company and has much greater potential to improve results despite its larger size.

For comparison purposes, I have also included in the table two life insurance companies that I do not own. Independence Holdings (IHC) sells life and health insurance, and National Western Life (NWLI) sells life insurance along with a lot of annuities. The final insurer in the table is European Reliance (EUPIC). This company sells life, health and car insurance, among other services. It looks better than the others by all metrics. The downside to the company is that it is in Greece. But I bet few would know that after four years of negative GDP, the country is poised to be positive again in the coming quarter. And in my opinion, the dirt cheap stock price gives me ample margin of safety against the company's risks; I EUPIC is a much better stock to own than KCLI. And therefore, I plan to close my KCLI position and use the proceeds to add to my EUPIC position.

	KCLI	AIG	IHC	NWLI	ATH:EUPIC
Price	$ 50.000	$ 54.000	$ 14.220	$ 271.970	€ 1.440
Market Cap	548.40 M	75.60 M	249.96 M	988.88 M	€ 39.60 M ($ 49 M USD)
P/E TTM	19.5 x	8.5 x	10.9 x	9.4 x	3.9 x
Div yield	2.2 %	0.9 %	2.5 %	0.1 %	0 %
P/BV	0.72	0.70	0.85	0.64	0.60
ROE	3.7 %	8.2 %	7.8 %	6.9 %	15.5 %
ROA	0.62 %	1.68 %	1.95 %	0.94 %	3.25 %

ITIC also reported earnings. The company earned $7.0M for the first 9 months versus $13.0M last year. This dramatic drop was not because of a drop in revenue, which was only slightly down, but due to positive effects of claim provisions last year. ITIC sells title insurance; however, I don't really think of it as an insurance company like the other five mentioned in the earlier table. Title insurance claims are a tiny fraction of the premium — less than 10% — and they don't take long to occur. If a claim is made on a policy it usually happens within a few years after purchase. Also, part of the cost of the title insurance policy is the title search that the insurer must perform. So, ITIC can be considered a service company as much as an insurance company.

And my fifth and final insurance company, Wellpoint, reported Q3 revenues up 4% and income up 3%. And most importantly, year end EPS guidance is now around $8.88, up from $8.81. The stock has gone up almost 40% year-to-date. Even the midterm elections last week couldn't drag it down. The Republicans now control both houses of Congress and now can ram through legislation to repeal Obamacare. Their rhetoric says they will too. Of course if they do president Obama will veto it and the Republics do not have the votes to override the veto.

Still, I was pleasantly surprised at the lack of reaction from the market. But I am really not at all concerned by the election results. Obamacare is most widely know for the individual mandate, which is mostly provided by the public exchanges. But the public exchanges only provide 750k customers out of 37M. Wellpoint is doing well now mainly because of better management and the benefits from medical insurance expansion through many aspects of Obamacare. If the Republicans do succeed somehow in changing healthcare, it will only be to tweak this system of private insurance with subsidies for the poor. But the spirit of Obamacare is here to stay. So Wellpoint will benefit no matter which party runs the government after Obama leaves in 2017.

AIG and McRae Industries Quarterly Update

AIG and McRae Industries are two recent purchases (meaning within the last half year). These are my two recent new ideas so I am watching them closely to see signs my thesis was correct.

I own AIG because it is a profitable business that trades at half of book value. In the 3rd quarter they earned an after-tax profit of $1.00 per share. The company breaks down the company into four segments: life insurance, property and casualty insurance (P&C), aircraft leasing and others (including mortgage related insurance). The good news is that all four are profitable. The only worrying sign to me the 105% combined ratio of the P&C segment. Combined ratio is the ratio of total insurance payouts and costs divided by the total insurance premium. A combined ratio over 100% does not necessarily imply an loss in the business however, because the business can eke out a profit through investment gains on the premiums held. In the coming quarters, we will also have to see the effects of Hurricane Sandy, but right now AIG cannot predict its affects.

But overall I am very pleased with the quarter and I am surprised that the stock price dropped more than 10% since the earnings announcement. Of course great investors all advise others to tune out the short term noise. So I try to ignore the crowd and remind myself that AIG has $69 of equity per share yet trades at $32. I may add to this position if AIG drops more.

McRae Industries is one of my two small cap holdings. Its market cap is a little over $50mil.

McRea makes high quality work/western boots and military boots. The company just finished its 4th quarter this summer and announced it earned $2.27 per diluted share for the year, versus $1.84 the previous year. Revenue was flat, so it indicates the company is able to increase margins. The stock trades on pink sheets recently at around $17. Its book value is about $20.50. And its net-net value is about equal to the market value. With such a strong balance sheet and a P/E of 7.5, what is there not to like?

I only found this stock after I started this blog and I documented it in this entry. So my entire history with it has been and will be documented on this blog. We shall see how it goes.

Why I Own AIG (Again)

In a future blog I will list my worst purchases. One of them is AIG. I bought AIG back in 2007 at about $65 and saw it go to $2. It is one of four stocks I bought that suffered an unrecoverable catastrophic loss. The other two are Alcatel, Citigroup and a startup where I worked.

So why on earth would I dive back in AIG? The answers I give are surprisingly psychological and subjective.

Firstly, AIG is not the same company that almost drove itself to insolvency in the summer of 2008. Back in the summer of 2008, the mortgage defaults from lax lending standards was driving down the price of various mortgage-backed securities (MBSs). This hit AIG doubly hard because it provided "insurance" on the MBSs, called credit default swaps (CDSs). The insurance AIG sold in theory hedged the possible loss for exposure to MBSs. And as with any insurance, the insurer collects a small premium in exchange for a small chance of a big loss. But AIG miscalculated on the small chance and the correlated MBSs were collectively a toxic mess that made CDSs a huge liability. And with the increase of these liabilities, the collateral payment requirements of the CDSs drove AIG to the point where it almost could not make the payments. This was when Federal Reserve called AIG too-big-to fail and stepped in — at a steep price. The Federal Reserve took over 80% of the company in exchange for funding an entity to hold all of AIG's toxic CDSs and MBSs. This entity is called Maiden Lane.

Now four years on, I am quite convinced the US financial system will not collapse. And I am beginning to believe in my gut that AIG is viable. Now, it certainly helped that the US government recently announced that all of Maiden Lane has been sold — and at a profit to the Federal Reserve! This is one psychological catalyst for me to feel good about AIG again.

AIG also really got my attention in the last six months when I found that Bruce Berkowitz has has invested 36% of his $7.7Bil Fairholme Fund in AIG. I always knew he was bullish on the financials, but I have never heard of a 36% investment in a single stock by a fund.  Berkowitz is one of my most respected investors with a tremendous track record. I wrote about Berkowitz in an earlier post here.

The Fed action of 2008 effectively wiped out my AIG holding. And although it stung, it didn't sting as much as my losses in the dot-com bubble. Following the dot-com bubble I vowed never to invest in tech stocks again. But over the subsequent years I have seen the cheap valuations tech and have come back to it in a big way. And I have realized my statement "I will never buy tech again" is in itself a contrarian indicator. I said that because I was reacting to the sting of my losses in my tech investments, but so are million of other investors and they too are saying "I will never buy tech again". This kind of knee-jerk thinking has caused the market to unfairly discount tech. So this time I purposely try to embrace AIG precisely because I was burned.

And so, in June of this year, I took a look at AIG (one source I used is Berkowitz's presentation on AIG).  I learned that AIG is now a plain vanilla life insurance, property and casualty insurance and a financial services company.  And I opened a position in AIG, again.