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Table of Contents
Key Focus Points for Each Sector.....................................................................................................4
Non-Life Insurance Companies – The Misunderstood Financial......................................................5
Pricing: The Trend Everyone Loves to Spot.....................................................................................6
The Balance Sheet and ROE – Still the Best Predictors .................................................................11
An Ever-Changing Landscape; the Role of Legislation and Litigation ..........................................16
M&A – What Happens When Nothing Else Works .......................................................................19
Focus on Primary Insurers ..............................................................................................................28
Focus on Reinsurers.......................................................................................................................29
Focus on Insurance Brokers............................................................................................................30
Focus on Title Insurers....................................................................................................................31
A Short Tutorial on Title Insurance ................................................................................................32
Company Profiles.........................................................................................................................35
Argo Group International Holdings (NASDAQ: AGII) .................................................................36
Cincinnati Financial Corp. (NASDAQ: CINF)...............................................................................40
Fairfax Financial (NYSE: FFH)......................................................................................................45
First Mercury Financial Corp. (NYSE: FMR) ................................................................................49
Harleysville Group Inc. (NASDAQ: HGIC)...................................................................................53
HCC Insurance Holdings, Inc. (NYSE: HCC)................................................................................57
Infinity Property Casualty Corp. (NASDAQ: IPCC)......................................................................61
Kingsway Financial Services, Inc. (NYSE/TSX: KFS)..................................................................64
Markel Corporation (NYSE: MKL)................................................................................................67
Max Capital Group (NASDAQ: MXGL) .......................................................................................71
Meadowbrook Insurance Group (NYSE: MIG)..............................................................................75
Navigators Group Inc. (NASDAQ: NAVG)...................................................................................79
Philadelphia Consolidated Holdings (NASDAQ: PHLY) ..............................................................83
PMA Capital Corp. (NASDAQ: PMACA).....................................................................................87
RLI Corp (NYSE: RLI) ..................................................................................................................91
Selective Insurance Group, Inc. (NASDAQ: SIGI) ........................................................................95
W.R. Berkley Corp. (NYSE: WRB) ...............................................................................................98
Arthur J. Gallagher (NYSE: AJG) ................................................................................................102
Brown & Brown Inc. (NYSE: BRO) ............................................................................................106
Hilb, Rogal and Hobbs, Co. (NYSE: HRH)..................................................................................110
IPC Holdings, Ltd. (NASDAQ: IPCR) .........................................................................................113
OdysseyRe Holdings Corp. (NYSE: ORH) ..................................................................................117
PartnerRe, Ltd. (NYSE: PRE).......................................................................................................121
LandAmerica Financial Group (NYSE: LFG)..............................................................................124
Stewart Information Services (NYSE: STC) ................................................................................129
Appendix I: Coverage Universe.................................................................................................133
Required Disclosures ..................................................................................................................134
Additional Disclosures..................................................................................................................136
Key Focus Points for Each Sector
Primary Insurers
• Price/book multiples are near multi-year lows. 2007 was a soft year for stocks of primary
insurers. Specialty insurers, multi-line insurers and standard line commercial insurers all
generally saw share price declines despite continued strong profitability. As a result, there was
significant multiple contraction as book values rose while share prices fell. This trend has
continued into 2008. This has created some good value opportunities, but as yet no clear
impetus for multiples to reinflate.
• Best ideas. Our favorite ideas in the primary insurance space are Max Capital (MXGL) and
HCC Insurance Holdings (HCC). Both companies have a very diversified business mix and
strong investment leverage, which should protect earnings even in a soft market. Max Capital
currently trades at 80% of book value, which is below peer multiples and an all-time low priceto-
book multiple. HCC is trading at 100% of book value, which is at the low end of its historic
range and a level not seen since the late 1990s when the company was much smaller.
• See additional focus points on page 28.
Reinsurers
• Price-to-book multiples remain stubbornly low. Growing book values combined with
modest share price declines have caused a gradual erosion in price-to-book multiples.
Throughout 2007 reinsurers were generally trading in a range of 1.1x to 1.3x book value. This
has declined to where many in the group are trading near or even below book value despite
solid underwriting results and double-digit ROEs.
• Best idea. While we have an Outperform rating on all of the companies in this coverage
segment, our favorite idea is PartnerRe (PRE). Partner is trading at 95% of book value despite
producing strong book value growth and steady underwriting profits. The company is well
diversified globally and management takes a conservative approach to reserving, investments
and underwriting. The company has good investment leverage at 2.7:1 and a track record of
steady investment results.
• See additional focus points on page 29.
Insurance Brokers
• A very challenging time to be an insurance broker. A four-year decline in insurance pricing
has taken its toll on top-line growth. Insurance brokers derive most of their revenues from
commissions and fees that are a function of insurance prices. In the early part of a soft market
they can sell additional products and services and generate new business. As a soft market
drags on, new business wins aren’t sufficient to offset price declines.
• Companies we like and why. With market conditions still weakening, we’re reluctant to own
most of the companies in the group and have an Underperform rating on Arthur J. Gallagher.
• See additional points on page 30.
Title Insurers
• More dependent on direction of originations than absolute level. Over the last 12 to 18
months, title insurance earnings have suffered from the sharp contraction in real estate
origination volumes. The mismatch between revenues and expenses, together with the need to
increase loss reserves, has pummeled results.
• Companies we like and why. Although it is difficult to call a clear bottom in the real estate
market, we have an Outperform rating on LandAmerica (LFG) and Stewart Information (STC).
We believe the stocks have sold well below their intrinsic value. We believe some investors are
factoring in a “risk of ruin” related to loss reserves and leverage that is not consistent with cash
flow patterns or levels of claim losses, even in previous severe downturns.
• See additional points on page 31.
Non-Life Insurance Companies – The Misunderstood Financial
Historically, financial stocks have comprised 15% to 20% of the S&P 500. Likewise, property &
casualty insurance companies have typically comprised 15% to 20% of the financial component of
the S&P 500. As such, the group has generally represented 2% to 4% of the S&P 500. The group
has similar representation among the Russell 2000 and 3000.
Despite its relative importance, it is a sector that is often not well understood. Part of this is related
to the cyclical nature of the industry. Part of it is the inherent uncertainty and “surprise” factor
associated with catastrophe and litigation losses. Some of the accounting can be difficult to
understand and the group is not highly correlated with the overall market.
However, in spite of the challenges, the sector can be an enormous source of wealth creation, as
amply demonstrated by Warren Buffett and Berkshire Hathaway. The key, in our opinion, is
understanding the wealth-creation characteristics of the business and grasping the industry’s
cyclical drivers.
The purpose of this report is to examine key business drivers in the property casualty insurance
industry, with a focus on those metrics and concepts that we believe are the most useful for
investors in the sector. We look at the sector from both a top-down and a bottom-up perspective,
focusing first on which company characteristics are most likely to be valuable at various stages of
the insurance cycle and then doing bottom-up analysis of those companies that appear to possess
those attributes.
This report is divided into five sections:
• Pricing: The Trend Everyone Loves to Spot
• The Balance Sheet and Roe – Still the Best Predictors
• An Ever-Changing Landscape; the Role of Legislation and Litigation
• M&A: What Happens When Nothing Else Works
• How We Value Insurance Companies
These sections are meant to be industry oriented and macro in nature. Following these sections we
have four short “Focus” articles that identify particular key metrics and business drivers for each
of our coverage segments: primary insurers, reinsurers, insurance brokers and title insurers.
These sections will be followed by a selection of time series industry data and “company league
tables”, which we believe illustrate some of the long-term trends we discuss in the preceding
sections.
This report also includes initiation-of-coverage reports for 25 companies in the non-life insurance
sector.
Pricing: The Trend Everyone Loves to Spot
It is well known that the insurance industry is cyclical. When the industry is profitable it creates
capital which the companies deploy by writing more insurance. As more capacity becomes
available, prices fall, thus reducing profitability. Eventually lower prices lead to underwriting
losses, destroying capital and reversing the cycle. Because pricing trends are so observable, it is
the one industry trend that even casual observers like to focus on as a barometer of industry health.
Although we firmly believe that the best insurance companies will find a way to produce
reasonable returns across the entire cycle, there is no denying the fact that overall pricing trends
have been in retreat for four years and that this has been detrimental to underwriting margins.
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