A reader Jeff S. sent me a good write up about potential risks about insurance companies in general. In the rush of posting this article yesterday, I should have mentioned them as they are important:
Insurance companies hold a lot of assets, mainly bonds. The value of those assets shift dramatically depending on market conditions and thus, book value can go up and down dramatically. For example, Federated holds $150 million in cash and investments and the majority of it is in bonds. If the value of those bonds goes down say 10%, we are talking about a $15 million hit to book value or about $2/share.
When you are investing in insurance companies, you are investing in bonds. Right now, it is not a great time to be an investor in bonds (especially, long term bonds) because of the low interest rates. About 16% of Federated’s portfolio bond portfolio, is in bonds that mature after 10 years. Another point is that any extra cash flow that the company gets will be invested in more bonds at the current anemic rates.
Loss and loss adjustment expenses
Insurance companies not only have to expense actual paid losses, but also losses they expect to pay in the future. As a result, an overly optimistic management team could increase earnings by underestimating losses they may have to pay in the future.
It is worth noting that losses this year for Federated were stable even with a 20%+ new business. Also, unpaid losses and LAE has gone down $10 million year over year from $59 to $49 million.
Management attributed it to “primarily to a reassessment of our losses by line and increased underwriting procedures to manage our risks.” Federated has been focusing on writing more profitable policies. This has resulted in lower reinsurance premium rates and obviously lower losses. However, I am not a huge fan of the first reason (reassessment of our losses).
One thing I like about Federated is that they have grown organically and not from takeouts (taking business/premiums from other insurance companies). Takeouts result in instant premium growth and a boost to earnings. Homeowners Choice, Inc. (HCI), an another florida insurer, has growth this way, but the Federated CEO is not a fan of this approach and is adding business policy by policy.
You need a good management team to manage risk. In regards to Federated, I can’t say either way they are good or bad, but I do like that they are saying the right things in the conference call.
With any investment, there is risk, but insurance companies are riskier. Federated is still a buy for me as I wrote in my previous article, but investors should invest with caution.
Disclosure: I own FNHC