March 2, 2009
Bads News is Good News: Montpelier Re

A 26-year-old former Marine first lieutenant who recently got a job as a financial planner told The New York Times why that profession appealed to him. "I could have an impact on people's lives," he said earnestly, "and help them prepare for future recessions."

Many would say that "financial planners" — who are in the business of managing their clients' assets until there is nothing left — helped cause the current recession. But it's worthy of note that this burgeoning financial planner is more concerned with future recessions than with future prosperity.

That times are tough is obvious to everyone. But industrious companies are adapting. Take A. Schulman Inc. In the spirit of austerity, the Akron, Ohio-based company, which sold about $2 billion of plastic compounds last year, determined it was no longer cost effective for the company to provide its officers and directors with a private plane. It also determined that without the private plane, it was "increasingly difficult and cost prohibitive to access our Canadian fish camp" (allegedly used for "business entertainment purposes" only). Consequently, the camp was sold to the only person who stepped up with an offer — the company's CEO, who paid a mere $55,000 for it.

Also adapting to the new environment is Integro Ltd., the startup insurance brokerage formed with $300 million in 2005. According to Insurance Insider, it recently jettisoned 22% of its staff. The good news: Integro still has about $100 million left. The bad news: That means it has spent about $200 million to get to where it is today — $65 million in revenues.

American International Group Inc.'s acquisition of Hartford Steam Boiler was a much better investment. In 2000, it bought the company for $1.2 billion in stock. AIG is now selling HSB to Munich Re Group for $742 million in cash, about 125% of book value and less than 5x earnings, price levels that sound remarkably cheap for a good business that's more of an engineering services company than a risk-bearing one. (Perhaps all this proves is that it's better to sell things during a boom than a financial crisis.)

It is easy to say that AIG is losing its shirt on this transaction, but that isn't exactly true. The stock AIG used to make the acquisition was wildly inflated; its present value is $5 million.

At the end of 2003, the insurance industry was in the middle of what I called "the return of irrational exuberance." Three years earlier, I had found dozens of good insurance companies selling below book value. In late 2003, I could find none. I wrote the following in Schiff's Insurance Observer on Dec. 21, 2003:

   The dearth of good, cheap insurance stocks tell us something about the future returns of the insurance industry, as well as the state of the industry. Richly priced insurance stocks are the enemy of good operating results. When companies are able to tap the capital markets on advantageous terms they tend to do so, bringing money into the industry. The increased supply (aka "capacity") eventually meets demand, then exceeds it, forcing prices and profits down…
   The insurance business is cyclical. Right now we're in the part of the cycle where things seem pretty good. But speculation is abundant. Most of the easy money has been made — at least for awhile. The risks have increased significantly for insurance investors and underwriters.
   Sonny Liston was supposedly asked who he wanted to referee his fight with Floyd Patterson. "It doesn't matter," Liston said, "as long as he can count to ten."
   Many things don't matter in the insurance business as long as you're aware of risk. It's no time to stretch for yield and higher returns. It is a time for caution.

Since that time, the SNL Insurance Index and the S&P Insurance Index are down 45.19% and 69.37%, respectively. It is now a time of great distress. That's pretty good news for investors who have been cautious because, as always, distress creates opportunities.

In the past five months, I've bought the securities of 10 insurance businesses. I've mentioned two of these in previous blogs: IPC Holdings Ltd., a catastrophe reinsurer with a clean balance sheet and a $33-per-share book value. (My average cost is $23); and White Mountains Insurance Group Ltd. bonds, with a yield to maturity of almost 13.7%.

I'll now discuss another investment I've made: Montpelier Re Holdings Ltd., a Bermuda-based writer of catastrophe reinsurance and property reinsurance. I like those lines of business and think conditions are favorable right now. But that's not why I invested in the company. The company's balance sheet is relatively conservative and liquid, which appeals to me. Assets total $2.8 billion, and liabilities, including $350 million of debt, total $1.44 billion. Shareholders equity is $1.35 billion. Net earned premiums were $528 million last year.

Montpelier's stock, selling at 80% of book value, is attractive. But the company's debt — specifically the 6.125% senior notes due Aug. 15, 2013 — is really cheap. The notes are trading around 74, a 14% yield to maturity.

The numbers are compelling. Montpelier could lose its entire $1.44 billion net worth (roughly half of its assets), and its bonds would still be money good. Last year, a bad year, Montpelier's net worth declined by $300 million. And in 2005 (Hurricane Katrina), the company lost $750 million, almost as much as it had earned in the three previous years. In a good year, Montpelier can make $300 million or so. There's no way to predict whether any year will be good or bad. Although it has never happened, the company could have a string of bad years in a row. I don't think that's likely, but it wouldn't necessarily be a disaster for bondholders anyway. If Montpelier lost, say, three-quarters of its equity in one occurrence, it would have to shut down or raise new equity. Neither of those scenarios would impair bondholders, but they would be disastrous for shareholders.

The 14% yield on Montpelier's short-term investment grade bonds is compelling. The bonds are priced for catastrophe even though none is apparent. Investing and underwriting are both about weighing risk versus reward. In the case of Montpelier's bonds, the risk is moderate, but the reward is substantial.