A few weeks ago I participated in an interesting discussion here about the pitfalls of accruals, and how companies with accruals-based earnings are net underperformers, over time. This creates a big problem if you want to invest in financial firms, who are the "poster boys" of accruals-based accounting.  In this context I thought it would be interesting to take a look at the one financial stock I hold, Lancashire Holdings (LON:LRE).

Just who are Lancashire, then?


Market Cap: £1.13bn (approx)

Current share price: 700.5p

Website: www.lancashiregroup.com

Lancashire Holdings (LON:LRE) listed on AIM in 2005, raising capital to take advantage of perceived opportunities in speciality insurance arising after Hurricane Katrina.  It transferred to to the main market in 2009 after an astonishingly succesful four years and is now firmly established in the FTSE 250.

Lancashire are a Bermuda-based P&C (property and casualty) insurer and reinsurer, with Lloyds- and non-Lloyds based operations.  In other words, they insure and reinsure risks such as offshore/onshore oil and gas operations, hurricanes and storm damage, other energy (e.g. power plants, nuclear), shipping, aviation, anything really except direct consumer facing stuff (such as say Admiral or Churchill) and life/life-related business. Their business is largely done through brokers so they are very different from the consumer facing insurers and more comparable with the likes of Amlin, Hiscox, Brit, other Bermuda-based insurers such as Catlin, and the many US P&Cs.

Like most insurers (and all P&C insurers) they make money in two ways: firstly, by paying out less in claims and expenses than they take in in premiums (the ratio of claims and expenses being known as the combined ratio, one of the most important metrics in insurance investment) and secondly by investing premiums and profiting on the investment yield on that premium before claims arise for payment.

So simple it's complicated

This sounds very simple, and, well, it is! All P&Cs operate within this basic model and therefore should, in theory, be highly comparable.  The problem that arises is that while the idea is simple, the practice is not.  This is for exactly the reason highlighted in the accruals article I linked to - namely that, at the point of sale (i.e. when a policy is concluded) the insurer does not know his cost of sales - and will not do…

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