Lancashire Holdings (LON:LRE)

Lancashire Holdings (LON:LRE) has built an excellent reputation amongst investors and analysts. Since floating the company has focused on shareholder returns over growth and has returned 190% of capital raised in its 2005 IPO. Cumulative ROE since that point is an impressive ~250%.

In the past six months, Lancashire seems to have fallen out of favour with the market. Taking into account the substantial distribution to shareholders – the company paid out 69p in March, 7.6% of its price at that point – the share price has lagged the market by around 13%.

Given the reputation that the company and its leader, Richard Brindle, have built up over the past eight years it is worth looking more closely at what factors have driven this under-performance and whether an opportunity has been created for investors.

Explaining Under-performance

First, insurance markets are softening dramatically. Softening has been driven to a large extent by third-party capital. Guy Carpenter estimates that $10bn of third-party capital has entered reinsurance markets over the past year and a half and now accounts for 14% of the global property limit. Premium declines in some property lines have approached twenty percent in mid-year renewals. In retrocession lines, Lancashire started the Accordion sidecar in response to favourable retro rates in 2012, declines are nearer thirty percent. As seen in the Q2 report Lancashire’s response has been to pull back rather than chase the market down.

Second, Lancashire recently announced the acquisition of Cathedral, a Lloyd’s insurer. To date, Lancashire had eschewed acquisitions as a way to create value. Although the opening pages of the 2011 Annual Report did make clear that it would consider them at the right price. Nonetheless, Lancashire has moved into uncharted territory with this move and investors may wonder whether the company has lost its focus.

Both of these factors are, in my view, legitimate and investors should take them seriously. The danger is that investors simply think: “Richard Brindle is great” + falling price = profit. The first point is certainly true to some degree, Brindle does have a fantastic underwriting record. At the same time, insurance is a highly competitive industry and Lancashire cannot escape the effects of their competitor’s actions. When competitors become more aggressive, Lancashire must pull back.

Investment Case for Lancashire

The starting point, for me, is always valuation. From this we get a sense of investors’ expectations and what the company will need to do to furnish us with a certain return. At 1.67x book and a 5-year compounded annual ROE of just under 17%, Lancashire is providing a fair but not extraordinary no-growth yield of ~10%. However, Lancashire achieves these results in a very measured, conservative fashion making the company an attractive investment.

The core of Lancashire’s business (around 60-70%) is built on speciality lines. In these classes, Lancashire is often the lead insurer and has cultivated strong relationships with brokers and clients. These classes are often far harder for third-party capital to break into. Clients require policies that fit their business and exposure.  There are no established models for exposure, severity, or frequency of loss. Competitors have been attracted to these markets due to the limited number of losses, particularly terrorism and aviation, but this core portfolio remains an attractive asset and is the core of Lancashire’s business. The value of this core should be considerable: attritional loss in these lines is low, acquisition costs tend to be slightly higher than commodity lines like retro but this is mitigated by Lancashire’s tight overall expense ratios. My guess is that this book is worth, at a minimum, $200m in underwriting profit per year.

On top of this core, Lancashire has been innovative in taking advantage of opportunities and has significantly reduced its exposure to elemental risk whilst maximising returns for current market conditions (Lancashire’s probable market losses from a 1 in 100 year windstorm and 1 in 250 year quake are under fifteen percent of capital). In 2011, retrocession rates increased in response to the large losses of the previous two years. If Lancashire was to enter this market alone it would have to increase significantly its exposure to elemental risk. Rather than take this on the company created the Accordion sidecar which brought in third-party capital. Lancashire retained 20% of the risk, and got some fee income, but the rest was passed on. Another example is the company’s opportunistic use of reinsurance, such as Industry Loss Warranties, which has become quite cheap due to the influx of third-party capital. Lancashire has clearly remained agile and opportunistic ensuring the best risk-adjusted return for shareholders.

Saltir and Kinesis vehicles achieve the same end. Rather than allocating capital to a specific category these vehicles aim to construct a diversified portfolio of cat and non-cat risks. Underwriting for these funds is separate from the Lancashire although the reputation of Lancashire is clearly a significant selling factor. Lancashire Capital Management earns an administrative fee, a performance fee based on outperformance beyond an ROE target, and the profit retained from its own investment in the vehicle. JP Morgan estimates the return on investment for Saltir is 25% without the performance fee. The expectation is that in a few years Capital Management will add two or three percentage points to the group ROE.

Lancashire has shown the flexibility to keep moving with the times in building Lancashire Capital Management. Equally, Lancashire continues to exit those businesses in which it fails. In 2012, it wound down the D&F and retrocession lines. Each choice was quite difficult; D&F in particular as the decision was not driven, as much as retro, by external conditions. Rather, the investment in people and resources into D&F failed. In this context, the acquisition of Cathedral looks more understandable. Lancashire exited D&F but bought into Cathedral which can and has made money in D&F. The acquisition, I believe, highlights the flexibility of Lancashire to keep moving with the times.

Summary

At this price, Lancashire offers a great risk-reward trade although will not surprise dramatically to the upside (i.e. mid-teens returns) whilst it continues to fight against a softening market in a lot of its lines. The company is showing a capacity to keep moving with the times and analysts, generally, appear to be overly pessimistic. It is clear that after $720m of GWP last year, the boost driven by property retro, that Lancashire will have to shrink. Property cat, the company argues, will be more sticky and its not a commodity like retro but it won’t fill the gap that exiting D&F and retro has left. Despite this, the move into property cat, the acquisition of Cathedral, the build up at Lancashire Capital Management, and the addition of some new lines (like energy liability and obligor) worth just under 10% of NWP suggest that Lancashire will keep moving with the market. The acquisition of Cathedral is not a sign of weakness but a recognition that times are changing. This flexibility and willingness to change rather than stick with what is comfortable is tremendously important. On the basis of this performance, I think investors should take advantage of any declines in Lancashire shares from this point.