Description

GLRE is a Cayman Islands-based reinsurance company that was founded in 2004. Unlike most (re)insurers, which invest their assets predominantly in fixed income securities, GLRE’s assets are invested entirely in a long-short strategy run by the advisor to the highly successful Greenlight Capital hedge funds. GLRE’s investment account is run pari passu with the Greenlight hedge funds. The underwriting operations have attractive features, but it seems too early to assess whether the company is likely to achieve its goal of underwriting profitability. However, the degree of underwriting risk is mitigated by low investment leverage and a high proportion of frequency business.

GLRE trades for 1.1x the December 31 book value, which is below the historical average of about 1.3x. However, since yearend, the investment account (results of which are reported monthly at http://www.greenlightre.ky/?q=node/142) is up 6%. Based on yearend investment leverage of 1.3x, it can be inferred that book value is likely to have grown by nearly 10% since December 31, assuming no underwriting losses in 2012. The resulting implied P/B multiple is only 1x.

Investing operations

GLRE is in large part an investment in the continued success of Greenlight Capital, which creates a level of opacity that makes many investors uncomfortable. Moreover, an investment manager may experience a certain amount of cognitive dissonance when contemplating investing in a stock that is largely a bet on another investment manager. This situation is exacerbated by the fact that the advisor to GLRE’s account extracts a 2% / 20% fee structure.

An objective view of the situation, however, would focus on the investment account’s prospects for returns net of fees, which appear excellent. The original Greenlight Capital fund has had an annualized net return of approximately 20% since inception in 1996. Its worst (and only down) year was 2008, when it was down 22.7%; however, the losses were made up the following year, in which the fund was up 36.9%. Greenlight practices value investing on both the long and the short side. The portfolio is concentrated in the best ideas, and there is minimal or no use of leverage. In recent years, Greenlight has added macro overlays, such as gold and interest rate call options, as hedges.

I believe that Greenlight’s investment success is likely to continue, because the factors underlying its past performance—such as talent, knowledge, experience, idea flow, and investor loyalty—are self-reinforcing. On the other hand, there is a headwind, which is that assets under management have steadily increased, recently reaching $8 billion. As discussed below, even if performance is significantly below the historical 20% net per year, GLRE’s book value compounding could still be attractive.

Underwriting operations

It is difficult to evaluate underwriting prowess in the absence of a track record that spans at least one full industry cycle, which, as a young company, GLRE lacks. However, the company does possess an unusual and promising characteristic, which is that unlike nearly all (re)insurers, employee incentives are aligned with the goal of producing underwriting profit. Quoting from the most recent proxy statement:

The calculation of the quantitative bonus pool is deferred for two years following the end of the applicable underwriting year because we believe that short-term results are not an accurate indicator of any contract’s performance. Thus, subject to the requirements of Code Section 457A, calculations are scheduled to be made with respect to the 2010 underwriting year on January 1, 2013 and payments made in calendar year 2013. As such, the employee’s receipt of the quantitative portion of his or her bonus is deferred until we can better determine the actual performance of the reinsurance contracts bound by us during such year. We believe that this is unique in the reinsurance business and helps us better align the interests of management and shareholders by paying bonuses once the business develops instead of based solely on initial accounting of results.

The majority of the each senior executive’s bonus in any given year is derived from the actual return on equity produced by the contracts underwritten in that year. Moreover, there are no implicit or explicit volume targets at GLRE—another highly unusual practice. I believe that the rational bonus structure and the absence of perverse volume incentives should bode well for the underwriting operations.

GLRE’s early results are encouraging. The most common measure of underwriting performance is the “combined ratio,” which is the ratio of expenses to earned premiums. As a whole, the insurance industry loses money on underwriting (implying >100% combined ratios), because of intense price competition. The years since GLRE’s inception in 2004 have seen one of the worst pricing environments in history. Moreover, for much of this time, GLRE’s the internal expense ratio (corporate overhead / earned premiums) was abnormally high, but has declined as the business has scaled:

                                                2004   2005   2006   2007   2008   2009   2010   2011

Earned premiums ($ mil)    0          0          27        98        115     215     289     380    
Internal expense ratio          NA      NA      34%    12%    12%    9%      6%      4%     

Despite these headwinds, GLRE has produced a cumulative combined ratio since inception of 101%--nearly breakeven. This is early evidence that GLRE’s unique underwriting approach may prove to be effective over the long term.

Further mitigating GLRE’s underwriting risk is its low level of investment leverage as compared to most (re)insurance companies. Stated another way, GLRE writes relatively little reinsurance relative to its capital base. While the reserves (the estimate of future insurance claims associated with policies written) of a typical (re)insurer amount to several times its equity base, GLRE’s current reserves are only 30% of its equity base. Moreover, GLRE has stated that reserves will not exceed 75% of equity.

Finally, GLRE provides disclosure about its loss exposures to natural peril events. Most recently, the company’s maximum exposure to a single event amounted to 8.8% of book value, and its maximum exposure to any series of events amounted to 12.3% of book value. While it would be painful to sustain such losses, it would not put the company in jeopardy.

Compounding

While Greenlight Capital has historically produced a 20% net return, recent results have not been as good. The following are the returns of GLRE’s investment account since 2005:

2005                           14.2%
2006                           24.4%

2007                           5.9%
2008                           -17.6%

2009                           32.1%
2010                           11.0%
2011                           2.1%

The annualized return during the period was 9.2%.

The key to the power of GLRE’s business model is that its investment returns are leveraged by the float, which is the policy holders’ money that is temporarily held by the company before claims must be paid. The ratio of total assets to equity is known as “investment leverage.” The ROE produced by investing activities is, therefore, given by the following formula: ROE = ROA x investment leverage.

The benefit of investment leverage is evident in GLRE’s book-value-per-share compounding since 2005 of 12.3% (as compared to the investment account’s annualized return of 9.2%). Yearly changes in book value per share are shown below:

2005                           13.9%

2006                           22.7%
2007                           16.1%
2008                           -19.2%

2009                           41.5%
2010                           12.9%
2011                           1.0%

Most recently, investment leverage stood at 1.3x. This figure should move higher through continued growth in the insurance book and, eventually, improving market conditions. Over a full business cycle, it seems reasonable to expect investment leverage to average somewhere between the current level and the stated maximum of 1.75x. If we assume 1.5x, then a 15-20% ROE is possible even if investment returns never recover to Greenlight’s historical levels.

Catalyst