Description

GLRE has been written up several times on VIC, however, the intrinsic value of its business model has not been adequately explained or quantified.  As previous posters highlight, GLRE is best understood as a hedge fund in disguise as an insurance company.  This is because 100% of GLRE’s investment portfolio is managed by David Einhorn’s investment manager, DME Advisors, in the exact same long-short equity strategy he uses to manage his hedge fund, Greenlight Capital (GL Cap).  In other words, GLRE’s investment portfolio will be nearly identical to that of GL Cap at any point in time; comparing investment returns of GLRE to GL Cap over the years (http://greenlightre.ky/?q=node/155), we see they differ by only a small rounding error.  But if GLRE were really just GL Cap in disguise, we would also expect its earnings power to be the same as GL Cap’s (GLRE pays virtually no corporate taxes).  But comparing GLRE’s ROE to GL Gap's ROI, we see below that GLRE has significantly outperformed GL Cap over time especially in good years like 2009.

In this write-up, we explain why GLRE’s ROE has and will continue to significantly exceed GL Cap’s ROI.  We will also explain three other reasons an investment in GLRE is superior to one in GL Cap.  Together, these four structural advantages – float, taxes, daily liquidity and multiple expansion – mean GLRE can generate healthy double digit ROEs even if Einhorn simply matches the SPX.  If Einhorn comes anywhere near the 19% annualized ROI he has generated at GL Cap since inception in 1996, GLRE will prove to be a rare investment opportunity.  In our base case projection, we assume he generates a 12%, which after pluggin in three other assumption, translates to a 17% ROE.

We conclude the write-up by comparing an investment in GLRE to one in GL Cap from a US taxpayer’s perspective in order to estimate GLRE’s intrinsic value.  Cutting to the chase, we believe a US LP of GL Cap with a 15-year investment horizon should be willing to pay approximately 2.8x book value for GLRE compared to its current trading levels of about 1.1x.  If you don’t think highly of Einhorn’s investment skills, consider the following.  A pedestrian 8% annualized return on GLRE’s investment portfolio (compared to 19% for GL Cap since inception in 1996) is the equivalent to you generating 14% returns in your PA.  This 6% excess return is GLRE’s “structural alpha”.

Advantage #1: the Float

For those new to the insurance business, we will let Warren Buffett explain:

“Invested assets of insurance businesses derive from shareholder capital as well as funds provided from policyholders through insurance and reinsurance business ("float"). Float is an approximation of the amount of net policyholder funds available for investment.”

Float is really just a loan from policy holders.  It allows insurance companies to invest significantly more capital than their shareholders’ equity without incurring traditional debt and, thus, magnifies investment returns.  GLRE is still in the process of ramping up its insurance business and building its float.  Indeed, GLRE’s investment portfolio has averaged just 125% of equity value – or 25% “float” – over the last six years compared to GLRE’s stated goal of 175% – or 75% float.  Current float for GLRE is about 40% meaning, all else being equal, you can expect GLRE’s ROEs to exceed that of GLCap by 40%. Back to Buffett:

“The increases in the amount of float plus the substantial amounts of shareholder capital devoted to insurance and reinsurance activities have generated meaningful increases in the levels of investments and investment income over the past five years.”

While float is similar to a loan, it has two unique and very valuable characteristics.  First, it has no maturity date as long as you keep writing premiums.  While banks may be unwilling to lend an insurance company money after a few poor quarters, policyholders are unlikely to stop needing insurance.  This is good for Einhorn as he is unlikely to get a margin call on his float.  Second, while no one would ever lend you money at a negative interest rate, it is entirely possible that the float’s “cost” is negative.  When an insurance company’s combined ratio (premiums less expenses and insurance losses) is less than 100%, the “interest rate” on the float is negative.  Berkshire Hathaway has enjoyed nine plus consecutive years with a sub-100 combined ratio.  Unfortunately, GLRE is unlikely to mimic Berkshire’s stellar underwriting performance.  After averaging a 91% combined ratio (pro forma using current expense ratio as expenses were higher during ramp up) for its first six years, GLRE’s Q3 2012 combined ratio spiked to a frightening 143%.  The industry has historically operated at about 103% and we expect GLRE to be in line over time.

Advantage #2: Taxes

Most of GLRE’s underwriting is done from the Cayman Islands and, therefore, GLRE pays virtually no corporate taxes.  Thus, as long as you hold GLRE for more than one year, you will pay only long-term capital gains when you sell shares.  An LP in GL Cap will pay both long and short-term capital gains taxes.

Advantage #3: Daily Liquidity

Getting your money back from GL Cap or other funds takes time due to redemption limitations.  With GLRE, you can exit daily by selling your shares.

Advantage #4: Multiple Expansion

An LP in GL Cap can only redeem at NAV or book value.  GLRE is intrinsically worth significantly more than book value for the reasons we outline above.  As GLRE proves itself and its multiple expands, you will enjoy a one-time step up in share price that essentially pulls forward future investment gains.

Financial modelling with just four assumptions

1. Float: GLRE’s “float” averaged 25% of book value during the last six years.  Over this time period, float has grown at a CAGR of 25% and is now about 40%.  While float growth has stalled a bit, we expect that the float will continue to grow again as the insurance market hardens.  Despite the fact that GLRE is targeting a 75% float and has historically grown the float fairly quickly, let’s assume the runrate float is 50% of book value.
2. Return on Investment:  GLCap has generated 19% annual returns since inception in 1996 with only one year of negative returns.  In GLCap’s worst seven years ever (the last seven years), returns averaged 8%. We have assumed 12% as our run-rate ROI.
3. Earned Premium % of Capital:  Has averaged 32% and is currently 47%.  We assume 50%.
4. Combined Ratio:  We use the industry’s long-term average of 103%.

Drum roll please...

GLRE vs. GL Cap

Using the following assumptions, we compare an investment in GL Cap to GLRE over a 15 year time horizon:

• Base-case assumptions from my write-up:  GLCap generates 12% ROI (net of fees); GLRE generates 17% ROE
• Investors are US-based for tax purposes
• 50% of the investment gains of GLCap are short-term (taxed at 43.4%) vs. 50% long-term (taxed at 23.8%)
• 15 year investment horizon
• Exit at 1x Book Value

You can see below that in order to generate the measly 7.5% after tax returns of GL Cap, GLRE would have to trade at 2.8x book value (again, it trades at 1.1x currently pro forma for recent investment performance).

How we lose money: It’s really just math

We can lose if any of our four assumptions above prove overly optimistic.  Let’s start with the easy ones.  Management decides how much premium they write/earn and, as a result, the “float” size is largely under their control as long as their willing to move up the risk curve.  In addition, both of these assumptions don’t affect results directly.  Rather, they serve to amplify/leverage both investment returns and insurance profitability.  Two down, two to go.

In terms of return on investment, Einhorn runs a balanced book – currently, 104% long and 75% short.  GLRE’s compounded annual ROI of 9.1% since inception in July 2004 is an impressive 4% better than the SPX (Einhorn’s “alpha”) over the same period.  Furthermore, GLCap’s 19% compounded annual returns from 1996-2012 bettered the SPX by 12%.  While we have assumed Einhorn can only generate 3% “alpha” in our base case, let’s assume he can’t generate any alpha at all.  Using a 9% ROI (the long-term average for the SPX including dividends reinvested), GLRE’s ROE would fall modestly to 13%.

This leaves us with only one more place to lose: the combined ratio.  We must admit, given GLRE’s limited operating history and Q3 results, this is the assumption we have the least conviction in.  So how bad can things really get?  Let’s assume Einhorn substantially underperforms the SPX and can only generate 5% annual returns.  Furthermore, we will assume that GLRE’s insurance operations have a combined ratio of 110%, well above the P&C industry’s long-term average of 103%.  Keeping float and EP/Capital at 50% each, GLRE will still produce a positive 2% ROE.  Furthermore, if Einhorn can simply match the SPX’s 9% long term returns, GLRE’s combined ratio would need to breach 127% before GLRE loses money.  Ultimately, it’s all just math. 

Catalyst