Shares outstanding (fully diluted): 8.4 million.
Market Cap: $105.4 million.
2009 EBIT: $22.69 million
2009 EBITDA: $30.85 million
2009 P/E (adjusted): 6.4X
2010 forecast (adjusted) P/E: 5.1X
The life insurance industry actively sought out risk in the past decade; investors paid a dear price.
In the 1990’s, the majority of North American and European lifecos were relatively capital rich, but prospect poor. Propelled by fears of banks moving into traditional insurance markets, the life insurance industry proceeded to fully participate in a roll-up and consolidation orgy. Initially, lifecos used low yielding internal capital for early cycle acquisitions. This was generally supplemented with balance sheet cash from the takeover targets. Forms of Inexpensive capital were fully exhausted by the midpoint of the last economic cycle. Late cycle activities were largely paid for with significant debt, equity underwritings and the selling off of fixed assets.
A reasonably straightforward industry has now become hopelessly complex. Balance sheets at many of the larger firms are sufficiently opaque that both seasoned analysts and credit agencies alike, find it impossible to assess the level of aggregate risk inherent at any specific firm. To the chagrin of investors, investment analysts and credit rating agencies have largely fallen prey to the “trust our assumptions, as we know our industry far better than you” verbiage issued by management of leading multi-line lifecos.
Many investors now consider insurance firms as value propositions. Those who seek to bottom-fish should carefully consider the investment merits, and demerits, of the industry as a whole. Insurance firms, even more than banks, possess a canny, yet legal, ability to mask a wide variety of poorly thought out business decisions, investment ills and money losing operations, through the machinations of actuarial assumption. Only in the insurance industry, can a firm convert a real pension fund decline to an assumed increase, simply by changing actuarial and interest rate assumptions for the better. There is an element of arbitrariness inherent in actuarial assumptions; one that is extremely well understood in insurance circles, while remaining virtually unknown to the investing public.
Relying upon positive investment reports and articles (including this article) to support a confirmation bias might be folly indeed. In practise, the life insurance industry earns diminutive returns on assets. When the low returning life insurance industry diversified into direct asset management, bottom line waters became further muddied. This was due to the fact that the investment management industry features a relatively unique, and highly unattractive operating model featuring both high fixed costs as well as high variable costs.
Companies with high fixed costs often endure terrible losses during periods of economic decline.
Companies with high variable costs, in contrast, often fail to capture appropriate returns during periods of economic expansion. The industrywide shift into money management, by lifecos, added a variable cost structure onto a staid business. During periods of positive investment performance, investment managers earn a disproportionate amount of the revenue. Over and above base salaries, asset managers are commonly entitled to bonus pools equalling 20%-25% of pretax profits A healthy percentage of what little profit remains is often ladled out, buffet style, to management and key executives. Asset management, to the chagrin of investors, tends to enrich managers, not the underlying shareholders.
Such a low yielding asset model requires (for the most part) enormous capital leverage to produce notable returns for shareholders. EV/EBITDA ratios, and other conventional valuation analysis, tend to fail miserably when assessing potential valuations for life insurers. This is due to the fact that lifeco balance sheets are overloaded with liabilities; cash positions are usually modest. As with banks, insurance stocks, for the most part, are no longer suitable for widows and orphans.
Despite a passion for obfuscation, capital market activities at insurers over the past 24 months have clearly separated the wheat from the chaff.
A VERY clear demarcation now exists between the weak and the strong insurers. At the risk of creating a false dilemma, weak firms stick out like a sore thumb, both by their capital actions, and by their prominence in the media.
Weak insurance firms are those who were forced (sic “chose to avail themselves of opportunities in capital markets”) to raise substantial equity, or to sell assets, during the period of sub-par global growth. Such capital undertakings, done at or close to market lows, will wind up diluting growth prospects down the road.
Many of the firms who bought high, and those who sold assets or raised capital at the low, remain heavily leveraged on an absolute basis. While some are no longer acutely ill, their conditions may remain chronic. These lifecos will be forced to rely on future profits to repair currently distressed balance sheets, rather than increasing dividends or expanding operations organically. This impacts the business model. Customers who insist on doing business with strong insurers may gradually shift business from the weak, as policies come up for renewal.
Some strong insurers do exist. These companies quietly go about their business, don’t covet media attention and accordingly, don’t receive accolades. The strong remained conspicuously absent from the flurry of equity raisings during the recent economic slowdown. Rather than acquiring market share, well run firms grow through hard work. It is from these insurers, that I seek a potential opportunity, for participation in the current economic cycle. A capital rich lifeco, in the current economy, should be able to organically expand operations, increase dividends and prudently serve the long term interests of shareholders and customers.
One very obscure and very well run lifeco, is BF&M.
BF&M (formerly known as Bermuda Fire and Marine) is a Caribbean multi-line life and property insurance company. Subsidiaries provide general insurance, health and life insurance, pension administration, asset management and real estate management. Operations are concentrated in Bermuda, Bahamas and Barbados. With net revenues of $206.6 million in 2009, it is a minnow in terms of size. That said, BF&M has the leading market share in both Bermuda and Barbados. Financial strength of BF&M is rated “A” by A.M. Best. At mid-point in the decade, the rating was A-. This is one of the few insurers, in the world today, that had experienced a credit rating upgrade, over the economic "peak to floor" cycle.
Bermuda and Barbados are two Caribbean economies that offer relative stability and superior historic growth rates to that of the US and Canada.
Bermuda is small, affluent nation. In 2000, GDP per capita was $31,200. Bermuda’s GDP per capita is now $69,000 US per person, the 3rd highest on the planet. The average price of a detached home in Bermuda exceeds $1 million.
Barbados is one of the more steadily growing nations in the Caribbean. GDP increased from $11,200 per capita in 2000, to $18,500 per capita in 2009, an annualized growth rate of 5.1%.
BF&M has primarily grown through organic initiatives, augmented by a few selected acquisitions.
Purchases have primarily been bolt-on and located in Bermuda and Barbados. In 2004- 2005, BF&M acquired the Bermuda group and personal life insurance business of Canada Life and Sun Life Assurance.
At the start of 2006, BF&M acquired 51.7% of the Insurance Company of Barbados Limited (ICBL) from the government of Barbados. The cost to acquire majority control of the leading general insurer in Barbados was $26 million. At the time of purchase, ICBL was unprofitable.
In 2006, BF&M invested $22.5 million to create and capitalize Bermuda International Insurance Services Limited and Bermuda International Reinsurance Services Limited.
ICBL and the real estate subsidiaries are represented on a consolidated basis.
BF&M consolidates 100% of the assets and revenues of both subsidiaries on its books, and then backs out a minority interest, as a liability, on the balance sheet. In 2005, the government of Bermuda’s 48.3% share of ICBL was valued at $23.63 million. The 40% interest in the two commercial properties was valued at $4.85 million in 2005. In total, the non-owned interests were valued at $28.48 million.
At the end of 2009, the minority interests were valued at $40.76 million.
From 2005-2009, BF&M generated net earnings of $14.11 US per share.
Since 2005, shareholders equity has grown to $173.78 million, up by $88.78 million ($10.60 per share) since December 31st, 2005. Book value has risen to $20.73 per share, an increase of $7.44 per share over the past five years. Goodwill and intangible assets represented $21.1 million of reported book value at year end 2009. As of March 31st, 2010, tangible book value was $18.21 per share.
Net cash dividends paid to shareholders over the past five years have totalled $3.28 per share. In 2008, BF&M issued a 1 for 10 share stock dividend, in addition to paying the regular $.80 per share dividend. Common share dividends have exactly doubled since 2000.
BF&M has a growing source of income from commercial real estate.
In addition to owning its head office outright, BF&M holds a 60% interest in two other commercial properties in Bermuda, the Ace Tempest Building and Argo House. BF&M generated $4.8 million of rental income in 2009, up from $4.2 million in 2005. Up to $1.92 million of annual rental income should belong to the 40% minority partners.
The book value of the real estate and land, at year end 2009, was $51.1 million. As per the 2007 appraisal of the commercial real estate, estimated market values of the portfolio are $95.5 million. A maximum of $18.2 million of the difference between the appraised value and the potential market value of the properties belongs to the 40% minority interest partners. The remaining amount of mortgage on commercial properties is less than $5 million.
BF&M’s accounting of commercial real estate differs greatly from Canadian peers. In Canada, there are no “hidden” values in the form of undervalued commercial real estate. Lifeco’s in Canada are allowed to move carrying values of owned properties to market, at the rate of 12% per annum.
Segregated fund assets are growing rapidly.
At year-end 2009, segregated fund assets totalled $579.4 million, up from $505.1 million at year end 2008. Segregated funds with no minimum rate of return represented 58.1% of assets under administration, up from 56.1% in 2008.
In 2005, segregated assets under administration totalled $374.2 million.
Fiscal 2009 marked the low point for BFM’s overall profitability, in the past decade.
For the past ten years, BF&M produced an average return on assets (ROA) of 4.08%. In 2009, the ROA was 2.76%, a full 32% below the ten year average.
For the past decade, BF&M earned an average return on equity (ROE) of 19.48%. In 2009, the ROE was 12.06%, or 38% lower than average
2009 reported earnings were down by 11.7% over 2008 figures and were greatly impacted by a number of one-time costs.
BF&M uses a conservative version of Canadian GAAP, and reports all figures in US dollars. The pending adoption of IFRS accounting standards in 2011 made a considerable amount of software redundant. Hence, the decision was made to write off $4.6 million of software costs in 2009, rather than amortize them over time.
An unrealized $3.4 million loss was also reported on the investment portfolio in 2009.
In conjunction with the write-off of software, 2009 operating expenses increased by more than $1 million over the prior year. This was required to harmonize historic financial statements with International Financial Reporting Standards (IFRS) scheduled in 2011.
Despite the subpar 2009, historic growth rates at BF&M have been impressive.
Over the past decade, gross insurance premiums grew from $69.5 million to $225.5 million. Net insurance premiums have grown from $51.2 million to $163.5 million.
Property and casualty insurance premiums have grown by roughly 50% over the past five years. Profitability has been very consistent in this division, averaging roughly 30% of revenues.
Health, life annuity and pension revenues have grown by roughly 56% over the past five years.
In 2009, the Barbados subsidiary, ICBL, produced net profits of $4.9 million, or 25% of the corporate net. At the time of acquisition, ICBL was seriously undercapitalized and moderately unprofitable. The capital infusion and discipline brought about by BF&M management has produced exemplary results. ICBL had recently achieved an A- rating by A.M. Best. $36.2 million of the 2006-2009 revenue growth was attributed to the acquisition of ICBL.
Insurers were hit hard in 2008-2009 for fears of subprime mortgage exposure and credit default swaps; more recently they have also been sold off by investors for fears of exposure to PIGS sovereign debt.
BF&M had no exposure to US subprime mortgages in the downturn, nor does it have any exposure now. There are no CDS on the balance sheet. All mortgages in the portfolio are first mortgages, issued in Bermuda and Barbados.
European insurance firms, in particular, are currently under pressure to confirm degrees of exposure to bonds issued by the nations of Portugal, Italy, Greece and Spain. Several US and Canadian firms with substantial European operations also have been impacted.
At year-end 2009, BF&Ms bond portfolio had a total of 97% of its bonds issued by governments or corporations located in the US, Barbados, Canada, Germany, Britain, and the Caribbean. Less than $5 million of the total bond portfolio is held outside of these jurisdictions. It would appear that any direct exposure to PIGS (be it sovereign or corporate) is miniscule, if present at all.
Life insurers, across the board, were most heavily impacted by potential segregated fund liabilities throughout 2008-2009.
Any lifeco with substantial guaranteed principle, or guaranteed minimum return segregated funds, find themselves under scrutiny. BF&M, as an issuer of segregated funds, carries the same industry risk as other operators. This risk was ignored by insurance investors during the last economic upturn. It remains foremost in shareholders minds today. Should a broadly based extended economic upswing continue, fears for the solvency of insurers will abate. Furthermore, potential liabilities, in a worst case scenario, will run down as segregated pools age and agents are instructed (by head office) to work diligently and convert guaranteed pools to non guaranteed product. New fund pools are much less generous with guarantees.
BF&M generated returns on assets, in tough conditions, that large insurance firms proved unable to duplicate at economic peaks.
BF&M had generated normalized returns on assets of 4.25% over the decade 2000-2009. In 2009, the return on assets was just 2.76%, after write-offs totalling $8 million. The 2009 charge off did not impair the future earnings potential of BF&M in any way. No income generating assets were eliminated, no business lines were divested. No equity was sold to buttress the balance sheet. Absent one-time items, BF&M’s return on assets for 2009 was a solid 3.76%.
Investors might consider a 2.76-3.76% return on assets in a sluggish time, and normalized returns on assets of 4.25%, to be low. BF&M is one of the few lifecos in the world that proudly displays the return on assets in annual reports. Most insurance companies try their utmost to assess capital returns in other ways.
It may be effectively argued that Lifecos operate with perhaps the very worst business model in existence.
Who would place capital into an industry that has proven incapable of generating a full cycle return on assets of at least 2%? As a frame of reference, perhaps compare BFM to the following peers: Sun Life, Manulife, Great West Life and Torchmark.
Sun Life Financial (SLF-NYSE, $28.51) generated a 2.3% return on total assets in 2007, the peak earnings year. In 2009, SLF earned less than a .5% return on total assets. Manulife (MFC-NYSE, $15.81) generated just a .75% return on assets for 2009. Great West Life (GWO-TSX $24.48 Can.) is arguably considered to be the best run among large Canadian insurers. The return on assets, for 2009, was 1.71% at GWO.
Torchmark (TMK-NYSE, $52.05) is considered by many to be an exceedingly well run US insurer. Revenues at TMK have grown by 3% (.6% per annum) since 2005. This company has been steadily selling off much of its commercial real estate portfolio to book short term gains. In turn, TMK leases back space, which increases future expenses. In 2009, TMK generated a 2.5% return on assets. Shareholders’ equity was 21.2% of net assets in 2009. Unfortunately, goodwill, intangibles and deferred amortization at TMK represent 24.2% of net assets, fully exceeding shareholders equity. Torchmark sells for 10.7X trailing 2009 earnings.
My 3 year business forecast for BF&M is as follows.
A. The steady state forecast assumes that operations continue to be as poor for the next 3 years, as were evidenced in fiscal 2009. In 2009, asset growth was 5.6% and the return on assets (after write-downs) was 2.76%. Should this persist, at year end 2012, BF&M could earn $23.77 million ($2.83 per share) on assets of $861.4 million. Forecasts 2012 year end book value could be $25.89 per share, and tangible book would be $23.4 per share.
B. The base case forecast assumes 36 month annualized asset growth of 5.6% and a return on assets of 3.2%, the same return generated in 2008. By year end 2012, BF&M could earn $27.6 million ($3.29 per share) on assets of $861.4 million. 2012 year end forecast book value could be $27.18 per share, and tangible book would be $24.66 per share.
C. The bullish case forecast assumes 36 month annual asset growth of 7.6%, which matches the sequential Q1, 2010 growth rate. This remains below the level of asset growth generated from 2000-2008. The return on assets improves to the historic rate of 4.25%. By year end 2012, BF&M could earn $38.7 million ($4.61 per share) on assets of $911.2 million. If the dividend rate increases from $.8 to $1.00, by the end of the forecast period, 2012 year end book value could be $30.42 per share. 2012 year end tangible book value could be $27.9 per share.
Under any of the three scenarios envisioned, BF&M’s common equity asset coverage could improve markedly. 2012 year-end tangible equity could range from 22.8% of total assets (steady state), to 24% of assets (base), rising to as much as 25.6% of assets in a bullish scenario. Even in a world with more stringent equity capital requirements, BF&M would clearly be an excessively capitalized insurer.
Under any of the three scenarios, BF&M’s balance sheet should be sufficiently strong to undertake expansion initiatives ranging from $24-$50 million in total investment, while all the while maintaining tangible equity coverage at 20% of assets. Should positive results persist, a dividend increase seems likely.
Fundamentally, on both a relative and on an absolute basis, BF&M looks very inexpensive.
Multi-line Canadian listed insurers are presently selling for an average of 11.8X 2010 forecast earnings. The average Canadian insurer currently trades for an average of 1.5X book value per share (not adjusted for goodwill and intangibles).
Great West Life (GWO-TSX) reported equity, as a percentage of total assets to be 13.1%, for 2009. However, intangibles and goodwill accounted for 51.3% of GWO total equity for 2009. Preferred shares and non-traditional equity represented a further 15.6% of capital at year end. EBITDA margins were 7.1% for 2009.
Sun Life Assurance (SLF-TSX), reported equity, as a percentage of total assets to be 14.5%. Intangibles and goodwill make up 42% of common equity. EBITDA margins were less than 1% in 2009.
Manulife (MFC-NYSE) reported equity, as a percentage of total assets, to be 14.1%, intangibles and goodwill make up 31.6% of equity. Tangible capital represents just 9.6% of total assets. There was no reported EBITDA for 2009, and therefore no margin.
US P&C insurers sell for roughly 10X 2010 forecast earnings and 1.1X book value (not adjusted for goodwill and intangibles.
European and British international lifeco’s sell for roughly 7.9X 2010 forecast earnings and .85X book value per share, not adjusted for goodwill and intangibles.
If rules regarding intangible assets were tightened, even modestly, for the insurance industry, many firms would, once again, find themselve on the verge of bankruptcy. International regulators are keenly aware of the issue and likely will not seek to greatly change rules on intangibles, for some time to come. The conequences of further tightening on insurers would be far too risky for global capital markets. The fact that regulators remain complicit with lifecos should not mean that we, as individual investors, should assume all to be well with the balance sheets of the industry at large. Many lifecos presently reported by Wall Street, Fleet Street and Main Street, as being well capitalized, would require a going concern qualification, if held to more exacting standards.
BF&M, in contrast to better known peers, sells for a TRAILING ratio of 6.42X 2009 earnings and .70X tangible book value (.61X reported book). BF&M’s common equity coverage is the highest class possible. With common equity coverage currently amounting to 23.3% of assets, even jaded/cynical analysts will be obliged to call this company well capitalized. There are no preferred shares, no hybrid securities and no corporate debentures carrying priority over BFM common shareholders. The substantial commercial real estate portfolio (almost 31% of 2009 book value) is largely unencumbered and has not been written “up” to enhance the balance sheet. I have no way of knowing if substantial off- book liabilities exist at BF&M; such uncertainties exist with every insurer in this day and age.
BF&M’s equity coverage represented 17.2% of total assets in 2005, immediately after the close of the ICBL purchase. Since that date, equity coverage has steadily risen. At the end of 2009, common equity as a percentage of total assets grew to 23.1%. As of March 31st, 2010, common equity as a percentage of total assets stands at 23.3%.
Minority interest accounting has the ability to mislead investors as to true underlying profitability of a company. If I was to change the accounting treatment of subsidiary investments to proportionate interest, rather than the current total consolidation, net earnings at BF&M would fall, on a 2009 basis, by roughly $.40 per share. Accordingly, BF&M would have likely posted net EPS of $1.95 per share in 2009. This would have priced the equity at 6.41X 2009 earnings. The stated dividend would have been 41% of net earnings.
One time write-downs reduced BF&M’s 2009 pre-tax earnings by more than $.96 per share. The increase in operating expenses to prepare historic reports in accordance with IFRS reduced pre-tax earnings by a further $.12 per share. Absent the non-recurring charges and backing out the minority interest earnings, BF&M would have posted 2009 earnings in the range of $2.7 per share, an improvement over 2008
Should my 36 month forecast bear out, shares of BF&M offer upside potential.
The current marketplace valuation assumes BF&M is less than a going concern. If the entire business was closed and real estate sold off, the profitable life insurance and P&C businesses would be have to be valued at less than zero to equal the current share price. This represents a quantifiable disconnect; BF&M produces profit margins that, if more widely reported, would appear to be the envy of the industry.
Provided that the general uproar about the solvency of PIGS abates and global economic growth continues, the insurance industry in general should recover. Offsetting the positive macro outlook is a reality of higher capital requirements to support credit ratings. Capital issues will hold back earnings growth for the more aggressive (leveraged firms). Investment income streams and underlying performance of the portfolios can no longer be “smoothed” out to the same degree as in the prior decades, based upon changes in mark to market rules.
In contrast to weak peers, BF&M has strong and improving capital ratios. BF&M generated $30.85 million of EBITDA in 2009, for a margin of 14.9%. 2009 adjusted EBITDA was the second best year on record.
This insurer did NOT raise dilutive equity during the years 2008-2009. Asset growth continues at a healthy pace. The balance sheet of BF&M is, for an insurer, quite clean and straightforward. The return on assets earned by BF&M, during a less than optimum operating period, dwarf what the vast majority of insurance companies generated at the 2006-2007 economic peak.
BF&M pays a current dividend of $.80 per share on an annualized basis. This dividend has recently been affirmed in the quarterly report. At $12.55 per share, a current gross yield of roughly 6.4% on invested capital is paid to shareholders, and seems well covered on the basis of trailing earnings. Based upon Q1, 2010 earnings, dividend coverage ratios have increased further.
There is both a philosophical and a practical obstacle confronting mainstream investors who contemplate ownership of quietly successful companies.
Many investors wish to own a “hidden value”; all the while they simultaneously demand voluminous supporting coverage from mainstream brokerage firms, so as to affirm their initial thesis and support their confirmation bias. This represents an oxymoronic conundrum that will remain, forever unsatisfied, for the majority of investors.
A surprising number of retail investors also expect to find an illiquid business, purchase it for their account, and immediately require the firm to metamorphasize into a liquid and actively traded security. More often than not, such illiquidity usually just metastacizes, trapping yet onother investor. In reality, most tend to buy a lightly traded stock and in doing so, merely drive up the price temporarily. When patience is exhausted, their accompanying sale tends to drive down the price.
The blog model portfolio is purchasing shares of BF&M on the Bermuda Stock Exchange today.
A total of $18,249 US has recently been credited to the account, from dividends on the portfolio of securities. This will be used to purchase 1440 shares of BF&M at the current price of $12.55.
I am also personally purchasing shares of BF&M for the very first time. The stock is highly illiquid now. It will be prove challenging to sell during in a period of adversity. Accordingly, BF&M will certainly not be a desirable investment candidate for those who require "ready and real" bids, even over the mid-term. The BFM website is one of the few, in a capital mad insurance business, that does not feature a corporate presentation. This company is certainly not looking to promote the existing business to potential new shareholders.
http://www.bfm.bm/about/index.html
Despite the dividend yield, as previously mentioned, insurers no longer represent investments for widows, orphans or the impatient. However, BFM's high and well covered current dividend yield provides me with a rationale to add this business to my long term collection of securities. I am quite willing to let the structural illiquidity issues of microcaps metastacize over a portion of my account. Accordingly, this purchase has neither an exit strategy nor an exit timeframe.