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Shooting fish in a barrel for profit

There are many terrible tales about insurance firms that got caught in the credit crisis. This advisory tells us about one that went straight.

“Making money in the insurance business is akin to shooting fish in a barrel. Everyone needs insurance, and as long as providers adhere to conservative underwriting standards, premiums flow in with little risk.”

Well, as we now know in the wake of the credit crisis, many insurance companies didn’t manage to hit a single fish.

As for the biggest of them all, AIG, we’re not sure what they were aiming at, but a whole lot of bystanders (innocent and otherwise) got caught in the crossfire.

We also know that while Canada’s biggest insurance firms initially claimed to be straight shooters, they got caught with more than a few barrels of rank-smelling fish as well.

At least one company got it right. The story is told in the latest issue of Louis Rukeyser’s Wall Street. The quote we opened with comes from this advisory’s editors.

Mr. Benjamin Shepherd, who now sits in the editor’s chair in place of the late Mr. Rukeyser, tells us about the company that could shoot straight.

It is Chubb Corporation (NYSE-CB) and it has prospered in the old-fashioned way — by giving up something that was bad for it.

The hot potato

Chubb made its reputation by taking a very conservative approach to business. It has been very careful in both its underwriting and its investments.

Enter that ticking time bomb, the credit default swap. In the simplest terms, this means selling credit with the seller getting the risk off his own books but still having to guarantee the worthiness of the credit to the buyer (there are many different variations with different contracts and conditions, of course).

In practice, it means throwing a burning hot potato around until somebody’s hands get seared.

AIG hot-potatoed itself into the poorhouse. Chubb made a brief foray into these contracts, says Mr. Shepherd, and then got out “after finding it too difficult to assess the risk the contracts posed.”

Think about it. They actually decided that if they couldn’t figure it out, they wouldn’t do it. While others in the financial world were rubbing their hands and saying: “Don’t explain it to me, just show me the money.”

(Do you suppose Chubb’s executives gave themselves bonuses for not doing the wrong thing?)

Even so, the sailing hasn’t been entirely smooth for Chubb.

Plain vanilla

No matter how conservative anyone’s portfolio has been over the past year, it is still liable to have been undermined by the crisis. And that has been the case with Chubb.

“But unlike many other insurance companies, Chubb has zero direct exposure to subprime mortgage-backed securities,” says Mr. Shepherd. “Its investment portfolio consists primarily of plain-vanilla stocks and bonds, a collection that’s in line with the company’s focus on generating underwriting profits rather than portfolio returns.”

Of course, during the boom years, Chubb’s conservatism made it the wallflower among insurance stocks. Investors flocked to what the editor calls “the high-flying Icaruses” (that’s the wayward son in Greek mythology who flew to close to the sun and had his wax wings melted).

But that also means Chubb is now poised to move up from its position as America’s eleventh largest property and casualty insurer while the others try to re-wax their wings.

Hurricane Ike

Chubb had a bad news-good news balance sheet last year. Net written premiums decreased 1 per cent as premiums fells by 3 per cent overall.

Overseas premiums rose by 6 per cent, but this was partially offset by currency complications due to the strong U.S. dollar. Hurricane Ike blew some ill winds Chubb’s way as well, pushing expenses and claims up.

Combine all this with investment losses, and Chubb’s net income was down 36 per cent and operating profits down 5.5 per cent.

But now Chubb is ready to profit from its prudent behaviour. For one thing, says Mr. Shepherd, “given its size and relative strength, Chubb finds itself in a position to poach business from its weaker peers.”

Meanwhile, premium rates in the industry are expected to improve. Natural catastrophes will push up commercial and residential rates, while the man-made catastrophe of the financial crisis will push up professional liability rates.

Strong financial shape

Chubb is in strong financial shape, says Mr. Shepherd. Its debt is less than the industry average and its valuation looks very attractive. It trades at a very low 1.1 times book value.

The company’s conservative investment portfolio offers $40 billion in liquidity and $2 billion in cash. Combine that with a low payout ratio and its quarterly dividend of 35¢ looks very secure.

“Steady income and moderate growth potential make Chubb an excellent company for a wide range of investors,” concludes Mr. Shepherd.

Our conclusion is that if more financial firms had behaved like Chubb, we might not be so deep in this mess. On second thought, we’d rather not think about it.