Some specialty carriers trade at book-value multiples of twice or better, compared with multiples of approximately one-and-a-half times book value, or less, for many standard market insurers.

Long-term returns to investors from specialty companies such as Glen Allen, Va.-based Markel Corp. and Philadelphia Consolidated Holdings in Bala Cynwyd, Pa., have been nothing less than spectacular, exceeding 20 percent annually in the last 10 years.

Not for nothing do some insurers trade at twice their book value. The reason is underwriting discipline, deeply ingrained in the culture of many specialty carriers. The observable outcomes of disciplined underwriting are superior combined ratios and higher stock valuations.

For investors in these companies, the happy reality is that policyholders subsidize shareholders, which is exactly the reverse of what usually happens in the insurance industry. This is not lost on Mr. Market, who reacts by assigning higher valuations to good underwriters and lower valuations to poor underwriters.

To underwrite with discipline is easy to say but difficult to pull off, especially in soft markets. It means holding the line on pricing wherever possible, thoughtful risk selection (such as not confusing a tavern with a white-table restaurant) and the intelligent use of exclusions.

It means a willingness to walk away from underpriced business, while turning up the marketing dial to keep an acceptable flow of quality submissions.

And it means protecting the balance sheet in the down part of the cycle so that you can fully enjoy the fruits of the next up cycle.

In every successful insurance company that we've observed, senior management has instilled a disciplined underwriting culture all the way down to the individual underwriter level. To enter a contract with the expectation of an underwriting loss, even a small one that investment income will probably offset, will get you thrown off the island. This is a concept that many specialty insurers, but few standard insurers, seem to understand.

So what kind of business do these specialty companies write that makes them so different from standard companies?

They write unusual, complex or smaller risks, mostly in commercial lines. (On the personal lines side, personal lines giant Progressive Corp. in Mayfield Village, Ohio, is a notable specialty insurer.)

Although there is not enough room here to compose even a partial list of specialty products, such a list might include earthquake, directors and officers liability, environmental, transportation, small contractors, or summer-camp insurance–products that many standard carriers avoid. The analysis of these types of risks demands skill and experience not commonly found among junior trainees sitting in Hartford.

If you are an average or preferred personal or business risk seeking a commodity-like insurance product, a standard-market insurer probably provides your coverage. That market, while hardening, remains overly competitive.

Specialty insurers can range in size from American International Group in New York, down to the smallest single-state writer of workers' compensation coverage. Most specialty companies are small enough so that entrepreneurial owner/managers, often a company's founder or member of the founding family, can exert considerable influence on the company's culture.

Running a specialty insurance company is not easy. Remember Frontier, Legion, GAINSCO, Kemper, Caliber One and Acceptance?

Some of these were “hot” stocks at one point, but foundered due to lack of discipline, risk selection and overly optimistic management teams.

Getting back to stock valuation, growth in book value is the sine qua non for insurers, and underwriting is the most important, enduring way to grow book value. Investing and capital management are two other interrelated levers of book-value growth. The best companies are capable of using all three levers to increase book value.

Some companies, including Berkshire Hathaway, Markel and Fairfax Financial, are distinctly better investors than most of their peers.

Others, such as the Bermuda (re)insurers, are able to manage capital more effectively than many because of their natural tax and regulatory advantages.

However, no insurance company, no matter how good at investing or managing capital, will achieve long-term book value growth without good underwriting performance. Of further comfort to investors is the likelihood that disciplined underwriters are also disciplined at loss reserve practices, a big issue here in the early years of the millennium.

The charts accompanying this article support our thesis that investors recognize and reward superior underwriters.

The first chart shows that an unweighted basket of specialty insurers (including W.R. Berkley, HCC Corp., Markel Corp., Penn-America Group, Philadelphia Consolidated Holdings Corp. and RLI Corp.) produced, on average, a four-point combined ratio advantage over the broader S&P Property-Casualty Index in the period beginning in 2000 and ending in the first quarter of 2003.

The second chart shows that specialty insurance stocks outperformed the S&P Property-Casualty Index by a wide margin. One dollar invested in the basket of specialty insurers on March 10, 2000 (the day insurance stocks reached bottom and Nasdaq peaked) turned into $2.47 by June 30, 2003. The same dollar invested in the S&P Property-Casualty Index would have returned $1.82.

So far, our analysis is unambiguous: for long-term insurance investors, the winning strategy is to invest in specialty companies. That said, valuations of companies that otherwise carry only modest long-term prospects do from time to time provide compelling “trading opportunities.” Additionally, we would be remiss to ignore the rare standard market carrier that consistently delivers superb results, year-in and year-out.

Such an exception is standard auto insurer GEICO, whose underwriting discipline and focus on cost control overwhelm the commodity nature of the product it sells. In the five years before 1996, when Berkshire Hathaway paid two-and-a-half times book value to buy what it didn't already own of the company, GEICO's combined ratio averaged around 98 percent, book value increased by 16 percent compounded annually, and its stock appreciated by 17 percent compounded annually. Not bad.

From our perch as equity analysts, we frequently talk to professional investors looking for companies that can create significant wealth over long periods. On no one's list is found an insurer that can do it without an intensely focused underwriting culture.

If the commitment to underwriting profitability isn't there, then nothing else really matters.

John Keefe is the senior vice president for Ferris, Baker Watts Inc. in Baltimore.

Reproduced from National Underwriter Property & Casualty/Risk & Benefits Management Edition, July 21, 2003. Copyright 2003 by The National Underwriter Company in the serial publication. All rights reserved.Copyright in this article as an independent work may be held by the author.