30 years of Markel shareholder letters – Insurance, investing and the Markel Style

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Letters on insurance, investing and the Markel Style

Investing and insurance are similar in that it requires decision making under uncertainty and incomplete information. Companies that do both well tend to compound capital at enormous rates. One standout example is Markel Corporation. Following their IPO in 1986 as a small US special insurance company, Markel has since become a global conglomerate across insurance, industrials and investments. It’s a testament to their disciplined underwriting and investment process.

In 1986, Markel’s former Executive Chair Alan Kirshner wrote down the company’s principles and operating philosophy, known also as the Markel Style. The company has also prepared insightful shareholder letters every year since then. With Kirshner’s retirement in 2019, I decided it interesting and fitting to revisit their writings. This post will summarise the lessons that I took from three decades of shareholder letters from Markel in insurance, investing, business and management.

Skip ahead:

The nature of insurance

“Insurance and financial markets are volatile by nature and the volatility itself creates significant business opportunities for Markel”.

Markel shareholder letters

We can learn a lot about insurance from reading Markel’s letters to shareholders. In their early correspondence, Markel identified three major risks to the company and the insurance industry: (1) impact of the insurance cycle; (2) their estimation of loss reserves; and (3) the risks associated with expansion and growth. Insurance companies must underwrite with discipline and conservatism to manage these three risks.

Waves and cycles

The insurance industry is cyclical. Markel observes how competitive forces can drive insurances rates up and down, sometimes without regard to actual costs. For example, in their 1995 letter, Markel recalled how competitors were selling insurance products like commodities, competing aggressively and almost exclusively on price. An industry-wide decline in underwiting leverage ratios (capital to annual premiums) is often a sign of a race to the bottom.

These “soft” phases in industry tend to translate into expensive liabilities, poor underwriting results and lacklustre returns. Industry consolidations and company failures are often soon to follow. They described for example the wave of consolidation that swept Home, Continental, Aetna, Talegen and CIGNA (representing ~6% of industry’ total premiums) in 1994 following years of excess competition.

But this wave of consolidation allows better insurance companies to take market share and purchase acquirees at attractive prices. Underwriting prudence tends to follow. Unfortunately, it’s difficult to know how long the “good times” will last. Competitive forces and short termism tend to kickstart the insurance cycle anew.

In their 1997 letter, Markel points out how easy it is to under price and under reserve in the pursuit of growth. For true long-term value creation, patience with regards to growth, particularly during periods of competitive fervour, is needed.

Convergence in risk

One major risk in insurance is how low frequency but high impact events can trigger large one-time losses to companies. While diversification might offer insurance companies more stable underwriting profits, extreme events can destroy several product lines simultaneously. The lesson is simple: don’t assume that the risk-return covariance between asset classes will remain static over time.

For example, Markel described how they had underestimated the severity and frequency of one-time events in their catastrophe models following the impact of Hurricane Katrina, Rita and Wilma in 2005. In response, they placed an even greater margin of safety into their underwriting and modelling standards.

Redundant, but not deficient

Markel takes a long-term, value-oriented approach to insurance, organic expansion, acquisitions and investments. They liken their culture for common sense decision making to Benjamin Graham’s description of a margin of safety. Graham’s principle was simple: we should incorporate room for error and negative consequences into every investment and business decision. Markel applies this concept not only to investment selection, but to their underwriting, loss reserving and accounting processes as well. Their commentary on the margin of safety, in their 1996 letter, was illuminating.

Accordingly, the most important balance sheet item for insurance companies is the reserve levels for unpaid losses and loss adjustment expenses. This is because insurance companies sell products before the actual costs are known. There is uncertainty with estimating the expected cost of claims and adequacy of their loss reserves. Most claims can take months or years to settle and report. So the estimation of required loss reserves is a major source of risk.

When it comes to loss reserving, Markel’s policy is to be “redundant than deficient”. This offers several benefits. Firstly, it allows Markel to nurture a culture of conservatism and discipline. Secondly, it encourages their underwriters to make good decisions in pricing and quoting. Thirdly, it helps Markel to resolve claims and settle losses with policyholders quickly and fairly during stressful events, which is important to customer service.  

Combined ratio

The combined ratio, or loss and expense ratio, is an important indicator of an insurance company’s underwriting profitability. It compares the company’s total losses and expenses to its earned premiums. An insurance company that achieves a ratio below 100% has made an underwriting profit. The lower this ratio, the better.

Markel noted in their 2003 letter how insurance operations with healthy margins and cash flows enjoy greater capital and regulatory flexibility for investments in equities. In their 1989 letter, they described how they achieved a 5-year combined ratio of 86%, compared to the industry average of 109%. This is a strong competitive advantage. They attributed this result to their unique product niches and high underwriting standards.

Deep waters

In insurance, Markel describes how companies tend to underestimate their actual costs and loss reserves. Sometimes, this is incentivised by their desire to report healthy earnings and ratios. But this can also influence pricing decisions and risk selection. And when the cost of claims and settlement rise unexpectedly, many insurance companies will find themselves underwater. This was the case in 1992, when Hurricane Andrew and Iniki left many insurers bankrupt due to “inadequate loss reserves, reinsurance bad debts, catastrophic losses and bad investments in real estate”.

Similarly, in their 2010 letter, Markel observed how industry and regulators sometimes confuse riskiness with capital adequacy. For example, when insurance rates and prices fall, company premium-to-surplus ratios will decline. This can make insurance companies to look overcapitalised and less risky. In reality, they are charging lower prices to take on the same level of risk. Conversely, as prices rise, so too will the premium-to-surplus ratios. Some interpret this as a sign of increasing risk and worsening capital adequacy. These companies however are charging higher prices for the same level of risk. Context matters.

Risky questions

In their 2006 letter, Markel outlines the four questions that they ask during the underwriting process.

Can we:

  1. Assess the risk we are taking?
  2. Design the appropriate coverage for our client?
  3. Price the risk to earn an underwriting profit?
  4. Assess the trends that may increase our risk in the future?

They also ask the following four questions when an underwriting decision goes wrong.

Did we:

  1. Misunderstand the risk?
  2. Misbuild our coverage form?
  3. Under-price the risk?
  4. Overlook adverse claim trends?

Markel, the value investor

Markel employs four options, in order of preference, to allocate capital and build long-term value: (1) Reinvest in existing operations with a proven track record and organic growth opportunities; (2) Acquire new businesses; (3) Allocate capital to common equity and fixed-income securities; and (4) Repurchase Markel shares if there is excess capital and the stock is priced attractively.

I’ll use this next section to summarise their investment framework and philosophy (focusing on common stocks and acquisitions).

Investment framework

“We buy shares of companies where we believe the business will earn good returns on capital and which are being run by honest and talented shareholder-oriented managers who are building the value of the enterprise”.

Markel shareholder letters

Markel’s focus is on the careful selection and purchase of companies at prices below their estimate of fair value. As noted in their 1997 letter, they’ll never try to time the market. And this value-oriented framework is the same, whether for private acquisitions or common stocks, which they summarise in four points.

Markel looks for businesses with:

  1. Good long-term profitability and returns on capital without too much debt
  2. Reinvestment opportunities and capital discipline
  3. Management teams with strong talent, honesty and integrity
  4. Reasonable prices

They’ll also review their mistakes against the four parts. For example, did:

  1. Competition, technology or other factors hurt returns and profitability?
  2. Management act dishonorably or ineffectively?
  3. Management allocate capital to bad projects or acquisitions?
  4. We pay too high a price?

Good companies at fair prices

To summarise the above, Markel looks for companies with durable competitive advantages that serve their customers well. It shares strong similarities with The Warren Buffett Way and Phil Fisher’s Fifteen Points for Investing. Like Buffett and Fisher, Markel avoids managers that focus on the short-term and self-enrichment at the expense of others. Capital allocation decisions, remuneration schemes and company cultures can be telling of this.

Similarly, Markel likes managers that deploy shareholder capital effectively into organic growth or acquisitions; Or otherwise return capital through dividends or buybacks (when prices are sensible). And managers should achieve all this with a healthy balance sheet. Markel’s own goal for example is to maintain a debt to capital ratio of 33% over the long-term.

At the end of the day, wise purchases comes down to price. Here, Markel shares the wisdom of Charlie Munger: “it is better to pay a fair price for a great business than a great price for a fair business”. Great businesses will compound value faster than mediocre businesses. If businesses are selling at exorbitant prices, Markel is happy to hold cash instead.

Risk and turnover

To Markel, risk is not a measure of short-term volatility, but the likelihood and degree of permanent capital loss. While diversification might help with volatility, they believe that their concentration on promising opportunities and circle of competence can earn them a higher and safer return on capital.

Markel also commits to very low portfolio turnover rates. In some years, their transaction costs were lower than that of various passive instruments. In addition to lower transaction costs and tax obligations, low turnover can reduce the likelihood of mistakes. They describe how concentration gives you the opportunity to think about your holdings across multiple years, as opposed to those who trade every day, week or quarter.

Forecasting the unknowable

“We believe in gradualism because it salutes the important measure of humility that any investor should bring to the task. The future is unknowable, and all decisions are probabilistic estimates about shades of grey.”

Markel, 2008 letter

Markel’s shareholder letters often emphasise the unknowability of the future and the limitations of forecasting. In their 2012 letter, they highlighted that they’ll never make an investment decision based on “important but fundamentally unknowable future developments”. This includes economic growth, government policies, taxation rates, exchange rates and interest rates.

This attitude towards forecasting is interesting given the actuarial and statistical horsepower that insurance operations have. But it’s perhaps the very same expertise, an appreciation for the unknowable, that reinforces their belief in a value-oriented approach to investing.

Markel also points out how sophisticated forecasts can hinder learning. It’s not always easy to learn from the mistakes of your forecasts from a causal standpoint. Put another way, they believe it’s easier to learn from and improve upon your evaluation of knowable fundamentals (e.g. return on capital, managerial skill, valuation, etc.) than predictions about complex systems (e.g. changes in oil prices, interest rates, etc.).

Expect the unexpected

Unexpected and unknowable events will hurt insurance and investment results, sooner or later, one way or another. Markel recommends readers learn to expect the unexpected. If you’ve read three decades’ worth of Markel letters, you’d have seen the long list of disasters that the company had to grapple with. Examples include, but not limited to: Hurricane Fran (1996), Northridge earthquake (1994), World Trade Centre Attack (2001), Florida hurricanes (2004), Hurricane Katrina, Rita and Wilma (2005), Global Financial Crisis (2008), Deepwater Horizon Disaster (2010), European Debt Crisis (2011), Hurricane Sandy (2012); and Hurricanes Harvey, Irma, Maria and Nate (2017). We can add COVID-19 (2020) to that list as well now.

Measuring intrinsic value

For insurance companies, underwriting profits and investment returns are two sources of long-term shareholder value creation. And it’s important to measure their success across these fronts (we’ve already talked about the combined ratio with regards to underwriting profits). On measuring intrinsic value, it’s interesting to document Markel’s evolution, and the measures they’ve looked at over time.

Revenue growth

Following their IPO in 1986, Markel had set two financial goals: (1) grow revenue by 20% or more per annum; and (2) achieve an annual return on equity of 20% or more. However, Markel abandoned their revenue target in 1990, citing the dangers of revenue growth under extreme industry price competition (as was the case in the early 90s). Markel placed a higher priority on underwriting profit instead. They described how long-term underwriters should walk away when competitors are pricing irrationally without regard for risk.

Return on equity

Markel reflected on the limitations and distortions of return on equity (ROE) as a measure of company performance in their 1990 letter. For example, they highlighted how amortization, as a non-cash expense, is not always reflective of the company’s intrinsic value, but is included in the calculation of ROE. Likewise, financial leverage may boost the company’s ROE without regard for risk; While accounting rules in the 90s required companies to record realised gains (losses) from equity investments on their income statement and unrealised gains (losses) on the balance sheet. You can imagine how this might distort reported ROE and incentivise financial shenanigans.

Earnings per share

For the reasons above, Markel began looking for a better measure for return on investment. They highlighted the need to distinguish between reported earnings and real cash money. In 1993, they began reporting earnings per share from underwriting and investing activities. This excluded non-recurring or non-cash items such as gains on sale, relocation expenses and amortisation expenses.

This, they believed, offered a more meaningful picture of their operating performance. However, they also recognised its limitations as an indicator of insurance performance, as it ignores the adequacy of loss reserves and balance sheet strength. But the introduction of comprehensive income (net income + change in unrealised gains) to accounting standards in 1997 helped to alleviate some of their concerns.

Book value per share

By 1995, Markel had specified their new financial goal to grow book value per share by 20% per year. If the underwriter is conservative and honest, then their balance sheet should present an accurate view of their insurance and investing assets and liabilities. Hence, Markel believed book value per share was a reasonable proxy of the company’s intrinsic value. Management also believed that this metric would meet the demands of their shareholders (growth in investment value) and policyholders (financial strength and security). This became their gold standard for nearly two decades.

Note that high quality insurance companies are likely to command a premium to book value. Contributing factors might include superior reputation, conservatism & integrity, customer loyalty (e.g. renewal rates) and long-term financial returns.

Book value growth per share

When Markel was a small insurance company, book value per share was a reasonable proxy for the value of Markel shares. But as they expanded with Markel Ventures, invested in Insurance Linked Services (ILS) and repurchased shares, book value per share became less meaningful. Earning returns from these activities were no longer well reflected in book value per share calculations.

By 2013, Markel began to focus on the 5-year CAGR in book value per share, as opposed to actual book value per share. Markel put it simply in their 2013 letter: If there are two companies with identical book values per share, the company with a higher long-run book value per share CAGR is more valuable to investors.

Also note Markel’s focus on the 5-year CAGR. Change in book value on a year-on-year basis can be volatile, whether due to economic realities or accounting factors. The seasonality in insurance businesses means that quarterly and/or annually comparisons within and between companies are potentially misleading.

Valuing Markel

If you wish to estimate the intrinsic value of Markel (or conglomerates like it), management recommends valuation by parts, as noted in their 2019 letter. Firstly, for insurance operations, you should determine Markel’s underwriting profitability under normalised conditions. Secondly, you estimate the expected long-run returns on their investment portfolio. Thirdly, you have to consider the normalised profits from Markel Ventures, ILS and Program Services.

Next, sum them up and subtract capital expenditures, interest and taxes. This should give you a view of Markel’s recurring, comprehensive income. If you have adjusted your estimates for volatility and cyclicality, you can then apply a reasonable range of multiples to estimate the intrinsic enterprise value of the company. Afterwards, you subtract debt obligations and divide by the number of outstanding shares to estimate the per share intrinsic value of Markel.

Financial shenanigans

“It is unfortunate that in the world of financial reporting and security analysis that current earnings receive more attention that the quality of loss reserves. That does not make it right.”

Markel, 1996

Markel warns readers about the leeway that insurance companies have with financial reporting. This is attributed in part to the insurance accounting cycle, the number of estimates that companies must make, and the long-tail of insurance outcomes. While insurance companies collect premiums and estimate loss reserves today, they will not pay for claims for many years. It’s only after some time that the accuracy of their reporting and adequacy of their reserves begin to show.

In their 1998 letter, Markel described how some insurance companies engage in financial shenanigans. Some will inflate their earnings per share through optimistic loss estimates and/or creative reinsurance rearrangements. Others will absorb underwriting losses with investment returns, relying on risky investments to drive their growth in reported earnings.

Unfortunately, such perpetual machines cannot continue indefinitely. It’s difficult for companies to outgrow their losses and risks. Insurance companies must settle their claims in hard cash eventually. Poor pricing and inadequate reserves cannot last forever. (For more on this topic, I recommend Howard Schilit, Jeremy Perler and Yoni Engelhart’s Financial Shenanigans.)

The Markel Style

“The Style explicitly describes attributes such as hard work, pursuing excellence, integrity, having a sense of humor, and adapting to change, among others. It also talks about having fun while doing so.”

Markel Corporation

The Markel Style is an important part of the company’s operating, managerial and cultural philosophy. Management often refers to their “creed [of] honesty and fairness in all [their] dealings”; And “a respect for authority but a disdain for bureaucracy” in the pursuit of exellence, market leadership and continuous improvement. They believe in the “spirit of teamwork”, and the “individual’s right to self-determination” and “reach their personal potential”, while “keeping a sense of humour”.

Interestingly, Markel’s acquisition targets must also demonstrate the potential to adopt the Markel Style. While cultural integration seems to receive less attention, it often underpins the success or failure of large M&A deals. Markel described how it can take several years to integrate new talent, knowledge and expertise.

The company also emphasises the importance of operating diversification and specialisation across their letters. While cliché (and Markel acknowledges this too), it’s a simple reminder of their commitment to customer needs and product quality. Specialisation allows you to deliver greater value to customers, while diversification enables the company to optimise growth on the basis of relative opportunity.

Strong alignment

Markel has often stressed the importance of alignment between customers, employees and shareholders. They disagree with the notion that business decisions involve trade-offs between the interests of company’s stakeholders. As described in their 1998 letter, a culture for performance can support the company’s financial strength and prudence. This then improves their capacity to support clients and deliver better shareholder returns. Amazon’s Jeff Bezos shared a similar philosophy in his letters to shareholders: “what’s good for the customer is good for the shareholder”.

Similarly, they describe how employee alignment and a strong workplace culture can become an enduring competitive advantage too. For employees and companies, it takes time to develop experience and specialty. So, if your culture is conducive to personal fulfilment, continuous improvement, and workplace productivity, long employee tenures is valuable.

Furthermore, companies should remember that they are competing globally for talent. Markel suggests that companies that attract and retain the best talent through shared values, sensible financial incentives and personal fulfillment are more likely to prosper. In their 1997 letter, Markel highlights how more than 25% of their associates have a tenure of ten years or more.

Markel also shares Berkshire’s sentiment in treating their shareholders as equal partners. They cite Warren Buffett’s Owner’s Manual in their 2002 letter: “Although our form is corporate, our attitude is partnership… [we] view the company as a conduit through which our shareholders own the assets.”

In their 1993 letter, they described their commitment to providing complete disclosure to help attract and retain long-term oriented shareholders. They prefer not to shy away or gloss over reasons for poor results. Their 2003 letter is one example of this, in which they discussed mistakes in loss reserving and the expenses associated with asbestos claims.

Right incentives

In addition to a competitive salary, Markel wants to reward and incentivise employee contributions with attractive bonuses. Their 1995 bonus plan for example had three elements: (1) cash bonus for high performance; (2) percentage share of underwriting profits; and (3) cash bonus for senior executives for a high five-year CAGR in book value per share (minimum threshold of 15%).

For insurance companies, the focus on long-term book value growth encourages managers to focus on balance sheet strength, and to make sensible long-run decisions, even if they’re not conducive to current reported earnings. Insurance companies that focus only on reported earnings are less likely maintain adequate loss reserves.

Markel does not hire compensation consultants or track competitor compensation schemes. The goal is simple: ensure executives are compensated fairly, and not at the shareholder’s expense. By 2005, incentive compensation payments accounted for more than 40% of employee base salaries.

Stock ownership was another element of their alignment strategy. One of the reasons Markel went public in 1986 was to increase stock ownership among employees. Stock purchases have a stronger effect on employee alignment than stock options or gifts. A personal investment in the company is more likely to encourage employees to think and act like a long-term business owner. By 1995, Markel estimated that associate ownership had nearly reached 32.5% of the company. And by 1997, Markel eliminated stock option plans in favour of stock purchase plans.

The not-so secret sauce

“We are happy to be accused of copying Berkshire Hathaway from time to time”.

Markel shareholder letters

We’ve reviewed the philosophies of quite a few companies already. This includes Warren Buffett’s Owner’s Manual, Jeff Bezos’ letters to Amazon shareholders, Dave Packard’s The HP Way, and Mark Leonard’s letters to Constellation shareholders. They’re very different enterprises of course. But like Markel Corporation, they share some common values: an owner’s mentality, strong capital discipline and exceptional stakeholder alignment. I’m inclined to believe that the science of organisation doesn’t have to be complicated. There appears a formula that is sufficiently robust, flexible and adaptive for the long-run. The challenge it seems is in sustained execution and innovation across time.

References

Gayner, T., Kirshner, A., et al. (various). Markel Corporation. Letters to Shareholders. 1986-2019. Available at < https://www.markel.com/investor-relations>

Further reading

Appendix: Commentary on acquisitions

I didn’t want to overload this post, but there are so many lessons to draw from Markel’s letters. I’ve included some more notes on Markel’s acquisition philosophy here for the interested.

Scratch and dent

In their earlier days, Markel preferred to buy insurance companies from the “scratch and dent sale”. While these companies had less than stellar profitability, they were available at reasonable prices. Markel’s growth strategy was to buy and fix troubled companies that could get better with age. Interesting case studies here include their acquisition of Shand Morahan and Evanston Services in 1987-1990, and Gryphon in 1998. Conversely, Markel didn’t hesitate to divest or shutdown “commodity oriented, poorly priced, or underwritten [businesses or divisions] without appropriate controls, knowledge and expertise”.

Dot Coms

“The five most expensive words in investing are, this time it is different.”

John Templeton

Markel avoided internet stocks during the late 90s because those businesses couldn’t demonstrate the returns on capital, managerial qualities and reinvestment opportunities at a price that satisfied their selection criteria. Markel highlights how investors, on the “seesaw of risk versus reward”, focus too much on reward and too little on risk.

Insurance companies that succumbed to the Dot Com mania, or involved themselves with companies like Enron, Tyco and Worldcom, destroyed value for shareholders and policyholders.

Markel avoided stocks in energy and commodity markets during the mid-2000s for similar reasons. They dislike investing in companies whose pricing power is weakening over time; or where intrinsic value depends primarily on perception, sentiment and/or geopolitical events.

Alternatives

Similarly, Markel describes an aversion to ‘alternative’ investments. They observe how demand for these products move from the innovators to the imitators, and later to the “swarming incompetents”. The company discusses how these investments tend to bring about terrible returns after the swarm has passed. Whether private, public or alternative – all investments must satisfy Markel’s selection criteria (their 2005 letter makes for great reading on this).

Passives

I found Markel’s take on passive investing interesting as well. While passive and indexed instruments can reduce costs, Markel describes them as “relatively brainless” product. That is, it’s possible for the prices of real companies to deviate materially from intrinsic value as products come in and out of favour. The past performance of any investment product, passive or not, does not guarantee future returns. Investors must still approach any investment activity with vigilance.

Goodwill

Finally, Markel reminds readers in their 1999 letter that price to book value is not necessarily an indicator of cheapness. That is, strong businesses with low capital requirements, high quality cash flows and low book values may justifiably command a high premium (goodwill). The same might be said about insurance companies with strong and growing premium volumes, high quality investments, longstanding business relationships and experienced staff members.