Podcast: Shree Viswanathan

I spoke with ⁠Shreekkanth Viswanathan ("Shree")⁠, Founder and Portfolio Manager of ⁠SVN Capital⁠, a Chicago, USA-based investment manager, on his background, how spirituality helps him keep his ego in check and the importance of serendipity. We then discussed one of his portfolio holdings, Kinsale Capital, the specialty Excess & Surplus insurer.

This transcript has been lightly edited for clarity.

Graham Rhodes: Hi everyone. Welcome to the Long River Podcast. My name's Graham Rhodes, and I'm delighted to be joined today by my friend Shreekkanth Viswanathan from Chicago. Hey Shree, welcome to the podcast!

Shree Viswanathan: Graham, I'm delighted to be here. Thanks for having me.

I'm so glad to have you on. We're going to be talking about your background today, your journey as an investor, and also a little case study of Kinsale Capital.

But before we get started, I just need to give this disclaimer: Nothing we talk about today is investment advice. You should always do your own research.

So, Shree, again, welcome to the podcast. Why don't you give us a little bit of background on your journey from Chennai to Chicago?

I'm originally from India, from a city in the Southeast part of India called Chennai. It used to be called Madras. I came here as a student to the U.S. pursuing a master's degree in accounting and forgot to return. I didn't buy a return ticket back home.

I pursued a career in accounting, became an accountant in a real estate firm, and then in an insurance company. That's when I decided to go back to the University of Chicago for my MBA. I was an investment banker at Alex Brown in Baltimore, and then at Thomas Weisel in San Francisco.

For a variety of reasons, I left investment banking and was a corporate developer doing essentially M&A for one client, Union Bank of California: acquiring small banks, insurance agencies, trust companies, and stuff like that. Then from 2005 on, I've been here in Chicago, essentially on the buy side, investing as a professional manager.

Tell us about what you're building today with your firm SVN Capital.

So, SVN Capital. I launched a few years ago, and I'm building essentially a wealth creation vehicle devoid of many of the issues I saw in the traditional asset management business. What I am creating at SVN Capital is essentially embracing the power of compounding. The average time horizon for some of my holdings, I would say, is ideally infinity, but I generally think about at least seven to 10 plus years, and it's highly concentrated. I think somewhere between 10 to 15 stocks would be appropriate, but I currently own only nine stocks in the portfolio, globally diversified. And we're going to talk about one today.

Which is an excellent point at which to segue to your second quarter letter, when you described yourself as a curator. Can you let us know what you meant by that?

Absolutely. I remember reading this book "Rework" by two entrepreneurs, Jason Fried and David Heinemeier Hansson. One of the chapters in there, it's a pretty easy read, is titled "Be a Curator." They talk about how museums display only a few pieces on the walls. There's a lot more that's not displayed, and that's what makes it a museum. If they displayed everything, it would be a warehouse. So this resonated with me, and what I'm trying to create at SVN Capital. As I said, it's a highly curated collection of businesses that meet my investment objectives. As a result, I currently own only nine businesses.

Of course, I have a few that are not in the portfolio, which I'm essentially tracking as watchlist companies, and if things come together, maybe in the future, I may add one or two.

But there are thousands, almost 40,000 publicly traded stocks around the world. As a curator, I need to say no a lot to create this museum. There's an editing process. So, I leave out a lot that's not on the wall, but the best is actually a subset of all these possibilities. That's very much what those two guys said in the book, and that's very much what I'm trying to do at SVN Capital.

I liked it because of this idea that the portfolio is defined almost by what's not in it as much as what is in it. And when you pick just nine stocks, you're essentially saying no to thousands and thousands of securities. So, to me, it was such a good way of capturing how subjective this is and how much it reflects the personality of the portfolio manager. I thought it was really cool.

As I understand it, you work alone. You obviously have a wide and rich network of friends and collaborators, but how do you cover the whole world looking for the pieces that you want to hang up on the wall of your gallery? If I think about your portfolio, we own a Swedish gambling services company together. We're going to be talking about an American insurer. I believe you also have a European luxury goods company. How do you approach the search for good ideas?

I remember reading this other book called "The Money Game" by Adam Smith. In this book, he says, "The first thing you have to know is yourself. A man who knows himself can step outside himself and watch his own reactions like an observer." That's the same spiritual exercise that the guru I follow uses to keep me focused and help me remain calm. It's essentially a spiritual statement that Adam Smith made in his book. To address your specific question about how I come up with ideas: the constant exercise is trying to find out who I am and keeping calm. But then I also run various screE&S, quantitative screE&S, using tools like Scap IQ. It gives me access to a global list of stocks. I read a lot and talk to managers like you, letting the process lead me.

I wanted to ask that question because, for me, one of the hardest challenges is prioritizing my time. So, I'm always keen to hear about how other people do it.

I love this process of starting from one end of a string and ending up at the other. You never know where you're going to end up. Maybe that wasn't the original intent when I started researching this particular company. Investing is an individual sport. You play it the way you want it to be played and let the process lead you.

I love that you talk about the journey to discover yourself. You gave an excellent interview a while ago about one of your favorite books on meditation. Also, referencing your Q2 letter, you mentioned that the market rewards inactivity. So, not to put you on the spot, but how do you keep yourself inactive, especially during periods of high volatility like we're experiencing now? What works for you, Shree? Meditation, yoga? Do you have any good habits you can share with us? I'd love to hear.

It's a combination of things, and it's not something I've always done. As I've mentioned before, spiritual pursuit is integral to what I do and how I live my life. I've designed my life to suit me. Particularly in the world of investing, finance, and money management, ego is often the biggest impediment. For example, when we believe we have absolute confidence in an analysis or a particular question we're trying to answer, sometimes an unexpected challenge can undermine that analysis. I believe this is often due to ego. My exercise is to tamp down that ego. How I do it might differ from how others do. This spiritual exercise helps me keep my ego in check. I'm not saying I'm completely devoid of ego, but I try to keep it in check as much as possible. This approach helps me maintain an open mind, which in turn allows serendipity to come into play. That's how I process my days: I read a lot, talk to people, keep an open mind, and let the process lead me.

I love it. And it's clearly working for you. So, let's go back to the story of how one of these conversations led you to Kinsale Capital.

Sure. Last year, a Chicago-based company called Ryan's Specialty Group emerged. It's a wholesale broker. I'll delve deeper into the business later when we discuss Kinsale itself. But Patrick Ryan, the former CEO of Aeon and a highly successful individual, moved on and established Ryan Specialty, this wholesale broker. He took the company public, and I spent considerable time studying this business. Insurance brokerage is a captivating domain—capital-light with high returns. I immersed myself in understanding his business, and that's what prompted me to explore further into excess and surplus, a subset of insurance. We'll delve deeper into that later. This specific company, Kinsale Capital, exclusively deals in excess and surplus insurance. That discovery led me to this company. Concurrently, as I was diving into the insurance domain, a friend of mine from New Jersey, Rajiv Lepasia, who runs a fund called RBL Capital, nudged me towards Kinship. He recognized me as someone deeply involved in financial services, having spent considerable time in insurance and banking sectors. He persistently recommended it, and eventually, I got around to investigating this company. And now, here we are today.

So, that's serendipity at work. Exactly. Among the nine companies in your portfolio, why did you suggest we discuss Kinsale? What excites you about this company?

There are a couple of reasons. The primary reason is it was the most recent addition to the portfolio earlier this year. Since then, I haven't made any changes to it. As new capital comes in, I've expanded several positions, but in terms of portfolio inclusions, that was the last. Therefore, it was the most relevant in that context. Moreover, this is a situation where the process naturally led me to it. I started with a company in a different industry and ended up somewhere entirely different. While quantitative screE&S are helpful in finding ideas, not all promising ideas are system-generated consistently.

Kinsale specializes in excess and surplus insurance. Can you contextualize that for us? How does excess and surplus insurance fit within the broader property and casualty insurance?

Insurance is one of the two oldest professions in the world. Today, we have approximately 1,100 insurance companies in the US. Less than a hundred of them are public. PNC, or property and casualty, is one of two primary categories. The other is life and annuity. I'll narrow down our focus to Kinsale. If we observe the entire insurance industry based on a net premium written basis—that's the annual premium adjusted for certain items—it amounts to about 780 billion as of 2022. Roughly 50 percent is for property and casualty, and the other half is for life and annuity. Kinsell operates within the property and casualty segment. Diving deeper into property and casualty, it divides into two major areas: commercial lines and excess and surplus. While some personal lines have recently ventured into excess and surplus, for this discussion, let's consider excess and surplus as part of commercial. This segment accounts for about 50%, or roughly 400 billion, of net premium.

Now, I need to clarify what excess and surplus means. Before a company can engage in business, it must secure a licE&Se and meet minimum capital and surplus requirements. Such companies are termed as "admitted" or standard underwriters. There's another category, where for various reasons, some standard underwriters—or in Kinsella's case—choose to operate on surplus lines or a non-admitted basis. These are the non-admitted surplus providers. They have the freedom to set rates and forms. In the traditional admitted standard underwriting process, there are certain requirements. Companies need regulatory approval and must file specific forms with the state regulator. Remember, each of the 50 states has its insurance regulator, and each oversees operations within their state. This results in what I term as a "rate and form" requirement. However, excess and surplus providers enjoy the liberty to operate as they see fit, offering them a significant advantage.

Approximately 80 percent of the commercial business, or the 400 billion I mentioned, is traditional risk. These are serviced by the admitted or standard underwriters. The remaining 20 percent falls into the non-admitted category. These represent risks that are bespoke, complex, and larger in nature, and are the domain of E&S or excess and surplus providers. This subset within the commercial category has been around for a while. However, in recent years, the excess and surplus segment has claimed a growing market share. To illustrate, from 2000 to 2022, excess and surplus grew at a compounded annual growth rate of about 10%, whereas the standard segment expanded just slightly above the GDP rate, around 4%. Today, of the 500 billion in net premium on the commercial side, 100 billion is attributed to excess and surplus.

What has driven that growth rate, which is more than twice the growth rate of the standard lines?

There are several reasons. One in particular – this fluctuates in cycles. I'd like to spend another minute discussing the nature of excess and surplus. There are certain lines that shift between excess and surplus and the standard category. Some traditional underwriters choose to write in the surplus market at times, but might later transition back to standard underwriting. It's somewhat fluid, not everything is fixed. However, as previously mentioned, excess and surplus have shown impressive growth. Within the larger excess and surplus category, about 30 percent of the market is property-based, while the remaining 70 percent falls under casualty. Changes in one can sometimes influence the other, though not always.

Since 2017, the U.S. has experienced a high number of natural disasters. Hurricane season typically spans from July to November. In 2017, for instance, we faced Hurricanes Harvey, Irma, and Maria, along with wildfires on the West Coast. More recently, Hurricane Ian severely impacted Florida. Such disasters not only cause property damage but also lead insurance companies to pay out large claims and increase their reserves. Consequently, many insurers go out of business. In a parallel development, inflation rates and interest rates have risen since the onset of COVID-19. Legal judgments in certain jurisdictions, termed "social inflation", have increased as well. Due to these factors, insurance companies have raised premiums, pushing policyholders to seek alternatives. This has bolstered the growth of E&S.

Now, looking ahead, the severity of natural disasters appears to be escalating. Coastal regions, especially Florida, continue to attract inhabitants, making the financial implications of such catastrophes even more significant. On the financial front, interest rates, which had been decreasing since 2000, have begun to rise in recent years. As rates dropped in the past, a lot of financial capital entered the insurance sector seeking better returns. Products like catastrophe bonds and Insurance Linked Securities (ILS) bridged insurance and financial products. However, as interest rates rise, this financial capital is now exiting the insurance sector. Factors such as increasing natural disasters, higher severity and frequency, rising interest rates, and the departure of financial capital are predicted to further spur the growth of the E&S market. How long this trend will persist is uncertain, but feedback from insurance companies, brokers, and industry participants suggests that the E&S market's rapid growth could continue for the foreseeable future.

I have two questions to gain further context. First, one of the businesses within Berkshire Hathaway that has grown remarkably over the past decade is Berkshire Specialty Insurance. Does that operate in this space, or is it a different subset of the insurance market?

Berkshire and AIG are two businesses that have their reach in nearly every subcategory you can consider. Berkshire doesn't appear as one of the top E&S (excess and surplus) players. I'm not entirely certain that Berkshire's specialty is focused on E&S, but AIG is the predominant underwriter in the excess and surplus line. The leading player is Lloyds of London, although it functions more as a platform than an insurance company. Lloyds commands about 27-28 percent of the market, while AIG holds around 23-24 percent. The list then includes entities like Arch Capital, Argo, Markel – a company I'm sure you're familiar with – RLI in Illinois, and WR Berkeley. These companies have a more diverse portfolio than Kinsale, which specializes exclusively in E&S. Presently, Kinsale holds less than 2 percent of the market share.

My other question is, am I correct in assuming that non-standard policies aren't regulated in the same manner? If so, what are the practical implications of that?

You're right in that statement. When I say "non-standard," I mean these excess and surplus providers are not required to adhere to the same form and rate requirement that standard underwriters are bound by the state regulators. If a company, for example, is regulated by the state of Illinois, it will remain a regulated, admitted player within that state. However, they can choose to write excess and surplus policies outside of Illinois, and in doing so, they won't be regulated by that state, say they write in Iowa or Indiana.

That term "regulation" largely refers to rate and form requirements. For instance, if they wanted to significantly increase the premium on a particular line, like workers comp in California which historically has been a challenging area for many insurance companies, they would need the state regulator's approval. The regulator might or might not agree. On the other hand, in the excess and surplus market — Kinsale, for instance, doesn't write workers comp, especially not in California — but if they wanted to, they could set the price to whatever they deem fit. That's what I mean by "non-standard" or "non-regulated."

Got it. Okay. I guess that's really important for these bespoke policies where they need the ability to set prices to match the risk.

Exactly. And in fact, it's an interesting point. AMBEST is a major player in the insurance industry. It's a rating agency. Many insurance companies seek an AMBEST rating and publish it to get approval from a variety of players, including brokers, regulators, and others. AMBEST released a report recently, stating that in 2022 there have been no surplus lines carriers that have been impaired. In almost 20 years, not even one surplus lines carrier has faced this issue.

Contrast that with standard underwriters. For example, in the state of Louisiana, which is often hit by hurricanes, in 2020 - I believe it was 2021 - 11 companies went under. When I say "under," I mean they went into liquidation. Insurance companies don't necessarily go bankrupt in the traditional sE&Se, like a technology company might, but they do enter liquidation. I think around nine did so last year, in 2022. This continues to occur in the standard market, while the E&S market remains robust, partly because of their ability to maintain high rates.

Okay. So, just to summarize, the E&S market is a subsegment of the property casualty market. Demand is growing as policy seekers look for a more standard product, and supply is shrinking as capital is leaving the market, leading the E&S market to enjoy above-industry growth. I think I got that right. Now, you mentioned Kinsale, the pure play within this, and it has, I think you said, a 2 percent market share. Help us put Kinsale into context. What is the history of this company? What is its story?

Kinsale is a company that was founded around 2010, but the story goes back to the founder—well, founders, I should say—but the CEO, Mike Kehoe. Mike Kehoe was at a company called Colony Insurance back in the nineties. It was acquired by Argo Group, which I referred to earlier as one of the players in the excess and surplus area. Colony was acquired by Argo in 2000.

At that point, a couple of the colleagues were able to raise capital from a pure insurance-focused private equity player called Stone Point and then, I think, the Bronfman family, which was involved in media and other sectors. That's how they launched James River. James River is the closest competitor in terms of size to Kinsale today. In any case, a couple of these former colleagues were able to raise capital, and they formed James River. They took it public in late 2000, around August or September, at about $18 a share.

Then a couple of years after that, there was some interest from private equity players. Fortress showed a lot of interest in acquiring the company, but they didn't invest. Later on, D.E. Shaw, Elliott, and a few others made an offer of about $580 million to invest in James River. That's when Mike Kehoe left. He had a non-compete clause, but by 2010, he launched Kinsale as a pure play excess and surplus company.

The statutory accounting books are available, and you can go back and look at the financials all the way to 2012 for Kinsale. Historical analysis shows the robustness of their performance. In the early years, they were getting their feet wet, but they were still generating a pretty healthy return. More recently, partly because of the growth of the market and partly because of how they structured their business model, they've been able to generate a high margin. In my analysis, I believe this can be sustainable.

Over the longer term, these guys have a great track record. They've been backed by private equity. They did well with James River. Then they left to form Kinsale. Questions for you, just to set the scene again: What kind of policy does Kinsale typically write? If you could help us understand what their exposures are in terms of sector and geography - I think you mentioned it's all within the United States - tell us about the length of the policies and what kind of risks they're underwriting there.

Today, Kinsale has about a third in property and the balance is casualty. What do I mean by property and casualty? Take commercial property, for instance. Imagine an office in the state of Florida, not necessarily on the coastal side, but within the state. Because of concerns about hurricanes, the severity and frequency and all that, some of the traditional underwriters have pulled out of Florida.

I'm just using Florida as an example; they operate around the country. California is their biggest exposure at this point, but let's continue with this Florida example.

So, in this case, for whatever reason, let's say it's a small commercial property or even a senior healthcare facility within the state of Florida. And because the standard underwriters have left the market, the property owner wants to get coverage. So what happens is the owner would reach out to a local or the company's traditional insurance broker. If it was possible to write that policy through a traditional underwriter, they would have been able to secure it.

But since a standard underwriter isn't available or willing, the broker then reaches out to the wholesale broker. I mentioned the Ryan Specialty Group earlier - they're a pure wholesale broker. The broker market breaks into two categories: the bigger piece is the standard broker market, and the other is this wholesale market. These wholesale brokers reach out to companies like Kinsale and detail the insurance needs. That's a traditional property, commercial property, exposure.

For the liability side, it could range from business casualty to a variety of other categories. In the U.S., given our litigious society, there's always a need for insurance coverage, leading many to the excess and surplus market when standard underwriting isn't possible.

A good example might be a cleaning crew for a building with a glass facade. They'd need insurance to work at height. If coverage isn't available through traditional means, they'd go through the process I described earlier to secure insurance from the excess and surplus market. Kinsale might then write that policy under their liability category, which makes up two-thirds of their book.

On the property side, contracts typically last a year, with a generally short claim process. On the liability side, duration can vary, with long-duration contracts reaching up to 10 years. But historically, around the 5th year after a policy ends, about 80% of claims have been settled. There are still lingering claims years later, but it's not like the long-duration policies we see in sectors like long-term care.

I hope that gives you a clearer picture of how Kinsale operates.

One of the things that makes Kinzale stand out is its position in this growing market. I believe it's growing faster than the market, and it has impressive curb margins. What does Kinsale do differently to be so profitable?

That's a great question. I would list at least five things that stand out.

The first one is their exclusive focus on excess and surplus. While there are other great underwriters, like Markel, Berkeley, and a few others such as RMI, they write in a number of other areas. This focus on excess and surplus, I believe, gives them a slight edge at a time when that market is growing. That's number one.

Number two would be their underwriting expertise. Numbers two and three go hand in hand. The third would be their use of technology as a unique competency. They have developed enterprise software. Think of it as a rectangular box they designed for themselves. There are guardrails on all four sides, which allow them to operate within that box. However, it also restricts them from going beyond the edges, which you can think of as self-designed limits on certain geographies, types of risks, and policyholders. This focus helps them stay dedicated to underwriting.

Another interesting aspect of their underwriting process is their location. They operate from Richmond, Virginia. Unlike New York, Richmond has a lower infrastructure cost, including employee salaries. It's a lovely town, smaller than many large cities in the U.S. Many competitors have offices globally, which leads to higher costs. This gives Kinzale a cost advantage.

This advantage segues into the fourth point, which is their significantly low expE&Se base or expE&Se ratio. Typically, wholesale brokers, who reach out to excess and surplus providers like Kinsale, get about 17.5 to 18 percent of the premium as their commissions. These brokers then share this commission with the broker that sourced the business. In Kinsale's case, they pay no more than 15 percent. A two to two and a half percent advantage might seem small, but it makes a significant difference over time.

Lastly, the claims process. An insurance company's reputation is often gauged by its claims department, especially in terms of the number of claims, the speed at which they're paid, and their processing efficiency. Within Kinsale, the second and third largest divisions in terms of employees are related to claims. Each claims adjuster handles about 100 open claims, a number that's significantly lower than many competitors.

In summary, Kinsale's advantages include an exclusive focus, a single location, underwriting expertise for hard-to-place risks, technology as a core competency, a significantly low expenses ratio owing to their tech and reduced commissions to wholesale brokers, and efficient claims processing. These factors set them apart.

Interesting. One of the famous mental models is "scale economy share." Thank you. I'm wondering if that applies in this instance. Do they pass on some of the benefits of their focus, their lower costs, and their modern IT systems in the form of lower premiums, or is that reflected just in higher than industry average margins?

Absolutely. They do pass on better coverage. It may not sound that interesting, but they do pass on that savings to the actual policyholder in terms of providing better coverage. But yes, they absolutely share with the eventual customer. The immediate customer is the wholesale broker, but the eventual customer is the policyholder.

I'm just wondering, with all these different layers in the sales channel between the actual insured and the underwriter, does anyone at any point ask for Kinsale by name?

That's a good question. The wholesale brokers that are currently in business, like Ryan, which I mentioned, are noteworthy. By the way, in the wholesale broker business, that's the only publicly traded company. The rest are all private. There's another significant company called Amwins. The brokers within these companies all know who Kinsale is. I'm not necessarily sure they ask for Kinsale by name because they are the immediate customer. The actual policyholder may or may not ask for Kinsale by name. They're actually just looking for coverage. By the way, these policyholders, the eventual policyholders, are relatively small. What I mean is the average premium for a policy at Kinsale is only about $15,000. If you look at even James River or some of the other bigger insurance companies, it's at least 10 times more than what Kinsale is getting.

This is a unique advantage that Kinsale has, targeting the very small employer base or the smaller end of the commercial spectrum. I'm not sure if they necessarily ask by name, but the immediate customers, the wholesale brokers, know Kinsale by name. Do they come to Kinsale on a mission? Some do, and some don't. They approach Kinsale because the turnaround is extremely quick. To explain the process: the policyholder goes to the broker, the broker goes to the wholesale broker, and typically the wholesale broker will submit this policy's details to various excess and surplus providers and underwriters, including Kinsale.

Most of them, like Markel, Berkeley, AIG, have been around for a while and have made numerous acquisitions. The legacy systems within these companies can be extE&Sive, having 20, 30, 40 legacy systems. For example, I mentioned that Mike Kehoe used to be at Colony, and even today, without specifying the company, there is at least one company I know of that uses the same enterprise system that Mike Kehoe used when he was at Colony in the nineties. These are outdated systems, and transitioning to a new platform isn't straightforward. In contrast, Kinsale, being a relatively new start, has developed a unified enterprise system that everyone within the company uses.

This structure allows for an incredibly quick turnaround. What do I mean by that? A submission comes into Kinsale, and they respond within 2 to 24 hours, unlike Markel and others, where it might take up to a week to even reach the specific underwriter. These advantages might not translate into tangible numbers on financial statements, but they're the unique edges that Kinsale has cultivated over time.

Yeah. So, they've designed the business to have a low enough cost base to be able to serve a small part of the market, which was previously uneconomical to serve. I think that's really cool. Like the data point that you shared there where the next underwriter might have an average premium 10X larger than Kinsale's.

Let me loop back to my next question then. Given the depth of your experience in the financial services industry, and even though you're an outsider when it comes to this company, how do you get comfortable assessing the risks in their book? Especially given that since 2012, we're just over a decade old. But how do you get comfortable with their underwriting?

Yeah, I think that's a very important question. I don't know if I have a concrete answer on that front, but I obviously spend a lot of time trying to understand a few things. Here are a few that provide some comfort. Insurance, by the way, is one industry where you don't know the cost of goods sold at the point of sale. That's unique to the insurance business. The cost in an insurance policy is essentially the loss or expenses that might arise in the future. Only time will tell how efficient the company has been in underwriting a specific risk. It's crucial to understand the quality and history of the management team. Meeting them, understanding their history and perspective provides some comfort. Not saying that just looking into their eyes gives 100% confidence, but to a large extent, history can provide context.

I've met with Mike Kehoe and his COO, Brian Haney, who also came from James River when Mike Kehoe was there. I've spoken to various brokers and other insurance investors. I feel comfortable with how the industry is progressing. But to provide a tangible, quantifiable metric that might inform this thesis: typically, in an insurance company, when you see the loss and loss adjustment expenses, which is the primary expenses in insurance financials, growing consistently at a rate higher than the gross written premium, trouble might be brewing.

Understanding the mindset of the management, their processes, and the boundaries they set helps in getting comfortable. As I said earlier, you can review historical performance. I mentioned there are about 1,001 insurance companies in the U.S., and I can access their statutory accounting financials. So, I did some analysis. I looked at the P&C industry's expenses ratio over time. The expenses ratio typically is in the 30-40% range in the larger industry. Kinsale, on the other hand, is in the low to mid 20% range, a significant edge. Even when compared to unique excess and surplus writers like Arch or Argo, Kinsale has a competitive advantage.

One critical metric in insurance is the combined ratio, which Warren Buffett often mentions. If the combined ratio is less than 100%, the insurance company is underwriting at a profit. When comparing Kinsale's expenses and loss ratios to the broader industry and even to specialized players like Progressive, Kinsale consistently comes out ahead. The margin difference is significant.

I'm making this loose analogy: the loss ratio is almost like the inverse of a gross margin. And if you're telling me that Kinsale's loss ratio is in the fifties, it's almost like they're charging for a policy premium twice what their expected loss would be. This reflects a lot of pricing power, which probably goes back to the bespoke nature of the policies and the fact that they're serving what was previously an underserved segment of the market. And then, because of all this automation and the other factors you described, the expenses ratio is also very low, resulting in a significant profit.

Yes, you nailed it, Graham. Essentially, you condensed it into a format that's more legible and understandable.

I want to ask a couple of things as we move towards the end of this conversation. How do you think about value in general and then specifically with this investment? Specifically, with Kinsale, the cheapest the stock has gotten in the last three years was six times trailing price to book, which is maybe a five times higher multiple than what one might typically want to pay for an insurance company. I'm just curious about the valuation in general and then specifically with Kinsale.

Fair question. Before I delve into valuation, I focus on three key factors: high return, high reinvestment, and a competitive edge. Kinsale generates healthy returns and reinvests heavily. Their growth in gross written premium and net written premium has been impressive, at over 30%. Their growth is driven by the industry's expansion, and given my projections for the sector, I anticipate continued strong reinvestment. The factors I've highlighted, such as their unique client focus, underwriting expertise, technology, and low costs, give them a competitive edge.

In a recent conversation with Mike Kehoe, I explored the issue of competition. I'm always concerned about competitors in any business. Mike expressed his own surprise at the absence of new players entering the space that Kinsale dominates. Although there are new excess and surplus providers, they tend to focus on medium to larger-sized policies, not Kinsale's niche. It remains to be seen if new competitors can disrupt Kinsale's momentum.

Now, regarding valuation, while Kinsale's metrics might seem high compared to traditional insurers, one can't evaluate them in isolation. One must consider the business's quality, management quality, and future prospects. With the kind of growth anticipated and if one is confident in the underwriting process, one can project over a longer term, say five years. Insurance is, after all, a long-cycle business.

It took almost 16 years for the soft market, where the premiums keep going down in the larger industry, to turn into what is now a hard market. In a hard market, premiums go up. It took almost 16 years for that to happen. I'm not saying it'll take another 16 years for the current hard market to transition, but it's essentially a fairly long-drawn process. Natural catastrophes have to subside. Social inflation rates have to decrease. Financial capital has to return. Interest rates must decrease.

Many other factors must align for this industry to see declining premiums and for the excess and surplus market to experience another soft market. I anticipate a relatively healthy market. I'm not suggesting it will grow at 30-40 percent for the next 5-10 years. Even before this hard market began, the company's objective was to grow gross premium in the low to mid-teE&S and to achieve a high teen's return on equity. Now they're exceeding that objective, performing more than double. In a soft market, they would revert to that level of return. That's my expectation.

Of course, the significant caveat is that they don't experience a massive loss, which some insurance companies and even some existing surplus providers have faced over time. That's why it's crucial to trust the underwriting and management team. Given that context, I anticipate healthy growth.

At the current price, this stock can maintain a robust return for five years. I expect that the EPS (earnings per share) five years from now will be substantially higher than today, translating into a reasonable return even if the multiples decrease from 40 to half that amount. You would still achieve a return with an IRR meeting my threshold. My threshold is at least a 15% return, a double over five years, or at least 15 percent annually. That's how I become comfortable with the current valuation.

Let me discuss the book value multiple you mentioned. If you recall Warren Buffett's acquisition of Geico in two parts: the first was at a multiple below book value, while the second in the 1990s was at a significant premium to book value. That's when he began discussing how the book value isn't always the best metric for valuation. While he didn't explicitly say this, you can infer why he made that statement from his discussions about the insurance float.

The float in insurance represents the difference between the policyholders' money currently held and the money not yet in hand. This difference essentially constitutes the float. Premiums are collected upfront, but claims aren't necessarily paid immediately. This delay allows for investment opportunities with the float. Buffett has leveraged this outside of insurance, achieving robust growth for the company.

I've conducted a similar analysis for Kinsale. However, not all insurance companies consistently turn a profit like Kinsale. Some experience severe downturns. I live in Chicago, and a few local insurance companies, some of them publicly traded, have a high combined ratio of 120-130%, indicating underwriting at a significant loss. It would be challenging to calculate the float and derive an adjusted book value in such cases.

With Kinsale, given their profitability track record, I'm comfortable doing this exercise. Taking into account various factors like policy reserves and reinsurance liabilities, we can determine the float's impact, adjust it for potential taxes, and arrive at a tax-adjusted float value. From there, we can decide if that value should be added to the book value as quasi-equity. When you look at the adjusted book value over time, you mentioned it never traded below six times. I agree. But upon further examination, it's clear it never exceeded three times the adjusted book value.

This assessment is subjective. You might argue that you can't always adjust in this manner. I would agree but offer another perspective on why the six times multiple might not be suitable for Kinsale. It currently sits at about three times, which, compared to the broader industry, is still on the higher side. Only time will determine if it can maintain that multiple. That's how I arrive at my comfort level regarding the valuation. I believe they will continue to grow and distance themselves from competitors.

Wow, Shree, we are just so lucky to benefit from your decades of experience in the industry. I'm blown away by the depth of your understanding. You were talking about ego before and how one of the most important things you do every day is to keep your ego in check so that you maintain an open mind. I'd like to know, what would change your mind about Kinsale?

Great question. Again, a few items would jump up front. I've mentioned that insurance is a business where you don't know the cost of goods sold. Therefore, the quality of the management team is crucial in this analysis. First, any sort of disruptive change at the management level would be concerning. Mike Cahill and Brian Haney, the CEO, are the two primary individuals driving the business. Brian Haney is an actuary, and even though he is the COO, he plays an integral part in the reserving process of an insurance company. Reserves are the most critical aspect of the balance sheet. If something were to happen to those two, it would be a significant disruptor.

Secondly, any major change in the drivers I described would be alarming. For instance, natural catastrophes are on the rise, according to the National Oceanic and Atmospheric Administration (NOAA). This trend isn't abating due to global climate issues, rising temperatures, and other factors. However, if these trends were to reverse and other factors, like interest rates decreasing and financial capital returning, began impacting this growth, that would be concerning. Additionally, if new competitors entered the space and disrupted Kinsale's specific growth, or if there were underwriting missteps, those would be red flags. In the insurance industry, from what I've seen, when there's one issue, there are usually multiple underlying problems.

That's why I mentioned that specific metric I keep an eye on. Over time, the loss and loss adjustment expense ratio shouldn't consistently grow at a rate faster than the gross written premium. While there might be occasional fluctuations, you wouldn't want a consistent trend. Those would be my indicators. Of course, other insurance-specific investors might have additional concerns that I haven't addressed in this podcast, and I'm always eager to learn and would love to hear their insights.

That's an excellent place to wrap up. This has been a really fascinating conversation, getting to know you better and your investment process through the lens of Kinsale. So, Shree, thank you so much for your time. My final question is: if anyone wants to get in touch with you to learn more, what's the best way to reach out to you?

Yes, I maintain a website at www.svncapital.com. I post some of my writings there regularly and feature podcasts like this. That's one way to follow me. My email is [email protected]. You can write to me, and I would love to hear from some of your followers and listeners.

Okay, Shree, thanks again for coming on the podcast. It's been an absolute delight to speak with you. We first met in Omaha this year, and I hope to see you again there sometime.

Absolutely. Looking forward to it. Thanks a lot, Graham.