Enstar Group Limited (nasdaq:ESGR)
(13.5 million common shares, 1/3 management owned, Book Value of $50/share)
What does Enstar do?
“Our principal business consists of acquiring and managing property and casualty insurance and reinsurance
companies that have ceased underwriting new business —i.e. they are in “run-off.” The vendors of such businesses
are often keen to find long-term solutions for their non-core legacy operations that may release capital, improve
ratings, free-up management time, effort and cost and provide financial certainty and finality. The solutions that we
provide to such vendors focus on the acquisition of the run-off business either by purchasing the entire share capital
of the run-off entity or, if the legacy business is part of an ongoing company and not able to be sold, assuming the
run-off liabilities by way of portfolio transfer or providing reinsurance protection.”
How does Enstar make money?
 settling net loss reserves below their acquired fair value:
 generating investment income on the cash and investment portfolio acquired with the run-off company or
portfolio;
 in some cases, purchasing companies at a discount to the fair value of the assets acquired, which results in
negative goodwill that has been recorded as extraordinary gains; and
 providing expert run-off management services for a fixed and/or incentive based fee in cases where vendors are
not ready or able to dispose of their run-off operations but require third-party services to stabilize the business
and, where possible, create value to the core business.
How should an investor measure the performance of Enstar Group?
24.4% CAGR over 5 years if purchased at 1.0x Book Value. Most of this gain came from reducing liabilities from
acquisitions and negative goodwill with only a modest portion from investment income.
What does the balance sheet look like?
What does the earning statement look like?
How can an investor value Enstar Group?
We must know three things:
1. The rate of return on the (generally decreasing) cash balance,
2. The ultimate discount (or premium) at which claims are settled,
3. The impact of new acquisitions & negative goodwill to offset the declining insurance ‘float’.
Catastrophe
Scenario
(Inflation = 5%)
Loss Reserves
Investment Income
Expenses
Book Value
Rate of Change
(per year)
2008
2018
No Reduction
2.5%
constant
2800
0
0
615
2800
875
800
690
Net
Difference
(thousands)
$0
$875
$75
$75
Present Value
$423 million or 50% above IV.
In this scenario, the company is not able to keep up with inflation nor is it able to execute their business model of
settling claims below face value. The historical evidence suggests this scenario is highly improbable.
Base Case Scenario
(Inflation = 5%)
Loss Reserves
Rate of Change
(per year)
-5%
2008
2018
2800
1764
Net Difference
(thousands)
$1036
Present Value
Investment Income
Expenses
Book Value
inflation
constant
0
0
615
1123
800
1974
$1123
$800
$1359
$1211 or 34-50% below IV
It is unlikely that Enstar will achieve no real return above inflation. Likewise, they’ve been busy doing acquisitions.
The insurance float will remain static as reductions in loss reserves are offset by new run-offs. Negative goodwill
and foreign exchange gains will already add about $100 million to equity in 2009. The base case scenario has some
substantial upside.
The good, the bad, and the ugly.
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The financial crisis will likely lead to more insurers wanting to exit their legacy assets and achieve finality
to release capital which is good for Enstar, however,
Enstar needs credit to buy these run-offs because run-off cash is released slowly each year and credit will
be expensive in the future.
By providing run-off services, they are able to “peek” at the books of business they may acquire in the
future.
10% of the investment portfolio ($200 million) was allocated to a private hedge fund run by JC Flowers &
Co. Mr. Flowers, in my opinion, is a mediocre investor at best with several disastrous investments made
recently. The investment has been written down by 60%. Mr. Flowers, who owns 10% of Enstar is a
liability to the company and the association with him is likely to lead to sub-par returns on invested funds,
unless he smartens up, which is unlikely.
Inflation is not friendly to financial companies, however, Enstar only needs to keep up with inflation and it
would still provide a reasonable return to owners.
Enstar is in the business of transforming insurance liabilities into owner equity from failure due to the miscalculation of risk, so why are they able to do this at all?
A poster on a message board offered these possible explanations:

On long tailed liabilities, there's the effect of the present value of money.
Asbestos and environmental policies have an average life of around 40 years. If Enstar settles a policy today, for
example, for $80 that has a face value of $100, it can book $20 to equity and re-invest the proceeds at a rate higher
than the discount rate. In an inflationary environment, which is what I expect, you want to get your money out quickly
(a bird in the hand is worth MORE than two birds in the bush).

For insurance operations not in runoff, they need to maintain certain rating, so take Traveler's case, you have to
reserve for AA rating, which is a pretty high standard and covers future liabilities with say 90% confidence (purely
speculation on the number). But the actual liabilities likely end up being somewhat less. Similarly, when you put one
of those things in runoff, the insurance regulator need to make sure there's enough reserve to cover the future
unexpected liabilities with a decent cushion even though the actual expected loss could be significantly less.

Why would an insurer sell off that reserve at a discount? First they need to keep that reserve anyway, whether it's
because of rating agency or insurance regulators. And for a AA rated entity, it's so over-reserved that ROE is not very
high, say only 7-8% (once again, purely speculation on number). It works for an ongoing operation, because you have
prospects for future business, and there will be those years that you earn 50% or 100% IRR's on new premiums like
immediately post Katrina. But for runoff, where future earning is defined, that probably isn't the most efficient
use of capital, where you leave it there for 30 years, earning IRR of 7-8%. It's very low risk, like a AA bond, but
just doesn't do it for you as equity capital. So you are willing to sell that for say 30% discount. Where you go wrong,
of course, is if you found out that the actuarial world underestimated the liabilities, Asbestos, Environmental, etc,
Conclusion
Run-off insurance can be a lucrative business without some of the risks involved in ‘live’ insurance companies.
When a hurricane hits, a ‘live’ company may have losses beyond what is reserved and that decreases shareholder
equity. Run-off is about “the past, going forward”. There are no new exposures, the risk is easier to quantify and
the outcome is more predictable. By buying insurance companies after they have failed, Enstar has the benefit of
float with the appealing benefit of regular profits from reducing the loss reserves and buying below net asset value.