Insurance is a mixed bag these days. Rates seem to be firming up, but many reinsurance companies have had to absorb losses tied to several disasters. Unfortunately, underwriting discipline has apparently become a problem at Flagstone Reinsurance (NYSE:FSR), and investors are looking at a multi-year rebuilding story with this insurer.

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Fourth Quarter Results More of the Same, Only More so
Flagstone ended the year on pretty weak footing. Gross written premiums dropped 3%, while net written premiums fell 18%. To a certain extent, this was not very surprising - not only have many reinsurers seen iffy premium growth, but Flagstone has been actively looking to cut its risk exposure.

Speaking of risk exposure, the combined ratio blew up this quarter. The reported combined ratio came in above 160%, as the company saw significant catastrophe losses. While that was not so surprising (catastrophes don't tend to be subtle), what was more surprising was the amount of prior-year strengthening the company had to take. In other words, the company had to increase its assumptions regarding losses on previously written policies.

All in all, Flagstone delivered weak operating results and book value linked about 10% on a linked quarterly basis. Across the board, these results were bad in comparison to other reinsurance players like Arch Capital (Nasdaq:ACGL), Axis (NYSE:AXS) and Endurance (NYSE:ENH).

Trying to Fix What's Broken
To its credit, Flagstone is trying to patch up its holes. The company is looking to aggressively cut risk exposures - by as much as 50% internationally and by about 30% in North America. Unfortunately, this comes with a cost. Insurance companies like Flagstone, Arch and Axis are in the business of taking on risk exposure in exchange for money. Reducing risk exposure will help shore up capital, but it also reduces the profit potential.

Flagstone is also looking to shrink its business. The company has decided that its Lloyds and Island Heritage business are "non-core" assets, even though they contribute about one-quarter of the company's premiums. The company has been seeing high catastrophe losses from these units, and apparently feels they're not worth trying to restructure or repair. Although it makes a certain amount of sense to jettison these businesses (especially if prior year developments are looking ugly), investors shouldn't expect the company to get much for them.

The Road Back
Flagstone relies pretty heavily on brokers like Aon (NYSE:AON) and Marsh & McLennan (NYSE:MMC) for business, but the company needs to improve its underwriting policies. As a reinsurance company, Flagstone doesn't review individual policies so much as they review the underwriting policies and records of the companies they reinsure. Given the high rate of losses, they clearly need to review and improve that process. Yes, catastrophes are unpredictable, but Arch, Endurance and Axis underwrite a lot of the same business and seem to fare better.

The Bottom Line
Increased retrocessional support should help preserve capital, but it's going to cost Flagstone growth. That also suggests to me that the company may well miss out on a lot of the benefits of the firming North American market.

Taking that all into account, I don't see many reasons to own the stock today. True, Arch Capital-like future performance would suggest these shares are cheap, but why assume that the company can achieve that? A more subdued analysis of likely returns suggests that these shares may be slightly undervalued, but not by enough to compensate for the risk.

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At the time of writing, Stephen Simpson did not own shares in any of the companies mentioned in this article.

Tickers in this Article: FSR, ACGL, AON, MMC

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