American Safety Insurance Holdings, Ltd. (ASI): Prem Watsa Likes This Small-Cap Insurance Business

Recently, shares of jumped by more than 20% within one trading day. The huge one-day gain was due to the fact that Fairfax Financial Holdings Ltd (OTCMKTS:FRFHF) agreed to acquire American Safety at around $29.25 per share in cash, with the total transaction worth $306 million. Fairfax Financial is run by the so-called “Canadian Warren Buffett,” Prem Watsa.

Let’s take a closer look at American Safety, which has a market cap of about $278 million, to see why Prem Watsa has a taste for this insurance company.

Cost of float is a bit lower than Treasury yield

American Safety is considered the specialty insurance and reinsurance underwriter, operating in three main insurance divisions: excess and surplus, alternative risk transfer and assumed reinsurance. Most of its earned premium, $138.5 million, or 54.5% of the total 2012 earned premium, was generated from the excess and surplus division, while the alternative risk transfer and the assumed reinsurance division contributed $56.47 million and $58.9 million, respectively, to earned premium.

In the past three years, American Safety Insurance Holdings, Ltd. (NYSE:ASI) had quite a reasonable combined ratio, fluctuating in the range of 100% to 111.8%. In 2012, the combined ratio was 108.1%.

In the insurance business, the float is one of the most important concepts. Float is the temporary free cash that insurers receive upfront when writing new policies. Insurers would only have to pay it out in the future when a certain insured event occurs. Thus, insurers could invest the float during the time they are holding it. I estimated that the 2012 float was around $633 million. In 2012, American Safety produced nearly $20.6 million in underwriting losses. Consequently, the cost to generate float was 3.2%, a bit lower than the 30-year Treasury yield of 3.3%.

As of March, American Safety Insurance Holdings, Ltd. (NYSE:ASI) had around $927 million in total investments. The majority of its investments were in fixed-maturity securities, some $818 million, while the short-term investments ranked second at $81.1 million. With the total amount of $306 million, the deal has valued American Safety at around 89% of the company’s book value.

Fairfax Financial and its terrific historical operating performance

American Safety was valued a much lower than Fairfax Financial in terms of book value. Fairfax, at $406.90 per share, is worth around $8.2 billion in market cap. Fairfax is trading at nearly 1.1 times its book value.

In 2012, Fairfax Financial’s insurance and reinsurance operation delivered an underwriting profit, with a combined ratio of 99.8%. The underwriting profit was caused by the significant underwriting profit of OdysseyRe and Fairfax Asia, with the low combined ratios of only 88.5% and 87%, respectively. Hence, Fairfax was paid to keep the float to invest.