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TWST: What are the macro factors that you feel will have an impact on these companies over the next 12 to 24 months?

Mr. Thompson: Generally, underwriting strain has been the most important factor, and the impact is different on personal lines compared to commercial. Beyond that, I see forces at work driving the commodity aspect of insurance. Technology as it’s applied to settling claims and managing claims, these colossal systems are leveling claims settlement practices. Distribution, e-based aggregator sites that allow for multiple quotes, serves to level the playing field. The easing of state regulation and licensing requirements under financial services reform will help efficiency in pricing and new product development. Companies more than ever need to distinguish themselves in the marketplace or they will not earn an adequate return. These challenges differ between commercial and personal lines companies. For example, financial strain will probably have a different effect on personal lines insurers. Generally for the industry, we’re seeing pressure on the loss cost components, and that’s eating into redundant reserve positions. Cash flows are still much weaker, and reserve deficiencies are certainly growing. So going forward, as there is more financial pain, I think there is more pressure to raise rates, and in the commercial lines industry it’s usually easier to raise rates than in personal lines. In personal lines we are starting to see signs that severe pricing problems are emerging. But the personal lines group was better reserved at the start of this year, so there is less balance sheet strain. Also, goals of cross-selling are driving the need to advertise and potentially lose money short term in order to control the customer. At the end of the day, the auto industry is setting itself up to need substantial corrective rate action, and as rate requests increase, that will drive regulatory concerns.

TWST: What are the most important factors to focus on in valuing these businesses?

Mr. Thompson: I guess the most important factor is the degree to which you think the companies are going to succeed. Those factors are driven by markets, product differentiation, strength of the balance sheet, strength of management, and discipline, because discipline, more than anything, is what is going to drive companies in this kind of environment. For example, the discipline not to write business too soon with a 5% rate increase, to think that’s enough to grow your market share to keep a strong and healthy balance sheet. What I’ve been looking at today more closely when valuing companies is their leverage toward improvement. Some companies have better earnings leverage toward commercial price increases than others. An example of an overlooked company is Selective Insurance Group, Inc. (Nasdaq:SIGI). I am probably one of the only analysts who is recommending it right now. I just upgraded the stock after I visited the company about a month ago. This is not a sexy story, but they are doing the right things today. They’ve remained disciplined in a regional market that was until now supported in part by cheap reinsurance. My view is that their earnings decline is leveling off. I think we are going to see earnings growth going forward. I have analyzed their reserves, went over them with the company, and they look adequate. They are getting rate improvement and they are better leveraged. If you assume for Selective a three-point improvement in their commercial lines loss ratio, that equates to 33% earnings growth next year. If you do that for the industry, you get 11% earnings growth, so they are 3 times more leveraged.