Markel Small Group Meeting

The Inoculated Investor

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1. Markel Corp. (MKL): CIO/EVP Tom Gayner a.

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How much is their desire to hold short term positions hurting ROE? i. Believes they are giving up 300-400 bps of performance in order to be very liquid ii. Their fixed income assets right now have an average duration of 3.5 yrs 1. P&C business usually has a 4-5 yr tail a. Would ideally have a portfolio with a 5 year duration i. But they feel they need to be more liquid iii. Treasuries are not attractive at all 1. Do think some munis are attractive but the rates don’t get that attractive unless you are willing to accept longer duration paper iv. Finally starting to look at buying common equities again v. Their marching orders are protect capital 1. Need to be able to react to volatile markets and do not want their money locked up long term 2. They are running the risk of underperforming their competitors by not using the money to write new business a. Not at the risk of negative performance though by letting the book run down Insurance pricing i. Pricing is increasing slower than they would like throughout the industry ii. AIG is still in the field and this makes the pricing environment very difficult 1. Why would anyone buy from AIG? a. Only based on the low price b. Brokers are pushing the cheaper products to clients i. Promise to pay issues (especially on contracts that are renewed yearly) are not a big consideration for cashstrapped consumers and businesses ii. No one ever thinks they will have a loss or claim so they are willing to gamble on AIG iii. These are mostly shorter tail policies 1. On longer tail policies people worry about AIG’s ability to pay c. Price movement is largely driven by AIG i. But brokers are afraid too 1. They know they are being shopped and they do not want to push expensive (albeit safer) products and risk that their customers go somewhere else iii. The international markets are a lot better than the domestic one in terms of pricing 1. The London office is apparently smiling a. Seeing good pricing on catastrophe, oil rigs, hull covers iv. Believe that the insurance companies still have capital holes to fill 1. The full effect of this has yet to be felt 2. People are in the denial state 3. Loss costs go up during a negative economic cycle a. But some companies are not seeing loss costs go up so they are not raising prices and therefore no one is b. Does think this could eventually lead to a hard market though What has been the best environment historically (or best opportunity) to grow book value per share? i. 1) After a massive, front page catastrophes ii. 2) When they have had the opportunity to make distressed deals and acquisitions

The Inoculated Investor

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In the past have even done deals with larger companies that helped them grow substantially iii. They are looking to add business and make acquisitions 1. But probably not anyone 2x their size anymore iv. For example: AIG’s Hartford Steam Boiler 1. MKL was not a preferred buyer but this is an example of what they are looking for 2. Are more likely to do incremental stuff in terms of investment allocation Talk about buying common stocks in this market i. Gayner is buying equities in his personal portfolio each month 1. He is in the position where he makes more than he needs so he can afford to invest that money in stocks ii. Take Coca Cola (KO) for example 1. At $42 and a 4% yield it looks very attractive a. That’s a great price but he can’t guarantee it won’t go to $38 i. MKL wants to be in the position to buy more at lower prices ii. When the insurance business is strong they can shovel the money into the investment portfolio 1. They are not seeing this now so they have to be judicious in their purchases of equities iii. You have to ask yourself what kind of insurance company you are 1. Like a 47 year old with a stream of income and capital to invest? a. When the insurance business is humming you can invest in slightly riskier securities 2. Or are you like a 78 year old on a fixed income? a. When the insurance market is soft you have to invest in safer assets Compensation and bonuses at MKL i. In the fire line there is a 2 year bonus pool 1. You know pretty quickly if there has been a loss on a fire contract 2. On other longer tail lines the bonus pool is 3-5 years ii. People in each line are measured by the compounded annual growth of book value 1. Not based on premiums written or earnings 2. Is that a problem since if book value per share does not increase then the management team gets no bonuses? a. What happens if they have to shrink the book for 4 years? i. Would they go without bonuses the entire time? 1. Thought that the board and shareholders would be willing to adjust those rules if they had protected capital prudently b. If they are right and there is significant inflation and rising interest rates on the horizon, doesn’t that mean that BV/Share could be impacted negatively? i. Yes, if they are directionally right and an interest rate spike makes all existing fixed income assets less attractive, BV/Share could go down 1. But they would be better off than everyone else in the industry due to their short duration 2. Also, the multiples on their businesses could contract as the whole world is worth less when interest rates increase

The Inoculated Investor f.

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How is One Markel progressing? i. Has been going very well but some of the encouraging results are being masked ii. The prototype was the Dallas office 1. It worked well from day 1 2. They tried out selling all the MKL products without silos and included the underwriting and marketing 3. Worked so well in Dallas they decided to roll it out nationwide as opposed to market by market or incrementally iii. In early march they turned the switch on for the entire company 1. Submission accounts are at record levels a. Brokers now have all the MKL products to sell i. Went from having 6 to sell to 100 b. Even though MKL has kept its price discipline, brokers are doing more business in MKL products i. How does that work? 1. They have one on one relationships with these brokers that are driving submissions ii. Remember the AIG book is being shopped 1. Anyone who has exposure to AIG is looking for other options iv. Concerns over potential cultural challenges are fair 1. Will not know for 5 years if the plan works 2. It is a very different model a. Their previous model of pods of entrepreneurs was not scalable i. Needed to change this to keep growing 3. Technology is very different today than it was in 1995 a. Don’t need to be as close to the exposure as they had to be back then i. Knowledge travels better now and that should make the transition easier v. This is not a statistically driven book of business 1. Do not have the years of data that GEICO has 2. This is more of a relationship-based model so of course there is some risk there vi. Where could One Markel go wrong? 1. Well, it has worked for the last year and a half so they are optimistic a. Producers are glad to have the full array of products 2. The extra cost of the system build out will add two points to the combined ratio in 2009-2010 period a. Since they are working off a smaller base now this could even be a bit larger impact i. Based on the operational build out With AIG and Chubb being the main players in the D&E/E&O space, has MKL thought about entering that business? i. How could anyone want to buy those policies from AIG? ii. MKL has been hesitant to enter this business in the current market environment What is the reason for betting on inflation? i. Deflationists have the right idea about the slack in the system potentially causing short run deflation 1. But Gayner is very concerned about the value of paper money a. Believes government actions will devalue paper money ii. Want productive businesses to protect against the inflation risk 1. They are less concerned about the supply and demand issue when it comes to the dollar

The Inoculated Investor

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iii. Is CPI a good measure of loss cost inflation? 1. Yes and no: CPI is a rough proxy but not a great one What’s going on in the excess and surplus business? i. These are very profitable right now ii. This business can be profitable or smooth but you cannot have both 1. Excess and surplus has peaks and troughs that other businesses do not 2. It makes a lot of money in good times and shuts down in bad times 3. So if you want to be profitable you need to be ok with it being lumpy and unpredictable What about the reinsurance market? i. They are not a buyer of reinsurance 1. They like to keep as much of this exposure as they can ii. They are a seller of reinsurance in the Lloyd’s market and are seeing prices firm Are there green shoots in the economy? i. Doesn’t feel like we are tumbling down the stairs anymore ii. Have seen some spotty signs of improvement 1. For example order counts at restaurants are up iii. However, things tied to housing and construction are weak and are not seeing green shoots Have they taken underwriters from other firms recently? i. Have only done a little bit of this ii. They have been approached by many people recently but they thought they were not a good cultural fit so they turned them down