Top Picks 2011: Catlin Group (CNGRY)

"It very conservatively invests its premiums, in cash and fixed income with only 2.5% in hedge funds, yet it managed to produce a return on equity of 1.8% in H1 and of 2.9% in 2009 and Q3.

"It keeps raising its dividend, more steadily if you buy in sterling than the ADR. Given its current yield of 6% I'm satisfied with the payout but Citigroup analysts say it will go to 7.7%..

"It's a family businees, under CEO Steve Catlin, established as a Lloyd's underwriter in 1984.

"It's green, funding the Catlin Arctic Survey to measures the thickness and density of ice floes in the Arctic Sea and carbon dioxide absorption (ocean acidification). Nice but not why to buy.

"Rather, you should buy because Catlin is a globally diversified insurance business operating 88-89% in US dollars. It is quick to develop new businesses to benefit from macro-economic trends.

"It shifted its casualty lines from insuring British solicitors and surveyors, to hot button more profitable US insurance lines: medical malpractice; directors and officers (D&O) insurance; cover for architects, engineers, and construction and design professions; and environment risk.

"Catlin justifies these new lines (priced by its experienced actuaries) as "short tail" controlled latent risk cover for underserved niches.

"Longer-tail risk is very selectively underwritten by Catlin based on claims made. (Tails refer to the extremes of a normal curve, the unexpected events. Longer-tails mean unexpected payouts.)

"'Crysalis' is innovative oil production insurance, launched in Feb for oil and gas drillers. New business is booming post-Gulf of Mexico, and not just from US drillers.

"BP's disaster explains the rush for Crysalis cover. BP had a Bermuda 'captive' (self-financed) insurance firm.

"What it will be able to collect for its captive, say industry sources, is $1.5-3.5 bn. Against this, the economic loss from the Gulf disaster is $40 bn.

"And since the Macondo sank, BP shareholders losses from the stock's drop topped $73 bn, a compelling argument for buying insurance. Crysalis standard contracts cap the amount of cover per event at $200 mn, and per company at $100 mn, shortening the tail.

"Not everything went Catlin's way. Its first half earnings were nipped 8% from prior year by Chilean earthquake claims and the Gulf of Mexico. However, we had a benign hurricane season.

"And for all the dollar's appeal, getting a decent investment return is not easy in the present QE2 environment.

"If inflation takes off, claims will be higher and coverage from investment income lower. But then Catlin can raise its premiums. And it may have shifted the policies it offers into another currency.

"Citi expects the total payout next year for this 'undervalued'' (rated low risk, high return) share to come to 23.4% in sterling, and 16.6% in dollars at its target price of $12.80.

"Citi's 2010 profit forecast is $369 million, vs $243.8 million in 2009 and $384.9 million in 2008. (Per share, the hit was even greater in 2009 because Catlin did a rights offering to invest more during the crisis.).

"Its Sept. quarter saw Catlin premium income up 9% and earned income up 13%. Market cap is $1.982 billion, with the ADR stock at $11.50. It has an A.M. Best A rating from the insurance watchdog.

"Its combined ratio, a key metric, is 97% -- meaning expenses are 97% of premium income so underwriting was 3% to the good before any investment income. Buy CNGRY."

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