Over the last 20 years, this insurance company from the outskirts of Copenhagen has been one of Denmark’s absolute best companies when it comes to creating shareholder value. We are co-owners because the company has the kind of quality, stability and predictability that we greatly appreciate. And even if the company is already a well-oiled machine, there are still opportunities for improvement on the sales as well as the costs sides.

Topdanmark has been one of the success stories on Copenhagen Stock Exchange. Over the past 20 years, it has delivered one of the best shareholders returns among Danish companies. At first glance, the insurance industry is not exactly one of the sexiest or exciting industries unless you are an actuary or a boring asset manager. Topdanmark is a good illustration of how a highly competent management team and intelligent allocation of capital have a great impact on long-term shareholder returns.

Topdanmark is Denmark’s second-largest non-life insurance company in a well-consolidated industry.

Combined, the five largest property and casualty insurance companies in Denmark hold more than 60 percent of the market. Topdanmark is a strong number two with almost 17 percent, only surpassed by Tryg (which is also one of our companies). Topdanmark operates only in Denmark while Tryg operates throughout the Nordic region. This focus (both in terms of geography and the types of insurance products) is one of the keys to Topdanmark’s success. Topdanmark’s return on equity is unmatched in the industry. In 2016 and 2017 it was more than 30 percent, while it was slightly below 22 percent in 2018 due to a negative investment result.

In a well-consolidated and mature insurance market such as the Danish, it is essential for the long-term value creation that the largest companies take a rational and disciplined approach to competition. Lowering the price of your insurance products may help you gain market share, but all other things being equal, it will have a negative impact on the earnings potential of the entire industry. However, compared to the international peers, the profitability of Nordic non-life insurance companies is outstanding. The Combined Ratio is impressively low at around 86 to 87 percent. This ratio indicates what proportion of the annual earned premiums either go to claims provisions or to operating costs such as costs related to the sales force, administration costs, or calculating the size of claim provisions.

Insurance companies continually keep track of what is expected to be paid out to customers in claims. Some of these will be determined within a few months while others might be payments that stretch over several years. In these cases, the initial uncertainty about the size of the pay-out will naturally be greater. A few years back, the average combined ratio for a non-life insurance company would typically be around 100 percent. This meant that the sum of the operating costs and provisions for future claims equalled the year’s earned premiums.

Complicated financial statements

Back then, the earnings came from the insurance company’s ability to invest the reserves that are gradually built up as provisions for future claims, what Warren Buffett has termed “floats” in Berkshire Hathaway. These reserves can be regarded as kind of an interest-free loan and thus act as cheap capital that can be invested and create attractive returns. An example is Berkshire Hathaway, where Warren Buffett has acquired some well-managed insurance companies with the purpose of using the interest-free loans to make sound investments elsewhere.

The calculation of future claims takes into account the difference in time between when the claim is reported and when the money is paid out. The calculation also includes the use of many statistics and assumptions. For this reason, we appreciate a historical track record of insurance companies being too conservative in their estimates of what the future claims will amount to. When this happens, the run-off gains will be positive, and since 2013, these have been at around 4 percent or above each year for Topdanmark.

Financial statements of insurance companies can be difficult to read and understand, and you cannot look at a single year in isolation. We therefore greatly appreciate that there is a strong degree of continuity and integrity among the management team. Additionally, we appreciate a continuing cautionary approach to calculating the size of the expected payouts for insurance claims.

For insurance companies, the key is to identify the right customers and sell them the right insurance products at the right price. We are pleased to note that Topdanmark has become even better at retaining its customers, resulting in a current annual retention rate of 90 out of 100 customers. The profitability of a customer relationship increases over time as the additional operating costs per customer are limited compared to the costs of acquiring a new customer. Similarly, a longer customer history provides better insights into the expected future profitability of the customer relationship.

The insurance discipline is measured by the so-called technical result which states the insurance premiums received less the operating costs and claim provisions. Topdanmark has demonstrated industry-leading insurance discipline. Since 2001 it has had only a single quarter where the technical result was negative, and this was a result of major national snowstorms in the winter of 2009/2010.

Over the past ten years, Topdanmark has focused its non-life insurance on its largest business areas, personal casualty and car insurance. As a result, these business areas now represent almost 60 percent of the earned premiums compared to 55 percent 10 years ago. This growth has mainly been driven by personal casualty insurance, while the exposure to workers compensation has been halved to around seven percent. The focus on the personal casualty and car insurance has added to the stability and predictability of Topdanmark’s technical result. The reason for focusing on these areas is that the insurance claims are many, but small. These claims will not collapse the entire structure of the company. They just might leave a few marks on the walls compared to the more capital intensive and price competitive industrial insurances.

Premium growth is expected to increase

Private insurance is an attractive business area where customer retention levels are high. In addition, the customers are not price sensitive as it can be difficult to compare the details of two different insurance companies’ terms and conditions. This perceived complexity also results in private customers not being very interested in insurance products. Thus, when they have found the needed insurance cover, they do not think about it much unless they find themselves in the unfortunate situation of having to make a claim. This results in high profit levels and long-term customer relationships.

We find it satisfactory that Topdanmark managed to grow their premiums by almost two percent in 2018 given that they are operating in a mature insurance market with no significant market growth. Insurance policies are generally linked to the development in the consumer price index in Denmark. This is positive for the growth of premiums on agreements already signed as it helps inflation-proofing the earnings and the capital that Topdanmark can distribute to its co-owners. For 2019, Topdanmark expects that the growth in premiums will accelerate from 2018.

Since the growth in earned premiums is relatively limited, it is important to only sign the correct insurance contracts. Additionally, it means that costs must be kept tightly under control. As the rest of the insurance industry, Topdanmark has many opportunities to take advantage of digitalisation projects that can streamline the organisation and free up resources.

As a result, Topdanmark has been able to reduce the number of full-time employees by 14 percent since 2016, and it continues to focus on increasing the proportion of automated processes. In the same period, the non-life premiums earned in Topdanmark have grown from 8.9 to 9.1 billion Danish kroner.

Operating costs currently amount to around 16 percent of premiums earned, and in the year ahead it is expected to be reduced by 1 percentage point. These days, every tenth insurance claim is processed digitally from start to finish. It is especially in this process that there are great opportunities for digitalisation, as it is in Topdanmark’s as well as in its customers’ interest to ensure that this takes place as smoothly and quickly as possible. Additionally, Topdanmark can use technology to help identify and minimise the risks of incorrect insurance claims.

The use of digitalisation and the subsequent improved ability to analyse large datasets will increase the economies of scale advantages in the largest insurance companies. At the same time, it will also result in the largest insurance companies being able to better price in the insurance risks they assume – and thus, it will also make them better at selecting the most attractive customers.

Currently, only a small proportion of the sales process is fully digitalised – around three percent of new sales. Despite the many opportunities for digitalisation, it may be an advantage to continue to create strong and personal customer relationships. Thus, we do not think digitalisation is a more efficient use of sales resources.

A distribution partner has been lost

Danske Bank has for a long time distributed Topdanmark’s insurance products to its customers via Danske Forsikring (Danske Insurance). Unfortunately, this partnership was terminated in 2018. Topdanmark is therefore on the search for a new bank to partner with in order to replace this distribution partnership. The Danske Forsikring customers are approximately 20 percent of Topdanmark’s current customer base in non-life insurance representing 10 percent of the premium growth in 2018. It is difficult to say how soon the two billion Danish kroner in annual premiums earned will be eroded. However, we are confident that management in Topdanmark will do their best to ensure a partnership with another large and attractive partner. It should be noted in this context that partnerships are not profitable from day one. Thus, there might be a period where the insurance business will see less profitability. However, a new partnership can be beneficial in the long run.

Non-life insurance is not the only area in which Topdanmark is active. Topdanmark is Denmark’s fifth largest life insurance company with a market share of just under 10 percent. Life insurance represents around 10 percent of Topdanmark’s earnings. In 2018, the pre-tax earnings from life insurance amounted to almost 230 million Danish kroner while non-life earned just over 1,400 million kroner.

Topdanmark got a new CEO in 2018, Peter Hermann. He assumed the post from Christian Sagild, who had 9 years of success in the role and a 23-year history in the company by the time he retired. Peter Hermann was promoted from his role as head of life insurance in Topdanmark, and he has extensive experience in the business. CFO Lars Thykier has been with the company for 33 years and served as CFO for the last 10 years. Lars Thykier has also been in charge of investing the significant insurance “float”.

When an insurance company receives premiums, these are set aside to cover any potential future claims. Until the money is paid, this capital acts as an interest-free loan from the customer to the insurance company. The insurance company can thus invest it and generate earnings in addition to the technical result. For the most part, these investments are allocated to bonds. For a number of years these had positive returns, but lower interest rates have lowered the expected returns. In 2018, the investments generated a mere 16 million Danish kroner, compared to 396 million kroner the year before. The assets invested was an investment portfolio of almost 19 billion kroner. The insurance companies have positive exposures to increasing interest rates.

That said, the investment skills are not the reason why we invest in insurance companies – though naturally, we are happy to see the extra earnings that the investments can bring.

A strong and experienced major shareholder

In 2018, Topdanmark will be distributing 15 kroner per share in dividends, equivalent to a dividend yield of more than 5 percent. We find it positive that in 2017, the board decided to cancel the share buyback programme and instead pay dividends to the shareholders. The total shareholder distributions, whether in terms of share buybacks or dividends, have been significant. Since 2010, they have on average amounted to almost 9 percent of the market capitalisation.

The finish company Sampo owns almost half of the outstanding shares in Topdanmark in addition to being the sole owner of the insurance company If P&C Insurance. Sampo increased its proportion of shares in Topdanmark significantly by not participating in the multi-year share buyback programme. Through these repurchases, Topdanmark reduced the number of outstanding shares by almost 80 percent, equivalent to 8 percentage annually in the years from 1998 to 2016. As a result, the proportional ownership of a share has increased by fivefold in that period. Sampo is represented on Topdanmark’s Board of Directors by Chairman Thorbjörn Magnusson, and Sampo has also succeeded in electing two others to join the board. Thorbjörn Magnussen has achieved some impressive results on the technical result during his time as CEO of the Nordic region’s largest non-life insurance company, If P&C Insurance.

We regard Sampo as a sensible major shareholder with a strong background in the insurance industry and an extensive knowledge of the customer base. We are confident that Sampo and the rest of the board will continue to work on behalf of all shareholders and have a positive impact on the value-creation of Topdanmark.