Tuesday, February 5, 2008

HCC Insurance (HCC) looks like reasonable value

Many insurance stocks have been sold off recently by investors due to fears over the credit crunch and expectations that softer insurance market pricing will further reduce insurers’ profitability.

One insurer which I think represents good value, despite these headwinds, is HCC Insurance. HCC insurance (HCC) is AA rated by S&P and began operations in 1974. It has offices in the US, Europe and the UK.

HCC Insurance is truly a specialty insurer with an excellent franchise . They don’t write general liability or workers compensation insurance. They write numerous products including directors and officers liability, aircraft insurance, marine insurance and life,accident and health products. Many of the insurance products fall outside the standard market so are subject to less price competition. HCC estimate that over 60% of their products fall outside the standard insurance cycle.

Historically, due to its specialty focus and underwriting discipline, HCC has maintained a combined ratio well below the industry average and their loss reserving has been overly conservative with loss redundancies consistently reported with one or two exceptional years. Since 1981, HCC has only made an underwriting loss on only two occasions in 2001 (combined ratio was 101.8%) which included $22 million in losses from the World Trade Centre attacks and 1999(combined ratio was 104.1%).

One way HCC maintains above average profitability is by keeping a solid grip on their underwriting. HCC will buy the Managing General Agents or MGAs that they use. This way they have more control over terms and the pricing of policies.

Around 12 months ago HCC was mired in controversy over the manipulation of options grants which cost the job of former CEO Stephen Way. The ultimate cost of these grants was minimal. A recent legal case resulting from this options was settled for $3 million , which was fairly immaterial. The loss of Stephen Way was far more damaging as he spearheaded HCC since founding the company in 1974 and has been instrumental in HCC’s success. Nevertheless, many of the key operating officers who have been part of HCC’s growth over many years including Frank Bramanti ,current CEO, and John Molbeck, current Chief Operating Officer, remain with HCC. Further, HCC has an experienced management team in each of its operating subsidiaries. Their de-centralised management structure is a key strength for HCC.

HCC under current management has been hitting on all cylinders over 2007. Net earnings are up 13% to $295 mil for the nine months ended 30 September 2007 from $261 million in nine months ended 30 September 2006. The GAAP combined ratio for 2007 and 2006 has been an excellent 83%. On a trailing twelve month basis their earnings are around $370 million.

Frank Bramanti has maintained disciplined & patient approach on the issue of making acquisitions , insisting they will wait for the right opportunities to come up as the insurance cycle continues to soften, and they will not over-pay. In the meantime, HCC continue to pay down their debt and build their cash reserves. Recently they acquired Mulitnational Underwriters (MNU) further adding to their health insurance arm and which will add $40 million in premiums to their business. They aso recently rceived approval for a new Lloyds syndicate platform to help expand their global insurance products.

HCC has a very conservative balance sheet, their fixed income investment portfolio had an average AAA rating. They have debt to capital of just 11.6%. Their fixed income investments are managed by New England Asset Management , a subsidiary of Berkshire Hathaway. They have just $20 million, less than 1% of shareholder equity, in subprime and Alt A bonds which are rated AAA and have not been subject to downgrade. They own no CDOs or CLOs.

HCC valuation looks reasonable and in my view is now being priced both for a recession and a soft insurance market (not to say the share price can’t go lower …all the better!). HCC Insurance has a market cap of around $3.1 billion or $27 per share, around 1.28x my estimate of closing book value of $21 for 2007. This is the one of the lowest price to book value ratios that HCC has traded at in the last decade. Its earnings for this year will be around $3.30 per share ,so the PE ratio is a modest 8x and pays a 1.6% dividend. A lot of downside risks have been priced into this company. Despite options related sales by two directors, insiders have been buying shares over the last 6 months. Of note, John Molbeck ,COO, bought $418K in stock on open market in August at around $27-$28 per share and during January Edward Ellis, Chief Financial Officer, exercised over $1 million in options at $18 per share and has not sold any shares after that exercise.

Finally,HCC Insurance could also become an acquisition target for a large insurance company such as AIG or foreign insurer such as Allianz, given the unique franchise HCC holds in the specialty insurance market. I would expect HCC would command a price to book value of 2x book or $42 per share if sold on a private market basis.

Disclosure: I own shares in HCC Insurance(HCC)

Disclaimer: The opinions expressed by the author’s own views and are not intended as investment advice and should not be relied upon as investment advice.


oldye said...

compared to whats available, why do you think these guys are cheap? I'm sure you are familiar with ORH, NB.to, WTM just to name a few value favorites trading at much lower multiples to book, invested assets.

Tarn P Crowe said...

hi oldye, I agree they are great companies, the whole P&C sector is under-pressure & I think thats a reflection of the panicky investment environment we are now in + soft market expectations.

On ORH & NB.TO ,Fairfax Financial is my largest investment ( for reasons as I discussed in my Jan article), as you know they have majority ownership of both Odyssey re & Northbridge. So I have made a indirect bet on both Odyssey re & Northbridge. Its just a question of how much exposure you want & getting exposure to Fairfax's other insurance businesses. I prefer owning Fairfax directly.

White Mountains has a great investment manager in John Gillespie & CEo in Ray Barrette. WTM is very different to HCC. I think WTM is generally a good buy for around book value , it operates in inherently more price competitive insurance areas & is more catastrophe exposed than HCC. WTM is very much a bet on their investment team as we enter a deteriorating pricing environment & WTM also has Symetra (there is hidden value which can be unlocked)

Look you probably can make a case for buying both - given the right price.

HCC is a very niche focused insurer. They really don't have a peer due to their niche focus - and I think thats where the premium to book value becomes justfied. They insure (a few examples) sports teams (like AC Milan), film actors , kidnap & ransom, "hole in one" golf course competitions, antique planes etc - these are very profitable,specialised areas , standard insurers don't want to go near. You can see in the lower combined ratio vs say White Mountains that HCC has considerable earning power by virtue of their specialised expertise (so HCC can generate much more low cost float than WTM). So I guess when looking at HCC I'm looking not just at their price to book but their ability to grow that book value. In their '05 annual there's a nice table that shows they grew adjusted book value at 20% over 1992 to 2005. Its been not 20% but still a very satisfactory high teens over last few years.

Look I guess its a relative value call , HCC looks like good value to me.

Tarn P Crowe said...

"so HCC can generate much more low cost float than WTM" per dollar of premium - correction

oldye said...

I understand you wanting to hold FFH directly. It makes up most of my portfolio. But If I had to buy anything else I wouldn't have a problem picking up pieces of the subs. My old finance prof. would probably have a heart atack.

Anyway, it sounds that HCC competes directly with Ajit Jain's unit at Berkshire. I know they insure special events, celebreties etc. The long-term growth rates of all these companies is around 20%, I think being able to pick up some of these names around book over say 1.3 will improve your shorter term results. But if you hold it long enough, which I'm sure you intend to your returns will simply reflect those of the busines. And they'll probably be satisfactory!

Keep up the good work.