1) Company Description:
Catlin Group Limited provides property and casualty insurance and reinsurance services worldwide. Catlin Group Limited was founded in 1984 and is headquartered in Hamilton, Bermuda. It offers insurance products and services in the areas of accident and health, aerospace, airlines, aquaculture, bloodstock/equestrian/livestock, professional liability, cargo, construction and engineering, contingency, downstream and upstream energy, energy liability, marine liability, facultative property, general liability, kidnap and ransom, life, marine and aviation reinsurance, marine hull, and medical malpractice and healthcare. & The main underwriting platforms are the syndicate at Lloyds, and the insurance subs in UK, Bermuda and US:
- The Catlin Syndicate is the largest syndicate at Lloyd's for 2008 based on a premium capacity of £1.25 billion. The syndicate is a recognized leader of numerous classes of specialty insurance and reinsurance.
- Catlin UK specializes in underwriting property and casualty insurance for smaller to medium size UK commercial clients through a network of regional offices. It also writes other business classes underwritten by the Catlin Syndicate.
- Catlin Bermuda is a leading participant in the vibrant Bermuda market, underwriting a diversified portfolio of property treaty, casualty treaty, political risk and terrorism, and structured risk coverage.
- Catlin US encompasses all of the Group's operations in the United States and underwrites a wide variety of insurance and reinsurance products from a network of offices throughout the United States.
Caltin Insurance Capital Structure - 2Q 2010
Total Debt: 687
Other Debt: 97
Hybrd Prefs: 590
2) Target Security Description:
Long position on: Catlin Insurance Non-Cumulative Perpetual Preferred Shares is a $590 million Fixed/Floating Perpetual non-Cumulative Preferred Shares, paid semi-annually. The Fixed Rate period will pay 7.249% until Jan, 2017. Thereafter, if the shares have not yet been redeemed, dividends will be payable quarterly at a rate equal to 2.975% plus 3 month Libor rate.
3) Investment Thesis:
3.1) Business and Risk Profile:
- Strong growth opportunities:
- New Areas: The company has been diversifying away from the Lloyd's with strong presence in Bermuda and recently starting a reinsurance unit in Switzerland. We see both initiatives a great potential for the company and they have been able to deliver growth with the already implemented initiative in Bermuda. The question raised here is if the company has been having loosen underwriting standards to gain market. Our due diligence was to talk to management and they have been reinforcing their underwriting standards and using the same models they use for every business, without loosening standards.
- Strong capital position: The company has 43% of its investment portfolio in Cash or approximately $2.5 billion investment. The other large holdings are Us and non-us government securities, but with no exposure to PIGS.
- Assets / Investment portfolio:
- Asset Profile: the company's asset portfolio is very conservative and the riskier assets such as CMBS is in most part AAA and above investment grade securities. The breakdown is ABS 3%, Agency MBS 5%, Non-Agency MBS 2%, CMBS 3%, Corporate Bonds 11%, FIDIC - Corp Bonds 5%, Gov. Agencies 10%, Non-US government 11%., Cash 43%, other assets 7%.
- Stress Test / Capital Cushion: The total statutory capital is ~$2.4bn. The total market cap is ~$2.0bn as of Sep 2010. In all stress-test analysis of write-downs for the different portfolio asset classes, the equity / stat capital was enough to support any losses.
- Loss ratio / Reserving history: The Company is perceived as a company who has done aggressive underwriting in the past and not been the most investor friendly. That view and reality has dramatically changed in the past years with the growth. Analyzing the losses, in peak loss years, like the years impacted by Katrina and other major cats reserves were not enough to cover losses, but in quiet years like 2008, the company had significant reserve releases. We see this as the common industry standard and the company has been profitable in the long-term.
- Pricing: The main market worry was the long-tail casualty book. But the company has disclosed through presentations different stress tests and the detailed profile of the portfolio, which is shrinking and risk controlled. Technically, on our due diligence with management, we know that the company uses state of the art systems and models to integrate all the underwriting worldwide, and have been doing conservative underwriting.
- Catastrophe: the riskier long-tail cat book has been shrinking in size and they have the risk profile identified and under control.
- Diversification: The company was focused in the Lloyds of London, but has been growing away from that platform to other markets and today issues almost half of all premiums from out of the Lloyds.
- Coupon deferral: Although coupons are deferrable, the company should not defer any coupon because:
- Impact on ability to raise money: It will be unlikely for the company to be able to raise capital in the future if they give that hit to investors.
- Negative business impact: With the company in need of deferring a coupon, the message sent to clients is that the company is in high need of cash and can trigger a cycle of policy cancelations.
- Macro-economic risks - Long term inflation scenarios:
- Inflation: The variable coupon protects against long term inflation, because it goes floating in 2017.
- Deflation: While we think it is unlikely that by 2017 there will be deflation, in that case, this instrument would present a risk since the floating rate is a low rate.
3.2) Return Profile:
- Equity like returns: Still in the high 70', has not caught up with other hybrids. At 79% of face, we believe this hybrid could be taken out at Par (21 points upside)or trade 10-15 points higher when it starts trading with fundamentals (based on current yield analysis), not just the risk-off trade we see going on now.
- Volatility: While we find equity like returns, the volatility of this asset is much lower than the equity.
- High cash yield: The current cash yield is ~10%. While the investor waits for the potential upside, they get paid 10% per year. Also, just as an investment comparables show that these hybrids pay 100-250bps more.
- Other Hybrids: Other hybrids trade at 100-250 bps tighter (AXA, Libmut).
- Buyback / Retirement upside:
- Regulatory purposes: The Basel III regulation and other regulations being discussed in the past year, are questioning the hybrids as an asset class and already banks have been retiring some of their hybrids. We believe that for insurance companies the same will happen and these securities may be retired in the near coming period.
- Issuer's motivation:
- Shareholder value creation: Buying these highly discounted securities will generate value to the stockholder since the amount of cash used to buy these back is much lower than the book value of the debt, thus accretive to shareholder. We also analyze the possibility of doing the trade for the hybrids with securities other than cash, but it does not make much sense:
- Exchange hybrids into equity: Low stock prices make the dilutive aspect of these trades unattractive, and as such stronger companies whose equity have outperformed are likely the best candidates outside the bank space, particularly if the hybrid securities have replacement capital covenants.
- Exchange hybrid into senior unsecured debt: This transaction does not require cash and does not result in stock dilution. However, replacing capital with debt increases leverage and will be unattractive for highly leveraged institutions.
- Rating benefit: Depending on the price paid to retire the debt, solvency ratios can be positively affected and thus more accretive to all stakeholders.
- Interest payment: the decrease in debt improves liquidity since the company won't have to pay the interest, which is very appropriate given the current capital markets situation.
- Book Value of Equity - Positive: The gain on the bond buyback will increase book value by the after tax amount of the gain.
- Downside: In the 08/09 market crisis, prices went to mid-to-high 40%'s of par. Since mid 09, this asset has been trading in the 70-90% of par range. We see the 08/09 crisis as an outlier situation and do not believe that scenario will happen again. Therefore on a current yield comparable basis, we see a maximum downside of 9 points (trading to 70's) but for the long-run investor this is just part of the inherent liability of this asset.
Catalyst: Two main catalysts. i) a market stability (risk-on trade) pushing results and bond prices up, or ii) a take out of securities, since even at a large premium to current prices it will generate value to the equity holder. This is the lower priced security in the capital structure and thus if retired, is the one to create the larger value to shareholder. Furthermore with new regulation standards these securities may be retired in the near-term future. And while one waits for the catalyst, they get paid ~10% yield.