HARTFORD FINANCIAL SERVICES HIG
November 30, 2014 - 9:55pm EST by
endur
2014 2015
Price: 41.30 EPS 3.36 3.76
Shares Out. (in M): 431 P/E 11.9 10.6
Market Cap (in $M): 17,212 P/FCF NA NA
Net Debt (in $M): 5,738 EBIT 0 0
TEV ($): 22,950 TEV/EBIT NA NA

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  • Insurance
  • Buybacks
 

Description

 

To:

ENDUR ICM

Date:

NOVEMBER 2014

Subject:

STRATEGY – BUY HARTFORD FINANCIAL SERVICES GROUP INC. (NYSE:HIG) BELOW $40/SHARE

Summary

HIG is now a leading provider of property/casualty insurance in the United States, and it has a large U.S. and international variable annuity business that is in run-off (known as Talcott Resolution). HIG sold its individual life, retirement plans and broker-dealer businesses and received $2.2 billion of proceeds. The restructuring plan came on the heels of pressure from investors, led by its then largest shareholder Paulson & Co, (now <2%) to completely split the company’s P&C and Life units in order to boost returns and HIG’s share price. We view HIG as being on the right strategic path, quarterly ROEs improving from 8%. Recent events during 2014 illustrate the successful execution of the Company’s restructuring strategy. The recent sale of the Japan VA block may unlock more value than is apparent in the transaction itself, as we think it would also accelerate and increase the probability of HIG becoming a takeout candidate.

Investment Highlights

  • High Quality P&C Insurance Operation: having made corrective actions in its large workers’ comp business, some aspects of HIG’s P/C insurance operation may have gone under-appreciated

    • HIG is among the largest and best in small commercial insurance with less price competition and more consistent underwriting profitability than other commercial lines

    • HIG’s consumer business writes personal auto and homeowner’s insurance in the United States. Distribution is mainly through a 29-year exclusive relationship with American Association of Retired Persons (AARP) which gives the insurer access to a large customer segment with favorable claims trends and growth through the aging of the population

    • HIG could be an attractive M&A target for large P&C insurers (Allianz or Berkshire) due to its position in the small and middle market commercial lines business as well as the AARP personal lines relationship.

  • Potential upside to capital plan with balance sheet improvements. HIG management’s original plan for >$1.3 billion in share repurchases through year-end 2014 was overly conservative in light of excess capital generation/ongoing dividend capacity at the P/C insurance company and faster run-off of Talcott. During 2014, the capital management plan has been expanded to total almost $4 billion, consisting of $2.8 billion in share repurchases and $1.2 billion in debt reduction.

    • HIG’s capital position strengthened meaningfully since the financial crisis and the Company repurchased its high cost Allianz debt and warrants in 2012

    • Improved equity market performance and good acceptance of The Hartford’s Enhanced Surrender Value (ESV) program are driving a faster run-off of legacy VA assets than originally expected. Also VA biz could be in a better position to be sold. We estimate that there is about $15/share to $20/share of GAAP equity tied up with VA assets.

A few concerns still remain. Firstly, equity market declines and longer prolonged low interest rates could damper the speediness of HIG’s recovery. Equity market pullback and low interest rates would increase the net amount at risk in the U.S. VA block and could lead to reserving increases, however this should be mitigated as their VA exposure lessens. Secondly, poor margin performance in the P&C businesses have dragged on valuation for investors. Combined ratios higher than 100% will cause significant pressure on ROE improvement, however we believe that management has been addressing this issue. Lastly, HIG’s Group benefits margins remain weak. While HIG’s disability margins appear to have stabilized, they remain well below historical levels and our outlook is cautious given the sluggish economy and aggressive pricing in recent years.

We believe an investment in HIG is warranted given the excellent execution of management, and view this investment as special situation turnaround opportunity. We value the shares at an intrinsic value of $60 per share over the next twelve months, implying a P/TBV of 1.5x (currently trades at 0.94x). However, any improvements in ROEs could result in much higher valuations. Therefore, we are buyers of the shares at prices below $40 per share, which should give us an adequate margin of safety.



Restructuring Timeline: Demonstrated Ability to Execute on Strategy:

  • 2012: The Company repurchased 8.0 million shares for $149 million, and all outstanding Series B and Series C warrants held by Allianz for $300 million.

  • 2013: the Board of Directors authorized a capital management plan for a $500 equity repurchase program to be completed by December 31, 2014. In June 2013 the Board of Directors approved a $750 increase in the Company's authorized equity repurchase program, bringing the total authorization to $1.25 billion. During 2013, the Company repurchased 19.2 million common shares, for $600 million, and 1.6 million warrants, for $33 million. $617 million of capacity remained outstanding as of December 31, 2013.

  • Feb 2014: Announced 2014-2015 capital management plan totaling $2.656 billion, including equity repurchases totaling $2.0 billion and repayment of debt maturities of $656 million.

  • April 2014: Sold Japan Annuity Company HLIKK to ORIX Life Insurance Corporation for $963 million, comprised of a purchase price of $895 million and an estimated positive purchase price adjustment of $68 million. The transaction provided a capital benefit of approximately $1.4 billion and eliminated HIG’s Japan variable annuity business.

  • June 2014: CEO Liam E. McGee’s announced resignation. CFO Christopher J. Swift appointed as new CEO, Douglas G. Elliot appointed President of the Company, and Beth A. Bombara appointed Executive Vice President and CFO, effective July 1, 2014.

  • July 2014: 2014-2015 capital management plan expanded by additional $1.275 billion, consisting of $775 million for equity repurchases and $500 million for debt reduction.

Corporate Structure

In the short-term HIG’s goal is to grow Core EPS and ROEs, and continue to execute on its capital management plan: (i) $2.775 billion in equity repurchases from January 1, 2014 through December 31, 2015 ($1,365.0 million repurchased through Sept. 30, 2014); (ii) $1.156 billion debt reduction plan for 2014-15.

Over the long-terms, HIG remains focused on returning excess capital to shareholders and over time reducing its leverage ratio to the low 20s and improving its ratio of earnings to fixed charges to a range of five to six times. This is the framework within which it will develop its future capital management initiatives. With respect to Talcott, HIG expects to remain capital self-sufficient. Holding company resources are used principally to pay interest in dividends and for equity repurchase or debt repayment.

To understand capital release, it is important to review the legal entity structure along with statutory capital allocations. It's important to note HIG manages Talcott in the aggregate as it has capital allocated among multiple legal entities and product lines. HLIKK, HIG’s Japan operation, and White River Re were part of the Talcott organization, but were owned by holding companies outside the life company legal entity chain. This is in the context within which HIG thinks about capital, its adequacy and where it is located. At year-end 2012, about 60% of HIG’s statutory capital was allocated to support the go forward businesses or $7.7 billion for P&C and $1.5 billion for group benefits. Group benefits is currently written in two legal entities, and HIG’s goal is to have one legal entity supporting this business going forward. That is part of the reason HIG’s total variable annuity (“VA”) book had been hard to sell. It takes time to reorganize a structure where VA policies were written under different legal entities. At YE 2012, Talcott statutory capital allocation totals $6.2 billion (~>$8.4 billion in GAAP equity).

 

Exhibit 1: Corporate Structure at December 2012

Source: Company filings.



Exhibit 2: Corporate Structure at September 2014

Source: Company Reports

As of September 2014, the Talcott Resolution has been separated and isolated from other business. As previously mentioned, in April 2014, HIG successfully sold the Company’s Japan Annuity Company HLIKK to ORIX Life. Currently, Talcott statutory capital allocation totals $5. 573 billion (~>$9.585 billion in GAAP equity). As Talcott runs-off, capital should free up.

Core Earnings Outlook

The Company has experienced strong improvements in the underlying performance of its core business. In addition, its legacy VA book of business has had good acceptance of The Hartford’s Enhanced Surrender Value (ESV) program, which are driving a faster run-off of legacy VA assets than originally expected. Also we believe that HIG’s VA business is in a strong position to be sold. We estimate that there is $15/share to $20/share of GAAP equity tied up with VA assets. Currently, Talcott is generating <22% of LTM core earnings. This run-off business is a melting ice cube and should contribute less to total earnings over the long-term. Management estimates there will be a 40% decline in US Variable annuity policy count over the next five years.

Property & Casualty is comprised of three segments: (i) P&C Commercial (63% of premiums); (ii) Consumer Markets (37% of premiums); and (iii) P&C Other Operations.

Exhibit 3: Company Total P&C Results

 

Exhibit 4: 2013 Total P&C Written Premium

 

Source: Company Reports

 

Source: Company Reports



Exhibit 5: HIG VA Surrender Rates

 

Exhibit 6: Ongoing Business Units' % Contribution to Total Core Earnings Before Corporate

 

Source: UBS, Company Reports

 

Note: Not meaningful for 2Q11 because of a catastrophe-driven large loss for P/C

Source: Company Reports.

M&A Considerations / Private Market Valuation

Following a roughly two year transformation process that saw HIG divest its Life Insurance and Retirement units and sell its Japan VA book, HIG’s stock has doubled over the last two years. We currently see modest fundamental upside for the shares as it will take time to improve operations and regain investor trust. However, private market value considerations represent more meaningful upside for the stock. We don’t believe investors have focused much on HIG as a potential takeover candidate mainly because its closed block VA books have represented a “poison pill” to potential suitors who would largely be attracted to the P&C franchise. That is why we think the sale of the Japan VA block may unlock more value than is apparent in the transaction itself, as we think it would also accelerate and increase the probability of HIG becoming a takeout candidate. We don’t necessarily think that HIG management is looking to “shop” the company, rather, we have approached it from the standpoint of how attractive its businesses would be to potential buyers to decide whether a meaningful private market value premium should begin to creep into the shares as the VA blocks wind down, or an immediate valuation “pop” should occur if one of the VA blocks is sold.

HIG’s hidden gem in plain sight is its P&C business, which we believe could be an attractive M&A target for a large P&C insurer due to its position in the small and middle market commercial lines business as well as its AARP personal lines relationship. We do not believe that HIG’s P&C business has been viewed as an M&A candidate by investors recently given its sizeable run off VA block, but we see that changing as the VA block shrinks or is sold. Allianz and Berkshire appear to be the obvious acquirers for HIG's P&C operations, however ACE or TRV may be more likely acquirers, since it could be more impactful, give their sizes. Below is a mix of key M&A party comparisons.



P&C Commercial Lines Highlights

Our outlook for commercial lines margins is positive, but we forecast modest premium growth and are wary of reserve adequacy in the workers’ comp line.

Exhibit 7: P&C Commercial Lines Highlights

Source: Company filings, J.P. Morgan

HIG has the 6th largest US P&C Commercial Insurance Operations according to A.M Best. Commercial markets' $6.2 billion of written premium in 2013 was divided 49% to Small Commercial (businesses with payrolls less than $5 million and revenue and property less than $15 million), 35% to Middle Market (small commercial; guaranteed cost insurance) and 15% to Specialty (large companies with high deductibles or retained exposure).

Exhibit 8: P&C Commercial Earned Premiums by Product

 

Exhibit 9: P&C Commercial Earned Premiums by Sector

 

Source: Company Reports.

 

Source: Company Reports.

HIG distributes its Small Commercial through online service portals and low touch underwriting, small business distribution partnerships, and national representatives.

Workers' compensation, commercial multi-peril and auto comprise around 80% of Small Commercial written premiums. HIG distributes to Middle Market through a national sales office footprint that provides expertise to local markets around the country. Worker's Compensation comprises 30-40% of premium, General Liability around 15% of premium, and Commercial auto and property around 15% of premium. In total, HIG has about 7% market share in US Workers' Comp.

Source: HIG Investor Presentation, August 2014. AM Best. Market share based on direct written premiums in the U.S. in 2013. Adjusted loss ratio represents five year average 2009-2013. Adjusted loss ratio defined as direct losses incurred divided by the difference between direct premiums earned and dividends to policyholders.

In the 3Q 2014, the commercial lines segment generated a combined ratio of 90.4% in 3Q13 compared with 98.1% in 3Q13 and 96.1% for year-end 2013. Excluding adverse development and cats, the combined ratio was 90.2% versus 93.3% in 3Q13 primarily due to a decrease in the current accident year loss and loss adjustment expense ratio before catastrophes, partially offset by an increase in the expense ratio due to higher commissions.

Below is a peer comparison of underlying combined ratios (ex cat) for select direct commercial insurers:

Most of the higher combined ratios relative to the industry to the company's overweight position in Workers' Compensation.

HIG’s margins over the past several quarters have been relatively strong, which we attribute in part to the benefit of ongoing price hikes, or hardening markets. Excluding the impact of potential weather-related losses, which tend to be volatile, we expect margins to improve slightly over the next several quarters as results benefit from price increases, especially in the workers’ comp line and commercial auto. In standard commercial, Management indicated that it achieved price hikes of roughly 5%, down from 6% in 2Q14 and 7% in 3Q13. In terms of product focus, HIG management has also altered its re-pricing efforts from the workers’ comp line (mid-to-high single digit price hikes currently versus low-teens previously) to commercial auto (10-11% price increase due to poor recent loss experience). Recent price hikes are a positive, but we remain concerned about profitability in the workers’ compensation block and are wary of further adverse development. Given HIG’s experience and industry-wide claims trends, we feel that there is potential for additional workers’ comp reserve hikes over time. Additionally, Management has indicated that the overall P&C market has become more competitive, which could make it challenging for the Company to grow while maintaining healthy underwriting margins.

Lastly, HIG's P&C Commercial expense ratio in 2012 and 2013 was ~30%, slightly higher than the peer group average of 27.24%. However, HIG's expense ratio tied to admin, salary, and employee benefits was 16.5%, the highest in the group where the average was 14%. Since we view this portion of the expense ratio as the ratio of fixed costs, we think HIG's current elevated fixed expense ratio highlights the potential to take costs out of the P&C business. Below is a comparison of peer expense ratios:

There could be cost savings and synergies which would be material should Travelers bid, while for the other potential buyers we highlight (ACE, Allianz and Berkshire), we would expect to have much less synergies given more limited business overlap when taking into account each company's specific case size focus (size of the commercial business purchasing insurance).

HIG's 5 Major LOB's vs. Potential Acquirer Shares In Those LOB's

Below is a potential pro forma combined company direct premiums written (DPW) U.S. market share analysis.

P&C Consumer Lines Highlights

Similarly to the commercial business, results in the personal lines business will be marked by healthy underwriting profits but modest top-line growth. We believe that management's increased focus on the preferred-risk 40+ market will drive margin expansion over time, but it is also likely to pressure near-term premium growth.

Exhibit 10: P&C Personal Lines Highlights