|Shares Out. (in M):||113||P/E||9.4x||8.6x|
|Market Cap (in $M):||3,256||P/FCF||NA||NA|
|Net Debt (in $M):||388||EBIT||525||571|
Sign up for free guest access to view investment idea with a 45 days delay.
Thesis: At $28.86 HCC represents an opportunity to purchase a truly franchise property and casualty insurance business at historically low valuations of ~1.1x 09E P/B and ~9.4x 09E P/E vs historical average valuations of 2.2x P/B and 13.5x forward P/E. While most financials have traded down due to concerns over 1) poor investment portfolios 2) funding / liquidity risk and 3) potential write-downs that would hurt book equity values, HCC does not have balance sheet risk with a AA+ $5Bn+ investment portfolio and enjoys an enviable AA credit rating by the credit agencies which is a meaningful competitive advantage in the current environment where companies are more concerned than ever on counterparty risk. More importantly, HCC is a very conservative insurance underwriter as historically HCC has had reserve redundancy (ie reserved more than they actually paid out in claims). The last time the Market was concerned about potential losses / future claim payments was in 1999 when HCC's ROE dipped from 18% to 6% and the stock traded down to 0.9x P/B. When HCC repriced their business and replenished reserves, its valuation increased significantly to 2x+ P/B. Using 1999 as a case study, it seems that the Market is already pricing in a punitive scenario for 2010 where HCC's ROEs and book value drops precipitously. If HCC's balance sheet and reserve levels prove to be more resilient than the Market thinks, HCC could experience significant multiple expansion. Longer-term, HCC is a business that should grow book value per share in the 10-15% area (HCC has grown BV/S by 13-14% since 1992 which is in-line with its 17 yr avg ROE of 13.7%).
Upside Case (+33%+ (incl. 1.7% div yld) / $38 ): With the market concerned about HCC's exposure to director and officer ("D&O") liability exposure after the subprime mess of 2008 and the general "softness" of the current pricing cycle, I believe HCC is adequately reserved for potential D&O losses and will grow book value per share to $29+ by the end of 2010. Putting a 1.3x P/B multiple on $29+ BVPS implies a ~$38 stock price (+31% from current $28.86 stock price). Typically insurance companies that enjoy ROEs in the low teen's trade at 1.5-2.0x P/B so one could argue that my multiple assumption is arguably conservative. Putting a 1.5x P/B multiple on a $29+ BVPS implies a $44 stock price (+51% from current levels).
Downside (-12% (incl. 1.7% div yld) / $25): Looking down for a moment, I believe downside risk on HCC is $25. Unlike most insurance companies, HCC provides significant disclosure on the amount and size of potential claims in their D&O book. To refresh, director & officer (D&O) insurance (also known as executive liability insurance) covers loss from claims related to "wrongful acts." Covered claims generally include (1) civil, criminal, regulatory or administrative proceedings and (2) written demands for damages against an insured. Common examples of such claims are securities class actions, derivative actions, SEC or state attorney general investigations. Covered wrongful acts include (1) actual or alleged breach of trust, breach of duty, breach of warranty of authority and (2) neglect, error or omission of fiduciary duties. Covered losses include damages, judgments, settlements and defense costs.
Using the latest disclosures, HCC has maximum exposure of ~$856MM of potential claims in their D&O book. This maximum number is very unlikely as it is assumes 1) a 100% claims rate which is unlikely given that the whole equity market collapsed in Fall 2008- not just financials and 2) that all of the "attachment points" are exhausted. In D&O insurance, insurance is structured in "insurance towers." After satisfying a deductible (say $5mm), primary D&O insurance underwriters stomach the first $20mm of losses and then excess insurance kicks in. "Attachment points" are the points at which excess insurance kicks in and excess insurers become liable for possible claims. HCC's average attachment point is in excess of $100MM, meaning that costs have to reach $100MM on average before HCC becomes liable for any claims. Assuming a 100% claims rate and all of the claims burn through the attachment points, gets us that $856MM number on potential exposure. Based on total net written D&O premium since 2002 (when HCC entered the D&O business) through 2008 and using a recent management conversation on loss and paid loss ratios, I estimate that HCC has D&O reserves of ~$566MM, implying exposure of $290MM which after-tax (30% tax rate), implies a book equity hit of $200MM or ~$1.80/share (113MM FDS). Assuming ZERO net income from the other parts of HCC's book of business (D&O is only ~16% of their book of business), this would take book value per share to $24.50+. Putting a 0.9x P/B multiple on that number would imply a $22 absolute downside stock price. Given the low likelihood that 84% of HCC's business will have zero net income, "distressed" book value is likely to be close to $27.50 at the end of 2010 (Q309 book value of $26.46). The $27.50 2010 BVPS assumes that 100% of the $290MM of D&O exposure hits net income in 2010 while other lines of business experience higher than average loss ratios. In this scenario, ROEs drop to 4-5% and 2009/10E book value growth is an anemic 2%. Putting a 0.9x trough P/B multiple on $27.50 implies a stock price of ~$25.
Business Background: HCC Insurance Holdings provides property and casualty, surety, group life, accident, and health insurance coverage, as well as related agency and reinsurance brokerage services to commercial customers and individuals. It operates primarily in the United States, the United Kingdom, Spain, Bermuda, and Ireland. The company was founded in 1974 and is headquartered in Houston, Texas. HCC writes several lines of business: 1) diversified financial products (~40% of premiums) that includes Director and Officer ("D&O") and Error & Omission ("E&O") liability insurance. D&O reimburses companies and directors (in part or in full) for the costs resulting from law suits and judgments arising out of poor management decisions, employee dismissals, shareholder grievances, etc 2) Group Life, Accident and Health insurance (39%) which consists of mostly medical stop loss 3) Aviation insurance (7%) which covers mostly helicopters and private planes (no commercial jets) 4) Other (14%) which includes marine, property, sports, event contingency, etc.
Variant View: HCC is one of the few truly specialty public insurance companies out there and has a significant advantage in its low cost structure and high AA S&P credit rating. While the Market is very concerned about future potential D&O claims, my own analysis suggests that HCC is well-reserved for any future losses in the D&O space. When the insurance cycle turns and the Market becomes comfortable with HCC's D&O book, HCC should experience significant multiple expansion from ~1x to 1.3x+ on a likely $29 2010 book value/share.
While difficult to predict, many believe that we are likely at the bottom of the underwriting cycle with accident year loss ratios above 100% (loss ratios + expense ratios). While the tightening of credit spreads and the rebound of the equity markets have helped the asset sides of the balance sheets in the industry which in turn may extend the length of this "soft" pricing cycle, I would argue current valuation already reflects this. Eventually when reserve releases abate and if the interest rate environment stays low, insurers will have to look to increase prices to grow book value/share; if/when the pricing cycle turns around (HCC thinks it will in mid 2010), the entire property & casualty insurance space should benefit from P/B multiple expansion. In addition, HCC believes if AIG starts to price their business appropriately and spins out their property & casualty insurer ("Chartis"), the entire industry would enjoy "an automatic 10% price increase." Unlike some of their peers, HCC is better positioned to gain market share from AIG given their exposure to professional liability (specifically D&O.)
|show sort by|
Are you sure you want to close this position HCC INSURANCE HOLDINGS INC?
By closing position, I’m notifying VIC Members that at today’s market price, I no longer am recommending this position.
Are you sure you want to Flag this idea HCC INSURANCE HOLDINGS INC for removal?
Flagging an idea indicates that the idea does not meet the standards of the club and you believe it should be removed from the site. Once a threshold has been reached the idea will be removed.
You currently do not have message posting privilages, there are 1 way you can get the privilage.
Apply for or reactivate your full membership
You can apply for full membership by submitting an investment idea of your own. Or if you are in reactivation status, you need to reactivate your full membership.
What is wrong with message, "".