Description

What should one pay for an insurance business that has the following metrics for growth and underwriting profits?

There is more to HALL, but I just want to start by pointing out that an attractive business is hiding in plain sight within HALL that many do not seem to be aware off. And management seems to be thinking the same as on Jan 21, 2021 it put out a press release stating that it was working on creating a separate entity around its specialty business with its own CEO. The company said they are working with among others, Raymond James. To me it looks like someone is creating a sellable entity of a fast growing and profitable part of the HALL business. How much is a specialty insurer worth that writes gross premiums of $500 million plus, is growing premium volume at a healthy clip and has done so at a 90% average combined ratio since 2015 in the middle of a hard market?

One way to think about it is to look at $500 million in gross premiums at a 90% combined delivers a gross profit of $50 million. To a well-capitalized buyer, would they pay 6 times for that? Which would give us a sales price of $300 million.

Currently there are $18.14 million shares outstanding at a stock price of $3.81 that makes for a market cap of $69.11 million. Then we have about $100 million in debt and trust preferreds outstanding. For an EV of $170 million. If we get to assume that the above business is worth about $300 million then I get to an equity value of about $11 per share. My guess is that this business is worth more than $300 million in a world of low bond yields and SPAC money.

Hardening pricing market

It is widely talked about that finally after many years pricing has started to improve. Even my admitted home and umbrella policies have increased about 15% over last year, after multiple years of zero growth in pricing.

For HALL’s specialty businesses, mentioned above, pricing has improved markedly too. Year over year starting Q3 2017 through Q3 2020 we have seen pricing cumulatively improve by 52%. Especially over the last four quarters through Q3 2020 pricing has improved by double digits. For Q3 2020 the increase yoy was 20.3%. For Q2 2020 the number was 23%. For Q1 2020 was 15.2% and for Q4 2019 the price increase was 18.3%.

So, why is Hallmark trading at $3.8 per share?

Well, a lot of not so good things happened during 2020. Let me back up to 2019. I as well as many others assumed that HALL was an average insurer and consistent PYADs happened which frustrated many. My thought was that they were just an average undersized underwriter. Little did I know that overall HALL had done an excellent job building the above-mentioned specialty business, but all that was being obscured by the commercial auto business, more specifically the binding small truck business segment. All this time this binding small truck business was performing horribly and was being reported as part of the “specialty commercial segment”. So, while the PYADs kept coming on this binding small truck business there was no way to see how well the other specialty lines were doing.

HALL first caught my active interest when I read in the press release where they announced the decision to put the binding small truck business in run off and that this business had been responsible for more than 100% of the PYADs for the company since 2015. So, it looked that this one binding small truck company line that was causing all the bad news.

Then in the Q3 2020 presentation HALL broke out the performance of its specialty business ex the runoff binding small truck business since 2015. And this confirmed what I had suspected earlier. It truly was that binding small truck business that had caused all the damage and there was a valuable and growing specialty business within HALL after all.

Just to give one an impression as to how much damage this binding small trucking company line did, since 2015 the cumulative adverse development was $7.43 per share and if I assume that they will also blow through the corridor of the LPT then the total per share becomes $8.43 per share.

I am not going to expand to widely as to what happened within HALL for management to allow this binding small truck business to get so out of hand. I have heard theories from overconfidence in the ability to fix the problem or they were being gamed by brokers or social inflation and massive verdicts overwhelming all actuarial cost expectations. Who knows really, for me what is important is that the binding small truck problem is being put behind us and that there is a limit as to what it will cost us financially.

That brings me to the LPT deal. In order to maintain their rating, HALL had to do a deal with a reinsurer in order to limit loss exposure. They did an expensive deal with Darag. If you go to the Q3 2020 presentation you can find a visual representation of the deal as it can come across as somewhat complex. This deal reinsures all the binding small truck company business before Dec 31 2019. It consists of four layers.

Layer 1: This is the actual actuarial loss estimate through Dec 31 2019 that both parties agreed upon till then. HALL had to take a number of charges in order to provide the additional reserves for this layer for a total $151.2 million.

Layer 2 – The corridor: Think of this as the deductible for HALL. It represents $24.9 million. HALL will have to pay this before Darag takes over payments. Currently HALL is $6.7 million into the corridor which leaves about $18.2 million or $1 per share. Just to be conservative I assume HALL will end up paying the whole of layer 2. Although it is not for certain this will happen, after all these are still actuarial estimates.

Layer 3 and Layer 4: Once we hit total cash outflows of $176.1 million and through $240 million Darag will pay.

This caps losses for HALL. And assuming HALL will pay for the corridor, from an economic perspective the binding small truck company business has become economically neutral. No doubt this was an expensive deal, but it allowed AM Best to maintain the A- rating that is so important to HALL.

This deal also allows for HALL to focus on the left-over businesses, being the specialty commercial business, discussed above, the standard commercial business and the personal lines business. Below are stats for the personal lines business and standard commercial business.

In standard commercial and personal lines, I keep hearing about high single digit, low double digit increases in pricing. Also, the higher cat losses for 2020 are at play too. Both standard commercial and personal lines are much smaller than the fast-growing specialty business, which makes sense. Why allocate that money to average businesses while you have a fast-growing and more profitable business to focus on.

It is my expectation that the sum of these businesses should be able to do well going forward, especially once the specialty business has its own corporate structure whose results will be visible to all. In addition, once it becomes more obvious to investors that HALL’s specialty business is an attractive franchise, I do expect a rerating towards closer to one-time current tangible book value.

So what is current “adjusted” tangible book value for the business

I come up with an adjusted tangible book value of $8.32 per share.

-        $9.6 per share in tangible book value end of Q3 2020.

-        Minus $1 per share for the corridor.

-        Minus $0.28 per share on the 2020 binding truck exposure. (Gross written exposure for binding truck exposure is about $24 million before ceding. Last policy will expire September 2021. I assume a 120% combined here or 28 cents per share.)

-        Total of $8.32 of adjusted tangible equity per share.

Current stock price 3.81.

Current price to adjusted tangible book value is 45%. I think this is a valuation that is way too low for this business, especially since the binding truck disaster is economically neutral going forward and since HALL has such an attractive specialty business that is in the middle of a hard market.

What is next?

Q4 2020 will report soon. Economically the hard market is working its way into earned net premium. I expect that during Q1 2021 we are seeing the same hard market dynamics. Offsetting that could be more conservative reserving and another adverse development on the corridor.

In time I will expect that HALL will continue to inform the investor public what an attractive business it has and the stock should rerate towards the $8/$10 level.

Catalyst

Attractiveness of the specialty business showing due to management separating the business. Potential for a sale of the specialty business or the entire company. My guess is that it would be hard to buy HALL below $9 per share.