Description

 Symetra Financial (NYSE: SYA) is an insurance business focused on four primary product lines: Medical Stop-Loss (26% of revenue, 25% of operating income), Retirement Products (26% of revenue, 32% of operating income), Income Annuities (23% of revenue, 13% of operating income) and Individual Life (24% of revenue and 30% of operating income).  Modern Symetra was formed in 2004 through the purchase of the life insurance business within Safeco Corp by a consortium of investors (led by White Mountains Insurance and Berkshire Hathaway).  SYA operated privately until going public in January of this year (discussed in more detail later in the report).  At the current price of $11.50 per share, I believe an investment in SYA represents a compelling opportunity at a risk / reward ratio of 3.5 to 1.

Upside:                $18.50

Base Case:          $15.50

Downside:           $9.50

Investment Positives:

1. Very inexpensive absolute valuation

2. High quality, and well managed balance sheet

3. Financially savvy owners

4. Leverage to increasing interest rates

5. Deploying excess capital from the IPO should boost the consolidated ROE

 Investment Risks:

1. Business lines are capital intensive, therefore the company is highly levered with equity to assets of just 8%

2. Persistence of low interest rates pressures annuity business

3. Low ROEs due to low interest rates, a conservative balance sheet and overcapitalization

4. Lack of identifiable near term catalysts

Background

As discussed above, prior to 2004 Symetra existed as the Life and Investments Operations within Safeco Corp.  In September of 2003 Safeco put that asset up for sale to more directly focus on its P&C operations.  In March of 2004 Safeco announced that an investor group led by White Mountains and Berkshire Hathaway would acquire the Life & Investments business for $1.35 billion, subject to a book value true up (dollar for dollar).  Other investors in the consortium included Franklin Mutual, Caxton, OZ, Highfields, JC Flowers and Fairholme Capital, among others.

At the time of the sale Safeco executives didn't give the exact book value of the business, rather management lumped two sales together that generated gross proceeds of $1.44 billion which had combined book of $1.77 billion (effectively 81% of book value in total).  At the time, management stated the assets from the Life and Investments business was generated an ROE below 10%.  Through a prospectus filed in 2007 (which is discussed in more detail below), Symetra had $1.37 billion of retained earnings and $400 million of paid in capital at the close of the acquisition (implying price to book of 0.76x).

Fast forward to the fall of 2007.  The new owners had cleaned up the business, improving the ROE to over 12% and growing adjusted book value from $1.12 billion in 2004 to $1.64 billion at September 2007 (an increase of over 46% including dividends of $166m).  Based both on market conditions (life insurers were trading well over book during most of 2007) and the improved results in the business, the company began preparing for an initial public offering.  According to the S-1's filed at the time, the company did not intended to complete a primary offering, rather the IPO was a way for members of the consortium to monetize a portion of their holdings.

The S-1 contemplated 39.5 million shares would be sold by existing owners, none by the company, at approximately $19 per share.  After the offering, there would be 92.6 million shares outstanding (not including warrants held by White Mountains and Berkshire Hathaway), which at $19 per share valued the equity at $1.76 billion or 1.2x adjusted book.  In this offering, all holders (including White Mountains and Berkshire) had planned to sell equally into the offering (~37% of their holdings).

Ultimately the 2007 IPO was pulled due to softening market conditions (which, I'm told by the company literally happened overnight).

Two years later, in October of 2009 the company re-filed its S-1 with a plan to go public early in 2010.  The motivations this time were somewhat different.  Symetra's annuity and life businesses had begun to grow in 2009 as a result of its very simple products and very conservative balance sheet.  The market turmoil in 2008 and 2009 had created an opportunity for SYA to gain share as a stable, well capitalized life and investment company.  The company believed that new capital could be deployed quickly and at high returns. 

At the prevailing market valuations (0.90x book), the larger owners (White Mountains, Berkshire, Mutual, Vestar and Highfields) were not sellers.  In total, Symetra sold 25.2 million shares of newly issued common stock for $12 per share (low end of the $12 to $14 range) and selling stockholders added another 9.7 million shares in the offering.  JC Flowers and Fairholme both exited their positions entirely.

Post the IPO

Since going public in January there have been some changes in the environment and the within the company that are worth noting.

The most notable change in the environment has been the decline in interest rates to historically unprecedented levels and the psychological effect that has had on the annuity consumer.  Low rates have two negative financial impacts on Symetra in the short term: 1) Consumers are not buying long term annuities, presumably because they believe that current rates are unsustainably low and 2) Symetra reinvests coupons received at lower and lower rates, which leads to a decline in investment income.

In the medium term persistent low interest rates are likely to cause a cashing out of existing annuities which are currently considered illiquid because they carry redemption penalties.  If that is the case, the annuity business effectively goes into a forced liquidation.

The second major change was an abrupt management shift in June, just six months after the company's IPO.  The board hired Tom Marra, a veteran of Hartford Life as the CEO to replace Randall Talbot, who had run the company for 12 years.  I'm told the change happened very quickly as Tom became available just one year after "retiring" as COO and a board member of HIG. 

Based on articles released in Hartford among other industry publications and conversations with analysts it would seem that much of the blame for HIGs balance sheet woes were placed directly on Tom (then ultimately on Ayer, who resigned just three months later).  I'm not familiar enough with the history at HIG to comment one way or the other, but at a minimum I'm skeptical that in just under two years as COO he was able to single handedly turn the entire investment portfolio over into high(er) yielding and ultimately ill-fated investments.  No question he participated in the mania, but complete blame feels like a stretch.

Based on the somewhat unique circumstances of the Symetra balance sheet (and investments), I would argue that Tom's ability as an investor is irrelevant - it is his ability to underwrite that will matter, and that doesn't seem to be questioned by anyone.

As noted above, the company had grown through the Retirement and Annuities business lines during the fallout of 2008 and 2009.  Collectively those business lines are 45% of operating income.  Tom believes growth in the future will come from the life insurance business over the annuities, which is definitely true in the current environment as no one apparently wants an annuity.  Going forward, the Individual segment should be the recipient of most of, if not all of, the excess capital carried by the company today.

Deploying the excess capital, which I believe to be around $200 million today, should remove the current drag on ROE, boost reported earnings (potentially by as much as 10%) and hopefully lead to multiple expansion.    

The Segments

Symetra has four primary products.  In its Group segment (26% of revenue, 25% of operating income) the primary product line is Medical Stop-Loss.  This product is offered to self-insured businesses as a sort of second layer protecting against certain health expenses above a certain dollar threshold.   Analysts describe this business as capital intensive with relatively low ROEs (low double digits) over a cycle.  While cyclical, the business is dependable and SYA has scale as one of the largest players with an estimated 7% market share.  Symetra has done an admirable job underwriting this business with loss ratios in the mid to high 60s and combined ratios in the low 90s.

The Retirement Services segment (26% of revenue, 32% of operating income) consists of both fixed and variable annuities sold through financial institutions and independent brokers.  The products carry lock up periods of between 5 and 7 years with surrender charges of between 5% and 8%.  Much of the current book of business was sold in 2008, 2009 and 2010 and therefore still carry surrender charges and are considered illiquid.

Symetra also operates an Income Annuities business (23% of revenue, 13% of operating income) which offers two products, primarily immediate annuities but also structured settlements.  The primary method of distribution tracks the Retirement business using financial institutions and independent agents.  As with the Retirement business, this product has grown significantly from 2008 (in terms of deposits).  Investment returns and spreads have both compressed which have pressured investment income and operating income.

Finally, Symetra has an Individual segment (24% of revenue and 30% of operating income) which consists principally of term life products but also some bank owned life insurance (termed BOLI).  The underwriting standards for the company are high and thus historically the mortality ratio has been low (mid 70s to low 80s).  Symetra reinsures between 50% and 90% of its life exposure further limiting risk.

Distribution is the same as the other products, primarily through financial institutions and independent brokers.

Symetra has an Other segment that captures unallocated surplus investment income, corporate expenses and interest expense. 

The Balance Sheet

Both sides of Symetra's balance sheet have some unique characteristics worth noting.  Starting with the left side, the investments for the most part are not managed by Symetra.  The fixed income book is managed exclusively by White Mountains, which is generally well regarded as a conservative money manager.  The equity book (just $200m today) is managed by Prospector Partners, a firm run by a former White Mountains executive.  Symetra does all commercial mortgages in house (sourcing, analyzing and investing), which is a $1.5 billion book today.  Importantly, these are whole loans (not securitizations), approximately 650 in total, with a current estimated loan to value of 54%.  My understanding is that Symetra has had just one default in its history managing this book.  Today all of the loans are performing.  I believe White Mountains management of a vast majority of the company's assets provides a level of comfort with Symetra's balance sheet that I would not afford other life insurers. 

If you would like more detail on the specific ratings and classes of investments, there is disclosure every quarter in a supplement filed with earnings releases (as well as in footnotes to the financial statements).

Another point to note on Symetra's balance sheet is the low absolute dollar amount of goodwill and deferred policy acquisition costs (which have value, though it is intangible).  DAC is less than 8% of the adjusted tangible equity at the end of September.

Moving to the right side of the balance sheet, the company has very little in the way of financial liabilities.  Notes payable are just $450 million today, of which 2/3s are due in 2016 and the rest are due in 2037.

The largest liability, of course, is policy holder's liabilities, which total $20.4 billion as of the end of September.  The company classifies those in three buckets: 1) illiquid liabilities ($7.3 billion or 36%) which are either contractually locked, or have penalties in excess of 10%; 2) somewhat liquid liabilities ($10 billion or 49%) which are accounts that would have either significant tax penalties on redemption or penalties in excess of 5%; 3) fully liquid liabilities ($3 billion or 15%) which have little no surrender charges or penalties.  The average duration of the fixed income portfolio today is 5.4 years (and has been stable) which matches the estimated rollover of policy holder's liabilities (effectively matching the timing of cash flows).

Depending on investment returns and spreads, the combined segments have produced ROE's of between 9% and 12% since 2005.  Since acquiring the company in 2004, adjusted tangible equity has grown from $1.12 billion to $2.39 billion (including $307 million of dividends), growth of over 113%.  From the original purchase price of $1.35 billion, adjusted tangible book has grown by over 77%.

Peer Comparison

From an earnings perspective, the small / mid cap insurance group is trading in a very tight band.  However, looking at book values (tangible, and adjusted for AOCI), Symetra is among the cheapest of the group.  I would speculate that the reason for the discount is the historically lower ROEs.  Over time, I believe the safety (and tangibility) of Symetra's balance sheet as discussed above will lead to consolidation or at a very minimum a 1x book valuation.

Valuation

I believe that over time Symetra will trade for adjusted book value, which I estimate to be $15.50 per share at the end of December.  However, I have modeled through both a downside scenario (which run rates persistent low interest rates and effectively liquidates the annuity business) and have created an alternative upside scenario where ROEs return to levels produced shortly after the company was acquired out of Safeco (effectively higher investment returns and spreads).

Base Scenario is status quo.  The company ends 2010 with $15.50 in tangible book, and is able to grow that book about $1.00 per year.  I value the company at 1.0x book with the belief that the business will be consolidated at some point - and I'm earning an almost 9% return while I wait ($1.00 per year in book growth on the current price of the stock).

Downside Scenario assumes the Annuity products begin to burn cash.  I believe the policies would take about 5 years to fully liquidate and estimate in that scenario the company would burn through ~$1.50 of book (about 25c per year in total) before that business is gone.  At that point, the tangible book would be $13.77 and the company would earn somewhere in the neighborhood of 34c per year.  I assume that none of the proceeds from the liquidation are put to work and assume the remaining two product lines have historically low spreads into perpetuity.  I value the business at 70% of book.

Upside Scenario assumes interest rates climb back to ~6% and spreads for the company widen in line.  I assume ROEs average about 11-1/2% which creates $1.60+ in earnings, which I value at 11.5x (or 1.20x book).

Conclusion

Through Symetra Financial you can purchase a tangible, well managed, conservative pool of investments for about 75c on dollar.  Among all the possible outcomes, modeling fairly draconian assumptions in a downside scenario, I believe you are still creating the business at a substantial discount to book (or fair) value.  And importantly, even in that scenario the business would be adding to, not subtracting from, its equity base.

At the current price I believe that shares in Symetra Financial represent a compelling investment opportunity at a risk / reward ratio of 3.5 to 1.

Catalyst