|Shares Out. (in M):||45||P/E||10.8||9.0|
|Market Cap (in $M):||397||P/FCF||10.8||9.0|
|Net Debt (in $M):||-2||EBIT||58||69|
State National Companies is a niche, high-return, fee-based insurance business trading at low multiple of current earnings (11.8x LTM EPS, below 10x NTM EPS).
The equity has a small market cap (~$400m), a smaller float and is very illiquid- it may not be investable for most funds.
State National operates two distinct businesses. The primary business is referred to as the ‘Program Services’ segment and it involves providing fronting arrangements predominantly to reinsurance companies. Fronting arrangements are agreements entered into between capacity providers (say an offshore reinsurance company), General Agents (GA) and State National to write P&C insurance in the US. State National actually writes the premiums, but then cedes 100% of the risk to the reinsurer, in exchange for a fee (ceding fee, usually ~5% of gross earned premium). State National thus takes on no underwriting risk, and is thus left with only counterparty risk (which it attempts to mitigate by 1) doing business with relatively creditworthy counterparties, or 2) demanding significant collateral be posted). The fronting business generates attractive economics and represented 79% of SNC’s LTM Pre-Tax Income.
The second business is referred to as ‘Lender Services’ and it involves providing Collateral Protection Insurance to credit unions, banks and specialty finance companies. Collateral Protection Insurance insures automobiles held as collateral for loans- the insurance is added by lenders to the loans of borrowers who “do not uphold their obligation to the lender to insure the collateral underlying the loan” (i.e. borrowers without auto insurance). State National maintains the full underwriting risk in this segment. This is a very short-tail business with a high frequency of losses but a low severity of losses. Historically, this business has been quite profitable, with Combined Ratios of below 90%. This segment represented 21% of SNC’s LTM Pre-Tax Income.
Reasons for Security to be Potentially Mis-Priced
Small Float and Low Liquidity – I think the biggest reason the stock is mispriced is due to the very low trading volume. The company first did a private placement through FBR in the summer of 2014, and then came public in the Fall of 2014. A very small amount of shares (relative to the position sizes of the top shareholders) trade on any given day
Misunderstood Business Model / Lack of Pure-Play Comps – It doesn’t appear the market appreciates the high-return, less-risky business model of State National’s Program Services segment. Assuming the long-term economics of this business are maintained, and assuming it becomes a bit less episodic over time, this business should garner an Earnings Multiple far above traditional insurance businesses
Lack of Sell-Side Coverage – Only one analyst (FBR) covers the stock and his estimates look to be a little aggressive, which may be contributing to poor near-term share-price performance
Loss of Meadowbrook Insurance Group – After being downgraded by AM Best in August 2013, Meadowbrook entered into fronting arrangements with State National. Meadowbrook represented 29% of SNC’s Gross Written Premium and 9% of revenues in 2014. It has since been acquired by Chinese conglomerate, Fosun International. It is likely that Meadowbrook will no longer need to enter into the Fronting Arrangements with State National
Increasing Loss Ratio in CPI business -- The CPI segment loss ratio has accelerated from 43.3% in 4Q14 to 44.8% in 1Q15 to 45.8% in 2Q15
Program Services Background and Overview
State National provides fronting arrangements to General Agents and Insurance Carriers that lack an AM Best rating or license. Essentially (and I am simplifying a bit here), through General Agents, State National writes P&C insurance for off-shore reinsurers that do not have access to the US market. These off-shore reinsurers pay SNC a “ceding fee” and immediately assume all the operating and underwriting risk. The ceding fee is usually equal to around 5% of gross premiums written (SNC’s average ceding fee in 2014 was 5.7%). This is a very low-risk, fee-based business, where the company leverages its strong AM Best rating (“A”, or “excellent”) and licenses in all 50 states to provide access to the US market for interest participants that do not have regulatory entities or licenses in the US. The only risk the company assumes is the credit risk of their counterparty, but they mitigate this through mostly doing business with very creditworthy counterparties or demanding substantial collateral be posted (collateral held is 167% of secured reinsurance recoverables). Management is conservative, and the company has ceded over $11 billion in premiums over the past 26 years with no unpaid reinsurance recoverables.
Fronting is a small part of the overall reinsurance industry. It gained in popularity in the mid-to-late-1990s, but irresponsible writing of policies led to large losses in 2001 and 2002 as the reinsurance counterparties couldn’t pay claims. Capacity Providers (insurance/reinsurance companies) seek fronting arrangements for a number of reasons:
Insurers with access to origination, bur require broader licensing- or insurers with low ratings that want access to an “A” AM Best rating
Lack ability to write new programs without alienating existing distribution sources
Alternative Investment offshore Reinsurance vehicles that wish to access the US P&C market without getting license in all 50 states (and without the associated tax consequences)
The relatively high-level of ceding fees (~5-6% of gross premiums written), means many traditional, lower-margin/higher frequency lines of insurance don’t make a ton of sense for fronting arrangements. State National’s customers tend to focus more on specialty/niche/higher-margin lines of P&C.
Episodic Nature of Fronting and Customer Concentration – Historically, insurance/re-insurance companies reached out to State National for Fronting arrangements on a case-by-case basis, causing revenue/earnings volatility. Additionally, there is currently a degree of customer concentration in the Program Services segment. The top five capacity providers accounted for 74% of Gross Premiums Written in 2014.
The episodic nature of the fronting business was one of the reasons why the company was unable to find a suitor when it shopped itself to private equity firms in 2013 / early 2014. However, I would argue that the nature of the business fundamentally changed when it entered into an agreement with $10bn weather/Cat-focused Hedge Fund, Nephila Capital. In 2014, State National and Nephila entered into an agreement in which State National would grant Nephila the exclusive right to produce wind-related Catastrophe insurance for 2015/2016 and Nephila agreed to produce minimum premiums written in 2015 ($300 million), 2016 ($400m) and 2017. Additionally, Nephila agreed to pay the equivalent amount of ceding fees if the premiums are not produced (which is the case this year).
The Nephila agreement is arguably a game-changer for State National’s business and the alternative re-insurance space. As Co-Founder/CEO Terry Ledbetter commented on the Q2 2015 Earnings Call,
“Over the past decade, alternative capital has been entering the reinsurance market at an accelerating pace. According to industry sources, alternative capital is projected to grow from approximately $60 billion to $150 billion by 2018. This influx of capital has the effect of suppressing rates for reinsurance. Lower reinsurance rates are driving industry capital to seek opportunity in US primary insurance risk for both property and casualty lines. These conditions create opportunity for State National because many of the participants require access to highly-rated, broadly licensed primary insurance carriers.”
Based on our conversations with State National’s reinsurance customers, there is a clear push across many sectors of the reinsurance industry to “get closer to the client”. Competition in reinsurance has reduced returns, and accessing the US P&C market is looking increasingly favorable. We believe that this is a trend you will continue to see play out over the next few years.
In my mind, the growth expected to materialize in the fronting business over the next few years helps to offset most of the risk around the episodic nature of the business.
Lender Services Business Segment
State National offers Collateral Protection Insurance (CPI), which insures automobiles held as collaterals for loans made primarily by credit unions. The CPI is added by the lenders to the loans of borrowers who don’t get their own insurance. This is a niche market as well, with the top 3 players comprising 70% of the Credit Union market (with SNC having ~25% market share). SNC management believe their vertical integration, their proprietary technology platform and their exclusive relationship with CUNA mutual are sources of competitive advantage. This is a short-tail, very profitable business, with management targeting and achieving very impressive 85-90% combined ratios.
Balance Sheet / Excess Capital
Given the low-risk nature of State National’s Program Services business, it can afford to operate at relatively higher levels of financial leverage. Management currently targets a gross operating leverage ratio (Gross Premiums Written / Shareholder’s Equity) of 3:1 to 5:1, despite at times historically running the business at much higher leverage levels than this. As of Q2, the company was at 4.5x. The high-end of management’s range would imply $126m of additional premiums, or $25m of “Excess Capital” (6.5% of Market Cap)
Current Fronting Competitive Dynamics
From State National’s 10-K: “We believe there are relatively few active competitors in the fronting business. We compete primarily on the basis of price, customer service, geographic coverage, financial strength ratings, licenses, reputation, business model, experience and generally not offering State National’s products for our own account…. Unlike us, some of our competitors offer policy administration and are willing to assume a significant portion of the underwriting risk. We believe our long track record of success in this market and long-standing relationship and credibility with A.M. Best enable us to maintain our “A” (Excellent) A.M. Best rating with a relatively high operating leverage that we expect would be difficult for a competitor to obtain.”
Key Risk – Increased Competition
Given the expectation for more growth in fronting arrangements, other market participants have attempted to start-up fronting businesses. Two have been in the news in the past 12 months, Clear Blue and Spinnaker.
Clear Blue is backed by Pine River Capital and is targeting writing over $200 million in premium in its first year (versus ~$1bn LTM for State National). It is also rumored to be partnering with Third Point Re.
While the increased competition is a negative, there are a few nuances that suggest the competition shouldn’t be extremely harmful to State National. First, Clear Blue is targeting an A- AM Best rating versus an “A” rating for State National (and I don’t believe they’ve received this yet). Second, Clear Blue acquired its shell from Maiden Holdings. Maiden, and the affiliated Karfunkel-related entities (Amtrust/NGHC) are both customers and shareholders of State National. Third, it is unlikely AM Best will allow Clear Blue to operate at the same operating leverage ratio as SNC. We think it is likely that Clear Blue will be allowed to operate at half the ratio (i.e. 2.5x vs. 5.0x), which means it would generate ROEs that are much less attractive than SNC (i.e. 7.5% vs. 15%). It’s worth noting that AM Best previously only allowed State National to operate at 3x.
The other new entrant is Spinnaker Insurance Company, who is supposedly targeting ~$120m in premiums in 2016, ramping to $200m by 2019. Spinnaker has said it plans on charging a standard, base fronting fee of 5% of gross written premiums (and would also offer per occurrence caps on programs for an additional fee).
While it is early days, State National management have said they have not lost any business due to new competition. I do not expect fronting fees to become meaningfully pressured from new competition, and State National claims that their ceding fees are already at the lower-end of the market range.
Other Risks (and potential Mitigants)
Increasing Loss Expense Ratio in CPI business
Mitigant: While losses in the CPI business have ticked up, management still targets operating at a 85-90% Combined Ratio, year-in/year-out. In 2009 the loss ratio ticked up to 55%, but prior to that the worst year was 44%. Applying a 55% Loss Ratio on LTM CPI revenue would be a $0.17 hit to EPS, which would put the stock trading at 15x LTM EPS
Mitigant: Management also claims their vertically integrated model allows them to act quickly and either re-price business
Regulatory Action on CPI business
Negative Impact to Earnings from loss of Meadowbrook as aa customer
Mitigant: The company has provided a lot of information around how much Meadowbrook represented in earnings and what would happen if the fronting arrangement is terminated. I expect the Program Services segment to still grow in 2016 despite the loss of Meadowbrook (partially helped by the ramp in premiums earned from Nephila)
Fall-Off In Premiums Earned from Nephila in 2017 (only $100 million guaranteed vs. $400 million in 2016)
Key Man / CUNA Mutual Agreement
Time / Earnings Growth / Recognition of the company’s attractive business model
Take-out by a financial sponsor or a strategic