Alleghany Corporation (NYSE:Y)
February 14, 2013 1:45 pm ET
Weston M. Hicks - Chief Executive Officer, President, Director and Member of Executive Committee
Jay Adam Cohen - BofA Merrill Lynch, Research Division
Jay Adam Cohen - BofA Merrill Lynch, Research Division
Okay, we're going to get started with our next speaker, Weston Hicks, CEO of Alleghany. We can all point to times in our own careers where you had a really good day, a really good event happen. Mine was when Weston Hicks retired as a sell side insurance analyst, because he was very, very tough competition. He was a great sell side insurance analyst. He's been a really good CEO as well. I'll turn it over to Weston.
Weston M. Hicks
Thank you, Jay. And Good afternoon, everyone. So, I -- hopefully, these slides will appear here, okay. Well, we don't do this very often, but when Jay asked if I would be interested in participating in this conference, I said, sure, why not. We had a pretty active year last year and we were kind of internally focused, but we're coming up for air at this point.
So it is a pleasure to get out and talk to the investment world. I'm going to, today, give you a brief tour through 70 years of history of Alleghany. Hopefully, I can do that quickly. And -- because, I think, in order to really understand Alleghany, you have to understand kind of where we came from, which is quite unique. But before I get to that, I have to show you this, which I'm sure you've seen over and over again, that we will be making forward-looking statements.
Okay. So, brief timeline on Alleghany. It was formed actually January 26, 1929, as a holding company for the railroad interest of Otis and Mantis Van Sweringen, who were 2 railroad entrepreneurs of the '20s that rolled up the railroad industry. And this, of course, was auspicious timing because it was right before the stock market crash of that year. The Van Sweringen brothers had become, up to that point, among the wealthiest entrepreneurs in the country in the roaring '20s by creating one of the largest railroad networks in the country. They had controlling interest in railroads such as the Nickel Plate, the Chesapeake in Ohio and the Erie, which were all household names at the time. In 1930, they acquired a controlling interest in the Missouri Pacific.
The Great Depression, however, had a devastating effect on Alleghany and its operations. Revenues fell 40% from 1930 to 1932. And in 1933, the Missouri Pacific filed for bankruptcy. And because Alleghany was highly leveraged, the company lost control of its affairs with JPMorgan actually gaining control of the company at the depths of the depression.
The Vans, as they were called, died in the mid-'30s, having seen their vast fortune basically reduced to 0. They died penniless, and from a high point, I think of as much as $100 million in 1929, which, of course, in today's money would be quite significant.
In 1937, an investment syndicate consisting of Robert Young, Allan Kirby and Frank Colby acquired control of Alleghany and Robert Young became Alleghany's first post-depression CEO in 1937. And this transaction is important because it marked the beginning of the Kirby family's involvement with Alleghany, which continues today.
Jefferson Kirby, who is the grandson of Allan P. Kirby, is Chairman of the Board of Alleghany today. From 1937 to the mid-1950s, Mr. Young and Mr. Kirby, that's Allan Kirby, nursed Alleghany back to health, rationalizing the railroad empire and working to build a nationwide, coast-to-coast passenger railroad, which was a great idea until they invented the airplane. And the airplane, of course, made that idea basically useless.
In 1949, Alleghany fortuitously made its first move in the financial services when it acquired 91% of the voting stock and 20% -- 27% of the common stock of Investors Diversified Services for the whopping sum, are you ready, of $2.3 million. Those of you know Ameriprise today, I think it has a market cap of $14 billion or $15 billion, something like that.
As you probably know, Alleghany became extremely valuable, was ultimately sold to American Express in 1983 for $800 million. When Robert Young died in 1958, Allan Kirby became the Chief Executive Officer of Alleghany, and when Allan Kirby became incapacitated due to a stroke, his son, F.M. Kirby II, took his place as Chairman and Chief Executive Officer.
In the following year, John Burns, my predecessor, joined Alleghany as Vice President of Finance, and the modern era of Alleghany began. Mr. Kirby and Mr. Burns formed a highly successful team with Mr. Kirby assuming primary responsibility for strategy and oversight, while Mr. Burns developed the company's business and found new opportunities.
Mr. Burns became CEO in 1992, although his influence was significant way before then. And I succeeded John in 2004. And I tell you this, just because I think it's fascinating that I'm only the fifth CEO in the company's history after the depression, which is really quite remarkable in today's day and age.
So Alleghany, as I said has a very rich history. It had a number of important railroads, which I've mentioned earlier. The Chesapeake in Ohio, by the way, ultimately became CSX Corporation.
In 1954, under Robert Young's leadership, Alleghany gain control of the New York Central in one of the most notorious proxy fights of that era. The New York Central was ultimately merged into the Pennsylvania Railroad to form PenCentral, which you may recall, ultimately, had an unhappy ending.
For most of its early history, Alleghany functioned as an investment company. And that was of course, prior to the 1940 Investment Company Act. In 1974, however, the strategy was changed as Kirby and Burns transformed the company into an operating company through the acquisition of MSL Industries, which was a diversified manufacturer and distributor of fabricated steel products, and in 1979, as I mentioned earlier, Alleghany gained full control of IDS.
After the sale of IDS to American Express, Alleghany became a process of building a leading position in the title insurance industry, acquiring Chicago Title & Trust, SAFECO Title and Ticor Title.
In 1987, some of you may remember that Alleghany acquired an 8% position in the St. Paul Companies, which marked the company's first exposure to the commercial P&C business, and I know I'm dating myself now because you're probably sitting there saying who is the St. Paul Companies? It's now part of Travelers, Jay knows.
In 1989, Alleghany acquired Sacramento Savings Bank. Later, sold to First Interstate and our current subsidiary, Alleghany Properties, resulted from some of that bank's real estate assets, which were retained.
In 1993, Alleghany acquired Underwriters Re, which was its first investment in the reinsurance industry. Underwriters Re was ultimately sold through Swiss Re in 2000.
So, that's it for the history. I think it's a fascinating history. You can read a lot more about it if you troll around on the Internet. But in the interest of talking about the future, let's bring it up to the modern era.
So by 2002, Alleghany had liquidated many of its investments, in what I can only refer to as a stroke of genius by John Burns, selling out of the money management business in 2000 at, what he would've called, a boxcar price. And Alleghany had spun off the title insurance business, which was ultimately merged with Fidelity Title (sic) [Fidelity National Title Group] .
Allegheny has just acquired Capitol Transamerica, you see it they're at the top; continued to own a small minerals company; as well as company called Heads & Threads, which was what remained actually of MSL Industries from the earlier days.
Most of Alleghany's capital consisted of investment portfolio at the parent company. You can see the $1 billion there at the parent, including a large Treasury bond portfolio and a substantial position in Burlington Northern Santa Fe, which of course, is ultimately sold to Berkshire Hathaway. John Burns, by the way, was instrumental in creating Burlington Northern Santa Fe by encouraging the merger of the Burlington and the Santa Fe.
I joined Alleghany later in 2002. John and I -- John basically asked me, what would you do if you took over the company? And I said, well, I would try to create a collection of underwriting companies that would produce underwriting profits, generating low or no cost float, which we could then invest to enhance returns. And notwithstanding the depressing charts of the previous speaker, we have, in fact, managed to find some companies that do produce underwriting profits most of the time.
So what do we look like 10 years later? Well, we -- following the acquisition of Capitol Transamerica in 2002, we started Darwin Professional Underwriters with Stephen Sills. It was started from scratch. And later sold to Allied World for approximately $600 million.
In July of 2003, we acquired RSUI group. The Atlanta-based wholesale specialty insurance operations of Royal & Sun Alliance. Royal, by the way, at that time, put that company on the block, not because it had problems, but because they had problems. And it was one of their most salable assets. RSUI has, since then, been a huge success for Alleghany. It has produced over $1 billion of underwriting profits since the acquisition.
In 2006, we acquired 1/3 of Homesite Insurance which is a mono-line homeowners insurance company that markets its products through direct auto insurance companies such as Progressive and Geico.
In 2007, we acquired Employers Direct, later renamed PacificComp, which is a California workers' compensation company.
And finally, in the penultimate transformational transaction, drum roll, in early 2012, we were fortunate enough to have the opportunity to merge/acquire Transatlantic Holdings, which is obviously, our largest acquisition to date for a total purchase price of $3.5 billion.
As this next chart shows, Alleghany looks quite different today. Trans Re is our largest subsidiary with $4.3 billion of equity at year-end 2012. RSUI is our second largest subsidiary, accounting for $1.5 billion of equity. Capitol Companies, PacificComp and Homesite collectively account for about 9% of our equity, and we still have almost $1 billion of holding company investments offset now by $700 million of debt and $100 million of other net liabilities. Stockholders' equity at the end of 2012 was about $6.4 billion.
Let me talk about briefly each of the operations. Trans Re, as mentioned earlier, we were quite fortunate to have the chance to acquire the company in early 2012 for $3.5 billion in cash and stock. Trans Re is a global professional reinsurer, a dying breed, I might add, with about half of its premium derived from outside of the U.S. with leading positions in a whole host of specialty lines and other non-property lines of insurance.
Trans Re produced an underwriting profit in its first 10 months as part of Alleghany despite substantial incurred losses related to super storm Sandy. We expect Trans Re will produce a combined ratio of approximately 96% in future years in the absence of large unusual catastrophe losses.
RSUI Group was acquired as a managing agency on July 1, 2003. Including the capital we used to form a new insurance company that was merged with the agency, our initial investment was approximately $626 million. At the end of 2012 stockholders' equity was $1.5 billion after the company has returned cash to us, net of capital contributions, of approximately $300 million. RSUI is a very unique company that focuses on creating an operating environment where professional underwriters could be rewarded for producing underwriting profit, while serving the needs of its wholesale brokerage customers. During our period of ownership, RSUI has averaged a combined ratio of 81% including losses from Hurricane Katrina and Super Storm Sandy.
This chart shows the recent history of RSUI under our ownership. And as you can see, combined ratio has been well below 100% in most years. In fact, RSUI has only had 2 years in its history, including its history before our ownership, where the combined ratio was above 100%. In 2005, the combined ratio was 122%, as you see on this chart. And in 2001, the combined ratio is over 100%, due to the September 11 terrorist attack.
Just an FYI. If you remove Katrina and Sandy from the recent history, you can see the combined ratio has tended to be in the 70% to 80% range. And we think that 75% to 85% is a likely future range for RSUI's combined ratio, absent major industry losses such as Super Storm Sandy.
Briefly on the other operations, this is the 9% of the total. Capitol Insurance Companies focuses on small commercial property and casualty policies and surety bonds. Over the past 3 years, Capitol results have been hurt by adverse experience in a discontinued specialty program line and absent this segment, in 2012, the company grew 8.5% and had a combined ratio in the mid-90s.
Everybody makes a mistake now and then, and this is ours. PacificComp has struggled with a very difficult California workers' compensation market, as well as, frankly, some execution errors on our managements part. Not only has the market been excessively competitive but lost cause trends have been unfavorable, due not only to economic influences, but also California-specific factors. Late last year, we installed new management of the company and we're encouraged by recent trends in industry pricing.
Finally, Homesite, which is our 33% minority investment, had a difficult few years over the last 2 to 3 years, due to -- primarily due to elevated weather-related loss activity, and these are not necessarily the losses you read about in the headlines, but more frequency of hail and tornado activity. Homesite continues to increase rates between 5% to 10% per year and we believe, should return to underwriting profitability this year, as long as weather-related losses remain at the average level that they've been at in the last couple of years.
In addition to our portfolio of insurance and reinsurance businesses, we are also building a portfolio of other investments with non-correlated returns and/or potential significant upside if the business plans develop favorably.
In 2012, we acquired Bourn & Koch, a Rockford, Illinois machine tool company for slightly over 3x EBITDA. Bourn & Koch has a steady profit stream from replacement parts while capturing upside earnings potential through highly-engineered specialty machines.
Stranded Oil Resources Corporation, or SORC, as we call it, is acquiring legacy oil fields with a goal of improving the ultimate oil recovered in those fields through innovative underground gravity-assisted drainage techniques. And ORX Exploration is involved in developing high-impact oil and gas opportunities onshore in the state of Louisiana. Finally, we have an investment in a company called Article One Partners, which was recently featured in a Bloomberg Businessweek profile, about 2 weeks ago, if you're interested. And Article One uses a crowd sourcing model to help high-technology companies prove the validity of their patents.
We see a number of opportunities in the current environment and I would highlight the following: First, over the past several years, our insurance companies have had to face the headwinds of declining exposure growth, which of course, was mentioned in a previous presentation. This was particularly harmful to Capitol Companies and PacificComp, but now appears to be changing for the better. Both RSUI and Trans Re are seeing improving pricing in property lines and some casualty lines as well. For example, umbrella pricing is now increasing at mid-single digit rates and certain classes of D&O and professional liability are clearly firming.
RSUI continues to see ample growth opportunities in the excess and surplus lines market as large, standard carriers appear to be consistently raising pricing and shedding their least profitable exposures, which are then repriced in the wholesale market.
Over the past 2 years, we've made a number of changes to the operations of Capitol and PacificComp and believe both companies have a potential for improved results going forward.
And finally, with upwards of $900 million of parent company invested assets, we have the opportunity, until recently, of repurchasing our shares at a discount-to-book value.
The principal challenges are relatively straightforward. First is negative real interest rates, and I would agree that we're probably going to be stuck with this as a macro environment factor for quite some time. Also, of course, we have seen increase in the frequency of severe weather events and I don't think anyone in this industry can price or underwrite hoping that, somehow, that's not going to continue. And finally, relentless claims inflation in California workers' compensation has been a major challenge to our profitability.
So to summarize. Over the past decade, the S&P 500, as you know, has returned approximately 7% a year, with somewhat of a wild ride there in the middle of this chart, resulting in the double -- a doubling of value had you blindly put all your money into the stock market in 20O2. Allegheny's book value per share over the same time period has compounded at roughly 9% a year, resulting in a 230% increase in value.
We believe we've done this with considerably less risk than the market as a whole. And although our stock price has not done much for the last 5 years, this is largely due to the fact that the stock was, with hindsight, richly valued in 2000, which we know was the peak of the last underwriting cycle. With the stock now trading at a slight discount-to-book value, we believe that investors should perspectively receive at least the growth in book value as a return going forward and, hopefully, somewhat more, should the fundamentals of our industry and our performance improve.
So with that, I will be happy to take -- we have about 15 minutes for questions to get you back on schedule. About anything, so...
About the investment philosophy and buying noninsurance assets, you mentioned the oil exploration and a few others.
Weston M. Hicks
Yes, that's an interesting question. You know, if you think about the financial services industry and the insurance industry, in particular, it is what, in his latest book, Antifragile, Nassim Taleb refers to as a negative skew business. We are in the business of collecting premiums and if we're really lucky, we get to collect the premiums. The worst case is Super Storm Sandy comes along, we lose a lot of money. So you're upside is capped your downside is fairly, fairly large. We want to couple that with positive skew businesses. Businesses in which we know we are going to lose money initially, but as the businesses develop, we believe, there's a potential for the realization of significant economic value. Our downside is known, our unside (sic) [upside] is unknown. And we think putting those 2 together creates, ultimately, a more powerful long-term compounding machine. I would highlight, some of you may be familiar the company that recently was in the news for a merger, Leucadia. Leucadia is probably the best example of a company that I can think of that has consistently invested in positive skew businesses. Often, things look pretty ugly in some of these companies that they're invested in. But then, somehow, you walk in one day and they have a $500 million gain. And you kind of say, where did that come from? So that's the basic idea. Just take one example, ORX. ORX has assembled a portfolio of mineral rights for salt domes are onshore in the state of Louisiana. As you know, there's been substantial discoveries of oil anywhere from 15,000 to 20,000 feet below level offshore. Typically, these exists underneath salt domes, those same salt domes exist onshore. The company has significant seismic expertise and geological expertise. They've identified these resource opportunities and they have contracted with a major oil company to explore these salt domes. If they find oil, then we're going to have a significant carry in the potential future value.
I have a couple of questions. First, as you mentioned for Trans Re, do you think a 96 combined ratio is a reasonable combined ratio for that business. Historically, I guess, where interest rates were [indiscernible] look quite good, is that okay now, given where rates are? What kind of ROE does that produce, I guess?
Weston M. Hicks
And I was afraid you're going to ask that question. If you look at Trans Re for, I believe, for the decade of 2000 to 2010, if I recall correctly, the all-in combined ratio averaged about breakeven, at the end of the day. And that includes, of course, some large losses. But if you take the average for the full decade, it was about 100. I think the question is not so much the absolute ROE, but the ROE relative to the risk-free rate. And we think that the premium, over the risk-free rate, that a 96 combined will generate will still be reasonably attractive game. It's certainly not a 15% ROE, obviously, but closer to high-single-digit to 10%. Of course, the unknowns are how the reserves will emerge, and we tend to be pretty conservative. They tend to be pretty conservative on the reserving. And you have to give companies time to let the losses develop before that can really be recognized. But I think, clearly, the industry is kind of, at least for the near-term, is a mid- to high single digit return on equity industry.
At Alleghany, have you lowered your own return hurdles when you look at various investments given the lower risk-free rates?
Weston M. Hicks
Yes. Our objective has been to grow book value per share between 7% and 10% a year over the long term, and the emphasis there is over the long term. I think this is really important because as a company that has long-term owners, we recognize that the way to really compound value is not to have 13% for 4 years and then minus 25%, or minus 50%, or minus 90% as has been the case with some companies. So the goal is to roughly double the value of the company every 10 years or less. To do that, you can't blow it up in the interim, that's point number one. And obviously, you want to try to add to the core growth rate by making investments that will create those positive skew opportunities. I mean, the math is pretty simple. We have about 2.6x our equity in invested assets now, on a consolidated basis. If you could get 2% after tax, because unlike some of the companies at your conference, we are a taxable U.S. company -- just had to get that in -- that would be 5.2% growth in book value before capital management or total return investing or underwriting profits. So we have RSUI, which is run anywhere from 75% to 85%. We pick up, maybe, 4% underwriting profits at Trans Re on $3.6 billion of premium. And we invest a portion of our capital in total return investments, which we think, over time, can do better than 2%. So I think we you add it all up, we hope to be somewhere in the 7% to 10% range.
Yes, on the left?
Well, Weston, can you talk about -- you said you made some changes and done something different in your West Coast workers' comp, probably you can talk about some of your strategy there today, what you're doing and what you've seen that didn't quite develop as you expected?
Weston M. Hicks
Yes. Well, under the prior management, I would say we were surfing the lost cause trend of deflation that was occurring post-reform in 2002. The background was that there were significant changes to benefits, claims cost dropped significantly, prices starting to go down and the company was not pricing to the risk, but pricing to the loss experience. When the loss experience turned, they found themselves writing business at a significant loss. We installed a new CEO in December, Janet Frank. Janet was the President of Zenith and prior to that, she was the head of the State Compensation Fund in California. She's a real heavyweight in California workers' comp, and she's thrilled by the opportunity to create her own company now. We think she'll make a big difference. She's has great relationships with agents. She understands that there's good business and bad business in the state of California, and you got to make sure you got enough good business to offset the bad business. And we think the environment is potentially going to move in our favor. So we're hopeful that things will improve.
Jay Adam Cohen - BofA Merrill Lynch, Research Division
That's great and, unfortunately, that's all the time we have. Just join me in thanking Weston.
Weston M. Hicks
Okay. Thanks, Jay.
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