Rethinking Reinsurance: A Common Approach To Preferred Investing In Axis Capital Holdings

Aug.28.13 | About: Axis Capital (AXS)

If you think investing in insurance is dry, boring and complicated, then try understanding and analyzing the field of reinsurance. Reinsurance is the practice of primary insurers transferring a portion of their underwriting risks to other parties. The party that transfers the risk is referred to as the "ceding" party. The party that accepts a portion of the potential obligation is known as the reinsurer. There, that wasn't so bad, was it?

Despite being tested by the global financial crisis, record catastrophe losses, low interest rates, and a tepid economic recovery, the reinsurance industry remains on stable footing. Although geographical diversity ranks high as a differentiating quality among reinsurers, the two important metrics that separate the wheat from the chaff, are Financial Strength Rating "FSR" and Enterprise Risk Management "ERM."

Standard & Poor's FSR ratings of the top 23 global reinsurers range from a low of BBB- to AA+, with the average rating coming in at A which is "strong." ERM is an integral tool used to identify, measure and manage risk as a means of preserving the reinsurer's financial strength. A complete and in-depth article recently released by Standard & Poor's that analyzes the ratings of reinsurers can be found at the following link here.

Sticking with the top 23 global operators, I went searching for the one company that not only excelled in FSR and ERM ratings but one that met my own personal standards of growth at a reasonable price and one that is shareholder friendly, paying a stable and growing dividend at sustainable payout ratios. The company that best passed these tests is Axis Capital Holdings, LTD (NYSE:AXS).

Aside from a small decline in 2008, AXS has had 10 consecutive years of top line revenue growth. Further, the company increased its dividend on its common stock each year during the same 10-year period from $.50 in 2004 to the current level of $1.00 per share, which is an average annual dividend growth rate of 8%. Currently, the stock is yielding 2.3 percent, which is not spectacular, but it is at the upper end of all reinsurance companies. The average payout ratio is around 20%. The table below lists some operating results from the last 5 years.

Year

Revenue

$Million

Dividend

Operating

CF $Million

Payout

Ratio

2008

$2810

$.76

$1526

33%

2009

$2815

$.81

$850

26%

2010

$3551

$.86

$1188

14%

2011

$3801

$.93

$1190

250%

2012

$3927

$.97

$1121

24%

Click to enlarge

In 2011, AXS experienced major catastrophic losses, which included $64 million related to flooding in Thailand, $32 million in relation to the Japanese earthquake and tsunami, and $31 million related to the New Zealand earthquake. Through it all, the company emerged with its capital structure largely intact and was actually able to increase the dividend on the common stock for 2012 despite the impact of these random events.

Looking at the operating results so far in 2013, the wild ride continues. We get two distinct pictures of company results when comparing year-over-year Q2 vs. year-over-year for the first six months. Q1 had extremely low catastrophe and weather activity in contrast to much higher activity in Q2. The combined year to date results were quite healthy with operating income up 19% over the prior year, despite the drag on earnings related to tornadoes and hailstorms in the US and flooding in Argentina and Canada in Q2.

Through all of this adversity, AXS repurchased $228 million of its common shares in the second quarter, bringing the year to date total to 8.5 million shares, or 7.2% of the outstanding shares at the beginning of 2013. The combined result of the share repurchases and dividends paid, AXS has a return of over 150% of operating earnings back to its shareholders.

In the Q1 investor conference call, the company's CEO made the following statement:

"I've always said that our insurance company is nothing more than capital and people."

The statement really sums up and punctuates the two important evaluative metrics for reinsurance companies mentioned at the beginning of this article; FSR (Financial Strength Rating) and ERM (Enterprise Risk Management). Among the top 23 global reinsurers, Axis excels in both of these categories with a FSR rating of A+ and ERM rating of "Strong," according to Standard & Poor's.

While I view the common stock, which is trading at $42.46 as of the date of this writing with a dividend yield of 2.6% attractive, I don't find it compelling. However, I do particularly like the recently issued series D 5.5% preferred (AXS.PD), currently trading well under its $25 par value at $19.73 with an effective yield of 6.97%. The shares are rated investment grade Baa1/BBB by Moody's and S&P with a call date, at the company's option, on or after 6/1/2018.

With the recent spike in interest rates, there is no shortage of beaten down preferred stocks sporting attractive yields. For me, the process of identifying buying opportunities in preferred stocks goes well beyond current yield. I only want to own preferred stocks of companies that have a stable and growing dividend on their common stock at payout ratios that favor the continuation of that common dividend. With preferred stocks ranking higher in the overall capital structure than common, it is the security of the common that pads my comfort level for the sustainability of the preferred dividend.

Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in AXS over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.