Company Background and Recent History
Hartford Financial Services (NYSE:HIG) has come a long way since the depth of the 2008 financial crisis and is now focused on property and casualty insurance, group benefits and mutual funds after shedding its high-flying individual life and retirement business. Its stock price dropped from the pre-crisis level of $60 plus to as low as $5 in February 2009, and has since been steadily clawing back to just above $30 level.
Prior to the financial crisis the company had been selling many variable annuity (VA) contracts that were mostly invested in the equity market and the account values therefore fluctuated along with the market. During the crisis the company ran into trouble with the minimum guarantees embedded in those contracts that then exceeded the account values, which had tanked along with the market. The company suspended this business in 2009, and raised capital from Allianz, U.S. Treasury's TARP fund, and two equity offerings to beef up its balance sheet.
Global equity markets have since recovered, and the company has put in place financial hedges such that after the first quarter of this year management declared the VA block to be capital self-sufficient. Therefore, the company is now left with a staid P&C business with some peripheral group benefits and mutual funds and a run-off VA block.
With a net book value excluding the more volatile accumulative other comprehensive income (AOCI) of close to $42 per share as of June 30, 2013, I would argue that HIG has the potential to trade at the same 1.3 x net book value it once commanded prior to the financial crisis, which is also the same multiple its direct competitor, The Travelers (NYSE:TRV), is trading at. This valuation would convert into a 76% upside to HIG's current price of $31. Ironically, the company's net book value as of December 31, 2008, including the outsized accumulated other comprehensive loss of $7.5 billion, resulted from the widening of credit spreads during the crisis, was a little over $30 per share. It seems to me that fast forward five years, market has only priced in a stabilization of the company's business without consideration of any growth prospects.
FY 2008 Financial Result
There were good reasons for the stock to hit bottom at the depth of the financial crisis. The company's life insurance unit bore the brunt of the declines in the equity markets from its VA business. The value of life's assets under management at the end of 2008 declined 20% from the year before. The division's revenue declined to $(1.1) billion in 2008 from $13.4 billion the year before because of declines in net investment income in equities and investment impairments, and it turned a net loss of $2.4 billion in 2008 from a net income of $1.6 billion in 2007.
The company also took an impairment charge of $3,964 million on its investments, mostly subordinated fixed assets and preferred equity in the financial services sector. These investments have since recovered significant amounts of fair values and the unrealized gain is captured every quarter by other comprehensive income, which is not a P&L item but is accumulated quarterly as part of stockholder's equity.
Newly Installed Enterprise Risk Management
In 2009 the company created a position of chief risk officer, and since then has established a comprehensive risk management policy addressing insurance risk, operational risk, and financial risk.
Neutralization of market risk on VA block
The company uses a metric called "Retained Net Amount at Risk" (NAR) to measure the amount of money for which it is on the hook pertaining to the VA block; it is the difference between the guarantee and the account values for the in-the-money accounts, net of reinsurance but excluding hedging impacts. The in-the-money accounts are those for which the guarantee exceeds the account values. The company has managed to shrink its NAR from $6.2 billion at the end of 2009 to $1.6 billion at the end of the first quarter this year.
Whatever remaining market risk the company retained over its balance sheet, it has dynamically put in place hedge positions, based on market conditions, to effectively neutralize the economic impact. The company uses a metric called "Market Consistent Value" (MCV) which is calculated by taking an average of the present values of cash flows from more than 5,000 stochastic scenarios. The MCV is the basis for the hedging program. This value ranges from a positive $0.6 billion in the stress scenario to a positive $2.3 billion in the favorable scenario. The takeaway from all of this complex calculation is that the company has effectively insulated its economic value from market fluctuations.
The company uses "core earnings" rather than reported earnings to measure its performance. "Core earnings" excluded one-time items and the realized gain (loss) on its Japanese hedging program, which are volatile and significant in value. This last item should be excluded from earnings in evaluating the company because the GAAP reporting is asymmetrical; the Japanese VA accounts for which the financial hedge is intended is not marketed to market, but the financial hedge is. Therefore, during the recent second quarter, with a rising Japanese equity market, the GAAP reporting reflects a realized loss after tax of $413 million from the hedging program.
Since current management took over in late 2009, the company has made significant stride in growing its core earnings ROE on the go forward business. The current management outlook is for this business to produce core earnings ROE in the range of 9.5 - 10.5% in a year. I am optimistic about this because the company has exhibited significant pricing power in the past few quarters; during the second quarter, 8% in standard commercial renewal rate and 13% in year-to-date long-term disability rate. Pricing has been outpacing loss cost trends, resulting in margin expansion. I think that management's target of consolidated ROE of 7.5 - 8% for this year looks reasonable, barring major natural catastrophes. But, even in the case of Hurricane Sandy, the company has managed the risk well, as evidenced by its subsequent rise in stock price. The VA business only earns a ROE of 5% so is a drag on the company, but it is making good progress in gradually winding it down.
The previous uncertainty over the VA business hung over the company like a dark cloud and requires a lot of capital buffer for regulatory purposes. Now this business is capital self-sufficient, there is increasing prospect of the company gradually releasing the excess capital for debt reduction and share repurchase. In February this year management announced a $500 million share repurchase program through the end of 2014.
$500 million does not sound all that exciting, but on this year's Investor Day, the CFO projected capital margins at the end of 2014 to range from $2.2 billion in the stress scenario (S&P 900) to $6.1 billion in the favorable scenario (S&P 1650). Management knows better than anybody else that the stock is under-valued and has expressed willingness for additional share repurchase. The projection here shows that it has significant potential wherewithal to carry out its promise.
My forecast of the company's FY2013 EPS is $3.04, lower than the average analyst estimate of $3.23 from Yahoo! Finance. Given the stability of the insurance sector, I think that an earnings multiple of 13 is reasonable. I mentioned at the beginning of this piece about the stock's historical multiple of net book value. Therefore, I would value the stock in the range of $40 - $55 a share. This sector has slightly suffered lately because of market's surprise at the lack of tapering at Fed's last meeting; investors sold insurers because of lowered expectations on the yield the insurers would be getting on their bond holdings. I would recommend taking this opportunity to accumulate shares of HIG at or below $30.
0 The NAR and capital margins calculations are from this year's Investor Day presentation from management.