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The property-casualty insurance industry is currently very competitive, so it makes sense that share valuations are not extraordinarily rich. However, valuations for a number of companies have reached depressed levels that value these companies at significantly less than they would be worth if the insurance underwriting operations were stripped away and they effectively became leveraged investment trusts. Pricing and underwriting conditions are not nearly as bleak as the market’s view on current pricing and underwriting conditions.
Valuations have been battered for many companies in many sub-sectors, but they are perhaps most severely depressed for mid-sized multi-line insurance and reinsurance companies. This group includes ACE (NYSE:ACE), Arch Capital Group (NASDAQ:ACGL), Aspen Insurance Holdings (NYSE:AHL), Allied World Assurance (NYSE:AWH), Axis Capital Holdings (NYSE:AXS), Endurance Specialty Holdings (NYSE:ENH), Everest Re (NYSE:RE), Transatlantic Holdings (NYSE:TRH), and XL Capital (NYSE:XL), all of which trade on the NASDAQ or New York Stock Exchange, and all trade at a discount to tangible book value ranging from 10%-30%. Even though all or almost all of these companies are undervalued, the relative valuations make sense for the most part. For example, Arch Capital Group trades at a discount of around 10% to tangible book value, but (at least in this author’s view) Arch’s reserves include perhaps the largest cushion (sometimes referred to as reserve “equity”) of any of these companies.
The one exception is Everest Re (RE). Like most of these companies, Everest Re provides property and liability insurance coverage to a wide range of businesses, and provides reinsurance coverage, which protects primary insurance companies from losses on the policies they insure. Everest Re prices and manages underwriting risk among the best in the industry, maintains very low operating expenses (a critical strength in a competitive pricing environment), and maintains an extraordinarily strong balance sheet. In the author’s view, the shares should trade at a premium to peer companies, but instead they trade at a discount.
The closing price of 71.78 yesterday, May 26, represents a 29.9% discount relative to book value of 102.46. Since going public in 1995, the shares have never closed a trading day at a steeper discount to book value. On a few occasions in October 2008, intraday lows for the share price dropped the ratio below 70%, but the share price rebounded during the day. Even though the credit crisis did not exert a tremendous impact on the businesses of most property-casualty insurers, their share prices have never really recovered. Everest is no exception.
Prior to the credit crisis, the shares traded at their steepest discount to book value on October 18, 1999, when the price fell as low as $20.50, a 30.1% discount to book value (the closing price of 20.81 was a 29.1% discount). In the subsequent 15 months, the share price almost quadrupled, reaching a high of 74.75 in December of 2000. This happened despite much more challenging market conditions then vs. now, less adequate loss reserves carried on Everest’s balance sheet, and a capital position that was not nearly as strong as it is today.
This last point touches on a key reason that the share price has remained depressed: the company is overcapitalized. In the recent past, it might have been acceptable to “husband” capital (a description management used in one investor conference call). However, with the share price depressed and at least $1B of excess capital, management would best serve shareholder interests by at least doubling its share repurchase authorization (to at least 17 million shares) and aggressively repurchasing shares at prices below $80, unless pricing for catastrophe exposed risks tightens significantly for July 1 reinsurance renewals.
The company can mitigate catastrophe risk, the largest and most imminent risk to the company’s capital cushion, by reducing direct or reinsured catastrophe exposures, or by purchasing protection in the form of reinsurance or industry loss warranties (contracts that pay the buyer if industry wide losses for certain events exceed predetermined thresholds). Recent pricing for catastrophe risk has been passable at best, but not nearly attractive enough to justify $1B+ of excess capital to support the risk.
The table below provides some very rough income projections over the next 12 months.
Average invested assets
$15B
Investment yield
4.5%
Investment income
$675M
Underwriting income
$0
Interest and amortization expense
$65M
Pre-tax income
$610M
Effective tax rate
20%
Net income
$488M
The $488M of net income equates to $8.28 per share (8.67 times the $71.78 closing share price on May 26) assuming no underwriting income (vs. a 2% underwriting margin over the past five years, which have included two major natural catastrophes), a yield on cash and investments about the same as the past 12 months, and an effective tax rate over twice the average over the past five years. Additional share repurchases at prices near current levels would increase earnings per share.
Despite being a largely defensive investment, Everest shares could easily double over the next year, even without more aggressive share repurchases. With relatively benign natural catastrophe losses and liability loss trends, book value per share should increase to around $120 in a year. A valuation 20% higher than book value (normal for prior to the credit crisis) would price the shares at $144.
Disclosure: Long RE (largest position)
Source: Everest Re: A Bargain in the Depressed Property-Casualty Sector