Chubb: Valuing Income From A High-Quality Bond Portfolio

Jul.15.14 | About: The Chubb (CB)

Summary

57% of Chubb's net income is derived from the float invested in high-quality bonds.

8% is derived from capital gains.

36% is derived from underwriting profit.

When net income is evaluated according to source, intrinsic value exceeds current market price.

A large portion of insurance company profit is derived from investing the float. Chubb (NYSE:CB) has historically invested in a high-quality bond portfolio, as demonstrated by extremely stable investment returns during the financial crisis of 2008-2009. When due consideration of this source of income is quantified, an intrinsic value of $119 per share emerges.

This article focuses on valuation. For a full discussion of Chubb's business, see this recent article by SA contributor Sure Dividend. Much of the analysis here relies on an understanding of insurance company float, a subject I covered several years ago and would refer readers to that source for additional information.

Here's a worksheet incorporating a breakdown of income by source, together with an estimate of an appropriate multiple or cap rate for each:

Click to enlarge

The insurance industry has its own cycle, driven by a tendency to cut rates for competitive reasons and then increase them when profitability decreases enough to be painful. As such, P/E ratios are frequently lower than the market, as is frequently the case for cyclical stocks. However, well over half of Chubb's income over time is rock-steady from the bond portfolio, and should command a higher multiple. I divided investment income by the value of fixed maturities to estimate an average bond yield, and added 1% to that to develop a cap rate.

Ben Graham recommended using long-term average earnings to smooth out the business cycle, suggesting investors buy at a multiple of 15X P/E5 or P/E7. In this situation, I'm suggesting a multiple of 12.5 for Chubb's 10-year average underwriting profits.

The capital gains are not a large item. Over the past 10 years, Chubb has booked capital gains in 9 of them, the exception being small losses during the financial crisis. I assigned a multiple of 10 to this portion of earnings.

Catastrophe Exposure

Insurance companies are routinely exposed to catastrophes such as hurricanes. Typically, they buy reinsurance to keep losses within a well-defined range. The biggest blunder I've seen on this topic occurred when Allstate (NYSE:ALL) went bare on New Orleans and bought the farm on Katrina.

Chubb's management is more capable that Allstate's. To develop a charge for unknown catastrophes, I took a guess that Chubb would take a hit of 15% to shareholders' equity, twice what Allstate actually incurred. Allstate, by the way, did well as far as share price goes in the wake of Katrina.

CAT bonds have become increasingly popular. Investors can buy bonds that have relatively high returns with the understanding they will lose their capital in the event of certain specified and very severe catastrophes. I used an estimate of current rates for this type of bond as a way to quantify unknown catastrophe risk.

Intrinsic Value vs. Fair Market Value

Other contributors have noted that insurance typically takes a P/E multiple well below the market average. Under the circumstances, a company like Chubb may never trade at or above its intrinsic value.

For investors who take a long-term view, this is not a problem. The point is that if the stock never trades at intrinsic value, management can always increase shareholder value by buying back shares. Chubb has very consistently reduced share counts over the years.

Investment Implications

Buying at recent market prices in the $94 area, investors have a reasonable expectation of satisfactory long-term returns due to steady increases in dividend income, buybacks and book value.

I'm investing on the basis that Chubb will return 11% annualized over the next five years. I plan to hold indefinitely, subject to a quarterly review when earnings are reported. I don't expect that it will ever trade at intrinsic value, as estimated here.

Other P&C Insurance Companies

I'm also long Travelers (NYSE:TRV), based on a similar analysis. It's important to consider the consistency of investment returns over a period including the financial crisis before applying a multiple. By way of example, CNA Financial Corp. (NYSE:CNA), Allstate and Hartford Financial Services (NYSE:HIG) chased yield in their bond portfolios and incurred distressing losses during the financial crisis.

Frequently, the 10-K will include information on the quality of the bond portfolio. In some instances, there may be sufficient detail to allow an accurate appraisal of the desired rate of return, based on the nature of the holdings.

Disclosure: The author is long TRV, CB. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it. The author has no business relationship with any company whose stock is mentioned in this article.