Hiscox- Does It Deserve A Premium Valuation?

| About: HISCOX LTD (HCXLD)

Summary

Poor re-insurance results is expected to cause lower earnings per share. This overlooks Kiskadee a strong operation which should offset reduced earnings.

Hiscox continue to expand total business and at an impressive 19.9% return on equity.

Hiscox are currently trading at a lower than trend P/B.

Expected to beat earnings consensus causing a positive revaluation.

Who are Hiscox?

Hiscox (FTSE:HSX) are a diversified insurance firm with operations across Europe and the US. They operate in a range of insurance demographics including: Property, Casualty, Reinsurance and Specialty sectors. With 2015 results being announced on the 29th February 2016, you should be holding a position in Hiscox.

For those less familiar with the insurance industry, it should be noted that insurance companies are not limited in the same way as consumer goods companies. Insurance firms are able to write as much as they wish whereas consumer good companies are limited by their factors of production. This can make revenues fluctuate and harder to predict. Yet not having this limitation allows for greater flexibility to write when insurance is profitable and conversely, to not write when it is unprofitable.

The profitability of insurance writing is cyclical throughout all sub-sectors. In periods of high underwriting profits, new firms will enter the market and due to a lack of product differentiation, premiums will be the driving factor of revenues, ultimately narrowing margins. This can lead the industry into an unprofitable period that overexposes inefficient firms hence reducing competition and increasing margins once more. Profitability of writing is measured through the combined ratio, where a ratio of less than 100% represents an underwriting profit (i.e. a ratio of 99% represents a 1% underwriting profit). (W. Buffett, 1987)

There are three primary focuses of my analysis:

  1. Insurance Market and Macroeconomic Factors,
  2. Hiscox's Re-Insurance and Insurance Operations,
  3. Hiscox's Implicit Valuation.

1. Insurance Market and Macroeconomic Factors

The underlying concept in the Insurance industry is to receive money (a premium) now in order to cover a client's potential loss in the future. In other words the insurer will take a loan from those who they insure which is profitable for the insurer when combined ratio is less than 100. Using Hiscox's combined ratio for 1H15 they made a profit of 17.5% on this borrowed money.

As previously mentioned insurance tends to be cyclical. Given the current highly profitable insurance operations, it is a good time to have insurance in your portfolio. Additionally there is a second benefit to insurance operations; investment returns. When a firm receives premiums they are added to the float; defined as the money held, but not owned, by the insurance firm. The float is then invested at a return for shareholders. Generally, insurance firms will have a bias towards shorter-term fixed income investments, which provides liquidity and returns to the firm.

In the present macroeconomic climate of low interest rates, investment returns of Hiscox have been 0.7% (3Q15). This creates an annualised return of 0.9%, which on short-term yields outperforms US treasuries by approximately 0.45pp. The total returns are even greater due to the profitability of the generation of funds for investment. This makes returns on premiums stand closer to 100 - 82.5 + 0.9 = 18.4%.

Should interest rates continue to rise in the next year, Hiscox would provide an opportunity to use their float to leverage returns into your portfolio. Providing a fixed-income exposure, Hiscox are a natural hedge against interest rate rises.

Figure 1 - Hiscox Annual Report 2014

One sector within insurance that is seeing a margin squeeze is the re-insurance sector. Premiums have been falling; this is mainly as a result of consistency low claims in recent years. Although this once made re-insurance a profitable sector, these margins are now being squeezed through new market entrants. As shown in figure 1, Hiscox are not overly reliant on the re-insurance market, partly due to risk adverse management spreading business over a range of streams. Hence when a margin squeeze occurs similar to the current conditions, a reallocation of aggregate (the maximum amount the insurer will pay out, in other words the maximum amount of liability the insurer is willing to take on) can occur. A good example of this is the recent shift from catastrophe aggregate to small ticket property, which is entering a more profitable period. This displays sound management, diversification of earnings power and also a prudent approach to an inherently risky business.

To conclude, Hiscox provide a natural leveraged hedge to interest rate rises, which should result in greater shareholder returns. Whilst perhaps falling profitability in re-insurance negates these returns, the freed up collateral from the present strategy can be assigned to sectors which are increasing in profitability, making any negative earnings effect minimal whilst also providing investment stability.

2. Re-Insurance and Insurance Operations

The re-insurance arm of Hiscox achieved a strong combined ratio of 49.8% (2014) generating strong earnings for shareholders, despite a reduction in premiums earned by 13.9% (2014); a trend expected to continue through 2015/6. However the 3Q15 trading update has shown the re-insurance business has remained stable, mainly due to the high performance of Kiskadee, the insurance linked fund founded in 2014. Hiscox again have demonstrated intelligent writing of business and superb risk management. I shall expand upon this in two ways; reserve releases and Kiskadee.

Hiscox have expanded reserve releases for it's re-insurance arm by £32m from £140m through 2014, maintaining their cautious approach. Although this caution will erode shareholder returns, it keeps generated capital within the firm and lowers the risks of large-scale catastrophes having a material effect on Hiscox's long-term prospects. This should have the effect of providing greater stability should large scale claims occur in the re-insurance market, which could otherwise cripple over-exposed firms. When this happens, re-insurance should become exceedingly profitable for Hiscox again, who will be in a strong position to take advantage of market conditions.

The 3Q15 trading update highlighted that re-insurance remains a challenging environment. In 2014 Hiscox founded Kiskadee, which provides investors with access to re-insurance markets. This spreads risk within Hiscox whilst generating returns for Kiskadee and investors. I believe there is potential for increased risk adjusted earnings, further offsetting re-insurance earnings reductions. In addition, Hiscox's strong credit position will allow them to take advantage of a change in market dynamic.

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Figure 2 - Hiscox Q3 Interim Management Statement

Hiscox's wider insurance operations show gross premiums written have increased 14.7%. This has been focused around a 24.5% increase in the London market, a division that experienced a highly profitable period. The expansion of business is backed with aggregate not being assigned to writing more re-insurance, allowing for a more efficient aggregate allocation within the firm.

The float operates as an investment fund, gaining a return between the period of premium generation and fulfillment of claims. As of 3Q15 total investment assets were £3.2bn, providing leverage on equity for investment returns. With claims continuing to remain low and stable, this should provide a perpetual income stream until conditions change.

Currently the consensus predicts a reduction in EPS and as with all insurance companies, January renewals will be a key indicator for the coming years earnings. My findings show that premium revenues should remain favourable; Kiskadee should continue to offset any downward pressure on re-insurance operations. Intelligent management is expected to continue to shift collateral to write more business in profitable areas, leading to continued profitability. I believe Hiscox will show a slight increase on last years EPS.

3. Hiscox's Implicit Valuation

Valuation of financial firms has a history of being very tricky, for this reason I have given primary attention to two metrics: return on equity and price to book.

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Figure 3

Return on equity is an impressive annualised rate of 19.9% (1H15). This outperforms most other companies in the sector (fig. 4). Hiscox have maintained this strong return over the last five years despite poor investment returns. In 2011 they saw losses in the re-insurance division while still achieving a modest 1.9% return on equity, further demonstrating diversification and financial security.

Click to enlargeFigure 4

Hiscox's price to book is at 1.7, which is historically low for Hiscox (10 year average P/B is 1.8). This fall below the average is primarily due to tough market conditions through December 2015 - January 2016. By constructing a relative valuation using similar listed companies it is clear that Hiscox (outlined in red) are achieving a materially greater return on equity than their peers, whereas it is trading only slightly above the sample median P/B (1.6). Highlighting the potential need for re-valuation.

Rating - Outperform

Research on Hiscox confirms that overall prospect for earnings are strong. Historically high returns on equity have been achieved alongside currently trading at a below average P/B. These factors compound my belief that there are good signs for a positive revaluation in Hiscox come earnings release.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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