There are a lot of bargains in the insurance industry right now, and Symetra Financial Corporation (SYA) is one of them. The company operates three lines of business: benefits, retirement, and individual life. In this article, I will argue that despite recent deterioration in operating performance, SYA has several catalysts in the next eighteen months that will propel the stock upwards.
Recent Performance
The most disappointing business segment of late is the benefits division, which offers disability and medical stop-loss insurance to employers and typically contributes about one-third of total operating income. Sales are flat over the past year and the loss ratio for stop-loss insurance jumped from 61.9 to 69.2 while the combined ratio increased from 88.2 to 96.6. This is higher than the company's long-term target of 63-65, and resulted in a 46.2% decline in the segment's pre-tax adjusted operating income (which omits net investment gains or losses). Management attributes this poor performance in part to increased competition and pricing pressure.
I believe that these headwinds are temporary. Over the next two years, more provisions of the Affordable Care Act will come into force. According to the Employee Benefits Research Institute, this will lead to a rapid expansion of the potential market for stop-loss insurance as smaller employers become self-insured:
(T)here is speculation that passage of the Patient Protection and Affordable Care Act of 2010 (PPACA) will result in an increasing number of smaller employers offering self-insured plans. Employers think that components of PPACA, such as the strict grandfathering requirements; the minimum-creditable-coverage requirement; the breadth of essential health benefits; taxes on insurers, medical-device manufacturers, and pharmaceutical companies; affordability requirements; and reinsurance fees will all drive up the cost of health coverage. Small employers concerned about the rising cost of providing health coverage may view self-insurance as a more attractive means to mitigate any expected cost increases.
According to the same report, only 13.2% of employers with 25-99 employees are currently self-insured while only 35% of employers with 100-999 employees are self-insured in 2011, and those numbers have trended downwards in the last decade. This dynamic has increased competitive pressure as companies fight over dwindling business. Given the new regulatory regime, this trend will likely reverse course and there will be plenty of business to go around, fueling both top line growth and easing competitive pressures.
Capital Policy
Over the last six months, management has become increasingly aggressive in returning capital to shareholders. In March, the company increased its quarterly dividend 14% from $0.07 to $0.08 per share, giving the stock a respectable yield of 2.16%. In February, the company announced a 10 million share stock repurchase plan, 7% of the total float. While these sorts of announcements are often vague statements of good intentions, the company clearly was not kidding around: on May 17 it announced a block purchase 6.1 million shares at $13.43 per share. On May 21, the company then expanded the plan to 16 million shares, 12% of the remaining float. Because the company is currently trading at less than book (see below), reinvesting dividends and repurchases will be tremendously accretive.
In Good Company
White Mountains Insurance Group (WTM) and Berkshire Hathaway (BRK.B) (though its General Re operating company) each own 21% of the outstanding common stock, including warrants exercisable for 9.5M shares. Not only do both companies have excellent track records for creating long-term value, they are well-respected for their conservatism. And while this arrangement is not exactly a catalyst, it is definitely reassuring to SYA investors to be in such good company.
Valuation
Because of its capital structure and its practice of carrying assets on its balance sheet at fair value rather than amortized cost, the best measure of book value subtracts accumulated other income (AOCI) from shareholder equity while adjusting for the exercise of the outstanding warrants. This adjusted book value is currently $18.32 per share. At a price of $14.81, SYA is trading at about 80% of adjusted book value. This method provides a conservative measure of book value, because $1.3B of the company's $3.6B in shareholder equity is unrealized gains in its bonds and derivative positions booked as AOCI (yellow box):
The operating return (which excludes after tax net realized gain or losses on investments) on this adjusted equity in the last 12 months is 7.9%. At a 20% discount to adjusted book, this gives investors an effective 10% yield. While this is a relatively attractive return in itself, recovery and growth in the medical stop-loss business should propel earnings upwards. Additionally, the share repurchase plan and discount to book should provide somewhat of a floor on the stock while also serving as an additional driver of EPS growth as the company turns $0.80 into $1.00 without any risk.
Risks to Watch
Although SYA boasts a solid risk-based capital ratio of 496%, there are a few issues with its investment portfolio that investors should monitor. Its bond portfolio is somewhat aggressive in terms of credit risk:
While the percent of the portfolio that is below investment grade declined from 5.4% to 5.2% in the last year (yellow box), that proportion could take a significant bite out of shareholder equity if credit conditions sour. Additionally, SYA is aggressively positioned in bonds just north of junk status, with 36.3% of the portfolio rated BBB.
SYA has also branched into commercial mortgages in its search for yield, which currently constitute more than 11% of the investment portfolio. The quality of those mortgages are tough to judge, but SYA provides some metrics regarding their riskiness:
Higher risk loans, which constitute 18.4% of the portfolio, have either a loan-to-value ratio of 80% or more or a loan-to-value ratio between 65% and 80% and a debt-service coverage ratio of less than 1.50. While these credit characteristics do not make me especially worried, the portfolio is unseasoned. Only two loans with an outstanding balance of $4.7M were non-performing and allowances for losses stood at a mere $7.9M. So reserves for losses stand at a miniscule 0.2% of the portfolio, a metric that will probably deteriorate somewhat over time.
Investment Implications
In summary, I believe that at current prices SYA is a good investment. Selling at a discount to book, the company's medical stop-loss insurance business will begin to accelerate in the coming quarters and its aggressive capital return plan will also create significant value. And while investors should be vigilant regarding the credit quality of its bond and mortgage portfolios, I believe that shareholders will be adequately compensated at current prices for bearing those risks.
Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in SYA over 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.
