Isn't Torchmark Supposed To Be Defensive?

| About: Torchmark Corporation (TMK)
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Summary

Torchmark zigs where other life insurance companies zag, offering plain vanilla policies aimed at middle class workers.

Simple policies with easily quantified risks have led to remarkably consistent and profitable underwriting profits.

Torchmark is traditionally considered defensive, but 15% long-term ROEs would still offer upside from here.

Life and supplemental health insurance company Torchmark (NYSE:TMK) is unusual in a lot of ways. Not only does the company have a pretty exceptional history of returns on equity, those returns have been remarkably consistent. The company's underwriting risk is low and not many companies can compete in its core life insurance markets. What's perhaps even stranger is that this supposedly defensive insurance stock is doing quite well in a market where conditions are seen as improving for the sector.

Even though Torchmark would normally have less to gain from the improving economy and rising rates, these shares may yet be undervalued. Torchmark's different model makes P/TBV valuation almost useless, but the shares look surprisingly cheap on the basis of an excess return model. I don't normally think to look at the 52-week high list for bargains, but Torchmark could still offer some meaningful upside from today's level.

Life Insurance For Regular People

Torchmark generates about two-thirds of its business from its life insurance operations, but this company is different from MetLife (NYSE:MET), Prudential Financial (NYSE:PRU), Lincoln National (NYSE:LNC), and Hartford (NYSE:HIG) in some pretty meaningful ways. Torchmark relies upon a large base of agents to generate business, targets affinity relationships like unions, and offers very basic policies targeted at middle-income workers.

Traditional whole life and term insurance make up more than 90% of Torchmark's life insurance business and these plans are very much "plain vanilla". Torchmark specializes in protection-oriented policies with small face amounts, minimal cash value, and virtually no savings or retirement component. With that, the underwriting becomes pretty simple and straightforward, and the company's claim-to-benefit ratio is pretty stable, leading to returns on equity about three to four points higher than the industry average.

To give a sense of how different this is, consider this - Torchmark's average life insurance policy in force face amount is about $17,000, versus over $135,000 for MetLife, over $150,000 for Lincoln, over $160,000 for Prudential, and over $270,000 for Hartford. Even if those examples are a bit extreme, Torchmark is well below the $70,000 or so average of the industry.

Torchmark's operations do have some challenges of its own, though. First, the company's performance is closely tied to the number of agents it has, and agent recruitment/retention has lagged of late (up in the low single digits yoy in the fourth quarter). On the other hand, MetLife and Prudential have dramatically shrunk their agent bases and it would take a lot of effort to replicate Torchmark's business.

There are also some concerns about the make up of the business. Union workers make up a significant percentage of Torchmark's business, but unions are on the wane in the U.S.. Mitigating this is the fact that Torchmark's share is only about 10% of unionized workers. The lower affluence of Torchmark's customer base could also be a concern for some investors, but lapse rates were not so bad even during the recession.

While maybe a bit off-topic, I wanted to share a quote from the Deutsche Bank analyst Yaron Kinar in reference to Torchmark's life insurance business, as this may be my all-time favorite quote in over 20 years of reading sell-side research. "Unlike auto insurance, however, these lines of business do not suffer from catastrophe events and, at least with life business, customer satisfaction in the event of a claim is not relevant to retention rates."

Health Fills A Niche

Torchmark decided a few years ago to bail out of standard health insurance products, due to both a challenging competitive environment against the likes of Humana (NYSE:HUM), UnitedHealth (NYSE:UNH) and so on, and the uncertainties of Obamacare. What Torchmark still has, though, is an attractive niche-oriented business built around supplemental policies that generally have capped benefits.

About one-third of the business is in Medicare supplement plans, where the company is a top 12 player, albeit much smaller than companies like Aetna (NYSE:AET) and Humana. Medicare Part D plans represent more than one-quarter of the business, while limited-benefit plans that cover specific situations like cancer or accidents make up the rest. This latter business is quite similar to what AFLAC (NYSE:AFL) offers and the launch of Obamacare isn't likely to alter the market all that much.

More Differences To Consider

As I said, Torchmark is very dependent upon its agencies to generate business. American Income covers unions and credit unions and generates around 40% of new business (mostly in life). Liberty National is a predominantly Southeastern business that targets middle-income clients for supplemental health and life policies. Management recently changed the structure here from a fixed to variable cost structure that saw the agents become independent agents (no longer TMK employees) paid completely from commissions and bonuses. Torchmark also has United American (Medicare supplement/Part D), Family Heritage (health), and a Direct Response direct marketing channel.

Like Berkshire Hathaway, Torchmark expects its underwriting businesses to be profitable on a standalone basis and it treats its investment operations as a separate business. That's an uncommon approach, but it seems to work here. Torchmark is also unusual in having a rather long maturity, long duration portfolio of high-quality fixed income investments (an average rating of A-). Torchmark has boosted its returns by investing out on the yield curve and it is generally less exposed to rates for its investment income than most other insurance companies.

With its very stable and low-risk underwriting, Torchmark is in some respects more like an insurance broker than a traditional insurance company. It does have its balance sheet technically at risk, but the limited nature of its policies significantly reduces its underwriting risk. What's more, the company has consistently generated surplus capital which it has put towards buybacks and dividends.

The Bottom Line

Torchmark is supposed to be a defensive insurance company that outperforms when the market turns against the sector. That may be true, but the fact remains that Torchmark is doing pretty well now even though sales and agent growth have both been pokey and a bit disappointing. I would also point out for the sake of completeness that Torchmark has been listed as among the "ten worst" insurance companies by the American Association for Justice, but I don't really know how significant that is (the U.S. Chamber of Commerce, for instance, is no particular fan of the American Association for Justice).

If Torchmark can deliver long-term returns on equity of 15% (the 10-year average is about 80bp below that), I believe the shares should trade between $81 and $97. I would normally use a 10% discount rate for a quality insurance company, and that leads to the $81 number, but I think Torchmark's demonstrated stability and superiority could argue for a lower rate of 9% (supporting the $97 target). To further stress test that model, dropping the assumed ROE to 14.2% would take about $5 to $6 per share out of the targets. Conventional ROE-based P/TBV multiples don't really work for Torchmark, as the company always looks expensive, but then Torchmark's different model explains why.

With a low dividend yield I suppose the $81 side of my value range isn't so appealing, but I think Torchmark could still be a good holding from here. It seems odd to consider a "defensive" insurance stock when the economy is improving and rates are likely to move higher, but sometimes the best offense is a good defense.

Disclosure: I 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.