XL Group Plc Is Over-Reserved, But Not That Undervalued

| About: XL Group (XL)
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XL Group is over-reserved and over-capitalized, but that actually weighs on reported results.

The nature of XL Group's underwriting demands higher-than-average reserves, but generates below-average premiums relative to capital.

Management is trying to change the business mix, but the valuation today seems pretty fair.

XL Group plc (NYSE:XL) may have nearly gone out of business during the worst of the credit crisis, but in the time since the company has done a pretty decent job of repairing its capital situation, even if at a high cost in terms of dilution. The bigger question today is whether the company can generate substantially better results for the long-term - while the company looks over-reserved and over-capitalized, the nature of its underwriting may well limit the upside.

Trying To Modify The Mix

Not unlike ACE Limited (NYSE:ACE) or AIG (NYSE:AIG), XL Group is a rather diverse mix of P&C and specialty insurance and reinsurance. It's also one of the relatively few truly global insurance players as, again like AIG and ACE, it has primary licenses in multiple countries.

Reinsurance is a relatively small part of the business now on the basis of net written premiums (around 15% in the fourth quarter), but it is a highly profitable part of the business. The problem, though, is that this business has historically been long-tailed and with high attachment points, leading to above-average volatility and more required capital to support it. XL has a sizable property component to its reinsurance business (more than 50% including property catastrophe), and its overall combined ratio history is not as strong as those at ACE, Arch Capital (NASDAQ:ACGL), or RenRe (NYSE:RNR).

On the insurance side, XL does not write very much "plain vanilla" property & casualty business and instead focuses on various specialty lines and professional liability. With AIG, XL is one of the larger underwriters of professional lines insurance, though the company did wind up with a sizable reserve deficiency in professional lines in 2013 and entered into a large quota share contract in the fourth quarter with reinsurers (including, at least according to rumors, Arch Capital). In part, I wouldn't be surprised if this quota share deal was done to allow the company to reduce its exposure to this line without alienating its customers/brokers.

Can Those Returns Get Better?

XL Group's current and recent ROEs are not good enough, not the least of which because it is almost certainly below its cost of equity capital and because it takes a rather large amount of capital for every dollar of premiums written. If XL Group is really going to work as a stock from here, it's going to be on the back of better returns on capital.

One of the first issues is that the company has too much capital. Some of this is because it has to (those high attachment points and long tails require stronger reserves), and management is addressing this by allocating capital away from long-tail business. It's also true, though, that the real underlying business is perhaps not as strong as it may look - a lot of the positive prior year developments came from prior hard markets and the core combined ratio is still in the mid-90%'s.

The problem, though, is that there's generally a risk-reward tradeoff in underwriting - if you want bigger returns, you generally take on bigger risks. A relatively small number of companies (Arch and RenRe come to mind) can outperform on underwriting quality, but I'm not sure that XL Group can. CEO Michael McGavick did do a good job of turning around Safeco, though, so I'm not going to just dismiss the possibility of better long-term performance.

Conditions Getting Tougher

It's not helping matters that this is an increasingly challenging environment for P&C insurance companies. Reinsurance rates, particularly prop-cat, were weak at the start of this year and RenRe has said it expects another decline at midyear. Overall P&C isn't particularly great either, as the company saw low single-digit rate increases a the start of the year.

Simply put, there's a lot of capital chasing business right now. Competitors are being pretty rational, but it's taking some extra effort to find good opportunities for underwriting profitability (consider, for instance, Arch Capital's large foray into mortgage insurance). On the whole, then, I believe that favors more proven operators like ACE, Arch, and RenRe.

The company's underwriting results are also not quite as strong as they had been. The quarterly reserve development for the fourth quarter was about 25% lower than the recent trend and the company reported a higher level of non-cat large losses. On the other hand, recent trends in paid-to-incurred losses continues to suggest that XL's reserves are basically in good shape and that reserve releases will continue to be a positive contributor to results.

Looking At The Long-Term Value

XL Group would like to get rid of its life and annuity reinsurance business if it could. It has been in run-off for some time now and it generates a pretty poor return on stated capital. I don't want to give the impression that finding a buyer would be any sort of catalyst for radical transformation, but it would be one of those "nice to have" moves.

Looking at the business, the CEO of XL Group has commented more than once that he would be disappointed if long-term ROEs were below 10%. At this point, I believe he's destined to be disappointed, albeit not by much. Unless XL Group can alter its business mix quite a bit more quickly than I expected, I think ROEs will reach the high 9%'s by the end of the next five years, but not quite break double digits. That supports a fair value in the neighborhood of $31.

There is also typically a reasonably solid correlation between returns and book value premiums in the insurance sector. The slope of the curve can (and does) change over time, but for now XL's returns would argue for a P/TBV of a little more than 0.9, leading to a fair value of about $31.50.

The Bottom Line

My biggest fear with XL Group is that the company is going to be structurally incapable of generating substantially stronger results. I think the key is changing the mix; if XL Group can alter its writing mix and generate more premiums for every dollar of capital, good things can happen. For the time being, though, I see the risk-reward as pretty balanced and not good enough to tempt me to buy.

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.