To Be More Than A Yield Play, Zurich Insurance Needs More Self-Improvement

Summary

• Zurich Insurance's performance has been dragged down by high loss ratios and high expense ratios, both of which the company is targeting with multiyear improvement strategies.
• Management believes its high loss ratios are a byproduct of strategic mistakes, not a sign of poor underwriting quality, and that business mix shifts will lead to meaningful improvements soon.
• The company's Farmers business is a source of lucrative low-risk fee income, but the underlying performance at Farmers hasn't been so good lately.
• Successfully reducing losses and expenses could drive the shares into the high $30s, but this is a "show me" story that will be driven by management execution.

With a dividend yield close to 6% and a healthy capital/solvency position, Zurich Insurance (OTCQX:ZURVY) (OTCQX:ZFSVF) (ZURN.S) is by no means a bad insurance company. With high expense ratios, high loss ratios, and weak trailing premium growth, though, it is likewise hard to say that Zurich is a particularly good insurance company. The extent to which Zurich Insurance's management can execute on cost-cutting and underwriting targets will shape the company's earnings growth potential, as "more of the same" is not going to be enough to move the shares significantly higher.

I would say that I'm cautiously optimistic on Zurich's potential from here. Shifting the business mix and delivering improved underwriting results will take time, but there is a pathway to mid-teens ROE and stronger total annual investment returns from here.

Weak Underwriting Needs To Be Fixed

One of the largest P&C insurers in North America, and a large player in Europe as well, I believe it's harder lately to argue that Zurich is one of the best - at least in terms of the underlying profitability of the business. Likewise, growth has not been all that impressive, with low single-digit annualized growth in the non-life business that is well below the likes of other Europe-based global insurers AXA (OTCQX:AXAHY), Allianz (OTCPK:AZSEY), Aviva (OTCPK:AVVIY), and Generali (OTCPK:ARZGY).

The reported combined ratio for 2017 was almost 101 and still much too high (in the mid-to-high 90%'s) depending upon how you adjusted for cats and reserve developments. Although the adjusted figure did improve close to one point on a year-over-year basis, the accident-year loss ratio of 65% is still too high when compared to other well-run insurers like Chubb (NYSE:CB), and the company's combined ratio of over 100 in its commercial business (versus is retail) is likewise not good.

This is not a new problem, as Zurich has been posting above-average loss ratios for several years. It's just a fact of life that certain lines, like commercial auto, generate higher losses for the industry, and Zurich does have elevated exposures to some of these lines.

But it's not just a mix issue, but rather something more serious in risk selection. The company's recent performance (over the last couple of years) in commercial auto is one of the worst of the major players, and well above the industry average. The performance in worker's comp has likewise been poor, with loss ratios around 20 points higher than the average, while the performance in multi-peril has been worse than average but relatively less worse (about five points above the average).

Management believes that this is not the fault of its underwriters or underwriting quality, but rather decisions made by past managers to get too aggressive on risk and volatility. That may be true, as casualty (which tends to have structurally higher losses) was a significant part of the book before the company's restructuring efforts, but I would say the company's underwriting quality is still a "show me" story.

To that end, though, management has a plan in place. The company is reducing its exposure to casualty and likewise shifting away from longer-tail risks in favor of shorter-tail business. Management is prioritizing growing those segments of its business that generate combined ratios below 95%, looking to fix the 25% to 30% that generate CRs between 95% and 105%, and looking to shrink businesses (<20%) that generate CRs above 105%. The company also seems open to M&A, with an eye toward short-tail P&C businesses.

Expenses Have Been Stubborn

There are two components to the combined ratio - the loss ratio and the expense ratio - and Zurich has had challenges with both. On the expense side, the company's expense ratio has remained stubbornly around 31% to 32% when many of its rivals manage sub-30% expense ratios.

Management is targeting this with a $1.5 billion cost savings programming that is due to be completed by the end of 2019. The company has achieved about half of its target goals so far (through the end of 2017), and full realization of this plan could offer a boost of more than two points to the combined ratio.

Still, it may be hard to hit those numbers. While the company has been making progress on controlling its internal costs, commission ratios have offset this progress. This has come about as part of a business mix shift that may be hard to reverse - particularly as the company has grown its LatAm business, and that has a significant commission component.

Can Farmers Improve?

More than a quarter of Zurich Insurance's operating profits come from its Farmers relationship, where the company provides services to Farmers exchanges in return for fees. Zurich takes on no underwriting risk and its balance sheet commitments are very modest (a small amount of reinsurance). This is a lucrative business for Zurich, with the company taking around 12% of premiums in fees (or 7% net), and its peer/rival Erie (NASDAQ:ERIE) has enjoyed healthy valuation multiples running a similar (but not identical) business).

My concern here is whether Farmers' underlying performance can improve. Zurich's operating profit from this business decreased 2% in 2017, with the underlying profit down about 4% and new business down 4% in the fourth quarter after a double-digit decline in the prior year. Farmers is a top-10 player in the U.S. (a little smaller than Travelers (NYSE:TRV) and Chubb) despite a largely West Coast historical focus, but the company has a high cost ratio and I'm not convinced it can offer meaningful growth for Zurich without some more significant changes to the model. While Farmers has been expanding its East Coast business for several years now, I do have some modest concerns that there could be pressure on Zurich's fee structure without better operating performance.

It's Not All Bad

I don't want to create the impression that Zurich Insurance is a bad company, because it's not. The company's ROE has underwhelmed for a couple of years, but it is not a bad business. What's more, management has been making some investments in growth.

Zurich's life insurance business is largely made up of unit-linked and protection businesses (which is good), and the company spent over $2 billion late in 2017 to acquire OnePath Life and boost its share in Australia's life insurance market. With mostly non-traditional products like protection and unit-linked, this should be a business that generates attractive cash flows in the years to come.

Likewise, Zurich has been using M&A to expand its Latin American P&C operations. Zurich is now #3 in Latin American P&C (with large presences in motor, as well as individual countries like Brazil, Chile, Mexico, and Argentina) and #1 overall in combined P&C and life. There are some challenges in the LatAm market (including the fact that the business it acquired, QBE's operations, had significant losses), including higher commissions and expenses, but it offers a lot more long-term growth than the mature North American and European markets.

Zurich also has a large presence in large commercial P&C (larger than Allianz or AXA). Although this business can be very competitive (and commercial auto loss rates have been high), it's a high-retention business that can generate good returns with below-average volatility over a full cycle.

The Opportunity

Zurich's solvency and capital figures have been rather healthy, allowing the company to redirect considerable sums toward M&A, but also a new share buyback and the first dividend hike in almost a decade. Management has said that they consider the new dividend level as the new floor, and directing more capital back to shareholders is a possibility in the coming years.

For that to happen, I believe the company has to execute on its improvement plans in the P&C operations, especially the North American P&C business. Rates are now starting to improve, and that's helpful. But what management really must demonstrate is that it can smarter about what risks it takes in its underwriting process, while also operating more efficiently from a cost standpoint. Can they do better? Yes. Will they do better? I believe that's the biggest unknown now with the shares.

If Zurich can drive its loss ratios more toward industry averages and generate some additional cost synergies, a mid-teens ROE is plausible (also including improved investment returns from higher rates and lower U.S. taxes). That, in turn, would support earnings growth in the mid-to-high single-digits and a fair value in the mid-to-high $30's. I also note, though, that the shares appear more or less fully-valued in terms of near-term return on equity (and/or return on tangible equity) and book value - this does not surprise me, though, as that valuation approach is a short-term approach and Zurich's improvement efforts are likely to only really start showing up in 2019-2021.

The Bottom Line

I like the operational improvements that Zurich is making, as well as the company's approach to managing surplus capital (balancing between reinvesting in the business and rewarding shareholders). I'm not completely convinced that management will hit its targets, nor am I completely convinced that there aren't some fundamental underwriting quality issues in some lines of business. That said, I expect Zurich to show good earnings momentum over the next two years and I believe there is worthwhile upside if those combined ratios continue to improve.

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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.