Execution At Kemper Still Offers Upside

Summary

• Halfway through a turnaround launched with a new CEO in late 2015, Kemper has started delivering better underwriting results, but there is still ample room for improvement.
• Acquiring IPCC will double the company's non-standard auto business, a fragmented, faster-growing segment of the auto insurance market that rewards scale, and improve its expense ratio.
• Kemper shares could head back into the mid-$60s on the prospect for improved earnings from the IPCC deal and ongoing turnaround efforts.

A lot has changed at Kemper (NYSE:KMPR) since CEO Joe Lacher was brought in to turn around this lackluster multi-line P&C and life insurance company late in 2015. While the company is by no means an industry leader in terms of its profitability, management has already delivered progress on improved underwriting quality and is in the midst of an acquisition that should meaningfully improve its position in the fast-growing non-standard auto insurance market.

Valuing Kemper is a little challenging, in part because the company’s ability to successfully integrate its acquisition and continue to improve underwriting quality are significant swing factors in the valuation. Today’s premium to book value of 1.4x looks fair in isolation, but this could readily be a $75 stock in a couple of years if management continues to execute well.

Non-Standard Auto Is The Driver

Kemper has long been a multi-line P&C insurer focused on personal lines, but non-standard auto has always been a sizable part of the business. With the pending acquisition of Infinity Property & Casualty (IPCC), it will become even larger, accounting for around 70% of the P&C business and close to 60% of overall earned premiums.

Non-standard auto is an imprecise term, which creates some challenges in sizing the market, but it generally means insurance sold to drivers whose risk factors are such that auto insurers won’t insure them at their standard or preferred rates. Drivers with bad driving histories are the most obvious example of non-standard customers, but it can also include those who lack prior coverage, those are on the far edges of the age spectrum, and/or those with subpar credit. These policies are often paid on a month-to-month basis, with average policy lengths below six months and retention rates below 50% - non-standard customers are often in tougher economic circumstances and will sometimes let their coverage lapse due to insufficient funds in one month and then restore it the next.

This makes non-standard auto a sort of semi-specialized market. The risks tend to be more idiosyncratic and the high churn rate really puts a premium on managing claims and policy processing as efficiently as possible. It is also a growth market, with this segment growing around 6% or so a year (more than double the overall auto insurance growth rate).

With the added scale of IPCC, Kemper has the opportunity to generate more value out of its non-standard auto business. For starters, there’s the added scale – IPCC will roughly double the size of the business; a key benefit in an industry that rewards scale. While Kemper’s expense ratio was already attractive relative to other non-standard operators (in the mid-20%’s versus the high-20%’s), IPCC’s sub-20%’s ER should drive this ratio down into the low 20%’s.

Along with expense scale, this acquisition should add leverageable tech/IT scale. IT is becoming increasingly important in insurance, as companies use increasingly sophisticated models to better understand and price risk. With the above-average risk that non-standard auto brings, it’s all the more critical here. This is also a competitive advantage in the making. Although many large insurance companies are active in non-standard auto, including familiar names like Progressive (PGR) and Mercury General (MCY), no one has 10% share, though Kemper is a top-10 player. Most of the larger players are in the low-to-mid single-digits in terms of share, and there are many small players that I believe will find it increasingly difficult to keep up with the necessary IT investments – not only for risk-modeling and pricing, but for interacting with customers (most non-standard insurance is bought electronically).

IPCC is also bringing diversification and new growth opportunities. About 60% of the non-standard auto market is in California, Florida, and Texas, but adding IPCC (which is concentrated on 15 urban markets in four states) will somewhat reduce Kemper’s dependence upon California (down to 66%) while adding more exposure to Florida and Texas (27% combined). On the growth side, IPCC has specialized in servicing Hispanic customers, including bilingual agents and representatives, and this is a leverageable opportunity for Kemper.

I would also note that Kemper has a good long-term underwriting history here. Although the business went sideways for a bit a few years ago (due in part to the poorly-executed Alliance Union acquisition), the company’s core loss ratios have been a little better than the average. Combine that with lower expenses and Kemper has generally been more profitable than the industry (which struggles to break even on an underwriting basis).

Life Doesn’t Offer Much Growth, But It Does Create Value

Kemper’s Life and Health business is relatively small – it will contribute less than 20% of earned premiums after the IPCC deal closes (versus around one-quarter today) – and it is not growing much, but it does generate value for the company. This business focuses on selling small value life policies to lower-income individuals through a network of over 2,000 (many of whom work door to door). The average face value is less than $6,000, but even so the company’s lapse rate is only slightly higher than average. These life polices account for about three-quarters of premiums, with the remainder largely Medicare supplement policies sold through a network of over 20,000 agents.

What growth there is in the life insurance space these days tends to be in more sophisticated unit-linked and protection products, and that’s definitely not what Kemper does. Instead, these are pretty bare-bones, basic policies (no variable annuities, etc.). That limits the growth rate, but Kemper’s investment team here does a good job and this business can generate high single-digit ROEs. Because of the value gained from the investment team, selling/spinning this business would likely do more harm than good, and I see it as a nice little slow-growth/high-value side-business that more than earns its keep.

Continue The Turnaround

Next to leveraging the growth and margin potential in the non-standard auto business, continuing the turnaround begun with the new CEO is Kemper’s best opportunity to generate better growth. Management has already done a good job of redeeming the Alliance Union acquisition, where aggressive reserving and underserved claims staffing led the company to miss impending issues in claims frequency and severity.

Beyond non-standard, there’s more “blocking and tackling” needed. The good news is that Kemper’s businesses are short lines, so there aren’t a lot of festering problems hidden in the reserves and positive changes show up relatively quickly.

The company’s small homeowner insurance business is doing okay, with underlying combined ratios in the high-60s to mid-80s (with higher cat losses in 2017, as seen across the industry). Preferred auto needs more work. Adjusted combined ratios have been above 100 (meaning Kemper is making an underwriting loss) too often recently. Improving this business comes down to better risk modeling and focusing on the profitable relationships/geographies in the business, but a hardening market should help.

The company’s small commercial auto business isn’t a bad business per se, and the underwriting results have been alright. While commercial auto losses were an issue industry-wide, Kemper’s underwriting seems to be getting better and management sees this business as a potential future growth driver.

The Opportunity

I expect little growth from Kemper’s Life and Health business (in the low single digits), but I do believe it will churn out reliably good operating income and support a good investment operation at Kemper. The growth, though, will come from the P&C lines and particularly the non-standard auto business. I expect mid-single-digit premium growth as the company takes advantage of harder markets, new product/customer opportunities, and cross-selling synergies. I also expect Kemper to execute on expense synergy opportunities with the IPCC deal (with management having identified about $75 million of such synergies).

Assuming Kemper management can execute like I think it can, I think $5.30 to $5.50 a share in 2020 earnings is attainable. Forward P/E multiples of 12x to 14x aren’t unusual in the P&C industry, so the stock could be in the mid-$60’s or higher in a year or so if the turnaround stays on track, the P&C insurance industry stays reasonably healthy, and the deal integration goes well.

The “but” is that that is not the only possible approach to valuation. On an ROE/BV basis, Kemper’s valuation already looks pretty fair, and a lot rides on the successful integration of IPCC and ongoing improvements in the other P&C (the non-non-standard auto) lines.

The Bottom Line

Kemper has already doubled from its early 2016 lows and the Street has bought into the idea that Kemper is a better run insurer today than it was a few years ago. There is also still elevated risk here, but if management can continue to improve operations and use the leverage and scale from the IPCC acquisition to become even more competitive in non-standard auto, there should still be some upside from here.

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Analyst’s 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.