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Travelers, Inc.: The Premium Reduced But Is Still There For This Shareholder-Friendly Insurance Company

About: The Travelers Companies, Inc. (TRV)
by: The CrickAnt
The CrickAnt
Long only, value, insurance, mid-cap

Travelers' quarterly net income dropped by 56% to $396 million. Year-to-date post-tax profit declined by 8% to about $1.75 billion.

The main driver of the drop was related to reserve strengthening associated with asbestos and environmental insurance.

Mr. Market punished the stock accordingly with a more than 6% drop and an under 30 RSI.

Some investors will see this pullback as an opportunity, considering the shareholder-friendly nature of the company; however, we are still holding out for a 1.2x price to book ratio.

Executive Summary

Travelers Inc. (TRV) recently reported results for the third quarter of 2019. Quarterly net income dropped by more than half to $396 million. Catastrophe losses of $241 million ($190 million after-tax) and a net unfavorable prior year reserve development of $294 million ($232 million after-tax) adversely affected the quarter with a combined ratio that ended at 101.5% vs. 96.6% in the comparable period last year.

Even though the company launched tariff initiatives to improve the underwriting profitability of the portfolio, adverse prior year reserve developments erased these efforts. In addition, investment income was not sufficient to offset the drop in the underwriting gains.

Source: Travelers' Q3 2019 Financial Supplements

On a year-to-date level, underwriting gains suffered from Q3 2019 reserve strengthening dropping by $219 million to $477 million. The reduction in underwriting gains resulted in an unfavorable increase in the combined ratio to 97.9%. Higher investment income was insufficient to offset underwriting losses. For the first nine months of the year, net income dropped by 8% to $1.75 billion.

The only positive point was Travelers continued to redistribute significant amounts of excess capital to shareholders via notable stock buybacks ($1.3 billion) and dividend payments ($636 million). In total, Travelers returned over $1.8 billion to shareholders for the first nine months of 2019 or 5% of the current market capitalization.

Although Travelers continues to be well-positioned to generate growing earnings that support its dividend-oriented strategy, I do not think paying more than 1.2 times book value is warranted.

Underwriting Margins:

In Q3 2019, net income dropped by 56% to $396 million, largely due to negative underwriting margins and lower investment income.

Source: Travelers' Q3 2019 Report

On a year-to-date level, net income dropped by more than 8% to $1.75 billion, adversely affected by third quarter performance. The post-tax profit drop was mainly driven by lower contributions from the business and specialty segments while personal insurance recorded higher earnings.

Source: Travelers' Q3 2019 Report

Personal insurance:

Although the personal insurance combined ratio deteriorated in Q3 2019, underwriting margins improved on a year-to-date level to 96.2%.

Source: Travelers' Q3 2019 Report

In Q3 2019, the segment benefited from tariff increases (+3.6% in Agency Automobile, +6.8% in International, and +6.9% in Agency Homeowners) and stable catastrophe losses. This was partially offset by an increase in the underlying loss ratio. All in all, the underwriting gain was $31 million or $20 million lower than in the same period a year ago.

For the first nine months of 2019, the combined ratio was 96.2%, down (favorable) by 3.7 percentage points on a year-to-year basis. The year-to-date combined ratio benefited from lower catastrophe losses and higher run-off gains.

Source: Travelers' Q3 2019 Earnings Release

The personal segment recorded an underwriting gain of $229 million for the first nine months of 2019 vs. a $49 million loss in the same period one year ago and a post-tax income of $497 million. This is a whopping 88% improvement over the same period last year. This significant increase in segment income reflects a combination of rate increases (+4.6% to $7.7 billion), lower catastrophe losses, higher net favorable prior year reserve developments, and increased investment income.

Business insurance:

Post-tax segment income declined to $179 million, a 56% quarter-over-quarter decline.

Source: Travelers' Q3 2019 Earnings Release

The business insurance segment experienced $284 million in underwriting losses. The Q3 2019 combined ratio increased by 6.4 percentage points (unfavorable), negatively affected by more unfavorable prior year reserve.

YTD, the underlying combined ratio of 95.9% increased 0.5 points, primarily driven by higher loss estimates in several commercial lines (general liability products, excess coverages, and commercial automobile business) and an adverse impact from the new catastrophe reinsurance treaty. This underlying combined ratio worsening was partially offset by lower loss estimates in the workers' compensation product line and a lower expense ratio.

Source: Travelers' Q3 2019 Presentation

Overall, YTD segment income was $944 million after-tax, a decrease of $303 million.

Source: Travelers' Q3 2019 Report

Bond & Specialty insurance:

Segment income for Bond & Specialty Insurance was $139 million after-tax, a decrease of $57 million. The drop in segment income was primarily due to a less favorable prior year reserve development (+8.2 points on the reported combined ratio) and a higher underlying combined ratio (+ 5.3 points), partially offset by lower catastrophe losses (-0.4 points).

Source: Travelers' 2019 Q3 Earnings Reports

The increase in the underlying combined ratio was largely due to loss re-estimations, higher losses during the quarter, and an impact related to the regulatory assessment.

Source: Travelers' 2019 Q3 Presentation

All in all, the quarterly combined ratio remained strong (83.3%) but weaker than expected.

On a year-to-date level, segment income dropped $122 million to $451 million after-tax. Q3 saw a decline that was primarily due to lower run-off gains, partially offset by lower catastrophe losses and a positive commercial development in both the surety and management liability businesses (+12% in net written premiums for Management Liability, +7% in Surety business, and + 50% in the international segment).

Source: Travelers' 2019 Q3 Report

Although the contribution of bond and specialty insurance to Travelers' overall income was lower than last year in the same period, the segment remains highly profitable and generates solid recurring cash flows. Specialty lines are the most profitable segment for Travelers in terms of underwriting margins. Thanks to this segment, Travelers Inc. succeeds in reporting a combined ratio below 100% most of the time. It then takes the float generated, invests it wisely, and produces respectable gains.

The Investment Portfolio: The Company's Lifeguard

As I have repeatedly written in many articles, P&C insurers need to focus more on underwriting excellence. For Travelers, the investment portfolio performs a sort of lifeguard duty. When the insurance portfolio suffers from adverse impacts (major catastrophe losses in 2017, an increase in asbestos, and environmental reserves in 2019), investment gains frequently help save the day.

In Q3 2019, Travelers' investment portfolio did reasonably well, income dropped by 3.7%, but they still produced $622 million ($528 million after-tax).

Source: Travelers' 2019 Q3 Presentation

This investment income benefited from higher returns in the long-term fixed income portfolio as rates fell. The short-term fixed income portfolio's return was comparable with the prior-year quarter, while equity portfolio income dropped from the prior-year quarter due to lower private equity and real estate partnership returns.

For the first nine months of the year, investment income increased slightly to $1.85 billion (1.57 billion after-tax). This increase primarily resulted from a higher amount of fixed maturity investments combined with a higher after tax yield.

Source: Travelers' Q3 2019 Report

Nevertheless, future interest rate cuts can impact the short-term end of investment income adversely putting pressure on the companies to improve the underwriting margins.

Dividend & Share Repurchases:

Travelers' capital allocation strategy is straightforward, emphasizing the distribution of capital to shareholders. Over the years, the company has consistently returned billions to shareholders via share buybacks and dividends.

Following the same strategy as the two first quarters, Travelers repurchased 2.5 million shares in Q3 at a total cost of $375 million (i.e., the same amount as in Q1 and Q2).

Source: Travelers' Q3 2019 Report

In total, 8.0 million shares were repurchased during the first nine months of 2019 at a total cost of $1.13 billion, causing total outstanding shares to decline to 258.1 million. This is about a 63% reduction over the last 14 years juicing shareholder reward by about 4.5% per year on average.

Source: Travelers' Financial Reports (+Author's estimation for FY2019 target)

I expect the company to spend $375 million during the fourth quarter to repurchase approximately 2.6 million shares (based on an average price of $140 per share) further reducing the share count to 255.4 million. This is more than they promised in prior guidance (original target is $1.1 to $1.3 billion). This year, Travelers is going to return about $1.5 billion to shareholders via repurchase shares, a slightly less than average 4.0% return to shareholders at the current $37 billion market capitalization.

Additionally, Travelers pays a quarterly dividend of $0.82 per share, a 2.4-2.5% forward yield with a low 30% payout ratio. Therefore, at current price, it is reasonable to expect an ongoing 6.4-6.5% return from shares (= 4% buyback return + 2-2.5% dividend return). While respectable, this is not particularly compelling for new purchases.

Debt Position:

On June 2, 2019, the Company's $500 million, 5.90% senior notes matured and were fully paid. The debt-to-capital ratio remains stable at 22%.

Source: Travelers' Q3 2019 Report

Investor Takeaways:

Q3 2019 results were driven by the underwriting margin deterioration. Unlike in Q2, net investment income was not sufficient to offset this underwriting deterioration.

Commercial lines remained adversely affected by reserve strengthening (asbestos and environment reserves increases) and could be further impacted when this loss estimates are again re-evaluated. On the other hand, personal lines showed a positive trend on a year-to-date basis, benefiting from rate increases initiated in 2019, and lower adverse impacts from catastrophe losses.

Specialty lines margins deteriorated on both a quarterly and year-to-date level; however, the segment remains highly profitable with a combined ratio that oscillates at around 80% over the intermediate term.

While Travelers offers a well-covered dividend and a straightforward consistent capital allocation strategy that favors share buybacks, long-term-oriented shareholders are probably better off waiting for more advantageous pricing. At 1.2x book value, about $115 based on the current book, investors could reasonably expect an 8% forward return. For a well-run mega cap firm that helps diversify overall portfolio risk, this is a reasonable goal to shoot for. The firm last saw those stock price levels near the end of last year.

Travelers is worth continuing to follow.

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.