Travelers: The Undercover Bond

Dec. 09, 2019 11:13 PM ETThe Travelers Companies, Inc. (TRV)6 Comments9 Likes
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Gedas Dirkstys
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Summary

  • Travelers earns the largest share of profits from investment income (c70%) among P&C insurance companies in the U.S.
  • Majority (c88%) of the investment portfolio is allocated to a diversified portfolio of bonds.
  • Travelers is also very likely to generate positive underwriting profits from its specialty insurance lines.
  • The current market price of Travelers ignores the low risk profile and growth potential of earnings.

Investment Thesis

Travelers (NYSE:TRV) earns the largest share of profits from investment income among P&C insurance companies in the U.S. Even with no underwriting profits, investment in Travelers at $132 would yield c7% of earnings. On top of this, we believe that Travelers is very likely to generate positive underwriting profits from its specialty insurance lines, once catastrophe losses normalise. The current market price of Travelers ignores the low risk profile and growth potential of earnings.

Travelers holds an investment portfolio of c$72 billion, whereas the current market cap of the company is c$34 billion. Majority of these investments are loss reserves for long-tail insurance policies, or as Warren Buffett calls them - the float. The company does not actually own the principal of all investments, but is entitled to the investment income. Majority (c88%) of the investments are allocated to a diversified portfolio of bonds, providing stable bond-like earnings to shareholders of Travelers.

If premiums written and related reserves grow, we expect to see a growing investment portfolio and rising investment income. On the contrary, if estimated reserves turn out to be insufficient, Travelers would have to cover excess losses from shareholders' pockets. We believe this to be unlikely, given the strong track record as well as the strong capitalisation of Travelers.

As for Macro risks, it is possible that interest rates will decline, gradually dragging down investment income. But in this environment the company’s book value would grow due to appreciation of bonds, mitigating the negative impact initially. Rapidly rising inflation would also hurt Travelers, especially in the long-tail insurance lines.

Travelers also has another trick up its sleeve, - share buybacks. Over the last 5 years, Travelers has reduced its share count by an average of c7% per annum. At the current market price, buybacks will create significant per share value to shareholders. We expect share count to continue declining, albeit at a slower pace.

Insurance Industry Developments

Over the last 3 years, the U.S. Property and Casualty industry has been negatively affected by catastrophe losses as well as declining reserve releases. Insurers hope that recent losses will help push through price increases and improve future profitability and reserves of the industry. We believe that the industry is likely to experience a period of lower underwriting profitability going forward.

Keefe, Bruyette & Woods report suggests that industry reserve releases have been trending down from $23.3 billion in 2013 to $6.7 billion in 2017, before rebounding last year, mainly due to positive developments in Workers Compensation line. Reinsurance News journal references a recent actuarial study performed by Morgan Stanley (MS), suggesting that P&C insurance industry is in a position of reserve deficiency.

Keefe report also suggests that industry has passed on rate increases at almost all lines of insurance, albeit at a modest rate. In recent years re-insurance industry has been plagued by overcapacity, making pricing difficult. Competition in primary insurance has also been affected by ample supply of reinsurance. S&P Global Market Intelligence’s Report suggests that “competition will remain intense in certain non-auto business lines given ample reinsurance capacity, high levels of industry capitalisation and a macroeconomic environment that remains characterised by relatively slow growth in gross domestic product.”

Overall, it would seem that reserve releases are likely to decline or at least stay at this lower level, as the industry will most likely struggle to pass on significant rate increases. Under this scenario, reserves can only be increased by taking bigger loss provisions, i.e. higher loss ratios.

Track Record

Travelers has been among the most profitable Property and Casualty insurers in the United States and we expect the company to maintain this position going forward. Travelers' profits have been driven by excellent underwriting results as well as stable investment income. Going forward we expect the company’s underwriting profits to decline along with the industry trend, but Travelers will continue generating growing investment income as loss reserves increase.

Source: Travelers 2017 Investor Day presentation.

Over the last 5 years, the company’s headline combined ratio has averaged 95% and the average underlying combined ratio was c91%. Headline combined ratio was positively affected by reserve releases and negatively affected by catastrophe losses. Travelers reserve releases have more than halved, from $957 million in 2014 down to $406 million in 2018. We expect the reserve releases to decline further or stay at this low level, providing less support to the loss ratio going forward. The last two years have seen a spike up in net catastrophe losses, higher loss provisions, increasing loss reserves, growing investment portfolio and rising investment income. We expect this recent trend to continue.

Source: image created by author with data from Travelers' financial statements

Over the last 5 years, Net Reserves of Travelers have remained broadly stable as the company has been releasing reserves and premiums written were rising. The investment portfolio has also stayed stable at $72-73 billion. We expect that lower reserve releases as well as higher combined ratios will increase Travelers reserves and will also boost its investment portfolio. In a stable interest rate environment, this should result in higher investment income.

Source: image created by author with data from Travelers financial statements

Travelers generates an average pre-tax yield on investments of 3.4%. Treasuries currently trade a c1.8% yield, significantly below the 3% level seen a year ago.

We take no view on future interest rates and assume that the current historically low investment yields (3.4%) of Travelers will persist. We believe this to be a prudent approach. In theory, given the fixed income like nature of Travelers earnings, decreasing interest rate should increase the value of Travelers. If we were to use the same earnings discount rate in valuation when interest rates are in decline, lower interest income would result in value reduction. This would be a valuation mistake as equity risk premium is most likely unchanged by lower rates. Earnings yield of say 7% is worth a lot more when rates are 1.8% than when rates are 3%.The weighted average effective duration of fixed maturities and short-term securities was 4.5 (4.7 excluding short-term securities).

Quality of Reserves

Reserve quality is the single most important risk factor for companies operating in the insurance industry and especially for those writing cover for long-tail risks. Travelers covers both short- and long-tail risks. Reserves for long-tail risks are inherently unreliable due to reporting lags, long payout cycles and potential changes in industry-wide inflation and loss trends. Workers’ Compensation and General Liability are the largest long-tail lines of Travelers, they account for c62% of the company’s gross reserves. We are concerned that some under-reserving might become evident in the future, and for that reason we are happy to see that Travelers has a strong balance sheet, which could absorb some potential reserve increases.

Source: image created by author with data from Travelers financial statements

Over the last 10 years, Travelers’ reserves, as compared to premiums earned, have been in decline along with the industrywide declines. The decline was most pronounced in the General Liability line, where asbestos reserves are included. To mitigate risk of not meeting obligations, Travelers normally makes conservative initial loss estimates and, as time passes and actual loss trends develop, excess reserves are gradually released. A declining rate of reserve releases can indicate a less conservative reserving of the recent past. Industry-wide changes in reserves are most likely driven by changing loss trends as well as price competition. As mentioned in Insurance Industry Developments, declining reserves was an industry-wide phenomenon, so reserve development in General Liability does not necessarily indicate a poor underwriting by Travelers.

General Liability provides coverage for businesses against third-party claims arising from accidents occurring on their premises or arising out of their operations, including as a result of injuries sustained from products sold. Asbestos and environmental reserves are included in the General Liability. Claims with longer reporting lags result in greater estimation uncertainty. This is especially true for alleged claims with a latency feature. The line has been reducing reserves, just as the written premiums were growing. We are concerned that General Liability reserves will not be sufficient. As of late, General Liability has been experiencing unfavourable reserve development related to asbestos in the tune of c$220 million per annum.

Workers Compensation is generally considered a long tail coverage, as it takes a relatively long period of time to finalise claims. Despite the possibility of long payment tails, the reporting lags are generally short, payment obligations are generally not complex, and most of the liability can be considered high frequency with moderate severity. Travelers’ Workers Compensation reserves have been growing as premiums written were also rising.

Commercial Auto line has been an issue for Travelers as of late. The company has seen a larger than anticipated increase in the rate of attorney involvement and a lengthening of the claim development pattern. As a consequence, the company has experienced a higher level of bodily injury severity than it had anticipated.

Source: image created by author with data from Travelers financial statements

On the other hand, Travelers is well-capitalised, the company has a A++ rating from AM Best and AA from S&P. AM Best claims that “historically, risk-adjusted capitalisation has consistently been strongly supportive of the group’s ratings. It exceeds the threshold for the strongest categorisation by a wide margin, as measured by Best’s Capital Adequacy Ratio (BCAR).” Strong capitalisation means that most likely if the reserves turn out to be insufficient, the shortfall can be covered from existing surplus and no new equity or debt has to be issued. Current net loss reserve of Travelers is $42 billion and, for example, a 10% reserve strengthening would reduce the company's equity from c$23 billion to $19 billion (-17%). One-off increase in reserves would have no immediate impact on assets or investment income, but could reduce future ability to return excess capital to shareholders or invest in risky assets. Over time, if the additional reserves are accurate and losses are paid out, investment portfolio would be reduced by only c6% (4/72).

Competitive Position

We believe that Travelers is very likely to continue generating positive underwriting profits because of above-average competitive position. The company has been able to achieve attractive underlying combined ratios because of specialty insurance business, which is shielded from industry capacity development trends. On the other hand, it seems that because of increasing competition in re-insurance and commoditised commercial insurance, more industry participants started competing in the specialty insurance lines. In the Personal Insurance line, Travelers has been losing market share to direct-to-consumer competitors such as GEICO of Berkshire (BRK.B). This trend is likely to continue.

Business Insurance accounts for 54% of Travelers' premiums earned. The largest segment within is Middle Market. "It provides mid-sized businesses with property and casualty insurance products and services, including workers’ compensation, general liability, commercial multi-peril, commercial automobile and commercial property, as well as risk management, claims handling and other services. Middle Market distributes its products and services primarily through a large network of independent agents and brokers. Each account is underwritten based on the unique risk characteristics, loss history and coverage needs of the account. Products and services are tailored to certain targeted industry segments of significant size and complexity that require unique underwriting, claim, risk management or other insurance-related products and services" (Source: TRV 10K report). We believe that Middle Market is an attractive market niche and can continue delivering profitable underwriting results for Travelers.

Personal Insurance accounts for 37% of premiums earned. Within Personal, the most attractive segment has been Homeowners insurance. Auto insurance has been struggling, though Travelers has been increasing pricing to repair underlying combined ratios. Personal Insurance is a lot more commoditised and competition is largely price driven. Personal Insurance products are marketed and distributed primarily through independent agencies; because of this, new business is generally less profitable than renewal business. In theory, Travelers should be able to offer returning customers a price that is competitive with direct-to-consumer competitors, though direct distribution has been gaining market share as some customers do decide to switch providers anyway. As of late, retention rate in Personal Insurance has been c85%.

Bond and Specialty accounts for 9% of premiums earned. This is a small but a very profitable line, generating underlying combined ratios of c80-90% and reserve releases on top. "Bond & Specialty Insurance provides surety, fidelity, management liability, professional liability, and other property and casualty coverages. Bond & Specialty Insurance utilises underwriting, claims, engineering, actuarial and product development disciplines for specific accounts and industries, in conjunction with extensive amounts of proprietary data gathered and analysed over many years, to facilitate its risk selection process and develop pricing parameters" (Source: TRV 10K report). We believe that Bond and Specialty is an attractive market niche and can continue delivering profitable underwriting results for Travelers.

Valuation

Current market price of Travelers undervalues the business as low risk profile of earnings and EPS growth potential are ignored.

Travelers derives earnings from stable investment income and volatile underwriting. In any given year, underwriting profitability, measured by combined ratio, can be both above and below long-term sustainable level. As mentioned in the Track Record section, the average 5-year headline combined ratio has been 95%. Applying a 97% combined ratio (lower profitability) and a roughly stable investment income, the company would derive approx. $11.8 of earnings per share. At the current market price ($133), this equates to P/E of 11.3X, or an earnings yield of 8.8%.

At a combined ratio of 97%, Travelers would generate only 23% of PBT from underwriting as opposed to c70% from investment income. Since majority of investment income is derived from a diversified portfolio of bonds, there would be little volatility in earnings.

On top of this, Travelers is very likely to grow both underwriting profits as well as investment income over time, and share repurchases will add further EPS growth. Underwriting premiums are likely to continue growing at least at the rate of expected future inflation and investment income will grow with the growing reserves. With a combined ratio of 97%, we expect an EPS growth rate of about 7%. With a combined ratio of 100%, EPS should grow at c5-6%.

We can expect the share price to grow with EPS at the rate of 5-7%. Adding the current dividend yield of c2.3%, we could expect a Total Shareholder Return of c7.3-9.3% per annum. TSR would be larger if stock was re-rated to a higher P/E, which we believe Travelers deserves.

We have initiated our position at prices ranging from $128-134 per share. $135 is the highest price we are willing to pay for the shares of Travelers.

Conclusions

Travelers is an above-average insurance franchise with a large investment portfolio. Even in a deteriorating underwriting environment, Travelers is likely to continue generating a growing stream of investment income and buyng back its stock at attractive prices. Travelers will continue delivering attractive and growing yield. In a bull market this resilient stock is likely to underperform, though is an excellent asset in stable or falling markets.

We have initiated a position in Travelers and feel that at the right price it is an excellent pick. Just like all investments, Travelers has risks and we will continue monitoring the company’s loss reserve developments as well as reinvestment yields on bonds.

This article was written by

Gedas Dirkstys profile picture
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Ventavalue.com | Off the beaten pathLike in many areas of life the best opportunities can be found in places where others are not looking. We scavenge the European and American markets for under-valued securities that are too illiquid for professional investment funds to buy. We carry out Wall Street grade in depth fundamental analysis of these securities and are confident we can outsmart the amateurs. Irrational market momentum will also create attractive opportunities in the large cap space though these will be far and few between. Our target annual return is 20%.Seeking Alpha covers a limited range of micro-cap tickers, - to get the best ideas go to ventavalue.com.
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Disclosure: I am/we are long TRV. 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.

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