When writing about Kemper (NYSE:KMPR) back in March, I said that I saw long-term value in the shares of this beaten-up non-standard auto insurance underwriter, but that the near-term prospects weren't so attractive as the company would continue to face elevated claims expenses and inadequate rate relief. So it has been, with the shares down another 10% on ongoing operating losses despite some progress on non-rate mitigation efforts.
I believe Kemper can return to profitability in FY'23 and double-digit ROE in FY'24, but is still going to require further rate hikes, and there's no guarantee that regulators will cooperate. Better-than-expected losses don't appear to be enough for the Street for now, and I do think the company will need to announce more progress with rates in California to really shift sentiment. For long-term value hounds, I still see some attractive long-term upside, but the risk of these shares heading back to $40 or below before that recovery is not insignificant.
The main issue for Kemper remains the same - in this post-pandemic recovery period, claims frequency (the number of accidents) and claims severity (the cost of those accidents) have risen significantly, but rates have not kept pace. While I don't want to completely absolve the company of blame from an underwriting perspective, the reality is that auto insurance rates have to be approved by regulators, so companies like Kemper (as well as Allstate (ALL), Mercury (MCY), Progressive (PGR), et al) can't just raise rates unilaterally.
In the core specialty auto business, Kemper reported 3% cumulative rate increases through the second quarter, and that's with no contributions from California (more on this in a moment). Management has filed for 19% increases on a further 30% of the book and expects 4.5% improvement in the third quarter as prior rate approvals work their way through. In the Preferred auto business, rates have risen more than 1%, and management expects a further improvement of nearly 3% in the third quarter. It takes time for these rate increases to work into the book, but it will help the business over the next 12-24 months.
The biggest challenge for Kemper remains California, which has accounted for as much as a two-thirds of premiums in past years (closer to 55% to 60% in recent quarters). Not only is this an election year for the insurance commissioner in California (and my understanding is that there has been some campaigning against the incumbent accusing him of being too close to the industry), but consumer advocacy groups are arguing that not only should higher rates not be approved, but that the industry owes California drivers larger rebates for lower miles driven during the pandemic.
Politicking aside, sooner or later rates are going to have to increase or insurers will reduce their exposure to the market. Overall policies in force in Kemper's Specialty declined 9% in the second quarter, despite 15% growth in commercial policies in force (so the auto business declined more than 9%), and I would expect further decreases if the rates aren't adequate to generate a worthwhile return.
Rates are the most straightforward way of addressing loss frequency and severity issues, but management does have other tools at their disposal, and Kemper has been using these tools to further mitigate the pressures.
These "tools" include non-rate actions like tighter underwriting standards, more stringent payment/billing frequency requirements, stricter non-renewal policies, and different tiers of coverage. Boiling this all down, it basically means that Kemper is being more attentive to making sure that drivers are in their proper risk tiers (less "benefit of the doubt"), reducing discounts on payment terms, and generally working to maximize their allowed revenue.
I've seen some analysts estimate that these actions could contribute as much as 50% to a return to profitability, and thus far through 2022, I would say that management has been executing well on these efforts. While there is a longer-term risk that such moves could alienate customers, non-standard auto insurance buyers tend to have fewer options (particularly here of late given the rate/loss imbalances in many states), and so I see relatively less risk here.
It may not be the best analogy, but one way to think about Kemper's business today is like a bungee cord. The company is currently losing money (an adjusted post-tax operating loss of $36M in the second quarter, and a $124M underwriting loss) as increased frequency and severity are hitting today and rate actions are working their way in. As those rate actions mature, though, they will more meaningfully boost net earned premiums, leading to a rebound in reported underwriting profits, with some potential additional upside if and when claims inflation eases off. At that point, further down the road, there will then be pressures on Kemper (regulatory and competitive) to dial back on rates.
Kemper has done modestly better than expected for the first six months of the year, with better rate and non-rate performance and better net interest income helping, but partly offset by higher loss costs on claims inflation. While the announced rate actions should continue to help reported results, the company really does need to see improvements in the California business to get back to sustainably profitable operations.
I've roughly doubled my loss expectations for FY'22 ($2.19 versus $1.10), but I expect a return to profitability in FY'23 (with a mid-single-digit ROE of 6%) and a 10% ROE in FY'24. Beyond that point, I believe Kemper can generate core earnings growth in the high single-digits as the company benefits from those booked rate actions and benefits from its strong competitive position in the non-standard auto market and its growing presence in the commercial insurance market.
Clearly a lot can still go wrong - claims frequency and severity could get even worse, and/or the company could see regulators push back on proposed increases. In such a situation, the company really has no good alternatives once non-rate mitigation efforts are exhausted; they either pull back from business or they write loss-making business.
Discounting the long-term earnings stream I expect from Kemper, and also valuing the stock on the basis of my FY'24 ROE and book value estimates, discounted back two years, I believe Kemper shares should trade around the mid-to-high $50's today.
I've said in past articles on insurance companies that once insurance companies start showing evidence of poor underwriting, investors do well to give those companies a wide berth until reported results improve. Kemper's situation isn't exactly what I had in mind when I wrote that, as I don't think there's fundamentally flawed underwriting here, but the principle still has some merit. I don't really see the Street warming to this name until more meaningful rate increases come through (and possibly not until rate actions in California come through) and/or loss inflation eases off.
For patient investors, I see the possibility of a double-digit long-term annualized total return. That's appealing, and I do think Kemper serves a fundamentally attractive market, but investors attracted to that return should at least be aware of the risk of further challenges in FY'22 to both reported financials and sentiment before those underwriting improvement efforts really take hold.
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