Tom A's Stock Picks

Property and Casualty Insurance - overlooked value in financials

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With the financials rallying 31% over the past week, all of a sudden there are a lot of commentators who advise buying banks, either selectively or by using ETFs. Lost in the shuffle are Property and Casualty and Multi-line Insurance, where many well-known companies are trading in the area of book value, normally a buy point. Over the past 10 years, you could make money consistently by buying insurance companies at around 1 X book value and selling at around 1.5 X book value. P/Es are under 10 in some cases, always appealing to the value investor.

Property and casualty insurance is not an easy business - many of the products are commodities, competition is intense, and the the business is cyclical. What happens is that when insurance companies make money they reduce rates, trying to buy market share. All the companies do the same thing, and rates go down until nobody is making any money. Right now, the insurance business is coming off a protracted run of profitability, where combined ratios have at times been under 90. The combined ratio is the sum of the loss and expense ratios, expressed as a percent, and anything under 100 indicates an underwriting profit. So, they can't stand prosperity, and rates have been declining.

In addition, insurance companies earn investment income. A large part of their statutory surplus is required to be in bonds. As a result, many of them are exposed to MBS, to include sub-prime.

Finally, insurance is prone to catastrophes, most recently Katrina did a number on Allstate (ALL), among others. From time to time something like asbestos liability surfaces, or a line of business like products or professional liability becomes wildly unprofitable.

Taking all of this together, some analysts have expressed concern that these companies may be value traps, with poor industry fundamentals outweighing what otherwise would be attractive valuations. On the other hand, these companies are unique among current financials in that most of them are over-capitalized. Specifically, an industry norm is to write 2 dollars of premium for each dollar of surplus - a two to one surplus ratio. Many companies, and the industry as a whole, are at a premium to surplus ratio of more like one to one.

That raises the question, what to do with the extra capital. The standard answer, use it to write business at a loss and make it up on increased market share, may be less attractive than formerly. Reading the papers and watching TV, industry executives may have become aware that having adequate or more than adequate capital is a huge business advantage, and they may attempt to deploy the capital in more useful ways. Buybacks come to mind, as do increased dividends. Where is Carl Icahn when you need him? He could take a stake, make a stink, and presto! Out comes a special dividend. Years ago it was a popular ploy, buy an insurance company with excess capital, strip it out, and take it from there.

Seriously, well run companies in difficult industries make good investments. I have had profitable results using a buy low sell high strategy on these companies, and now may well be a time to start the cycle again. Meanwhile, most of them pay a dividend. Here are some ideas:

Chubb (CB) - At 47.00 on 7/21, P/E of 6.6, P/B 1.1. Specializes in D&O Liability and in high end Personal Lines. Over the past ten years it has always traded at a P/B of 1.5 or better at some time during the year. Dividend 1.82, 2.81% yield. My target 62.

Cincinnati Financial (CINF) - 26.93 as of 7/22. P/E of 7.4, P/B 0.8. Very strong relationship with the Agencies who represent them. Premium to Surplus ratio is low. Large equity investments, largest holding is Fifth Third Bank (FITB). The appeal to me is, its assets are all liquid and FITB will presumably recover. Dividend is 1.56, yielding 5.79%. Meanwhile, buying liquid assets at 80 cents on the dollar seems like a good idea, at least in moderation. My target, 36.

Hartford Financial Group (HIG) - 62.55 as of 7/22. P/E of 8.9, P/B of 1.1. Large and diversified. Over the past ten years it has always traded at a P/B of 1.6 or better at some time during the year. Dividend 2.12 yielding 3.39%. My target 85.

Allstate (ALL) - 44.33 as of 7/21. P/E of 7.4, P/B 1.2. Well-known, Personal Auto and Homeowners, large market share in hurricane exposed states. Over the past 5 years, share buybacks have averaged 3.4%. Dividend is 1.64 yielding 3.7%. Over the past ten years, has always traded at a P/B of 1.6 or better at some point during the year. My target 57.

American International Group (AIG) - 28.14 as of 7/22. P/E N/M, P/B 0.9. Large and diversified, misadventures in bond insurance are well-publicized. Recently added capital and changed management. Accounting has been less than pristine. Over the past ten years it has always traded at a P/B of 1.9 or better at some point during the year, so it is potentially a doubler from where it lies. Dividend .88 yielding 3.13%. This requires some risk tolerance, my target 56.

I would not jump in with both feet here, because the Property and Casualty price cycle seems to be heading down right now. However, I do plan to accumulate meaningful positions in all of the above, and will monitor and hopefully enlarge the positions over a period of time. For any of you who use options, distant expiration in the money calls seems like an attractive strategy to to me - the leverage would increase returns. Patience will be rewarded.

I am planning a series of posts over the next several weeks, covering each of the above in detail.