Insurance companies are known to have a robust cash supply in the form of collected, but not yet paid out, premiums. The longer the time span between the two events, the more careful an investment operation should be. The supply of funds are used for investment purposes and, underwriting operations held constant, result in generation of extra return on equity for shareholders. In the current interest rate environment, having the flow of cash at their disposal might turn into an advantage for sagacious managers of insurance companies.
I will discuss three insurance businesses that may good value for investor today. These companies currently trade at their respective historical low price-book ratios, have robust returns on their assets and seem to know where they are heading businesswise. But what really interests me as an investor is why the current ratios are low. Is there something to discover?
Employers Holdings
The market currently values Employers Holdings Inc. (EIG, Financial) at 0.98 of its book value. The 10-year price-book ratio high for the stock was 1.83. The current valuation is as the lower end of the last 10 years' range with a market price trading slightly below the GF Value Line, indicating the business is fairly valued.
Employers Holdings provides workers' compensation insurance, primarily to small and medium-sized businesses. The company is focused on that line of business and works with clients with low hazard levels of production operations. The coverage is limited in time and, due to the nature of business, the company will be less prone to find itself with a number of unsettled claims several years into the future.
About a half of its business is generated in California, which can be viewed as geographic overconcentration. In 2020 and 2021, the amount of premiums collected fell as the Covid-19 pandemic caused a reduction in business activity. But California also experienced an outflow of businesses because of a tough tax environment, resulting in a loss of workforce and population, or, in other words, a reduction of the company's target market. Employers, however, is licensed to operate in many other states and will be capable of gaining market share. The associated costs of such expansion should probably be reflected in the current share price.
The business generates very healthy returns on its assets compared to peers.
With such high and stable returns on assets, an investor might see a market price of a focused insurance business close to 1.2 to 1.4 times its book value. As such, Employers seems to be a good business trading at a 10% to 20% discount because of concerns about new business generation. Some of it is temporary, but some of it is macro related due to the tax environment in California.
Aviva
Aviva PLC (LSE:AV., Financial) is one of the largest insurance companies and asset managers in the U.K. and internationally. It offers multiple lines and operates in both the property and life insurance businesses. The business is currently priced at 0.62 times book value. The 10-year price-book ratio high for the stock was 1.7. The current valuation is at the low end of the 10-year range with a market price trading slightly below what the GF Value Line would suggest, indicating the business is fairly valued.
The chart above shows the returns that comparable conglomerates have on their assets. Historically, Aviva has not been the best performer.
Aviva is an international diversified insurer that is currently undergoing a transformation, including divesting businesses in many countries in order to concentrate on the U.K., Ireland and Canada. The company has already divested its French, Italian, Polish, Vietnamese, Chinese and other Asian businesses and returned the capital to its shareholders via buybacks and dividends. This payout, according to Insurance Journal, “marks new CEO’s Amanda Blanc’s commitment to move at pace to overhaul the insurer after years of lackluster returns.”
While such divestitures influence the company's bottom line, what interests value investors most is the core business and its continued operations. In 2020, net income from continuing operations was $447 million. That used $27.63 million of book value to produce such a modest return. That means the ROE number was driven by the profit from discontinued operations. That, in turn, leads me to question if the price of share buybacks was justified or not. I believe these two factors are what has to be seen in the low current valuation.
Many insurance market studies show that diversification and managing multiple lines of business is inefficient and steals a few percentage points from ROE. On the contrary, focusing on the product and the market pays off in the insurance business. Studies by Liebenberg and Sommer in 2008, Cummins, Weiss, Xie and Zi in 2010 and others found there is no such thing as economies of scope in the insurance business. That means if you manage many lines of business, it does not give you any additional advantage, such as being able to reduce overhead costs, getting better investment results and so on.
Overall, I believe the company's low price-book ratio might be explained by concerns of returns on continued operations and past capital allocation decisions. In my opinion, the low ratios are justified.
Direct Line Insurance
Direst Line Insurance Group PLC (LSE:DLG, Financial) is an insurer conducting business mainly in personal lines - auto and property insurance. The company operates in the U.K. only.
The market values the business at 1.14 of its book value. The 10-year price-book ratio range is 1.05 to 2.20. The current valuation is at the lower end of range with a market price below the GF Value Line, indicating the business is modestly undervalued.
Direct Line generates very robust returns on its assets and equity. Such levels are hard to match, even by leaders of the industry worldwide.
The only company returning comparable numbers on its assets is Progressive Corp. (PGR, Financial), whose valuation is well outside of Direct Line’s range.
Direct Line appears to distribute almost all of its profits in the form of dividends. This model reminds me of some kind of cash machine. It seems the management team does not have a goal to finance new initiatives, acquisitions, nor form some kind of investment portfolio when the rates are low. While a lot depends on the style and personal beliefs of an investor, such a simple model with no illusions and no questionable investments seems very appealing to me personally. Yet Direct Line shows some modest activity on the acquisitions front, having bought insurance innovator Brolly in 2020.
The current dividend yield stands at roughly 10%. Needless to say, the discounted cash flow model shows a comfortable 20% margin of safety when discounted at 10% with the assumption of no growth in earnings per share.
Overall, I believe such a simple model with a focus on one market and one line of business can pay off and bring robust results.
