Finding Value in Discontinued Insurance Business
Following years of competitive pricing, the property and casualty (P&C) insurance industry seems to be settling into a ‘realization phase’, one in which firms more fully acknowledge past underwriting sins and attempt to streamline their portfolios. Encouraged by regulators, activist shareholders, and consolidation in the industry, more firms appear willing to shrink and exit unprofitable lines. We believe this environment is well suited for long-term Diamond Hill holding Enstar Group (ESGR), a ‘run-off’ consolidator who stands to benefit when others look to exit business.
P&C insurance markets have been in a hyper-competitive phase for several years now. Global insurance rates have now seen 15 straight quarters of decline.1 Low interest rates and the absence of significant catastrophe losses have encouraged competition both from within the industry and from non-traditional sources of capital such as insurance-linked investment vehicles. Initially, property coverages starting with the Florida reinsurance market saw the most pressure. Over time, as players have looked to diversify, competition has spread to casualty lines as well.
Insurance is a business where today’s premium revenues are certain but tomorrow’s claim costs are not. With ‘cost of goods sold’ an estimate, the insurance business demands management discipline in pricing risk and setting aside reserves. If losses stay below norms for long, however, discipline begins to falter and many start expanding into new business lines and resort to aggressive pricing in their quest for growth. If losses continue to be benign, you can have long periods when the release of prior year reserves supports stellar earnings and makes it seem that insurers can ‘have their cake and eat it too.’
2016 reminded us that such periods do not last forever. We saw several companies record reserve charges, noting adverse claims trends in past written business. AIG’s was perhaps the most high-profile charge with $5.6 billion in reserve additions across several business lines including workers compensation, excess casualty and financial. In Europe, we saw several such instances of ‘clean-up’ quarters when large global insurers added to their reserves.
To be clear, it would be hasty to call this a change in the pricing cycle. The industry remains competitive with pricing under pressure in most lines. What we have seen is the first hints of stress, at least for some companies and in some business lines. With excess reserves getting depleted and prices continuing to fall, we expect more stress for the industry in 2017.
The insurance game is easier to get into than to exit. This is because, unlike other industries, insurance involves the assumption of customer liabilities. An insurance company commits to take on a customer’s future risk for the payment of premiums. The longer the contract term, the longer the company is stuck with this liability. Over time, the firm’s motivations could change. Macro and regulatory changes as well as its own unprofitable history lead a company to exit a line of business. So, what happens when an insurance company no longer wants to service an old liability? This is where run-off consolidators, such as Enstar Group, find opportunity.
Enstar acquires discontinued or run-off business (unwanted liabilities) from insurance companies by acquiring either specific portfolios or whole firms. It then manages the run-off by settling claims in a professional manner until the liabilities are exhausted. Where possible, Enstar also seeks to reduce the duration and administrative burden associated with these policies by buying them back from the insured. Scale, efficiency and pricing acumen are the core strengths in this business. As the largest standalone run-off consolidator with over 75 acquisitions under its belt, Enstar Group has parlayed these strengths into a long record of value creation. This has translated into steady growth in the company’s book value per share, a reasonable proxy for growth in intrinsic value.
Fully Diluted Book Value Per Share
Source: Enstar 2016 Form 10-K
During the time period illustrated in the chart, Enstar has enhanced its core franchise in at least two ways. First, it has added active insurance platforms to complement its run-off operations. Having both run-off and active platforms provides Enstar the ability to evaluate acquisition opportunities not only for run-off potential but also for the ongoing value of its profitable business lines. Second, the company has been very successful in attracting long-term investment partners.2 Recently, Enstar was able to leverage these relationships to launch KaylaRe, an investment vehicle that allows third-party capital to participate in both run-off and live insurance business. Besides bringing in fees, KaylaRe gives Enstar added flexibility in structuring new transactions.
Demand for such run-off transactions has grown, especially in the U.K. and Europe, buoyed by several tailwinds. First, stricter regulatory regimes (such as the Solvency II framework in Europe), are requiring firms to hold additional capital. This has forced capital-starved firms to optimize their balance sheets by shedding non-core business lines. Second, underwriting woes are encouraging firms to exit unprofitable lines. In recent years, firms have had trouble with several lines of business such as worker’s compensation, construction defect, asbestos and environmental, and general liability. The combination of a harsher regulatory environment and continuing losses from some lines have encouraged CEOs to engage in ‘clean up.’ This is perhaps best summarized by Stephen Hester, CEO of RSA Group, when describing his firm’s recent run-off transaction with Enstar. He deemed it a “valuable risk clean-up transaction” that lets the company free up capital and pay down expensive debt resulting in “earnings accretion, risk reduction and capital improvement.”
Enstar Group has been methodical in growing its franchise in both good and bad times. With some players in the P&C industry looking to streamline business, we see a long runway of value creation ahead for Enstar. As long-term investors with low turnover in our portfolios, we welcome such opportunities to stay invested with companies that can create value across business cycles.
1Marsh’s Global Insurance Market Index Q4 2016.
2Canada Pension Plan Investment Board and Hillhouse Capital own about 20% and 10% of equity outstanding respectively.
As of February 28, 2017, Diamond Hill owned shares of ESGR.
Originally published on March 15, 2017.
The views expressed are those of the research analyst as of March 2017, are subject to change, and may differ from the views of other research analysts, portfolio managers or the firm as a whole. These opinions are not intended to be a forecast of future events, a guarantee of future results, or investment advice.