5 Undervalued Insurance Companies: But Which One Will Let You Claim a Payout?

Brendan is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

The insurance and reinsurance industries are highly cyclical and characterized by favorable pricing trends during periods of diminished underwriting capacity.  These years are followed by oversupply and less favorable pricing trends with a complete cycle lasting three to four years.  Mid-2011 witnessed a cyclical bottom in the insurance industry and it is expected that insurance companies will continue to outperform in the near term.  Below is a chart, which illustrates the cyclical nature of the industry.

<img src="/media/images/user_14730/figure-1_1_large.png" />

Mid-2011 was the optimal entry point, however, if you have missed the rally so far don’t despair, there are probably 12-18 months of outperformance yet to come.  Five reasonably priced insurance companies are: AFLAC (NYSE: AFL), ACE (NYSE: ACE), Allied World Assurance Company (NYSE: AWH), Chubb Corporation (NYSE: CB) and The Travelers Companies (NYSE: TRV).  The table below compares these companies across a number of valuation metrics.  Allied World is the clear winner, with the lowest beta, price/book and EV/EBITDA while sporting the highest ROIC, ROE and among the highest profit margins.

 Table 1: Comarision of Five Insurance Companies

<table> <tbody> <tr> <td> <p>Company</p> </td> <td> <p>Price to Sales</p> </td> <td> <p>Price to Book</p> </td> <td> <p>EV/EBITDA</p> </td> <td> <p>Gross Profit Margin</p> </td> <td> <p>ROE</p> </td> <td> <p>ROIC</p> </td> <td> <p>Beta</p> </td> </tr> <tr> <td> <p>AFL</p> </td> <td> <p>0.99</p> </td> <td> <p>1.55</p> </td> <td> <p>5.78</p> </td> <td> <p>36.12%</p> </td> <td> <p>20.51%</p> </td> <td> <p>16.18%</p> </td> <td> <p>1.83</p> </td> </tr> <tr> <td> <p>ACE</p> </td> <td> <p>1.58</p> </td> <td> <p>1.04</p> </td> <td> <p>8.66</p> </td> <td> <p>26.31%</p> </td> <td> <p>10.78%</p> </td> <td> <p>9.51%</p> </td> <td> <p>0.72</p> </td> </tr> <tr> <td> <p>AWH</p> </td> <td> <p>1.31</p> </td> <td> <p>0.85</p> </td> <td> <p>3.94</p> </td> <td> <p>50.80%</p> </td> <td> <p>22.25%</p> </td> <td> <p>17.80%</p> </td> <td> <p>0.48</p> </td> </tr> <tr> <td> <p>CB</p> </td> <td> <p>1.527</p> </td> <td> <p>1.294</p> </td> <td> <p>8.68</p> </td> <td> <p>52.50%</p> </td> <td> <p>12.20%</p> </td> <td> <p>9.90%</p> </td> <td> <p>0.49</p> </td> </tr> <tr> <td> <p>TRV</p> </td> <td> <p>1.125</p> </td> <td> <p>1.114</p> </td> <td> <p>4</p> </td> <td> <p>48.40%</p> </td> <td> <p>11.10%</p> </td> <td> <p>8.80%</p> </td> <td> <p>0.69</p> </td> </tr> </tbody> </table>

The growth of book value over time is also an important consideration.  The greater the appreciation in book value the more premiums the firm can underwrite leading to faster share price appreciation.  Allied World has led the pack, although AFLAC has been on quite a run recently. 

<img src="/media/images/user_14730/figure-2_1_large.png" />

Company Fundamentals for Allied World Assurance Company

Thus our screen has quantitatively focused on Allied World, but does a closer examination of the company support the investment thesis?  First a bit of history, Allied World was established in the aftermath of the September 11th terrorist attacks to focus on insurance opportunities in a world that had suddenly and tragically become far less certain.  The company is divided between U.S. insurance, International insurance and Reinsurance (43%, 27% and 29% of revenues respectively).  It seeks to capitalize on healthcare, professional liability and general casualty insurance (24%, 28% and 25% of revenues respectively). 

The company has evolved since its inception and seems to have found a profitable niche in these areas.  It focuses on ROIC rather than gaining market share and has returned an exceptional amount of money to shareholders as a result.  In the past 10 quarters the company has repurchased $1.065 billion in stock and paid $129 million in dividends, a level of shareholder friendliness that is unmatched next to the $1.35 billion in net income the firm has produced.  Allied World does not pursue growth at any cost; instead it invests in the most profitable areas (as evinced by its high ROIC) and returns the rest to shareholders.

Risk Factors: Portfolio Risk and Underwriting Risk 

Running an insurance company is a relatively straight-forward affair and there are two primary risks.  Insurance companies must retain a portfolio of fixed income securities that bear portfolio risk, while they underwrite insurance bearing risk if claims were to ever exceed the profits from writing the insurance policy.  First, let us focus on Allied World’s fixed income portfolio.

The portfolio currently consists of cash and cash equivalents totaling $8.1 billion  The average duration of the portfolio is 1.9 years, mostly A+ and above with an effective annual yield of 2.5%.  The company is not reaching for yield in these low interest times and should be only slightly exposed if interest rates start to rise due to the short duration of their fixed income securities (Figure 3).

 Figure 3: Allied World’s Fixed Income Portfolio

<img src="/media/images/user_14730/figure-3_large.png" />

The next factor to consider is Allied World’s underwriting risk.  Over the past three years the firm had gross liabilities of $4.88, $4.76 and $4.58 billion  leading to total insurance claims to $685 million, $597 million and $458 million, respectively.  Over the longer-term the cumulative net loss on underwritten premiums has been relatively stable.  It does not seem likely that the business model will change in the near-term and based on the past performance this portends continuing outperformance for Allied World. 

Conclusions 

Before investing it is important to consider the return that you should expect.  The chart below gives metrics that I will use to establish a 12-month price target for Allied World.  Price to Sales and Price to Book have compressed by 28% and 27% respectively since the company went public, even as the outstanding share count has been reduced by 41% due to share repurchases.  While the market has already discounted the rapid rise in earnings per share, further upside is expected in much the same way as the price continued to rise in 2010 after a rapid cyclical recovery.

<img src="/media/images/user_14730/figure-4_large.png" />
 

The price to sales and price to book valuations allow one to calculate an expected 12-month return.  Each correlates well with the forward one year return and both predict a price target of approximately $95/share, a 16% return from the current price.  The scatterplots below show forward 12 month return vs. price to sales and price to book.  At 1.31 and 0.85, respectively, investing now puts you on the far left of each scatterplot, from which point forward returns have historically been quite good.  A discounted cash flow analysis also indicts a wide margin of safety at the present time.

Figure 4: Predicted 12-Month Returns from Price to Sales and Price to Book

<img src="/media/images/user_14730/price-to-sales_2_large.png" />

So What Is the Best Trade?

There are two ways to go long; the first is to sell puts, while the second is buying the stock outright.  At this moment an $80 June 22nd put sells for approximately $4 representing a 5.3% return over 4 months if the contract is not executed, or an entry price of $76/share if it is executed.  Because I expect a 15% return from purchasing the stock the strategies seem relatively comparable at the present time.  My only concern at the moment is the market seems quite overbought (although Allied World does not appear to be).  Thus I lean toward selling the puts, especially if we see a few days of selling and the premium rises toward $5 where it was trading one week ago.

In total, the future of Allied World looks bright.  The firm should benefit from a continuing cyclical recovery in insurance underwriting; it is the most attractive among peers on a variety of metrics and is incredibly shareholder friendly.  Going through the most recent annual report, I don't see anything indicating a shareholder in Allied World is taking more risk than one in any other insurance company.  Thus, Allied World seems to be the best pick from a good lot.  One central tenant of my stock selection methodology has been to avoid crowded trades and Allied World fits the bill as a wonderful company that most investors have never heard of.  Thus, the firm will likely continue to churn out good returns year after year, out of sight and out of mind. 



brenoboyle has no position in any stocks mentioned. The Motley Fool recommends Aflac. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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