Insurer Offering 8% Senior Notes to Investors

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Tampa-based Homeowners Choice Insurance (NYSE: HCI) recently announced that it would issue a senior debt offering with an aggregate value of $35 million and a $5.25 “over-allotment” allowance. Assigned a par value of $25 and a steady annual yield of 8 percent, the notes (NYSE: HCJ) began trading on the open market in late January. During their first month of trading, they have appreciated in value at a pace that exceeds the performance of the broader market. Their value currently sits near $26.50 per note.

Since the company appears to be in a solid financial position and has thus far demonstrated an impressive return on equity, there appears to be little downside risk to this offering.

About Homeowners Choice Insurance

Homeowners Choice Insurance is a small property and casualty insurance company that primarily does business with residential customers in Florida. It specializes in condominium and single-family homeowner’s insurance policies of various types. However, it does underwrite some tenant insurance policies for individuals who rent apartments around the state. As a holding company, Homeowners Choice conducts the bulk of its business through subsidiaries and direct-sales agents. It employs about 200 people, and had an EBITDA of $38.8 million on 2012 revenues of $149.4 million.

How the Offering Is Structured

Under the terms of this senior debt offering, Homeowners Choice issued senior debt notes worth $35 million in the aggregate. Including the $5.25 million over-allotment allowance, the total potential cost of the transaction is $40.25 million. The debt notes are expected to issue quarterly payouts of 50 cents per unit from April 30, 2013 until at least Jan. 30, 2016.

On that date, Homeowners Choice’s management team will have the option to redeem the shares at par value plus accrued interest. If the company’s management team chooses to do so, investors who buy into these notes before the first dividend payout will receive payments of $30.50 per unit and earn a three-year premium of 22%.

If the management team chooses not to call the notes until the agreed-upon maturity date of Jan. 30, 2020, investors will receive $43.50 per note and earn a seven-year premium of about 57.5%.

The company also offers a tranche of redeemable preferred shares (NASDAQ: HCIIP) that currently yield about 3.3 percent. It is important to note that these shares have a par value of $10 and currently trade near $22. This is primarily due to Homeowners Choice Insurance’s strong financial performance and lack of additional debt.

Potential Risks

The principal risk factor for any company that underwrites property insurance policies in Florida should be obvious. Giant insurers like Berkshire Hathaway (NYSE: BRK-B) and Aviva (NYSE: AV) with operations around the world will certainly have exposure to Florida, but since they are more diversified, they don’t have as large of a risk. Plus Berkshire and Aviva each have over $45 billion in cash to cushion any blow. Large conglomerates like Berkshire have other businesses on the go as well, and Aviva sells many insurance products over that property insurance.  Berkshire owns railways, a brick company, a chocolate company, utility companies, and a manufacturing company, to name a few non-insurance related companies.  Not to mention that Berkshire has a massive stock portfolio in a diverse range of businesses.  

Aviva isnt just a property insurance business either.  They offer life insurance, health insurance, savings products, and many other products.

Should the peninsula sustain a direct hit from a strong hurricane, a relatively small, non-diversified firm like Homeowners Choice Insurance could well face catastrophic losses. Whether or not such an event would force the company to declare bankruptcy is an open question. Statistically speaking, it is probable that a major hurricane will strike some part of Florida between now and 2020.

Such an event would undoubtedly have a devastating effect on the company’s common shares. However, holders of its senior debt would enjoy an additional layer of insulation from any losses. At worst, the company might be forced to suspend its quarterly distributions for a year or two. Unless Homeowners Choice Insurance is forced out of business and files for liquidation, the company would have little legal leeway to renege on this particular obligation. Its ample cash hoard makes such a move even less likely.

Long-Term Outlook

It is important to note that Homeowners Choice Insurance’s common stock currently pays a sizable annual dividend of 90 cents per share. At its current share price of about $21, this works out to a yield of well over 4 percent. Investors who wish to take advantage of this company’s solid performance by purchasing its 8 percent notes may wish to consider the potential for further appreciation in the price of its common stock.

Although Homeowners Choice Insurance’s common stock has more than tripled in value since October of 2011, it consistently beats analysts’ expectations and may yet have more room to run. It is entirely possible that the common stock’s returns could beat those of the senior notes during the coming half-decade. Of course, this assessment must take into account the potential for the company to increase its common stock’s dividend payouts as well.

In short, investors who find Homeowners Choice Insurance attractive are faced with a choice. While it is unusual for a stable company to issue senior notes that yield 8 percent, the company’s regular dividend is also impressive. However, homeowner’s insurance companies that do business in Florida face the potential for catastrophic losses at any time. As such, conservative investors may opt for the security of Homeowner Choice Insurance’s senior notes over the uncertainty of its common stock.

mthiessen has no position in any stocks mentioned. The Motley Fool recommends Berkshire Hathaway. The Motley Fool owns shares of Berkshire Hathaway. 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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