Description

Alleghany Corporation (Y) offers an attractive long-term buying opportunity. The company’s status as an orphaned security with minimal investor communication and analyst coverage in addition to concerns over significant catastrophe losses driven by Hurricanes Harvey and Irma have provided an attractive entry point at 99% of book value. Alleghany is an $8.4B market capitalization holding company that is predominantly focused as an insurance and reinsurance underwriter.  The company also has much smaller private investments through their subsidiary Alleghany Capital. Alleghany has a long legacy as a holding company dating back 87 years.  Initially the company was focused on the railroad industry and had industrial interests in legacy companies including MSL Industries, Jones Motors, and World Minerals.  By the 1960s, Alleghany had predominantly transitioned into financial services businesses and held interests in IDS, Chicago Title and Trust, and later Underwriters Re.  Prior to CEO Weston Hicks joining the company in 2002, then CEO John Burns sold “everything that wasn’t nailed down.”  Hicks notes that when he joined the company 70% of assets were in treasuries and Burlington Northern Santa Fe stock.  Management notes that today they are a reinsurance and specialty insurance group with a “differentiated asset management capability.”  Alleghany’s goal is to use insurance underwriting, public investments and private investments with a long-term goal of producing 7-10% growth in book value per share over time.  

The investment thesis for Alleghany is based on the following points:

1. Alleghany is an attractive absolute value at 99% of book value and 110% of tangible book value.  The current valuation is below historical averages on an absolute basis and the stock trades at a 40% discount to a peer group including Chubb, Travelers, Markel, Allstate, and XL on a price to tangible book value basis.  Alleghany has shown a willingness to repurchase stock opportunistically and currently has an automated share repurchase program that purchases stock more aggressively based on where the stock is trading relative to book value.  Downside is limited. Looking back over the past 30 years, Alleghany has bottomed at 85-86% of book value on multiple occasions.  Specific dates include October 2001, March 2003, November 2008, September 2011, and December 2012.  I believe the stock has 14% downside to 85% of book value – matching its financial crisis and 9/11 lows.  Alternatively, if the stock were to trade at a more reasonable 1.3x book value on my estimated YE 2018 book value of $563, there is 35% upside.  This is an attractive risk/reward proposition using conservative underwriting that assumes significant underwriting losses over the next two quarters.

2. Alleghany has two extremely high quality insurance businesses in RSUI and TransRe, which account for 84% of shareholders’ equity.  Over the last ten years, on a consolidated basis Alleghany has generated an average combined ratio of 87.8%.  Additionally the company has been profitable on an underwriting basis each and every year with the highest combined ratio being 94.1% in 2012.  The company likely has an understated book value as reserves have developed positively each and every year for the past ten years.  RSUI is known for having an extremely disciplined underwriting culture where underwriters are paid for the profitability of their business and the company focuses on unique, wholesale risks that are more difficult to underwrite.  TransRe is an extremely high quality reinsurer that Alleghany acquired at an attractive valuation of .9x TBV.  Alleghany outbid Berkshire Hathaway for the deal and in retrospect 2011 (when the deal was announced) was a fantastic period to be investing in reinsurance.  The bottom line is that these two extremely high quality franchises account for over 84% of shareholders’ equity and would receive premium multiples if they were standalone companies.

3. Alleghany has a high-quality management team and operating structure with a track record of value-creation.  Since the end of 2001, book value per share has increased at an 8% CAGR and the 10-year growth rate is 7.8%. The only year that book value fell was 2008, by 5%, and on a two-year basis book value growth has never been negative.  CEO Weston Hicks is a former Bernstein insurance analyst and has proven to be a very sound operator.  He is considered one of the top minds in the industry.  Both the RSUI and the TransRe acquisitions have been fantastic while the Darwin and Homesite deals were also savvy.  Additionally, when mistakes are made – Hicks owns up to it – referring to the 2007 Employers Direct acquisition as “unsuccessful.”  Due to the recent strength in the S&P 500 Alleghany’s stock price and book value growth has underperformed over the last five years.  Alleghany’s book value growth has trailed the S&P 500 in four of the past five years.  This is a timely period to invest with a solid management team with a track record of execution.

Operations

Alleghany classifies its business into two reportable segments; Reinsurance & Insurance with underwriting activities for the two businesses evaluated separately from investment and corporate activities.  In 2016, Reinsurance underwriting profits were $260MM while Insurance underwriting profits were $140MM.  Total insurance pre-tax profits which combine segment underwriting profits with investment income, gains, losses, interest expense and other miscellaneous expenses were $903MM.  Corporate activities, which include Alleghany Capital, Alleghany Property and corporate overhead, generated a loss of $200MM.  Total pre-tax profits for the company were $647.8MM.  

Reinsurance – The Reinsurance segment consists of TransRe, formerly known as Transatlantic Holdings that was acquired by Alleghany for $3.5B in cash and stock on March 6, 2012.  TransRe is a leading specialty professional reinsurer with a diversified offering of property and casualty products.  TransRe is headquartered in New York City with five locations in the US and other operations on a worldwide basis. In 2016, TransRe reported net written premiums of $4B, net premiums earned of $3.8B, a combined ratio 93.3% and pre-tax income of $580.5MM

In 2016, property reinsurance accounted for 35% of gross premiums written.  Principal lines of business within property include fire, allied lines, auto physical damage and homeowners’ multiple peril lines. Casualty and other reinsurance risks accounted for 65% of gross written premiums in 2015.  Principal lines includes directors and officers liability, errors and omissions liability, general liability, medical malpractice, ocean marine & aviation, auto liability, accident and health, surety and credit.  

TransRe utilizes both direct and indirect distribution.  In 2016, approximately 85% of TransRe’s gross premiums written were written through brokers with the balance written directly.  Aon, TigerRisk Partners, LLC and Marsh & McLennan were their largest brokers accounting for 25%, 20%, and 16% of gross premiums written.  

TransRe utilizes a team underwriting approach of utilizing underwriters, actuaries, and claims staff.  TransRe will often conduct underwriting and claims audits at the offices of a ceding company before and after entering into major treaties as with their role as an insurer they are always tied to the quality of underwriting of the ceding company.  TransRe will often participate in treaty arrangements where the lead reinsurer on a treaty generally accepts one of the largest percentage shares of the treaty and takes the initiative in negotiating, price, terms and conditions.

Insurance - Alleghany’s Insurance subsidiary consists of RSUI, CapSpecialty and PacificComp.  RSUI accounts for 72% of the insurance premiums written and 98% of underwriting profitability as CapSpecialty reported marginal underwriting profits and PacificComp reported underwriting losses.  In 2016, RSUI reported a combined ratio of 84.6% and underwriting profits of $138.4MM, CapSpecialty reported a 97.9% combined ratio and underwriting profits of $4.9MM, and PacificComp reported a 101.9% combined ratio and underwriting losses of $2.6MM.  RSUI’s wholly owned subsidiaries are RSUI Indemnity Landmark American Insurance Company, and Covington Specialty Insurance Company.  

RSUI is a specialty underwriter in the property, umbrella/excess liability, general liability, directors’ and officers’ liability and professional liability lines of business.  As a “specialty” insurer RSUI is focused on providing coverage for “hard-to-place” risks that generally do not fit the underwriting criteria of the standard market which provides coverages for largely uniform and relatively predictable exposures.

RSUI writes business on an admitted and a non-admitted basis.  Admitted insurers are generally required to obtain regulatory approval of their policy forms and premium rates.  Non-admitted insurance markets have developed to provide insurance that is generally unavailable from the admitted insurance markets within a state.  Non-admitted is produced by state-licensed surplus lines brokers who place risks with insurers not licensed in that state or by insured’s direct procurement form non-admitted insurers.  Non-admitted insurance is subject to considerable less regulation with regards to rates and forms.  

RSUI writes specialty business in the admitted specialty market through RIC, a New Hampshire-domiciled insurers in all 50 states and the District of Columbia where RIC is licensed and subject to state form and rate regulations.  Most of the risks in the admitted specialty market are unique and hard-to-place in the standard market, but must remain with an admitted insurance company for regulatory and/or marketing reasons.  

RSUI writes business on an approved, non-admitted basis through Landmark, an Oklahoma-domiciled insurer.  Landmark is not subject to state form and rate regulations and has more flexibility in rates and coverages due to their coverage of specialized or hard to place risks.  

Covington, also an RSUI subsidiary writes small specialized coverages pursuant to underwriting arrangements and managing general agents.  

RSUI distributes its coverage through 125 independent wholesale insurance brokers located throughout the U.S. and 29 managing general agents.  These wholesale brokers are appointed on an individual basis based on management’s appraisal of “expertise, premium production potential, loss history with other insurance companies, the size and experience of the agency, and on specific locations of a wholesale broker’s operations.”  RSUI’s top wholesale brokers – CRC and AmWINS Group accounted for 43% of gross written premiums in 2016 and their top five brokers were 68%.  

RSUI has a strong underwriting culture and has reported a cumulative combined ratio of 82% since being acquired.  Management asserts that their underwriting is based on only handling lines in which its underwriters have expertise.  RSUI focuses on high-severity, low frequency specialty risks that can be effectively desk underwritten without the need for inspection or engineering reviews.  Underwriters are given significant authority and CEO Hicks believes that they have the best underwriters in the industry.  Underwriters are paid on profitability and not volumes.  

CapSpecialty is a focused small business specialty underwriter focused with regional binding authority, professional liability, and commercial surety.  Subsidiaries are Capital Indemnity Corporation (CIC) and Platte River Insurance Company operating in 50 states and the District of Columbia.  

CIC conducts its business on an admitted basis throughout the country.  CIC writes surety products such as commercial surety bonds and contract surety bonds on a notional basis.  Commercial surety bonds include all surety bonds other than contract surety bonds and cover obligations typically required by law or regulation, such as license and permits.  CIC offers contract surety bonds in the non-construction segments of the market which secure performance under supply, services and maintenance contracts.  CIC conducts substantially all of its business on an approved, non-admitted basis nationally and writes primarily specialty lines of property and casualty insurance including the professional lines of business.  

Platte River is licensed in all 50 states and D.C. and operates in conjunction with CIC primarily providing surety products and offering pricing flexibility.  

CapSpecialty largely distributes products through independent wholesale brokerage and retail agents and general insurance agents located throughout the U.S.  CapSpecialty had approximately 123 independent wholesale brokerage and retail agents and 69 general agents licensed to write property and casualty coverages, approximately 118 agents specializing in professional liability coverages and approximately 271 independent agents licensed only to write surety coverages.  No agent had writings in excess of 4.9% of gross premiums written.  

PacificComp is a result of the legacy Employers Direct acquisition.  Prior to June 2009, the company primarily wrote workers comp with a primary focus on California – specifically Los Angeles.  In June 2009, the company determined that is was unable to write business at rates that it deemed adequate due to the state of the California workers comp market.  They stopped soliciting business and sold the renewal rights to their business.  The company has now effectively relaunched under new management as a providers of workers comp through independent insurance brokers.  Premiums are still modest at $140MM and the group reported an underwriting loss of $2.6MM in 2016.  

Corporate & Other – Corporate and Other is effectively a “grab-bag” of corporate overhead, allocated interest expenses, some investment gains and losses and Alleghany Capital.  Alleghany Capital allocated capital was $748MM at June 30th, 2017.  Alleghany Capital oversees private capital investments in non-financial companies.  The company’s strategy is to invest in closely-held businesses with meaningful cash generative abilities, where owners are seeking a long-term home for their business or patient capital to support growth.  Alleghany has also made “growth capital investments” in more speculative opportunities – specifically Stranded Oil Resources Corp (SORC).  In 2016, Alleghany Capital’s Manufacturing and Services businesses generated $51.5MM in adjusted EBITDA.  This was offset by $14.1MM in negative adjusted EBITDA from SORC and -$12.3MM from corporate and other expenses.  

Underwriting & Reserves

Alleghany is an excellent underwriter.  The company has reported a ten-year mean combined ratio of 87.8% and a ten-year median combined ratio of 89.6%.  The worst year the company has reported in the last decade was 2012 with a 94.1% combined ratio.  

Source:  Alleghany Corp

Alleghany has had positive reserve development each year over the past decade and in the first six months of 2017 implying that book value is conservatively stated.  Additionally CapSpecialty and PacificComp have generally reported underwriting losses over the last several years, weighing down the aggregate combined ratio.  Below is the company’s reserve triangle from the 2016 10K.  This is clearly a company with sound underwriting discipline, redundant reserves and a book value that is likely understated.

Source: Alleghany Corp 2016 10K

Balance Sheet & Investment Portfolio

Alleghany is overcapitalized and has a sound balance sheet.  Debt to capitalization is 15% and is only 8% on a net basis.  The company has a total investment portfolio of $17.9B relative to common equity of $7.9B and tangible common equity of $7.6B.  Net written premiums to common equity is only .59x on a LTM basis.  There is significant room to increase writings with no needed capital in a more favorable environment.  Regarding the breakdown of total investments 71.6% of investments are in debt securities, 17.7% are in equities, 3.8% are in short-term investments, 3.4% are in commercial mortgage loans and 3.5% are “other invested assets.”  Within other invested assets, there is a $210MM equity stake in Ares Management with an agreement to engage Ares to manage up to $1B in certain investment strategies.  Alleghany also has an ownership interest in Pillar Capital Holdings, Limited, a Bermuda-based insurance asset manager focused on collateralized reinsurance and catastrophe insurance-linked securities.  The Pillar investment is $226.5MM.  The duration of the fixed income portfolio is 4.5 years, average credit quality is AA- and the annualized investment book yield is 2.3%.  Regarding equities, the company has a $2B “core” portfolio where the largest eight positions account for 70% of the portfolio.  The top eight holdings are Google, JP Morgan Chase, Visa, CSX, Microsoft, Comcast, Roper, and Amazon.  They have an additional $1.4B in passive equity strategies.  

Source: Alleghany Corp

Earnings

I have attempted to model a draconian scenario for underwriting losses from Hurricanes Irma and Harvey.  Alleghany’s modeled probable maximum loss (PML) from a Florida wind event on a net basis is $.4B on in a 1 in 100-year event and $.6B in a 1 in 250-year event.  

Source: Alleghany Corp

I am modeling combined ratios of 123% in each of the next two quarters.  This would equate to combined underwriting losses in the next two quarters of $561MM and fully assumes that Irma is a 1 in 250-year event.  In this scenario, the company will lose $9.37 per share in 3Q and $9.92 per share in the fourth quarter.  In 2018, I have modeled flat premiums, 2% growth in investment income and a 90.8% combined ratio leading to $35.26 in EPS.  I have not modeled share repurchases but if the stock is to trade consistently below book, I expect the company to aggressively repurchase stock.  

Management

CEO Weston Hicks joined Alleghany in 2002 and was officially named CEO in December of 2004.  He served as the CFO of Chubb for one year prior to joining Alleghany.  Before joining Chubb Hicks served as a Senior Research Analyst for Sanford Bernstein from 1991 to 1999.  Hicks is a Chartered Financial Analyst and is a graduate of Lehigh.  Hicks was consistently considered to be the top insurance analyst in the industry while at Bernstein and has a deep understanding of the history and tendencies of management teams in the industry.  Hicks is a value creator that is focused on long-term value creation in the form of book value growth.  I am favorably disposed to Hicks and his position is a core part of the investment thesis.  Jack Sennott is the CFO since April of 2013.  He joined the company from Allied World Assurance where he held positions as CFO and COO.  He also served as the CFO and a board member of Darwin Professional.  Mr. Sennott is a graduate of the University of Massachusetts at Amherst, is a CPA and began his career at Coopers & Lybrand.  Insider ownership is 4%.  Weston Hicks owns 66K shares of stock and Sennott owns 4K shares.

There are multiple risks to an investment in Alleghany:

• Alleghany faces pressure from historically low yields.

• Alleghany has substantial investments in common equities.

• The underwriting cycle is currently in the midst of a downcycle.

• All P&C insurers have black box characteristics.

• Losses from natural disasters may be significant and accurately modeling P&C insurers is impossible.

Catalyst

• Underwriting losses from Harvey and Irma are quantified
• Positive capital allocation in the form of share repurchases conducted at a discount to book value or higher premiums
• Improved industry pricing post Harvey and Irma