Description

AXIS Capital Holdings Limited (AXS) offers an attractive buying opportunity.  AXIS is a $4.2B market capitalization Bermuda-based hybrid insurer and reinsurer with a focus in insuring specialty risks on a global basis.  AXIS is part of the “class of 2001,” a group of reinsurers that was founded in late 2001, post the events of September 11th in the midst of rapidly hardening commercial insurance market.  The company was originally backed by Marsh and McLennan, Blackstone, DLJ, Thomas Lee, J.P. Morgan and G.E.  AXIS issued 15.5MM in shares of stock in June of 2003 at $22 per share.  In 2003, AXIS wrote $2.3B in net written premiums and they are likely to write over $5B in net written premiums in 2107 although ceded premiums have grown substantially.  AXIS operates through two segments – Insurance (48% of 2016 net premiums earned) and Reinsurance (52% of 2016 net premiums earned).  Primary lines written in the insurance segment are Property, Marine, Terrorism, Aviation, Credit and Political Risk, Professional Lines, Liability, and Accident and Health.  Primary lines written in the Reinsurance segment include Catastrophe, Property, Professional Lines, Credit and Surety, Motor, Liability, Agriculture, Engineering, and Marine & Other.  

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

1. AXIS is an attractive absolute value trading at 91% of book value and 93% of tangible book value.  The stock trades at 10.7x my estimate of 2018 EPS, 8.1x my 2019 estimate and 6.9x my 2020 estimate. Of note, I am modeling combined ratios of 98.3%, 96.4%, and 95.3% in these three years – far above the company’s historical averages.  While these valuation levels are below the company’s historical averages, they are at all-time historical relative lows.  While not a large sample size, at a minimum such historically cheap relative valuations have led to outperformance.

Price to Book Value

Relative Price to Book Value

Relative price to book ratio correlated with relative price performance

2. AXIS is a high quality insurance and reinsurance franchise with an excellent underwriting history, positive history of capital allocation, reserve development and book value growth. While AXS trades at a discount to book value and tangible book value the company’s book value is likely understated.  AXS has experienced positive reserve development each and every year since the inception of the company.  YE 2016 IBNR (incurred but not reported) reserves account for 65.4% of total reserves.  2016 reserve development was positive $292MM, 2015 was positive $243MM, and 2014 was positive $259MM.  A comparable group of high quality competitors (i.e. - not AmTrust) averaged a 57.5% IBNR ratio in 2016.  This difference in percentage terms accounts to $766MM to AXS or $9.20 per share.  Underwriting results at AXS have been sound.  Utilizing my full year 2017 estimate, the company’s average combined ratio since inception has been 89.9% and the median has been 90.4%.  Over the last five years, the average has been 97.8% and the median has been 94.8%.  AXS has a strong history of capital allocation.  Shares outstanding have fallen from 164.5MM at year-end 2007 to 83.3MM in 3Q17.  The company began paying a 14-cent per share dividend in 2003 and has increased this dividend each and every year to the current level of $1.52 per share.  This currently equates to an attractive 3.1% dividend yield.  AXS has a history of value creation.  Including accumulated dividends book value per share has increased from $16.88 in 2003 to $68.11 in the third quarter of 2017.  This equates to a 10.7% CAGR and this fully penalizes the company for the losses of third quarter 2017.  

3. AXS is a likely merger candidate in a rapidly consolidating reinsurance market.  The reinsurance and insurance markets have been rapidly consolidating over the last several years.  This has been driven by several forces.  The first is the maturity of the underwriting cycle and deteriorating results industrywide.  The second force is that alternative capital driven by catastrophe bonds and other forms of capital have pressured results.  Reinsurers are dealing with a highly consolidated brokerage industry and further consolidation is a natural response.  Finally, in a world that is increasingly complex, with potentially larger loss events, more significant capital bases are needed. AXIS and ParterRe announced a merger of equals in 2015 but EXOR eventually made a more compelling offer to PartnerRe and the deal was cancelled.   Below is an M&A comp sheet dating back to 2014.  It is worth noting that Validus, a company that I consider to be of lower quality than AXIS was taken out by AIG on January 22nd at a valuation of 1.74x book value and 1.53x tangible book value.  I do not believe that 91% of trailing book value is a sustainable valuation for AXS.

My "initial" price target for AXIS Capital is $68.37 or 1.2x YE 2018 book value per share.  This equates to a total return opportunity of 39%.  I believe downside risk is 75% of current book value or $41.50.  On a total return basis, this equates to 14.8%.  The risk/reward proposition is 2.6 to 1 with conservative underwriting on both accounts.  A more aggressive scenario incorporates a potential takeout.  Using YE 2020 estimated book value of $67.19 and a takeout valuation of 1.5x book value leads to a target of $100.79 in three years.  

Below is a brief summary of AXIS Capital’s operations, balance sheet and investment portfolio, earnings outlook, and management team.  

Operations

AXIS operates through two divisions – Insurance and Reinsurance.  Insurance accounted for 48% of net earned premiums and produced a 97.8% combined ratio in 2016.  Reinsurance accounted for 52% of net earned premiums and produced an 87.8% combined ratio.  The company produced a total combined ratio of 95.9% in 2016.  Through the first three quarters of 2017, Insurance has produced a 118.7% combined ratio and Reinsurance has produced a 111.1% combined ratio.  The total company’s combined ratio is 118.1% on a YTD basis.

Insurance – AXS’s Insurance segment operates through offices in Bermuda, the U.S., Canada, Singapore and the Middle East offering specialty coverages.  Below is a description that the company provides of the risks that they cover within the segment:

Property- (23% of 2016 segment premiums earned) -provides physical loss or damage, business interruption and machinery breakdown coverage for virtually all types of property, including commercial buildings, residential premises, construction projects and onshore energy installations.  This line of business consists of both primary and excess risks, some of which are catastrophe-exposed

Marine – (8%) -provides coverage for traditional marine classes, including offshore energy, cargo, liability, recreational marine, fine art, specie, hull and war.  Offshore energy coverage includes physical damage, business interruption, operators extra expense and liability coverage for all aspects of offshore upstream energy.

Terrorism – (2%) - provides coverage for physical damage and business interruption of an insured following an act of terrorism.

Aviation – (3%) - provides hull and liability and specific war coverage primarily for passenger airlines but also for cargo operations, general aviation operations, airports, aviation authorities, security firms and product manufacturers.

Credit & Political Risk – (3%) - provides credit and political risk insurance products for banks and corporations.  Coverage is provided for a range of risks including sovereign default, credit default, political violence, currency inconvertibility and non-transfer, expropriation, aircraft non-repossession and contract frustration due to political events.  The credit insurance coverage is primarily for lenders seeking to mitigate the risk of non-payment from their borrowers.  For the credit insurance contracts, it is necessary for the buyer of the insurance (usually a bank) to hold an insured asset (typically an underlying loan) in order to claim compensation under the insurance contract.  

Professional lines – (29%) - provides coverage for directors’ and officers’ liability, errors and omissions liability, employment practices liability, fiduciary liability, crime, professional indemnity, medical malpractice and other financial insurance related coverages for commercial enterprises, financial institutions and not-for-profit organizations.  This business is predominantly written on a claims-made basis

Liability – (10%) – AXS primarily targets primary and low/mid-level excess and umbrella commercial liability risks in the US wholesale markets. Target industry sectors include construction, manufacturing, transportation and trucking.

Accident and Health – (22%) - includes accidental death, travel insurance and specialty health products for employer and affinity groups, as well as accident and health reinsurance for catastrophic or per life events on a quota share and/or excess of loss basis, with aggregate and/or per person deductibles.

Insurance Distribution - AXS produces business primarily through wholesale and retail brokers worldwide.  Some of their insurance products are also distributed through managing general agents (MGAs) and underwriters.   The company’s largest broker relationships were Marsh and McLennan (14%) , Aon (15%), Willis Tower Watson PLC (9%), Others (50%), and MGAs and underwriters (12%).

Reinsurance - The Reinsurance segment operates through offices in Bermuda, the U.S., Canada, Switzerland, Singapore and Brazil.  They write business on a proportional basis, receiving an agreed percentage of the underlying premium and accepting liability for the same percentage of incurred losses.  AXS also writes business on an excess of loss basis, whereby they typically provide an indemnification to the reinsured entity for a portion of losses, both individually and in the aggregate, in excess of a specified individual or aggregate loss deductible.  The following are the lines of business in the reinsurance segment:

Catastrophe – (11% of 2016 segment net premiums earned) - provides protection for most catastrophic losses that are covered in the underlying insurance policies written by their cedants.  The exposure in the underlying policies is principally property exposure but also covers other exposures including workers comp, personal accident and life.  The principal perils in this portfolio are hurricane and windstorm, earthquake, flood, tornado, hail and fire.  In some instances, terrorism may be a covered peril or the only peril.  AXIS underwrites catastrophe reinsurance principally on an excess of loss basis.

Property – (14%) - provides coverage for property damage and related losses resulting from natural and man-made perils contained in underlying personal and commercial policies.  While their predominant exposure is to property damage, other risks, including business interruption and other non-property losses may also be covered when arising from a covered peril.  While their most significant exposures typically relate to losses from windstorms, tornadoes and earthquakes, they are also exposed to other perils such as freezes, riots, floods, industrial explosions, fires, hail, and a number of other loss events.  They assume business on a proportional and excess of loss basis.  

Professional Lines – (15%) - covers directors’ and officers’ liability, employment practices liability, medical malpractice, professional indemnity, environmental liability and miscellaneous errors and omissions insurance risks.  The underlying business is primarily written on a claims-made basis.  Business is written on both a proportional and excess of loss basis.

Credit & Surety – (13%) – AXIS provides reinsurance of trade credit insurance products and includes both proportional and excess of loss structures.  The underlying insurance indemnifies sellers of goods and services in the event of a payment default by the buyer of those goods and services.  The company provides credit insurance coverage to mortgage guaranty insurers and government-sponsored entities.  Also included in this line of business is coverage for losses arising from a broad array of surety bonds issued by insurers to satisfy regulatory demands or contract obligations in a variety of jurisdictions worldwide.

Motor – (17%) - provides coverage to insurers for motor liability and property damage losses arising out of any one occurrence.  A loss occurrence can involve one or many claimants where the ceding insurer aggregates the claims from the occurrence.  They offer traditional proportional and non-proportional reinsurance in addition to structured solutions.

Liability – (17%) - provides coverage to insurers of standard casualty business, excess and surplus casualty business and specialty casualty programs.  The primary focus of the underlying business is general liability, although workers’ compensation and auto liability are also written.

Agriculture – (7%) - provides coverage for risks associated with the production of food and fiber on a global basis for primary insurance companies writing multi-peril crop insurance, crop hail, and named peril covers, as well as custom risk transfer mechanisms for agricultural dependent industries with exposure to crop yield and/or price deviations.  AXS writes both proportional and aggregate stop loss reinsurance.

Engineering – (3%) - AXS provides coverages for all types of construction risks and risks associated with erection, testing and commissioning of machinery and plants during the construction stage.  This line of business also includes coverage for losses arising from operational failures of machinery, plant and equipment and electronic equipment as well as business interruption.

Marine and Other – (3%) - includes marine, aviation and personal accident reinsurance.

The reinsurance segment also writes primarily derivative based, risk management products designed to address weather and commodity price risks.  The majority of these contracts cover the risk of variations in quantifiable weather-related phenomenon, such as temperature. In general, the portfolio of such derivatives is of short duration, with contracts being predominantly seasonal in nature.  

Reinsurance Distribution  – The largest brokerage relationships for the Reinsurance segment in 2016 by gross premiums were Marsh and McLennan at 30%, Aon PLC 25%,  Willis Tower Watson 15%,  Capsicum & Gallagher 10% Other brokers at 10%, and 6% direct.  

Underwriting & Reserves

AXIS Capital has an excellent history of underwriting profitability and reserve development.  The company has had positive reserve development each and every year in its existence and has a 65% IBNR reserve ratio, far higher than peers.  Book value is understated.  Below is a summary of reserve development over the last three years followed by the company’s reserve development triangle, which outlines positive reserve development over the past decade.

While underwriting reinsurance and insurance is inherently a lumpy business AXIS has a history of underwriting profitability.  2017 has been a historically difficult underwriting year.  In addition to the low level of absolute pricing, Munich Re notes that the $135B of catastrophe losses in 2017 is likely to be the highest in industry history and total industry losses of $330B is second only to 2011.  Below is the company’s historical annual combined ratio including my estimate of 2017, which is likely to be the worst in the company’s history.  Again, it is worth noting that despite low interest rates, poor pricing, and the high catastrophe years of 2005, 2011, and 2017 that AXIS has compounded book value at a 10.7% CAGR including dividends.  

Balance Sheet & Investment Portfolio

AXIS has a sound balance sheet and a conservative investment portfolio.  Debt to capitalization at 9/30/17 was 15.4% and treating preferred equity as debt, the ratio deteriorates to 27.4%.  On July 16th of 2017, the company announced the $605MM acquisition of Novae Group a specialty Lloyd’s insurer and the deal closed on October 18th.  The deal is expected to be accretive in 2018, accretive in the double digits percentage in 2019 and neutral to book value.  While the deal is neutral in my view, it is negative in that the company has suspended share repurchases.  Additionally AXS recently issued $350MM in 10 year 4% debt.  This will increase the debt/capitalization ratio in the near-term.  AXIS has $250MM in debt maturing in April of 2019 and $500MM in June of 2020 so this was a very rational issuance.  

Excluding cash, AXS has a $13B total investment portfolio.  This equates to 2.8x TCE.  Including cash, the portfolio is $14.6B.  The portfolio is 76% fixed income.  Average credit quality is AA- and the portfolio duration is 3.3 years.  Including cash, the duration is 2.8 years.  Below is a breakdown of the portfolio and a stress test:

Earnings

I have modeled earnings per share of $4.67, $6.17, and $7.29 for 2018, 2019, and 2020.  For 2018, I have modeled net earned premium growth of 20% due to Novae, 7% investment income growth, and a 98.3% combined ratio.  For 2018, I have not modeled any share repurchase activity.  For 2019 and 2020, I have modeled 2% net earned premium growth annually and 3% investment income growth.  I have modeled no share repurchases in 2018, followed by 3MM shares in 2018 and 4MM shares in 2019.  I have modeled a 96.4% combined ratio in 209 and a 95.3% combined ratio in 2020.  As noted, there is a tremendous amount of volatility in the combined ratio and that is primary driver of earnings.  Below is a sensitivity analysis for my 2018 numbers to AXS’ s combined ratio.  For perspective at a 102% combined ratio the company will earn $2.75, and an 89% combined ratio they will earn $9.76.  Clearly, this does not come close to incorporating the full range of possibilities.  

Management

Albert Benmichol, 60, has served as the CEO of AXIS since May of 2012.  He originally joined the company as CFO in January of 2011.  Benmichol served as the CFO of PartnerRe from April 2000 to April of 2010.  Prior to joining ParterRe, he was employed as a Vice President and Treasury of Reliance Group Holdings and was employed at the Bank of Montreal.  He holds an Undergraduate degree and MBA from McGill University.  The original CEO of AXIS was John Charman, a legendary figure in the insurance industry in London.  Charman had groomed Benmichol to take his position and voluntarily retired, taking the position of “Executive Chairman” with Benmichol taking the CEO role.  There was a fallout between Charman and Michael Butt, who has served as Chairman of the company the entire period of his existence.  Charman left and took over as the CEO of Endurance in 2013, eventually selling Endurance to Sompo in November of 2016 and personally pocketing $325MM.  Charman stated that he owned 5% of AXIS when he left and would not be selling his holdings.  Peter Vogt was named CFO of AXIS after the retirement of Joseph Henry that had been announced in May of 2017.  Vogt served as Deputy CFO and as COO of AXS’ s Insurance from 2013 to 2017. Prior to joining AXIS, he held roles at Penn Mutual, CIGNA and Hartford.  He holds a BBA in Actual Science and Economics from Temple and is a member of the Academy of Actuarial Sciences.  John Butt, 74, has been Chairman of the company since its inception and has a long history in the industry.  He served as the CEO of Eagle Star Holdings a subsidiary of Allianz as well as CEO of Mid Ocean Limited from 1993 to 1998 until the company was sold to XL Capital.  He then served as a Director of XL from 1998 until 2002.  He is also a former director of the Farmers Insurance Group, BAT Industries, and Instituo Nazionale delle Assicuranzioni.  Insider ownership is 2.6% of the company.  Butt has 973K shares of fully diluted holdings and Benmichol has 365K shares of fully diluted holdings.  7% of the ownership is “unknown.”  My speculation is that a reasonable portion is John Charman’s ownership.  

There are multiple risks to the AXS thesis:

*  All P&C insurance companies have “black-box” characteristics where the company’s cost of goods sold is an actuary’s estimate.  This can lead to tremendous volatility in underwriting results.

*  Current insurance pricing is weak and the general consensus is that the industry has too much excess capital for pricing to harden substantially

*  The industry is subject to downside from heightened catastrophe loss activity such as the third quarter of 2018. 

Catalyst

 Continued industry consolidation

Improvement in pricing environment

 Renewed book value per share growth