An Insurance Company with 50+% ROEs

We initially stumbled upon ADM while screening for companies demonstrating exceptional and consistent returns on equity.  ADM is one of only nine public companies we found that has generated ROEs greater than 40% in each of the last eleven years.[3]  The other eight happen to trade at a mean P/E ratio of 25x and include household names like Colgate, Campbell, and Accenture.  Given the capital intensity of the insurance business, we were surprised find ADM on the list.

However, a cursory look at ADM’s public filings reveals its unique capital-light business model.  ADM reinsures 75% of its premiums through an increasingly diverse group of strong counterparties.

What is less obvious is the extremely favorable terms that ADM has been able to secure with these reinsurers.  While almost all market participants we spoke to were aware of ADM’s extensive use of reinsurance, none appreciated the terms of these agreements.  Furthermore, most viewed ADM’s reliance on reinsurance as an incremental risk to the Company because of the additional counterparty exposure. 

These views are misinformed.  ADM’s reinsurance contracts provide extremely efficient capital relief.  In its Q3 2011 conference call, ADM disclosed:

"If we were to achieve an 85% combined, what would be our share of the various different profit flows?"…looking at our more recent contracts we're up to knocking on the door of 90% of the return.”

In other words, ADM keeps approximately 90% of the profits while being exposed to only 25% of potential losses.

ADM discloses the terms of its proportional reinsurance arrangements covering 35% of their premiums.  Under the terms of these contracts, ADM is able keep 100% of the profits below a 98% combined ratio.  At an 85% combined ratio, this means ADM retain 87% of the profits (13% retained / 15% profit margin).  We can back into the economics of ADM’s 40% coinsurance with Munich Re, which appear to be similar to its reinsurance deals.

Importantly, the terms of ADM’s co/reinsurance arrangements have improved dramatically over time as ADM has diversified its counterparties; in 2005, ADM kept only 29.5% of profits under the Munich Re co-insurance agreement for example. This demonstrates the strong demand for ADM’s premium.  From a reinsurer’s perspective, ADM’s premium represents a safe and stable way to diversify their more volatile exposures.  While a 2% margin seems small, given the security of that return, we believe reinsurers allocate very little risk capital to ADM’s premium. 

ADM’s capital-light business model allows ADM to grow without consuming much capital, which in turn allows ADM to preserve its dividend.  We estimate that in a 13% annual premium growth scenario, ADM is able to dividend twice as much cash under its current reinsurance-dependent structure than it would if it were traditionally capitalized with equity.

Valuation: The ADM Bond[4]

While there is some noise in ADM’s current financials due to reserve releases, ADM’s current earnings power can be estimated as presented below.

·         Drivers: Per H1 2014 results

·         Average Premium: Per 2013

·         Combined Ratio:  In addition to its own loss reserves, which has over-reserved consistently by ~13%, ADM discloses its actuary’s best loss estimate, which has proven much more accurate (though still conservative) historically.  Since 2004, ADM has averaged an 84% combined ratio.  We have assumed 85%.   

·         Other profit per driver: based on current trends.  See risks section.

We believe that 14x (7% dividend yield) is a reasonable price for ADM without any growth.  However, it is highly likely this multiple will contract (and the dividend will expand) materially as the cycle hardens, which has been the historical pattern.  As COO David Stevens explains:

“In the great inflation of 2010–11 our increases lagged the market and we declined to participate in others’ large scale withdrawal from higher risk segments. As a result, we grew by nearly 60% in the two years – and quite rightly. It’s now clear that the business written at the time was very profitable. Conversely, as prices have fallen, we’ve lagged the market and reduced our share of new business volumes, particularly in the higher premium segments, currently (temporarily?) attractive to some of our competitors.”

Below, we present ADM’s earnings power in 5 years under various growth assumptions.  In our admittedly unscientific base case, we assume 7.5% annual driver growth, which is significantly lower than ADM’s historical 5 year CAGR of 13-19% since 2009 for conservatism and also because of the law of large numbers.  This implies ADM grows its market share to ~17%, compared to 12% today.  We have also assumed a higher combined ratio of 88% (vs. 83% since 2004) and a lower profit take of 88% (vs. 90% currently).   The data table shows ADM’s year-5 P/E ratio under various growth and combined ratio assumptions.

Ultimately, we like to think of ADM as a bond.  We believe ADM’s current earnings stream can support a ~6-7% dividend (“coupon”) and believe it is a fair yield in today’s interest rate environment.  For context, ADM’s recent 10 year subordinated bond yields just 5.3% currently.  However, we believe it is highly likely that ADM’s earnings power will grow meaningfully over the next 5 years.  If we are right, and ADM grows earnings by 6+% annually, our compounded annual rate of return will likely be in the teens.  In more aggressive growth scenarios, and/or assuming some multiple expansion, 15-20+% annual returns are not out of the question.

In terms of current price target, an 18x entry multiple (~£ 1900 currently) with 7.5% annual growth and a 14x exit multiple implies a 7% annualized return, which seems fair to us both intrinsically and compared to other yielding equities.

Closing Thoughts on Management

Assessing a management team is mostly subjective and we encourage readers to develop their own opinion.  However, we would be remiss not to mention the overwhelmingly positive feedback we have received from industry experts regarding ADM’s top management: Henry Engelhardt (CEO), Alastair Lyons (Chairman), David Stevens (COO and likely next CEO) and Kevin Chidwick (CEO of US Operations).  There seems to be a mystique to ADM’s extraordinary management and performance, which confounds competitors. 

ADM’s management team are iconoclasts.  The Company’s history is littered with examples of their “outsider”[5] culture:

• ·         Headquartered in Wales, separate from other insurance companies located in London

• ·        Founded first price comparison site recognizing that “the internet is an irresistible force”, while legacy insurers fought to retain their captive broker business

• ·         Pricing policies driven by data (leader), not market trends (follower).  Not afraid to do things differently.  This enables ADM to take advantage of cycles.

Capital allocation decisions have also proven extremely wise and shareholder-friendly.

• ·         Dividend ~90% of excess capital

• ·         Extensive use of extremely favorable reinsurance

• ·         Issued fixed rate debt in July 2014, taking advantage of extremely low interest rates:  £ 200 million of 10 year subordinated notes with a 5.5% fixed coupon.  The net cost of this offering to ADM is just 2%[6] and it provides additional capital buffer to support the dividend and/or take advantage of the cycle hardening.

• ·         Rapidly expanded market share in 2010/11, which was controversial at the time, but has proven prescient.

ADM’s management team is also highly aligned with shareholders.  Recently-retired CEO Henry Engelhardt owns 12.2% and COO David Stevens owns 3.6%.

Alternative View / Risks

1.    Reliance on Reserve Releases: 

ADM has been criticized by the market for its reliance on reserve releases.  David Stevens explains the flaws in this criticism:

“Bizarrely, some commentators discount the value of reserve releases as somehow generating lower quality profits. I say “bizarrely” for two reasons. First, to my mind, underwriting profits derived from releases on older, more developed, more predictable years cannot be lower quality than underwriting profits reported on current, undeveloped, years. Second, in Admiral’s case, profits from reserve releases can’t be considered “one-off” – we have released reserves every year since our flotation in 2004, at an average of 12% of premium earned.”

2.    Dividend cut:

A dividend cut is not out of the question given a weak 2014 underwriting result.  ADM’s financial statements reflect a 2014 accident year combined ratio of 107% and loss ratio of 92%, which is elevated by historical standards.  ADM’s historical average initially-booked combined ratio and loss ratio of 99% and 84%, respectively.  ADM’s actuary has initially estimated a loss reserve of 82%, which is the highest in the Company’s history. 

It seems likely that 2014 has a larger reserve buffer than a typical year.  2014 was a similar to 2011 in that there were a few large bodily injury claims early in the policy year, which was surprising given the mix of business was less risky than other years.  In 2011, ADM’s actuaries initially booked a loss reserve of 74%, which was subsequently reduced to just 64%.  A similar 10% reduction in loss reserve would bring ADM’s 2014 combined ratio to 87%. 

ADM also has significant excess reserves to release.  We estimate ADM’s current reserve buffer by comparing ADM’s most-recently disclosed accident year booked loss ratio to its actuary’s best estimate loss ratio.  We estimate that ADM has booked approximately £500 million of excess reserves as of FYE 2014 and we estimate that this figure stayed relatively constant in H1 2014.  This is 1.5x ADM’s pretax profit. 

Lastly, ADM has £ 300 million of excess capital, more than at any point in its history.  In total, we estimate that ADM has total excess capital (including reserve buffer) of ~£800 million (20% of market capitalization).

3.    Technology and Self-driving cars:  If/when self-driving cars become mainstream, ADM’s profitability will be severely impacted.  Best estimates are 2-5 years until the technology is publicly available.  The adaptation after that is anyone’s guess, however, the benefits of the technology (cleaner, safer, cheaper) likely significantly outweigh the disadvantages (not as fun, perhaps) especially in urban areas.  On the other hand, given the average vehicle life is 11 years, it may take significant time for the technology to have a meaningful impact on ADM.  Furthermore, Generation 1 self-driving cars are likely to be capable of driving only in relatively benign climates as bad weather (as in the UK) provides additional hurdles technologically.  We do not profess to have any unique insight here, but will continue to monitor the situation and adjust the position size if needed. 

4.    US and International Expansion:  ADM is spending a substantial amount of money on its international expansion, especially in the United States.  It plans to spend £ 40 million on its US price comparison site, comparenow.com.  While business in the US is growing, it is still far from profitability.  While the opportunity in the US (as well as Spain, Franc and Italy) is large and management’s track record is strong, we assign no value ADM’s international businesses.

5.    Ancillary Income:  ADM, like all UK insurance companies, generates a significant amount of profit from selling ancillary products like legal expense cover, car hire insurance, and administrative fees.  Some of these products are under scrutiny from regulators and ancillary profit has been falling for ADM.  We believe long-term this helps ADM relative to other less-profitable underwriting franchises, who are more reliant on ancillary income to generate profitability.  Industry-wide premiums should adjust higher over time, which plays to ADM’s strength.

6.    Lack of growth:  The market is overly concerned about ADM’s lack of growth since 2012.  It’s unlikely that ADM will continue to grow at its historical pace, however, we believe it still has substantial runway in the UK and, potentially, abroad. 

7.    Management change/Retirement: The CEO recently retired.  However, COO David Stevens is equally (perhaps, more) talented. 

[3] Source: Capital IQ.  United States, Canada and Europe Developed Markets only.  Excludes Oil and Gas Exploration Companies in order to avoid trusts.