Alea Group Holdings ALEA LN
September 19, 2005 - 2:18pm EST by
valueguy201
2005 2006
Price: 2.52 EPS
Shares Out. (in M): 0 P/E
Market Cap (in $M): 440 P/FCF
Net Debt (in $M): 0 EBIT 0 0
TEV ($): 0 TEV/EBIT

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Description

Alea Group Holdings represents a catalyst-driven opportunity to invest in one of the cheapest publicly traded insurance companies in the world with compelling risk-return characteristics. The company’s board recently announced they are exploring strategic alternatives including the sale of the company. I believe that a sale at a significant premium of approximately 30-45% to the current stock price is likely in the near term, and at roughly 60% of its tangible book value, I believe that Alea’s stock price offers significant downside protection.

Company Background
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Alea is a global property and casualty reinsurance and specialty insurance company. The company is headquartered in Bermuda, with operations in the major insurance and reinsurance markets worldwide. Alea’s book of business is diversified by geography and product, with a split of roughly 70% casualty / 30% property and 70% reinsurance / 30% insurance. Alea has focused on developing attractive niche businesses that focus on small to medium sized commercial customers on the primary insurance side and small to medium sized insurance companies on the reinsurance side.

Alea’s current business model was largely developed by KKR, the company’s largest shareholder with a 40% stake. The original platform was created with the acquisition of Rhine Re in 1997. Since that time, the company has acquired a number of insurance companies and business lines with KKR’s sponsorship, which were re-branded under the Alea name in 2000. Post-September 11th, Alea raised additional private capital from KKR and other institutional investors. The company was taken public in November of 2003, with an additional infusion of new capital.

Valuation
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Stock Price (pence) 140p
Shares Outstanding 174.4mm
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Market Cap (Pounds) 244mm Pounds

Book Value (6/30/05) $718.3mm
Intangibles 9.8mm (estimated based on 12/31)
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Tangible Book Value $708.5mm
$ / Pound Exchange Rate 1.80
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Tangible Book Value (Pounds) 394mm Pounds
Tangible BVPS (p) 226p

Price / Tangible Book 0.62x

In addition, Alea has estimated its pre-tax losses from Hurricane Katrina at $20 – 30 million, which is well within the company’s earnings run-rate and should not result in a decrease in book value in the second half (the company earned $79 million pre-tax in the first half excluding a $35 million reserve hit and a $19 million impact from windstorm Erwin in Europe).

Current Situation - How come the stock is so cheap?
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Since its IPO at 250p per share, Alea has steadily declined to its current price of 140p per share. The declines have largely been due to a continual flow of bad news, to the point where I now believe most investors have effectively thrown in the towel. Unlike the class of reinsurance companies that was founded post-September 11th, Alea has had some exposure to U.S. casualty business that was written in the poor underwriting cycle years of 1997-2001. Because of this, the company’s performance has suffered as adverse claims development on this portion of the book have overshadowed otherwise reasonable operating performance (first half ’05 ROE of 12% excluding reserve development and 16% excluding windstorm Erwin).

To turn the Company around, KKR brought in a new management team in June 2004. The new team initiated a comprehensive review of the company’s reserves in the second half of 2004 that led to a charge of $73 million in the company’s 2004 results. After a significant delayed reaction, AM Best unexpectedly placed the company’s credit rating on negative watch in June 2005, and the Company began a process to raise additional equity capital to maintain their critical A- rating – this move drove the stock down over 10%. While the company was in the process of exploring its capital alternatives, it reported first half results at the end of August and announced an additional reserve charge of $35 million – this drove the stock down roughly an additional 10%. Following this announcement, S&P also placed the company on negative credit watch and subsequently downgraded the company to BBB+. S&P cited poor operating results following the reserve strengthening at year-end as the primary reason for the downgrade. This is a somewhat unusual move, as ratings downgrades are generally related to capital adequacy, and it puts Alea in a position where a new equity raise is ineffective at solving the ratings problem. As a result, the board announced that the company is exploring strategic alternatives including a sale.

High Likelihood of a Sale at a Premium in the Near Term
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I believe that the company’s current situation makes a sale to another insurance company at a significant premium to the current stock price a high probability outcome. An insurance company in this rating agency situation would normally have three options: (i) raise capital to restore their rating to A- (the minimum level for most reinsurers), (ii) sell the company, or (iii) run-off the existing book of business. As discussed above, the possibility of raising capital and returning to status quo is highly unlikely given S&P’s ratings action which was specifically not based on the company’s capital adequacy. Between options (ii) and (iii), I believe that a sale is the most likely outcome due to the company’s valuation and the presence of a controlling shareholder that is motivated to exit.

Acquiring Alea at anywhere up to book value would be an accretive proposition to an acquiring insurance company and would represent up to a 60% premium to the current share price. As a point of reference, Alea’s reinsurance/insurance peer group generally trades in a range of 1.2x to 1.5x book value, further highlighting the accretive nature of acquiring Alea. The attractiveness of purchasing an insurance company at a discount to its tangible capital is especially attractive following Hurricane Katrina, as it is generally expected that industry-wide pricing will improve, making the availability of additional capital to write new business extremely valuable. In addition, Alea’s niche position serving small to mid sized commercial customers and insurance companies should provide added value and be attractive to many competitors. While the market price clearly reflects uncertainty about the book value, I believe the company’s reserves may now be balanced or even conservative given that the amount of business written in the recent hard market far outweighs the business written in the soft market (see discussion below on reserves). I therefore believe that a fair result could easily be at least in the range of 80% to 90% of book, which represents 30% - 45% upside from the current price. As reported in the Financial Times on August 12th, Alea has received expressions of interest from at least four companies (ACE, Partner Re, Axis and Odyssey Re), indicating that the sale process will be competitive.

In addition to the compelling economics to a potential acquirer, I believe that KKR is a highly motivated seller. KKR has a long 8-year history with their investment in Alea and has injected additional capital at numerous points along the way. The unsatisfactory result of the investment thus far and the fact that Alea would now be considered a small investment for KKR, leads me to believe that they would certainly prefer a full exit. The proposition of putting the company into run-off and managing the investment for an additional, indeterminate time period I believe would be a poor outcome from their perspective.

Limited Downside
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If for some reason Alea is not able to complete a sale to a strategic acquirer, I believe that the current stock price would represent an attractive return in a run-off scenario. For purposes of clarification, a run-off analysis estimates the discounted value of the residual net cash flows to the company’s equity holders that would be generated from the company’s balance sheet if it were to stop writing any future business. The key components of the run-off analysis are: (i) the investment income generated from the company’s invested assets, (ii) the cash claims payments made as the reserves are ultimately settled, and (iii) the expenses necessary to administer the run-off. A brief summary of my run-off methodology and assumptions is as follows:
(i) Make the following adjustments to the current balance sheet:
- Write-off intangibles, including DAC, and PP&E
- Adjust the reserve balance for reserve discounting
- Convert the unearned premium balance to reserves at an assumed loss ratio (in this case the company’s rough historical average of 65%)
- Liquidate the company’s other net tangible assets
(ii) Generate investment income from the company’s invested assets – I have assumed a portfolio yield of 4.5%
(iii) Estimate a pay-out schedule for the company’s adjusted reserves – I have assumed a 3.5 year weighted average payout
(iv) Estimate run-off admin costs – I have assumed 2% of the average reserve base
(v) Pay taxes at a rate of 25%
(vi) Maintain enough tangible equity in the company to keep the claims / equity ratio at 3.5x for regulatory purposes
(vii) Pay out the residual cash flow to equity holders

I have not assumed the company will benefit from commuting any of their contracts (settling outstanding claims before they are due), a practice which is typically employed during a run-off. I believe that this is conservative since commutations in a run-off generally result in a gain (the claimant will accept a lower payout due to the uncertain position of the insurance company) and accelerate the timing of the dividends to equity holders, both of which increase the value in a run-off.

The following table summarizes the analysis:

($ millions)

Cash Flows:

2006 2007 2008 2009 2010 2011 2012 2013 2014
---- ---- ---- ---- ---- ---- ---- ---- ----Inv. Inc. 93.0 76.5 62.0 50.1 39.6 29.0 18.5 9.2 2.6
Runoff Exp. (32.8) (26.4) (21.4) (17.3) (13.7) (10.0) (6.4) (3.2) (0.9)
Taxes (24.5) (12.5) (10.1) (8.2) (6.5) (4.7) (3.0) (1.5) (0.4)
Claims (364.7)(273.5)(227.9)(182.3)(182.3)(182.3)(182.3)(136.8) (91.2)
Other Assets 200.1 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0
Equity Divs (255.1)(115.7) (95.5) (76.7) (71.5) (66.3) (61.2) (43.6) (27.3)
---- ---- ---- ---- ---- ---- ---- ---- ----Chg. In Investments
(383.9)(351.7)(293.1)(234.4)(234.4)(234.4)(234.4)(175.8)(117.2)

Balance Sheet:

2006 2007 2008 2009 2010 2011 2012 2013 2014
---- ---- ---- ---- ---- ---- ---- ---- ----
Avg. Invest. 2,067 1,700 1,377 1,114 879 645 410 205 89
Reserves 1,459 1,185 957 775 593 410 228 91 0
Book Value 417 339 274 221 169 117 65 26 0
Res./Equity 3.5x 3.5x 3.5x 3.5x 3.5x 3.5x 3.5x 3.5x 3.5x

Valuation:

Discount Rate 12% 15%
Sum of Discounted Equity Dividends 599 563
$ / Pound Exchange Rate 1.80 1.80
---- ----
Value in Pounds 333 313
Shares Outstanding 174.4 174.4
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Value Per Share (p) 191p 179p

Using a discount rate of 12-15%, which I believe is a fair return for this situation, Alea is valued between a range of 179p to 191p, or 0.79x to 0.84x book value. This set of assumptions generates an attractive return even in the run-off scenario, and I believe provides a significant amount of downside support for the stock.

Risks / Concerns
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- Uncertainty of Alea’s book value / Adverse claims development

The largest risk to the above analysis is if Alea’s stated book value is not currently a true reflection of economic reality. Clearly investors have long ago tired of adverse development from the company’s US casualty business and do not believe the current book value. While it is impossible for anybody to know exactly how accurate the company’s estimate of future claims is, I am optimistic about the company’s reserve position for the following reasons:

(i) Industry wide, the most toxic years for US casualty business were between 1997 and 2001. Fortunately the company wrote almost no US casualty business before 1999. Between 1999 and 2001, Alea wrote $466 million of “bad” US casualty business. Additionally, professional lines business, which has been the most problematic in terms of negative development, was only approximately $70 million between 1999 and 2001, or 15% of the $466 million. As a comparison, the company wrote $3.1 billion of total premium in the hard market years of 2002-2004 – more than 6.5x as much “good” business than “bad” business and approximately 45x the “toxic” business.
(ii) The simple passage of time and maturity of the book should limit future negative surprises.
(iii) The company’s reserve review that was undertaken at the end of 2004, which resulted in the $73 million charge, was a comprehensive analysis of their portfolio and reserves. The management team reviewed all reserves, territories and time periods, identified major accounts, contracts and lines of business that required further review and then went as far as visiting the primary companies to conduct additional reviews of the most problematic accounts.
(iv) Finally, and perhaps most importantly, it has generally been the case in the insurance industry that business written during the recent hard market years since 2002 has been conservatively reserved for initially. As a result, most companies have experienced significant positive development on reserves from these years. As a predominantly longer-tailed casualty writer, it is difficult for Alea to release reserves at this stage, but the expectation is that this portion of the book is significanty over-reserved. Management has indicated that this book is developing ahead of original expectations. Given the amount of business written in good years vs. bad years, it is conceivable that Alea’s book is at a minimum balanced between positive and negative development, and possibly actually now biased towards a more over-reserved position.

- Forced sale / Inability to get full value

The rating agency downgrade has put the company in a suboptimal position from a seller’s perspective. While this is a concern, it is mitigated by the fact that there appear to be multiple interested parties in the company. To the extent a competitive process is maintained the company should eventually achieve a fair value outcome. It should also be noted that while KKR may be a highly motivated seller, they are not a distressed seller and as a financially savvy sponsor they will seek the best outcome to maximize their return.

Catalyst

* Sale of the company at a significant premium in the near term
* Investors focus on the intrinsic value of the business in run-off
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