Description

ELEVATOR PITCH

Enstar acquires and manages insurance policies in run-off.  Along with Berkshire, it dominates this unique niche.  Enstar’s primary objective is to grow book value per share which has compounded at almost 20% since 2001 (and at 14% over the last decade despite post-crisis interest rate repression).  Management are excellent operators, good capital allocators, and act like owners because they are owners with a $400MM stake.  They have personally bought $7.5MM of stock over the last two years (including $500k just last week) and sold none.  The company bought back 17% of its shares in the second quarter.  Despite a $4B+ market cap and a twenty year history of compounding capital at high rates, Enstar flies below the radar.  It has essentially no sell-side coverage, has never been written up on VIC, and trades rather thinly.  It does little investor outreach, holds no quarterly calls and does not participate in broker conferences.  Today the stock trades near a historically low 73% of book while other highly regarded insurance companies with lesser business models and financial profiles trade at 2x this level.  And with a long history of reserve redundancy it is highly likely book value is meaningfully understated.  With a strong business model, a shareholder-oriented management team, and a washed out valuation, we think now is an interesting time to invest.  

COMPANY DESCRIPTION AND BACKGROUND

Enstar was created 20 years ago to acquire and manage insurance and reinsurance policies in run-off, which is defined as an insurance line that an insurer previously wrote but has discontinued writing.  While the insurer is not writing new policies it must still manage the existing policies in run-off.  These discontinued insurance lines are often associated with large potential claims and lengthy resolutions, often requiring unique claims management skills.  Selling run-off business is an attractive option for an insurer, allowing them to avoid management distraction from the core business, additional reserve issues, and credit rating implications.  If an insurer wants to maintain these assets & liabilities on the balance sheet but not divert company resources to managing the claims, they are still likely to engage a run-off specialist like Enstar to manage the portfolio for them.  

Unlike other insurers, Enstar does not write new business so it is in perpetual decline and running off every day, making acquisitions essential.  Acquisitions feed the machine, providing sustenance.  While acquisitions are typically considered inorganic growth, they are the foundation of Enstars organic growth.  It has completed over 100 acquisitions or portfolio transfers since its founding.  Deal activity is volatile - a result of Enstar’s opportunistic nature, disciplined approach, and changing price environment.

Deals can take a number of forms but most typically are acquisitions of insurance blocks or loss transfer transactions.  Acquisitions are driven by proposed acquisition price, reputation, and relationships within the insurance industry. Enstar’s industry focus, experience, stellar reputation, and strong industry relationships may serve as small competitive advantages in the deal making process.  It’s acquisition process is highly disciplined, focused on risk exposures, claims practices, reserve requirements, and outstanding claims. 

The runoff market is large and growing.  PwC publishes a piece on the state of the run-off market each year - they estimate global non-life runoff market liabilities of $860B in 2020.  However, only a small fraction of this is sold and available to Enstar each year, as most of it remains with legacy carriers.  On average, roughly $10B in liabilities has come to market in recent years.  To put this into perspective, Enstar acquired $1.7B of liabilities in 2019 and $3.6B in 2020, and has total loss reserves of $13B.  So despite having only 1.5% of the run-off market, their large market share of annual deals is a gating factor to growth.  However, industry run-off liabilities have been growing high-single digits in recent years so the amount coming to market should grow correspondingly.  The run-off market is generally considered counter-cyclical (Enstar did a lot of deals during the financial crisis); however, in today’s hardening insurance market P&C companies are looking to offload discontinued lines to free-up capital to reinvest in their improving core business.  As a result, Enstar is seeing robust activity today. (They have already done seven deals in 2021 representing $3.8B in liabilities, more than they did in all of 2020. This should provide earnings and book value growth in the coming years).

Run-off buyers like Enstar are able to re-underwrite risk with more information than the original underwriter.  For example, claims typically have more predictable payout patterns as they mature and loss trends are well developed.  By the time liabilities come to the run-off market reserves may be multiples of the original reserve.  Still, Enstar resets loss reserves upon acquisition.  It typically pays a discount to book value and assumes more investment portfolio assets than liabilities.

Value is created by acquiring business at attractive prices, then aggressively managing the claims by commuting policies (essentially cutting deals) with claimants for less than liability reserves (what the company calls claims “savings”).  A core principle of the claims process is to expedite the claim, truncating a potential long-tailed liability and in the process reducing the expected loss, generating claims savings and reserve releases.  Enstar considers claims management to be the primary key to their success - running a best-in-class claims center combined with legal and actuarial skills in running off blocks of insurance policies, with a successful process that has been in place for two decades.  Their primary aim is to use their expertise to settle litigation and claims, commute policies with individual policyholders, and negotiate reinsurance proceeds (often trying to receive more from the reinsurer than it thinks it will pay the claimant).  Enstar’s deep experience in settling claims allows it to typically settle claims quickly and for less than what was reserved.  We believe they have an advantage over others when it comes to settling claims as they are typically willing to settle for cash, quickly, and efficiently.  More importantly, they know what works and what doesn’t better than others because they have more experience and data from years of settling claims.  This also helps them price acquisitions appropriately and determine proper reserving upon acquisition.  

The commutation process can take months or years.  Once settled the commutation agreement is binding and irreversible.  Every commutation, irrespective of value, requires the approval of senior management.  If they cannot commute a policy, they will continue to settle claims from the policyholder and collect reinsurance receivables from the reinsurer.  The company has found that it is sometimes easier for policyholders to negotiate with Enstar than the legacy insurance company with whom the claimants had an ongoing and sometimes contentious relationship. 

Analyzing an insurer specializing in run-off is very different from analyzing a traditional active P&C insurer.  Premium growth and combined ratios are of little use in analyzing an insurance company in run-off.  It often acquires business others disdain (e.g. (e.g. asbestos, environmental, workers comp).  It’s unique nature, lack of public peers, structural complexities, thick industry lingo, and a relative information void, can make analyzing Enstar challenging.  It can easily end up in the too hard pile. 

RETURN ON EQUITY

Return on tangible equity is a key factor in analyzing any financial stock.  There are two main drivers of returns: 1) underwriting profitability and 2) interest rates and their impact on investment portfolio returns.  Let’s start with underwriting.  

For most insurers claims are just an expense.  For Enstar the claims process is an opportunity to generate earnings by settling claims for less than associated reserves.  When net losses paid (paid insurance claims) are less than the change in reserves, Enstar books a reduction in expected net losses (favorable development).  Check out 2020 loss development by segment below, as well as get a feel for their exposures. 

When the change in reserves is greater than paid claims as it is above, a negative expense, or contra-expense, is recognized.  So in the table above the (127,116) change in net losses is a negative expense on the income statement, which you can think of as “claims savings”, or income.  Over the last ten years they have averaged $250MM per year in claims savings, driving healthy underwriting profits.  As you can see, in 2020 they had favorable reserve development in every segment except for Motor (they strengthened reserves when claims handling was transferred to a third party administrator who specializes in commercial auto claims).  If Enstar’s current reserves are as redundant as they have been historically, book value is probably materially understated.   

These claims savings, not premiums,  drive underwriting income.  We use history as a guide in estimating underwriting income and its contribution to its ROE.  As you can see below, they have a history generating healthy underwriting income, although a weakening trend.  

What are these “adjustments”?  They mostly relate to electing the “fair value option” for acquired insurance contracts.  They are non-cash charges that Enstar will end up recognizing as real costs as a cash expense over the life of the insurance contract and will show up on the income statement.  It’s normal insurance accounting.  Enstar adds these adjustments back when reporting non-GAAP earnings and we think that’s right. 

As you can see, the contribution to pre-tax ROE from underwriting has averaged 6.9% over the past decade, although the last couple years it’s been closer to zero.  Given the opaque nature of insurance underwriting, it’s difficult to pinpoint any particular problem; however, we don’t think the deteriorating underwriting results reflect a lack of discipline.  We think it is more likely just base rate stuff, i.e. you just don’t go 20 years without hitting some bumps along the way. This is a highly disciplined management team.  The long-term numbers going back to inception speak for themselves.  Further, significant reserving issues seem unlikely in light of recent insider buying.  Our base case is a 5% contribution to pre-tax ROE from underwriting, higher than recent levels but lower than long-term averages.  

Let’s move on to the contribution to ROE from the investment portfolio and the huge impact interest rates have on ROE.  The investment portfolio is well diversified, conservative, and liquid (Enstar maintains a relatively liquid investment portfolio because it seeks to settle claims as quickly as possible).  Enstar has, on average, 83% of its investment portfolio in fixed income, thus the sensitivity to rates.  The bond portfolio is high quality with an average credit rating of A+ and a duration of 4.7 years.  Unfortunately, these assets have been stuck in a low rate environment for a decade now.  This has weighed heavily on their investment returns and subsequently, their ROE.  However, nothing would be better for Enstar than higher interest rates.  While it would lead to losses in the bond portfolio, reinvestment rates would increase and the multiple would expand...a lot.  More on this later.    

Our base case assumes we stay in a low rate environment while our bull case assumes we return to a pre-crisis rate regime.  Our estimate of the contribution to pre-tax ROE from the investment portfolio is below. 

Keep in mind these are long-term returns and average allocations.  We believe their allocation will flex as relative returns change.  Investment leverage has averaged 2.5x over the past decade with a range of 2.2x-3.0x.  Its equity allocation includes private equity in some of their insurance company investments.  

Putting it all together we model an ROE of 12.2%.  Wait!  Don’t stop reading!  I’ll tell you why you want to invest in a company with a 12% ROE below.  Keep reading!

*if you counted preferred stock as equity P/S dividends reduce the ROE by .4%

You can see below we are modeling an ROE fairly consistent with what they have done in the low rate post-crisis era.  Notably, the post-crisis periods below include historically low rates as well as two uncharacteristically bad years of underwriting results.

*2020 had exceptionally high investment gains (hedge fund related) that likely won’t be repeated, so we chose to exclude them from the last period above. 

(In theory Enstar’s book value growth should equal its ROE because they retain and reinvest 100% of earnings; however, as you can see above book value growth has exceeded ROE by 2-3% annually.   This is attributable to good capital allocation, or more specifically, issuing equity when it was dear and buying it back when it was cheap.)

See Enstar’s annual ROE since inception below.

As you can see 2020 was a huge year for Enstar with an ROE of 31%.  This was primarily driven by “windfall” investment gains in their allocation to a hedge fund managed by Hillhouse Capital and should not be expected to repeat.  2019 was simply a reversal of 2018’s negative trends in their fixed income portfolio (credit spread widening then tightening, rates higher then lower).  

In summary, absent unusual underwriting or investment results returns during the current low rate environment point to a low double digit ROE.  While this doesn’t sound great relative to the average ROE in Corporate America of 16.5%, Enstar retains and reinvests all of its capital, so a 12% ROE translates into 12% growth in book value.  Adding a percent or two of book value growth from capital allocation (buying back stock at a discount to book value) drives book value growth to 13-14%. All of this is consistent with history.  Combined with a 27% discount to book value you can generate a very attractive return.  Also, we have very valuable optionality in a higher rate environment which would lead to higher returns, higher  growth, and a big valuation re-rating.  At the same time, the odds of a further material decline in interest rates seem low. 

BOOK VALUE GROWTH

Book value per share growth roughly mirrors their ROE, just a few points higher. As can be seen below, book value has increased by more than 10% every year since going public, except for one (4% in 2013).

Given the volatility in annual returns, we looked at book value per share growth on a five-year rolling average too.  To no surprise, Enstar’s book value growth has never had a five-year CAGR below 10%.

The consistency of this growth points to: 1) excellent operations without major incidents and 2) a well-managed investment portfolio that has weathered multiple cycles and a range of conditions. This has resulted in impressive compounding over the past decade despite repressive interest rates. (FYI - book value and tangible book value are essentially the same, and AOCI is a non-factor).

VALUATION

Trading at only 73% of tangible book value, Enstar is as cheap as it’s ever been except for a brief time during the pandemic lows.  The stock has re-rated three times in its history.  The first was after the financial crisis when we entered a new era of low interest rates, pressuring ROEs and valuations of many financials.  Enstar’s ROE went from high-teens pre-crisis to low-teens post-crisis while its P/B multiple fell from ~2-3x pre-crisis to an average of ~1.3x from 2011-2018.   It re-rated again in 2018 from ~1.3x book to ~.95x book after reporting weak results due to a weak fixed income market that hit it’s bond portfolio returns.  It re-rated a third time in 2020 from ~.95x to ~.75x upon entering the pandemic. This is illustrated in the chart below of P/TBV over the past decade…

The re-ratings are mostly explained by the chart below - a 10-year log chart of P/TBV (in blue) and the 10-year T-bond yield (in red).  Note the long-term correlation and the recent disconnect.

While the stock has increased in price from the pandemic lows, its P/B multiple has contracted as earnings and book value have grown rapidly the last couple of years.  Maybe investors see the recent investment-related gains as unsustainable, which they are, but regardless, the cash generated and book value are real.  That cash can be used for acquisitions and investments and provide continued growth in book value.  They are already putting this capital to work via the large share buyback and signing a record number of loss transfer deals this year.  

With a tangible book value of $320 per share, just an 11% ROE puts the current stock price at 6.4x earnings.  Said another way, todays stock price implies an ROE significantly below its cost of capital, as well as recent historical levels.  Valuation using basic FCF/(k-g) DCF-style math is below.

As shown in the table below, some of today’s highly regarded insurance companies with lesser business models and financial profiles trade at 2x Enstar’s book multiple.

I could be accused of just slapping some average ROE on current book and pointing to some cheap numbers.  I can accept that criticism with the caveat that this is the essential nature of investing in insurance companies.  You frequently take on long-tailed and opaque risks, and complex (many would say black box) accounting, which is why trust in management is so critical in investing in financial stocks.  We think management has proven their operating and investment metal over the last 20 years.  Not perfect, but dang good.  We don’t claim this is a great business with a huge moat, but rather a good business with a good managment and a compelling valuation.

MANAGEMENT

The longtime CEO, Dominic Silvester, is the co-founder of Enstar and has been CEO since its creation in 2001.  He is 60, a citizen of the U.K and a resident of Bermuda.  He has specialized in run-off insurance for almost 30 years.  He is well known in the industry and is primarily tasked with identifying acquisition opportunities.  He has 91% approval on Glassdoor.

Executive compensation is high, although 99% of shareholder votes approved their say-on-pay this year.  Incentive pay is linked to growth in book value per share, ROE, and earnings excluding investment gains/losses.

FINANCIAL STRENGTH 

Enstar is rated BBB at S&P and Fitch, both with a positive outlook.  S&P describes their capital as being redundant at the AAA level.  Overall financial leverage is reasonable (for an insurer) at 3.2x assets/equity.  From a funding perspective, Enstar targets leverage of 25% debt/capital vs. only 16% in Q2, however, the recent $879MM share repurchase and $229MM purchase in Enhanzed Re should bring debt/cap closer to target.  As already noted, reserves have generally been redundant, indicating conservative underwriting.

STRATEGIC INVESTMENTS

Enstar has made a number of investments in young, active bermuda insurers with mixed results.  It now appears to be retreating to focus on the core business, which we think is the right strategy.  Its largest strategic investment to date has been in Starstone, in 2013, investing $415MM for a 60% interest, as a way to enter traditional active insurance to increase deal flow in run-off.  After extensive losses and further investment via a recapitalization they sold their position down to 25% this year.  Starstone is no longer consolidated and is reported under the equity method at a value of $224MM.  As a result of selling the majority of StarStone and Atrium (another active insurer), they have exited much of their previously controlled active underwriting investments and are re-focused on their core nonlife run-off business.  

The number of entities Enstar touches via holding company subsidiaries, majority investments, minority stakes, and JVs will make your head swim and can be quite distracting from focusing on the core business.  In addition to StarStone, here are their investments in non-core runoff insurance companies:

Atrium - acquired this specialty insurer in 2013 for $183MM in its effort to extend its business into traditional P&C insurance to increase deal flow in run-off.  Sold down to 14% this year, deconsolidated and now reported under the equity method.

KaylaRe - Enstar invested $300MM in 2016 (48% stake) to launch KaylaRe.  Partnered with Hillhouse Capital and Stone Point Capital.  In 2018 Enstar acquired the remaining 52% stake and it is now fully consolidated.  KaylaRe writes business sourced from Enstar.

Enhanzed Re - Invested $223MM in 2018 (47% stake) to launch this reinsurer with Hillhouse Capital and Allianz as partners.  Enhanzed Re writes business sourced from Allianz and Enstar.  Enstar’s stake today has a carrying value of $434MM, accounted for under the equity method. In the current quarter Enstar acquired Hillhouse’s stake at 90% of TBV and now owns 75% of Enhanzed Re.  It is now consolidated into Enstar.

Amtrust - Bought a minority stake for $200MM in the $3B take-private of Amtrust in 2018.  At roughly the same time, Enstar entered into a $2.7B loss-transfer agreement with Amtrust (runoff business).

Monument Re - Enstar invested $69MM in 2020 for a 23% stake.  Carrying value of $204MM

Citco - Invested $50MM in 2018 for 6%.  Citco is a fund administrator. Carrying value of $54MM

PwC INSIGHTS

Here are some highlights from this years’ PwC report:

1. The vast majority of respondents believe the market will experience the same or higher growth over the next two years.  

2. 60% of survey respondents said they believe the runoff market is in its growth stage, 22% said it is just emerging or developing, while only 10% said it is mature.

3. The #1 reason insurance companies sell run-off business is to release capital.  Finality of moving on from non-core discontinued lines also ranks highly.

4. 79% of respondents foresee run-off specialists targeting IRRs of 10-20%.

5. Workers comp. is expected to see the most transaction volume.

RISKS

RESERVE ADEQUACY

The process for establishing loss reserves entails a significant level of judgement. They are only estimates based on the facts at hand, actuarial assumptions, historical industry loss experience, loss patterns, and uncontrollable factors like inflation.  Losses are difficult to forecast.  Tort reform is unpredictable.  The general nature of many insurance lines, like, for example, asbestos and workers comp liabilities, are unpredictable.  While Enstar has historically reserved conservatively, we could still be blindsided tomorrow and never see it coming.  We are  unusually reliant on management integrity as we are with other insurance investments.  

COMPETITION

While the number of industry participants has grown in recent years, there are only two companies of size in the industry - Enstar and Berkshire.  Their success and the large and growing nature of the run-off niche has bred new competition.  Since 2019, PwC estimates that there has been over $5bn of new capital invested in the non-life run-off sector.  This is roughly equal to the estimated cumulative investment in the sector over the preceding six years.  Enstar is highly dependent on doing good deals to generate good returns, and the IRRs of such deals could decline as competition gains scale.  Mitigants include Enstar’s scale, reputation, the capital to do big deals, and pricing discipline.  Here are some of the competitors in the run-off space:

Equity Assets

Berkshire Lots More

Enstar $7.2B $24.6B

Catalina $1.0B $6.7B

Riverstone $0.5B $2.6B

(Other small players include Compre, Randall & Quilter, Tawa, DARAG.  There are also large diversified insurers that have some run-off business, but none that challenge the size of Berkshire and Enstar.)

As you can see, Enstar is 7x the size of the next largest competitor.  A quick review of Catalina’s financials show roughly break-even profitability in run-off in 2019 & 2020.  Fairfax recently sold Riverstone to private equity after reporting losses every year since 2015.  In other words, despite the clamor of new capital wanting to get into this niche, the results for the smaller players appear uninspiring.  A casual observation, having followed the industry, is that players seem to come and go as industry returns cycle up and down.  Also, one has to wonder, if the market is that attractive for new players to enter, why not buy an established player like Enstar at book value, with all its intangibles like actuarial data, experience, and reputation, rather than launching a start-up? 

INVESTMENT RETURNS

Insurance companies are levered investment portfolios, particularly bonds.  As such, with stocks and bonds near record valuations investment returns could suffer.  Enstar estimates book value would decline by $455MM, or 7.9%, for a 100 basis point change in interest rates, and $430MM, or 7.2%, for a 100 basis point change in credit spreads.  A 10% decline in the equity market would result in a $248MM decline in book value, or 4.3%.  These risks are mitigated by our margin-of-safety in the stock price as well as the favorable impact higher rates would have on its reinvestment rates and market valuation.  While higher rates would lead to losses in its bond portfolio, valuation would likely expand (as it has in the past) as investors anticipate higher investment income in the future due to the higher reinvestment rates.  Nothing could be better for Enstar than higher rates.  While a low rate environment generates capital gains in its bond portfolio, over time the low reinvestment rates weigh on its ROE, and valuation suffers. 

RESOURCES (other than company filings)

PwC annual survey:

https://www.pwc.com/gx/en/financial-services/assets/Global-Insurance-Run-off-Survey-2021/global-insurance-run-off-survey.pdf 

Enstar’s mid-year 2021 update:

https://www.enstargroup.com/wp-content/uploads/2021/08/2021-Mid-Year-Update-final.pdf

NAIC webinar: 

https://www.naic.org/documents/cmte_e_res_mech_sg_190523_c_2.pdf

Enstar’s 2017 Investor Day Presentation:

https://www.enstargroup.com/wp-content/uploads/2017/06/Enstar-Group-Investor-Presentation-2017.pdf

Reading  the transcript of this is helpful.

Random article:

https://www.globalinsurancelaw.com/wp-content/uploads/2021/02/GILC-Run-off-report-Feb-21.pdf

DISCLAIMER: THIS IS NOT A RECOMMENDATION. The securities described are neither a recommendation nor a solicitation. There are no assurances that securities identified in this note will be profitable investments. The stated opinions are for general information only and not meant to be predictions or an offer of individual or personalized investment advice. This information and these opinions are subject to change without notice. Security information is being obtained from resources I believe to be accurate, but no warrant is made as to the accuracy or completeness of the information. Any type of investing involves risk and there are no guarantees. The author may or may not have material positions in the securities mentioned in this note and will not be obligated to give notice of any changes in their views or positioning. The author makes no representation or warranty, express or implied, regarding the accuracy, completeness, or adequacy of the information. The author accepts no duty of care to you in relation to investments. Past performance cannot be relied on as a guide to future performance.

Catalyst

Re-rating upon improvement in underwriting profitability, higher interest rates, or a take-out.