Description

Description

We believe Employers Holdings represents a compelling investment opportunity. Despite ongoing market share gains, a substantial share repurchase authorization (12% of float), a conservative and properly incentivized management, and a likely near term catalyst, shares trade at a discount to estimated year-end book value, and are substantially below adjusted year-end book (adjusted for the company’s significant excess reserves).

Employers Holdings (“EIG”) is the 18^th largest provider of workers’ compensation insurance (rated A- by AM Best) in the US, with significant market share in California (72% of premiums in 2007), and Nevada (17%). EIG also writes premiums in 9 additional states. EIG employs a disciplined approach to its underwriting and focuses largely on low hazard groups. Using this approach and a thoughtful distribution strategy, EIG has steadily gained share in its markets over the past several years, driving significant growth in polices-in-force (California policies-in-force up 17% in 2007 and policies-in-force outside of California and Nevada up 38% in 2007).

EIG was formed in 2000 when it assumed the assets, liabilities and operations of the former State Industrial Insurance System of Nevada. The Company expanded its footprint into California in 2002 via acquisition (Fremont Compensation Insurance Group). Since then, EIG has enjoyed strong policy count growth in that market largely due to strategic relationships with ADP (non-exclusive, 11% of premiums) and Wellpoint (exclusive, 18%), as well as the intentional coverage reductions by the California State Insurance Fund. On January 30^th 2007 EIG converted into a stock company via demutualization and IPO and membership interests were extinguished.

EIG priced its IPO at $17, above the range of $14-$16, and there was substantial excitement at the time of the deal. Since its IPO, EIG has had solid operating performance, growing policy count 13% in 2007 (versus 7% in 2006) and earning $2.32. The Company has also been investor friendly, repurchasing $75mn of stock in 2007 (average price of $19.17); in February 2008, EIG authorized an additional $100mn of repurchases, to be completed by June 2009. Despite this solid operating performance and return of capital, EIG is currently trading at $16.84-below its IPO price, at approximately 1x estimated 2Q book value, and at approximately .9x estimated year-end 2008 book value.

Moreover, we believe EIG is one of the most over-reserved companies in the insurance industry. Consistent with many former mutual insurance companies, EIG has seemingly accrued reserves for future losses in excess of expected loss levels. According to our analysis of the company’s statutory filings, EIG has at least $300mn ($6 per share) in excess reserves.[1] This excess reserving results in book value being understated by $6, suggesting true book value today lies closer to $23 per share. This would imply shares are trading at .7x current adjusted book. Even as Nevada’s workers compensation policies will likely lead to a fairly long tail for losses written in that state (extending the time for recognizing the excess reserves), we still expect substantial reserve releases to benefit EIG in the next several years.

Even before considering the excess reserves on its balance sheet, EIG is currently significantly overcapitalized, which serves to depress the reported ROE and profitability. The company currently has $675mn in statutory surplus, but is writing less than 50 cents of premium for every dollar of statutory surplus, a ratio of under .5x. A typical ratio for companies in this industry is approximately 1.0x. As EIG improves the leverage on its capital through acquisitions, share repurchases and premium growth, ROE and related profitability metrics will substantially improve.

In an effort to lever its capital and geographically diversify its premium base, EIG announced the acquisition of AmCOMP in January 2008 for $194mn (approximately 1.2x year-end 2007 book value). Though the transaction has yet to close, we believe this would be an excellent acquisition for several reasons. First, it would immediately improve EIG’s ratio of written premium to statutory capital from under .5x today to .7x on a pro-forma basis for this year, causing it to be highly accretive to EIG’s ROE and EPS. Second, there are significant synergies in this acquisition, with management providing very conservative initial cost savings guidance of at least $10mn ($8mn after-tax, $0.16 per share; we believe the number would be significantly higher). Third, our conversations with experts indicate that the benefits of AmCOMP receiving EIG’s AM Best rating (AmCOMP is not currently rated) could have a dramatic impact on its ability to grow premium in its current markets (which is not contemplated in EIG’s synergy guidance). Finally, it significantly diversifies EIG’s geographic base, with only 1% geographic overlap between the two companies, and expands EIG’s footprint into 15 additional states. [Note: Presently the transaction is on hold as AmCOMP received a Notice of Intent to Issue Order to Return Excess Profit from the Florida Office of Insurance Regulation (FOIR). AmCOMP is currently disputing this finding and pending the resolution of this dispute, the acquisition will likely go forward].

While we are hopeful that the AmCOMP acquisition will proceed (likely in 3Q), if it does not, EIG remains well positioned for policy count growth, and a likely resumption of premium growth in 2009. Our expectation of premium growth in 2009 is based on our view that California will recommend a policy rate increase of approximately 10%, following a decline in policy prices of almost 70% since 2003. In addition, we believe that with the AmCOMP transaction pending, EIG has made limited repurchases on its $100mn authorization, despite shares trading well below levels at which the company purchased shares in 2007. We expect EIG to aggressively repurchase shares at current prices once the acquisition uncertainty has been resolved.

Finally, while EIG management appears conservative, and non-promotional, they are appropriately incentivized to create value. Notably, 6 months post IPO (July 30th) the company made equity awards to officers comprised of one-half non-qualified stock options and one-half performance shares. Grants of performance shares are earned based on 3-year average combined ratio and adjusted return on average equity (up to 150% of targeted award). Management’s ability to generate strong performance on these metrics is critical for creating long-term shareholder value. Importantly, management is not incentivized based on premium growth, which should help EIG avoid pursuing bad business simply to inflate top-line growth.

Reason for Mispricing

While EIG has been public for a year and a half and continues to deliver strong results, the stock trades below its IPO price, below estimated year-end book value, and substantially below adjusted book value (adjusted for excess reserves). We believe a significant reason for the mispricing is that the stock has suffered with much of the insurance industry due to fears regarding its investment portfolio. In EIG’s case, these fears are not well founded. EIG employs a very conservative portfolio approach—it noted in its 10Q for 1Q08 that it holds less than 0.03% of its investment portfolio in subprime mortgage debt securities, and more than 68% of its portfolio consists of U.S. government and municipal debt. The current fearful environment and lack of distinction between risky financial companies and conservative financial companies is helping to create this compelling investment opportunity.

Other possible explanations for the mispricing include uncertainty around the AmCOMP acquisition and management’s generally conservative style, which extends to its communication with investors. Regardless of the outcome of the AmCOMP process we expect EIG to significantly expand its ROE and EPS in coming years by leveraging its capital and expense base via organic policy and premium growth. We also remain confident that management will be aggressive with its buyback once AmCOMP is resolved (it is worth noting that at current prices the $100mn buyback represents approximately 12% of outstanding shares).

Thesis:

We believe shares of EIG represent a compelling opportunity at approximately .9x estimated year-end book and .7x adjusted year-end book. We expect the resolution of the uncertainty regarding the pending AmCOMP acquisition and resumption of the buyback to be significant catalysts for share price appreciation.

Excluding AmCOMP, we expect EIG to earn over $2.10 in 2008 and $2.27 in 2009, meaning shares are trading at 8.0x current year EPS and less than 7.5x 2009 EPS. When valuing EIG, we use normalized earnings based on our expectation that over time the company will be able to write sufficient premiums to achieve a 1:1 ratio to statutory capital. On a normalized basis, we expect EIG to experience accident year losses of slightly above 60% (better than normalized industry averages, which is consistent with EIG’s historic superior underwriting experience). Commission expense would remain at 13% of earned premium, while other underwriting expense would decline to 13% of earned premium (about half its recent range, which we believe is reasonable) as these costs are largely fixed. In summary, normalized pre-tax margin from underwriting would be 13%, resulting in after tax margin of 10.5%. Investment income conservatively adds 4.5% to ROE resulting in a normalized net margin of 15%. Based on true statutory book (adjusted for excess reserves) of greater than $20 per share, we would anticipate normalized earnings of greater than $3.00. Using a 11-12x P/E would generate a target of $33-$36, while a price/book of 1.5x (consistent with a 15% ROE) would generate a value of close to $32.

We believe the risk/reward of an investment in EIG is compelling given a likely near-term catalyst, significant excess reserves which result in vastly understated book value, a conservative and properly incentivized management, likely continued market share gains in its core markets, and investment disinterest in the sector which has led to investors overlooking this significantly mispriced security.

Catalyst

Closure of AmCOMP acquisition, implementation of $100mn (12% of float) authorized share repurchase (due to pending acquisition the company has not been actively repurchasing shares, despite shares currently trading at 13% discount to average 2007 repurchase price). Continued strong operating results.