Description

Global Indemnity is a small, specialty property & casualty insurer that trades at 73% of tangible book value (TBV). It has been over-capitalized and underperforming for a number of years but a series of recent transactions, including buying back almost 1/3rd of its shares, should right-size the balance sheet and earnings. I expect that this eventually trade closer to its peers in the 1.0X TBV range. Plus, the company has option to buy another 3.38 million shares or 19% of the now remaining shares between $23.00 and $25.13 from Fox Paine & Company.

History: Fox, Paine & Company bought the company in September 2003 from the Ball family trusts and injected capital to maintain its ratings. An IPO was completed in December 2003. From Fox Paine's web site:

Global Indemnity plc's IPO completed at a value twice Fox Paine's initial investment thesis.

Global Indemnity plc (NASDAQ: GBLI), is one of the leading excess and surplus lines insurers in the specialty property and casualty industry, with operations in the U.S., Barbados and Bermuda.

In early 2003, Global Indemnity plc management requested Fox Paine's help in averting an imminent ratings agency downgrade, which led to Fox Paine investing in and acquiring Global Indemnity plc's predecessor.

Fox Paine worked exclusively with management to structure the transaction to secure required regulatory approval and ratings agency support as well as position the company for an immediate IPO. We filed a registration statement just 12 days after completion of the acquisition.

It bought the Penn-America Group in 2005, sold the agency operations in 2006, hired a new CEO in 2006, fired the CEO and hired another in 2007, impaired the goodwill from the Penn-America acquisition, took a hit on investments and began letting unprofitable accounts & agents go in 2008, and did a rights-offering equity raise in 2009. The company embarked on expanding the business, particularly admitted lines, but it did not go well. In 2011, the company went through a formal strategic alternatives review with Morgan Stanley but opted to stay independent. A new CEO was brought in at the end of 2011 and the company retrenched to focus on its core business.

This resulted in an over-capitalized, under-performing insurer that was majority-owned by a PE firm for a decade. In other words, no buyer would even bother looking at it. So, the company decided to do something about it. In 2013, GBLI sold one of its insurance subsidiaries, United National Casualty Insurance Company that wrote very little direct business but shared in the inter-company pooling arrangement. Earlier this year, GBLI bought American Reliable Insurance Company (ARIC) from Assurant, which focuses on personal property, and farm and ranch-owners. Although ARIC writes admitted business, it focuses on hard to place risks. I will talk more about ARIC in Earnings. Lastly, this month, the company did a significant buyback of shares from Fox Paine.

Capitalization: This is the heart of my thesis. Prior to the buyback, there were 25.7 million shares outstanding. This was split between two classes, with 13.7 million "A" shares and 12.1 million "B" shares. Both classes of shares are economically equal but the B's have 10X the votes as A's. The B's are also convertible into A shares. Fox Paine owned 3.8 million A's and all of the 12.1 million B's. After the buyback, there are 17.5 million shares outstanding. Assuming Fox Paine sold all its A's and some of its B's, it now holds 7.6 million B's or 43%, but still has majority voting control.

The company has an option through 2019 to buy an additional 3.4 million shares from Fox Paine at $23, that increases 3% per year in price. If the company bought back those shares now, it would reduce P/TBV to 67%. The company is negotiating an additional option for 1.1 million shares on similar terms.

Pro forma adjusted tangible equity is around $700 million and projected net written premium is around $520 million. If the company exercises the buyback option within a year, that would cost about $80 million, which would reduce tangible equity by a like amount.

The parent company floated $100 million of 30-year baby bonds this summer at 7.75% that trade under the symbol "GBLIZ." It's a curious transaction due to the over-capitalization but it has to do with where the capital is held. Most of the capital is in the subsidiaries. At the beginning of 2014, the subsidiaries paid $200 million in extraordinary dividends that required regulatory approval. Given the limitations on insurance companies paying dividends in terms of amounts and when, floating the notes was the most expedient way. Normally, well-capitalized insurance companies can only dividend up 10% of their surplus in a given year.  $114 million was used for the ARIC purchase, which only left $86 million.

While the company does not disclose how its subsidiaries are structured, I did find it in a market conduct exam for Diamond State Insurance Group from 2012. I have included the chart at the bottom but it is difficult to read. There are two updates to the chart that are not reflected. One is that Wind River Reinsurance Company changed its name to Global Indemnity Reinsurance Company in 2014. The other is the addition of ARIC which is somewhere below Global Indemnity Group. I know I am going into a lot of detail but there is a reason.

Buried in the 2014 10-K, the company disclosed the statutory capital and surplus, in millions, for its US operations (which matches to the NAIC information on Global Indemnity Group) and Global Indemnity Reinsurance Company (GIRC):

Based on the structure, GIRC represents the consolidated operations of its business and all its subsidiaries. I had assumed that the special dividend was paid to the parent but it was not. So I started looking to find out more information on where the dividend was held. This was in a recent A.M. Best report for GIRC:

"U.S. operations paid a $200 million extraordinary dividend in December 2013 to Global Indemnity Group, Inc., the U.S. holding company. Global Indemnity Group, Inc. provided a loan to Global Indemnity Re's parent, Global Indemnity (Cayman) Ltd., as a three year loan. Parking the funds there provides financial flexibility for acquisitions, investment opportunities, shoring up of capital as needed at operating subsidiaries; or capital redeployment in general while affording the company tax benefits and efficiencies as well. Global Indemnity Cayman has repaid $125 million of the loan."

My guess is that $125 million loan repayment was done via the contribution of ARIC. This provides three important pieces of information. One is that it looks like the US operations have been right-sized in terms of capital, as it appears that written premiums to capital are about 1.5:1. That is about the optimal ratio. The second is that more of the capital is upstream from the US subsidiaries, which should make it easier in terms of using the capital. Lastly, in issuing the notes, it was easier to do so before the buybacks. Thus, it paves the way so that after additional buybacks, the company's balance sheet is optimally capitalized.

In the speculation department, I am wondering if the buyback allowed Fox Paine to cash out investors in his fund. From a market conduct exam, it listed the shares as being held by Fox Paine Capital Fund II. That appears to be the main fund left at Fox Paine. Looking at the Fox Paine web site of investment companies, Global Indemnity is the only one listed without an exit date. In turn, that concentrates the impact of what happens to GBLI to the remaining investors. So let's see what might happen by looking at earnings.

Earnings: Due to the ups and downs over the years, earnings are hard to project. GBLI had good years in 2013 and 2014 that benefitted from realized investment gains but 2015 has been challenging, including losing money in the most recent quarter. This is probably what has made investors sour on the company. However, that is where the buybacks really pop.

The company did talk about ARIC in the 4th Qtr 2014 conference call. The company typically only does a call for year-end results. The replay can be accessed by calling 800-475-6701 and entering the access code 354441. The CEO, Cynthia Valko, expects premiums to double with the deal and feels that the integration should provide at least 50% savings on about $7-8 million of corporate overhead from ARIC. [Aside - Valko talked about cross-selling opportunities and leveraging both product forms. I would categorize that with the usual pixie dust, investor story that you hear with M&A deals.]

Those comments were made in February and seem to be playing out as described. Looking at the 3rd Quarter 2015 earnings, it looks like premiums have doubled and that more savings were achieved as Corporate and Other Operating expense only rose from $3,481K in 3rd Quarter 2014 to $3,567K in 3rd Quarter 2015. This is offset by the added interest expense.

Getting to projected earnings going forward, Valko indicated the combined ratio would eventually normalize around 95%. That is what GBLI has done in the past and based on the observed cost saves with ARIC so far, I believe it is reasonable for the combined operations. Assuming $525 million of earned premium at 95% combined ratio results in $26.3 million underwriting profit, plus $35.2 million investment income, minus $7.8 million interest expense and minus $14.5 million overhead, that gets to $39.2 million in operating EBIT. The wildcard is realized investment gain but it has averaged $9.3 million over the past nine years. That gives us $48.5 million in EBIT or $36.1 million in net income, after 25% Irish non-trading tax rate. That comes to $2.07/sh. Thus, GBLI trades around 14X projected earnings.

If the next buyback is done in a year, projected EPS goes to $2.56. 14X that number is $35.87. If the 1.1 million buyback happens, projected EPS rises to $2.78, and 14X that comes to $38.91. I realize that is not very exciting but it also does not require anything more than management doing what they've been doing. The main idea is to allocate excess capital into something more productive than the 2% being earned in the investment portfolio. The great thing about low expectations is that it leaves some room for something to happen. This is a Howard Mark's kind of investment.

Institutional Ownership: Besides Fox Paine, there are three 13G filers (percentages adjusted for buyback and on both classes):

- 6.7 % Hotchkis & Wiley

- 5.7% Richmond Hill

- 5.1% Dimensional Fund Advisers

Investment Portfolio: The portfolio is fairly conservative. The slant to property insurance means that durations are shorter than other property and casualty insurers. Excluding agency mortgage-backed securities, the duration was 2.1 years as of September 30, 2015. The embedded book yield was 2.1% for the same time period. Overall, there is not a lot of interest rate risk.

Reserves: The company has been conservative with reserves and producing redundancies. I like insurance companies with boring reserves!

Management  and Board of Directors: Cynthia Valko is 60 years old and is the youngest member of the board. Valko had previously worked on the turnaround of GMAC Insurance for Cerebus Private Equity. Prior to that, she worked in various management positions in life insurance, but I think this position is more about location. Her husband is a doctor and assistant professor at Jefferson University in Philadelphia, and has been there for the past 26 years. However, I believe she is like her predecessors, in that they do not make the big decisions. Also, management does not respond to investor questions, except for the annual call.

The chairman of the board is Saul Fox, 61, who heads Fox Paine. He has been running the show since 2003. Prior to starting Fox Paine, he worked thirteen years for Kohlberg, Kravis & Roberts (KKR). Fox graduated from Temple University and University of Pennsylvania law school, where he is currently an overseer of the law school. Fox Paine is located in the San Francisco, California area.

Despite the ages of Valko and Fox, the average age of the board is 68 years old. That might lead to speculation that this is a buyout candidate. However, I don't think so. GBLI is a collection of established, niche businesses. Let me provide a brief overview of the businesses.

Business Overview: The company has three main business segments: Personal, Commercial and Reinsurance.

Personal: This is half the business of GBLI and is entirely from ARIC. It primarily covers personal property (mobile home, dwelling, homeowners), personal recreational vehicles, and farm & ranch, including equine coverage. Here is the distribution by state:

The company uses two excess of loss reinsurance treaties, including one for earthquake, to mitigate catastrophe losses.

ARIC writes most of its business through managing general agents (MGA's). An MGA serves as intermediary between insurers and other agents. The MGA handles most of the customer services in terms of collecting premiums and issuing policies, as well as dealing with the agents marketing the business. There are pros and cons to using MGA's. It makes it easier for insurers to write blocks of insurance without having to commit a lot of resources. Downside is the dependence on the MGA to write good business. Most MGA's write for multiple insurers, so there can be conflicts of interest. In my experience, some MGA's will play insurers because, periodically, some insurer wants to grow and will venture into new areas. Imagine someone just learning poker walking into an established poker game. Thus, I view the ARIC deal as being better, due to established relationships, than trying to start the business from scratch.

Commercial: Global Indemnity writes business on an admitted basis and non-admitted basis through it various insurance subsidiaries. Admitted insurance means that an insurer has filed and received approval for its rates, rules and forms with the respective state insurance departments. An insurer can apply to write non-admitted insurance, a.k.a. surplus lines, but it can only be admitted or non-admitted in a particular state, not both. It is kind of like the difference between mutual funds and hedge funds. Surplus lines requires less in the way of filing requirements with the insurance department but requires that any insured have at least three rejected insurance applications from admitted insurers. Thus, it can be very profitable because the insureds are price takers. However, surplus lines are most impacted by hard and soft markets. In soft markets, admitted insurers are more willing to write riskier business.

Global Indemnity has five segments in commercial:

1. Penn-America Group - Focuses on small business surplus lines.

2. Diamond State Group - Writes commercial property and casualty, with an emphasis on professional liability for both medical and non-medical.

3. United National Group - Program business of like risks.

4. Vacant Express - Targets vacant dwellings and buildings, buildings under renovation and tenant occupied dwellings.

5. Collectibles Insurance Service - Covers collections, antiques and collectibles.

Unfortunately, the company does not provide details on each segment but I was able to piece together information from its financial statements. Here are the top 5 states by gross premium:

While I cannot tell exactly how much each segment writes, I can estimate based Annual Statement Line of Business (ASLOB) from the financial statements filed with state regulators and available through NAIC.org. The total gross written premium (GWP) was $230 million for commercial. The Collectibles segment most likely constitutes most of ASLOB 9.0 Inland Marine, which had $23.2 million in GWP. Vacant Express would be the bulk of ASLOB 1 Fire and ASLOB 2 Allied Lines, which has $39.9 million of GWP. The "GL" or liability ASLOB's 17 & 18 had $54.2 million in GWP which is probably a lot of Diamond State. The biggest category was $101.5 million of GWP in ASLOB 5, Commercial Multi-Peril, or Commercial Package. This is probably where a lot of United National and Penn-America business resides.

Reinsurance - Despite being the smallest segment in terms of premiums, its earnings definitely make an impact. While the reinsurance operations do write external business, the bulk of its premiums come from affiliates. Almost half of Commercial premiums, $112.3 million, was ceded off shore to its Bermuda sibling. These transactions are eliminated in consolidated financials and are mainly about tax efficiency.

Catalyst

Value and buybacks