Description

Summary

HIG is now a leading provider of property/casualty insurance in the United States, and it has a large U.S. and international variable annuity business that is in run-off (known as Talcott Resolution). HIG sold its individual life, retirement plans and broker-dealer businesses and received $2.2 billion of proceeds. The restructuring plan came on the heels of pressure from investors, led by its then largest shareholder Paulson & Co, (now <2%) to completely split the company’s P&C and Life units in order to boost returns and HIG’s share price. We view HIG as being on the right strategic path, quarterly ROEs improving from 8%. Recent events during 2014 illustrate the successful execution of the Company’s restructuring strategy. The recent sale of the Japan VA block may unlock more value than is apparent in the transaction itself, as we think it would also accelerate and increase the probability of HIG becoming a takeout candidate.

Investment Highlights

• High Quality P&C Insurance Operation: having made corrective actions in its large workers’ comp business, some aspects of HIG’s P/C insurance operation may have gone under-appreciated

  • HIG is among the largest and best in small commercial insurance with less price competition and more consistent underwriting profitability than other commercial lines

  • HIG’s consumer business writes personal auto and homeowner’s insurance in the United States. Distribution is mainly through a 29-year exclusive relationship with American Association of Retired Persons (AARP) which gives the insurer access to a large customer segment with favorable claims trends and growth through the aging of the population

  • HIG could be an attractive M&A target for large P&C insurers (Allianz or Berkshire) due to its position in the small and middle market commercial lines business as well as the AARP personal lines relationship.

• Potential upside to capital plan with balance sheet improvements. HIG management’s original plan for >$1.3 billion in share repurchases through year-end 2014 was overly conservative in light of excess capital generation/ongoing dividend capacity at the P/C insurance company and faster run-off of Talcott. During 2014, the capital management plan has been expanded to total almost $4 billion, consisting of $2.8 billion in share repurchases and $1.2 billion in debt reduction.

  • HIG’s capital position strengthened meaningfully since the financial crisis and the Company repurchased its high cost Allianz debt and warrants in 2012

  • Improved equity market performance and good acceptance of The Hartford’s Enhanced Surrender Value (ESV) program are driving a faster run-off of legacy VA assets than originally expected. Also VA biz could be in a better position to be sold. We estimate that there is about $15/share to $20/share of GAAP equity tied up with VA assets.

A few concerns still remain. Firstly, equity market declines and longer prolonged low interest rates could damper the speediness of HIG’s recovery. Equity market pullback and low interest rates would increase the net amount at risk in the U.S. VA block and could lead to reserving increases, however this should be mitigated as their VA exposure lessens. Secondly, poor margin performance in the P&C businesses have dragged on valuation for investors. Combined ratios higher than 100% will cause significant pressure on ROE improvement, however we believe that management has been addressing this issue. Lastly, HIG’s Group benefits margins remain weak. While HIG’s disability margins appear to have stabilized, they remain well below historical levels and our outlook is cautious given the sluggish economy and aggressive pricing in recent years.

We believe an investment in HIG is warranted given the excellent execution of management, and view this investment as special situation turnaround opportunity. We value the shares at an intrinsic value of $60 per share over the next twelve months, implying a P/TBV of 1.5x (currently trades at 0.94x). However, any improvements in ROEs could result in much higher valuations. Therefore, we are buyers of the shares at prices below $40 per share, which should give us an adequate margin of safety.

Restructuring Timeline: Demonstrated Ability to Execute on Strategy:

• 2012: The Company repurchased 8.0 million shares for $149 million, and all outstanding Series B and Series C warrants held by Allianz for $300 million.

• 2013: the Board of Directors authorized a capital management plan for a $500 equity repurchase program to be completed by December 31, 2014. In June 2013 the Board of Directors approved a $750 increase in the Company's authorized equity repurchase program, bringing the total authorization to $1.25 billion. During 2013, the Company repurchased 19.2 million common shares, for $600 million, and 1.6 million warrants, for $33 million. $617 million of capacity remained outstanding as of December 31, 2013.

• Feb 2014: Announced 2014-2015 capital management plan totaling $2.656 billion, including equity repurchases totaling $2.0 billion and repayment of debt maturities of $656 million.

• April 2014: Sold Japan Annuity Company HLIKK to ORIX Life Insurance Corporation for $963 million, comprised of a purchase price of $895 million and an estimated positive purchase price adjustment of $68 million. The transaction provided a capital benefit of approximately $1.4 billion and eliminated HIG’s Japan variable annuity business.

• June 2014: CEO Liam E. McGee’s announced resignation. CFO Christopher J. Swift appointed as new CEO, Douglas G. Elliot appointed President of the Company, and Beth A. Bombara appointed Executive Vice President and CFO, effective July 1, 2014.

• July 2014: 2014-2015 capital management plan expanded by additional $1.275 billion, consisting of $775 million for equity repurchases and $500 million for debt reduction.

Corporate Structure

In the short-term HIG’s goal is to grow Core EPS and ROEs, and continue to execute on its capital management plan: (i) $2.775 billion in equity repurchases from January 1, 2014 through December 31, 2015 ($1,365.0 million repurchased through Sept. 30, 2014); (ii) $1.156 billion debt reduction plan for 2014-15.

Over the long-terms, HIG remains focused on returning excess capital to shareholders and over time reducing its leverage ratio to the low 20s and improving its ratio of earnings to fixed charges to a range of five to six times. This is the framework within which it will develop its future capital management initiatives. With respect to Talcott, HIG expects to remain capital self-sufficient. Holding company resources are used principally to pay interest in dividends and for equity repurchase or debt repayment.

To understand capital release, it is important to review the legal entity structure along with statutory capital allocations. It's important to note HIG manages Talcott in the aggregate as it has capital allocated among multiple legal entities and product lines. HLIKK, HIG’s Japan operation, and White River Re were part of the Talcott organization, but were owned by holding companies outside the life company legal entity chain. This is in the context within which HIG thinks about capital, its adequacy and where it is located. At year-end 2012, about 60% of HIG’s statutory capital was allocated to support the go forward businesses or $7.7 billion for P&C and $1.5 billion for group benefits. Group benefits is currently written in two legal entities, and HIG’s goal is to have one legal entity supporting this business going forward. That is part of the reason HIG’s total variable annuity (“VA”) book had been hard to sell. It takes time to reorganize a structure where VA policies were written under different legal entities. At YE 2012, Talcott statutory capital allocation totals $6.2 billion (~>$8.4 billion in GAAP equity).

As of September 2014, the Talcott Resolution has been separated and isolated from other business. As previously mentioned, in April 2014, HIG successfully sold the Company’s Japan Annuity Company HLIKK to ORIX Life. Currently, Talcott statutory capital allocation totals $5. 573 billion (~>$9.585 billion in GAAP equity). As Talcott runs-off, capital should free up.

Core Earnings Outlook

The Company has experienced strong improvements in the underlying performance of its core business. In addition, its legacy VA book of business has had good acceptance of The Hartford’s Enhanced Surrender Value (ESV) program, which are driving a faster run-off of legacy VA assets than originally expected. Also we believe that HIG’s VA business is in a strong position to be sold. We estimate that there is $15/share to $20/share of GAAP equity tied up with VA assets. Currently, Talcott is generating <22% of LTM core earnings. This run-off business is a melting ice cube and should contribute less to total earnings over the long-term. Management estimates there will be a 40% decline in US Variable annuity policy count over the next five years.

Property & Casualty is comprised of three segments: (i) P&C Commercial (63% of premiums); (ii) Consumer Markets (37% of premiums); and (iii) P&C Other Operations.

M&A Considerations / Private Market Valuation

Following a roughly two year transformation process that saw HIG divest its Life Insurance and Retirement units and sell its Japan VA book, HIG’s stock has doubled over the last two years. We currently see modest fundamental upside for the shares as it will take time to improve operations and regain investor trust. However, private market value considerations represent more meaningful upside for the stock. We don’t believe investors have focused much on HIG as a potential takeover candidate mainly because its closed block VA books have represented a “poison pill” to potential suitors who would largely be attracted to the P&C franchise. That is why we think the sale of the Japan VA block may unlock more value than is apparent in the transaction itself, as we think it would also accelerate and increase the probability of HIG becoming a takeout candidate. We don’t necessarily think that HIG management is looking to “shop” the company, rather, we have approached it from the standpoint of how attractive its businesses would be to potential buyers to decide whether a meaningful private market value premium should begin to creep into the shares as the VA blocks wind down, or an immediate valuation “pop” should occur if one of the VA blocks is sold.

HIG’s hidden gem in plain sight is its P&C business, which we believe could be an attractive M&A target for a large P&C insurer due to its position in the small and middle market commercial lines business as well as its AARP personal lines relationship. We do not believe that HIG’s P&C business has been viewed as an M&A candidate by investors recently given its sizeable run off VA block, but we see that changing as the VA block shrinks or is sold. Allianz and Berkshire appear to be the obvious acquirers for HIG's P&C operations, however ACE or TRV may be more likely acquirers, since it could be more impactful, give their sizes. Below is a mix of key M&A party comparisons.

P&C Commercial Lines Highlights

Our outlook for commercial lines margins is positive, but we forecast modest premium growth and are wary of reserve adequacy in the workers’ comp line.

HIG has the 6th largest US P&C Commercial Insurance Operations according to A.M Best. Commercial markets' $6.2 billion of written premium in 2013 was divided 49% to Small Commercial (businesses with payrolls less than $5 million and revenue and property less than $15 million), 35% to Middle Market (small commercial; guaranteed cost insurance) and 15% to Specialty (large companies with high deductibles or retained exposure).

HIG distributes its Small Commercial through online service portals and low touch underwriting, small business distribution partnerships, and national representatives.

Workers' compensation, commercial multi-peril and auto comprise around 80% of Small Commercial written premiums. HIG distributes to Middle Market through a national sales office footprint that provides expertise to local markets around the country. Worker's Compensation comprises 30-40% of premium, General Liability around 15% of premium, and Commercial auto and property around 15% of premium. In total, HIG has about 7% market share in US Workers' Comp.

Source: HIG Investor Presentation, August 2014. AM Best. Market share based on direct written premiums in the U.S. in 2013. Adjusted loss ratio represents five year average 2009-2013. Adjusted loss ratio defined as direct losses incurred divided by the difference between direct premiums earned and dividends to policyholders.

In the 3Q 2014, the commercial lines segment generated a combined ratio of 90.4% in 3Q13 compared with 98.1% in 3Q13 and 96.1% for year-end 2013. Excluding adverse development and cats, the combined ratio was 90.2% versus 93.3% in 3Q13 primarily due to a decrease in the current accident year loss and loss adjustment expense ratio before catastrophes, partially offset by an increase in the expense ratio due to higher commissions.

Below is a peer comparison of underlying combined ratios (ex cat) for select direct commercial insurers:

Most of the higher combined ratios relative to the industry to the company's overweight position in Workers' Compensation.

HIG’s margins over the past several quarters have been relatively strong, which we attribute in part to the benefit of ongoing price hikes, or hardening markets. Excluding the impact of potential weather-related losses, which tend to be volatile, we expect margins to improve slightly over the next several quarters as results benefit from price increases, especially in the workers’ comp line and commercial auto. In standard commercial, Management indicated that it achieved price hikes of roughly 5%, down from 6% in 2Q14 and 7% in 3Q13. In terms of product focus, HIG management has also altered its re-pricing efforts from the workers’ comp line (mid-to-high single digit price hikes currently versus low-teens previously) to commercial auto (10-11% price increase due to poor recent loss experience). Recent price hikes are a positive, but we remain concerned about profitability in the workers’ compensation block and are wary of further adverse development. Given HIG’s experience and industry-wide claims trends, we feel that there is potential for additional workers’ comp reserve hikes over time. Additionally, Management has indicated that the overall P&C market has become more competitive, which could make it challenging for the Company to grow while maintaining healthy underwriting margins.

Lastly, HIG's P&C Commercial expense ratio in 2012 and 2013 was ~30%, slightly higher than the peer group average of 27.24%. However, HIG's expense ratio tied to admin, salary, and employee benefits was 16.5%, the highest in the group where the average was 14%. Since we view this portion of the expense ratio as the ratio of fixed costs, we think HIG's current elevated fixed expense ratio highlights the potential to take costs out of the P&C business. Below is a comparison of peer expense ratios:

There could be cost savings and synergies which would be material should Travelers bid, while for the other potential buyers we highlight (ACE, Allianz and Berkshire), we would expect to have much less synergies given more limited business overlap when taking into account each company's specific case size focus (size of the commercial business purchasing insurance).

HIG's 5 Major LOB's vs. Potential Acquirer Shares In Those LOB's

Below is a potential pro forma combined company direct premiums written (DPW) U.S. market share analysis.

P&C Consumer Lines Highlights

Similarly to the commercial business, results in the personal lines business will be marked by healthy underwriting profits but modest top-line growth. We believe that management's increased focus on the preferred-risk 40+ market will drive margin expansion over time, but it is also likely to pressure near-term premium growth.

In 3Q 2014 the consumer markets division (which comprises HIG’s personal lines business) reported underwriting income of $85 million, above estimates of $72 million, driven by upside in revenues and underwriting margins. Specifically, margins benefited from favorable reserve development, benign cat losses, and a decrease in underwriting expenses.

HIG's $3.7 billion of 2013 written premium for Personal Markets were distributed 69% Auto/31% homeowners. 78-80% of HIG's personal lines premiums are distributed through AARP Direct and Agency, where HIG has an exclusive partnership. 21% of HIG's personal lines written premiums are distributed through independent agents. Thus, HIG’s personal lines business is somewhat insulated from aggressive price competition given its exclusive relationship with AARP.

Personal Lines achieved and 94.7%/94.9% underlying combined ratio for 2014 YTD and 2013 YTD respectively. This includes a 95.6% underlying combined ratio in 2014 YTD Auto and a 94.1% underlying combined ratio in YTD Homeowners.

The Hartford’s combined ratios for the last five years have outperformed the industry. Strong pricing and underwriting initiatives continue to improve profitability, particularly in homeowners.

Group Benefits and Mutual Funds (Core Life) Highlights

HIG’s group benefits results will be marked by declining premiums and depressed margins, but results appear to be improving faster than assumed. Management indicated that disability claims incidence has begun to decline after stabilizing over the past few quarters. Furthermore, disability recoveries improved for the third straight quarter. We view recent results favorably, but expect the group benefits loss ratio to remain above historical levels (72-74% pre-crisis) over the next year. Based on anecdotal evidence and competitor commentary, we believe that HIG priced group benefits business aggressively during the financial crisis in order to retain market share. HIG’s margins to gradually improve as recently sold business with higher pricing constitutes a greater proportion of its book and industry-wide disability claims and recoveries normalize. HIG is in the midst of a re-pricing cycle and has raised prices on roughly two-thirds of its disability block. Ongoing price hikes are likely to pressure premium growth, but they bode well for margins.

In 3Q14, total group insurance earned premiums dropped 9.7% due to discontinued Financial Institutions relationships. Sales (ex. buyouts) declined 9.5%, driven by lower new business in both the group disability and group life lines. Hartford generates the majority of its sales in the first two quarters of the year (1H14 is down 17.3% versus 1H13); thus, it is unlikely that the Company will be able to grow sales in 2014. On a positive note, however, analyst research and company commentary suggests that competition in the disability market has become rational as several leading competitors (LNC, MET, PRU, SFG, UNM) are implementing steady price hikes to bolster margins and offset the impact of low interest rates.

As of December 2013, HIG has a solid Group Benefits business, with a strong market position as the number 3 group disability and number 6 group life player (LIMRA), making it an attractive property for companies who are trying to grow in these lines of business. The mix of business is skewed towards the large case market, where pricing has been less favorable. Despite this, HIG has remained disciplined in pushing through rate increases, which has resulted in a decrease in premium (~7% YTD) but improvement in profitability, as the expense ratio is down to 28.1% in YTD 2014 vs 30.0% in YTD 2013 while the loss ratios have stayed relatively flat near 76%.

With the legal separation of the Group Benefits business from the life stack, which is expected to occur at the end of the first quarter of 2014, we see a potential sale being cleaner now than has been the case in the past. We think that this puts the Group Benefits business in play for a potential acquisition, which we think LNC should pursue. We believe that LNC would be a good fit for the HIG Group Benefits book, as it would help LNC improve its mix of business away from VA, which currently stands at about 42% of core earnings, the highest in the Life group. While the large VA earnings has been a driver of the stock this year due to higher equity markets and interest rates resulting in better than expected earnings and positive EPS estimate revisions, the sheer size of the book has become somewhat of a concern from an enterprise risk management standpoint, we think acknowledged by LNC through its reinsurance deal on new VA sales. With a lack of retirement deals in the marketplace, we think HIG's Group Benefit business makes the most sense to further diversify LNC's book of business. In addition, with LNC shares up almost 100% YTD and now trading at 1.2x BV ex. AOCI, buybacks have become less attractive, in our view.

Finally, we expect HIG’s mutual fund business to have weak flows and mixed investment performance, partly driven by the runoff of the variable annuity business. Consequently, we project earnings to grow at a mid-single-digit pace in the next few years, slower than peers with similar businesses (PFG, VOYA). Total assets under management at Sep 2014 were approximately $96 billion with $23 billion in annuity mutual funds, $55 billion in retail mutual funds, and $18 billion in retirement mutual funds.

Talcott Runoff Highlights

Talcott (which comprises Hartford’s U.S. & Japan variable annuity blocks, legacy institutional products, and private placement life businesses) generated core earnings of $122 million in 3Q14, exceeding analyst estimates. The upside was driven by both the U.S. annuity and other product lines. However, the risk profile of the U.S. VA block worsened slightly relative to 6/30/14 due in part to the weak equity market during the quarter. We believe that as this asset gets less risky and “cleaner” it will be more attractive M&A candidate for run-off investors looking to finally move from traditional annuity books to GMIB VA blocks of business. We believe any indication of purchase should serve as a catalyst for the stock. However, we agree with some research that Runoff and distressed VA, fixed annuity, and life deals have averaged 1.0x statutory capital and 0.8x BV in the past few years. With ~80% in U.S. VA, and higher return hurdles for financial buyers, we think Talcott would not go for over 80% of statutory capital in the current environment. HIG's Japan VA runoff sale to Orix went at 80% of Japanese statutory book, and we think the composition of HIG's block implies a significant discount to the Guggenheim–Sun Life multiple of 1.2x statutory capital.

Valuation Considerations

A sum of the parts analysis for HIG is the most appropriate approach to valuation. Management has provided its LTM normalized earnings (“core earnings”) for its “go-forward” businesses, namely P&C commercial and consumer, Group Benefits and Mutual Funds. It also provided core earnings for Talcott and the holding company corporate office. We believe that underwriting and margin improvements in its P&C business has been over-looked by the market and should surprisingly result in long-term normalized earnings closer to $1.2B per year and $300 million for its remaining life operations. Talcott’s long-term earnings profile is that of a “melting ice” cube due to the fact that the operation is in run-off.

Although there are several ways to run regression analysis for the insurance industry (e.g. P/BV, P/BV excluding FAS 115, P/TBV, P/TBV excluding FAS 115), we decided to use P/TBV, because over time it has proven to be the most consistently accurate method to value insurance companies. We also decided to regress the entire insurance universe since HIG currently operates in different sub-sectors of the industry. As a result, we found it best to do a Sum-of-the-Parts valuation for this business since different insurance sub-sectors are valued distinctly at various points in time. We used the following insurance names to form our regression analysis:

MetLife, Inc. (MET); Prudential Financial (PRU); Ameriprise Financial (AMP), Hartford Financial (HIG); Principal Financial (PFG); Lincoln National Cor (LNC); Unum Group (UNM); Torchmark Corporatio (TMK); Reinsurance Group of (RGA); Assurant, Inc. (AIZ); Protective Life Corp (PL); CNO Financial Group, (CNO); StanCorp Financial G (SFG); Primerica, Inc. (PRI); Kemper Corporation (KMPR); FBL Financial Group, (FFG); American Equity Inve (AEL); Cigna Corporation (CI); Aetna Inc. (AET); Humana Inc. (HUM); Centene Corporation (CNC); Health Net, Inc. (HNT); WellCare Health Plan (WCG); Universal American C (UAM); Triple-S Management (GTS); Allstate Corporation (ALL); Chubb Corporation (CB); Loews Corporation (L); CNA Financial Corpor (CNA); Cincinnati Financial (CINF); Alleghany Corporation (Y); American Financial G (AFG); HCC Insurance Holdings (HCC); Hanover Insurance Gr (THG); Employers Holdings, (EIG); United Fire Group, I (UFCS); HCI Group, Inc. (HCI); ACE Limited (ACE); XL Group plc (XL); Arch Capital Group (ACGL); Everest Re Group, Ltd (RE); AXIS Capital Holding (AXS); PartnerRe Ltd. (PRE); Reinsurance Group of (RGA); RenaissanceRe Holdings (RNR); Validus Holdings, Lt (VR); Aspen Insurance Hold (AHL); Endurance Specialty (ENH); Enstar Group Limited (ESGR); Platinum Underwriter (PTP); Third Point (TPRE); Montpelier Re Holdings (MRH); Greenlight Capital Re (GLRE); Argo Group Internati (AGII); Maiden Holdings, Ltd (MHLD); EMC Insurance Group (EMCI); Progressive Corporation (PGR); Mercury General Corp (MCY); RLI Corp. (RLI); Selective Insurance (SIGI); Navigators Group, In (NAVG); State Auto Financial (STFC); Infinity Property an (IPCC); National Interstate (NATL); Donegal Group Inc. (DGICA); Assured Guaranty Ltd (AGO); MBIA Inc. (MBI); Ameriprise Financial (AMP); Assurant, Inc. (AIZ); Markel Corporation (MKL); W. R. Berkley Corporation (WRB); AmTrust Financial (AFSI); Horace Mann Educator (HMN); Kingstone Companies (KINS); Fidelity National Fi (FNF); First American (FAF); Stewart Information (STC);

To value the businesses we took current trading multiples of sub-sector insurance and asset managers (see Exhibit 23), we assigned it a low 1.2x multiple for the remaining cash flows since the only way a larger value could be assigned to this asset would be if there were an open M&A sale of the business.

HIG Sum of the Parts Analysis

At current levels, we believe that HIG has a floor valuation at $30 per shares assuming LTM core earnings of $1.5 billion as well as $23.07 in TBV for the P&C business and $5.59 for Group Benefits. In addition, at current ROEs of 8.2%, HIG should be trading closer to 1.2x TBV or $45 per share, according to peer comparable regression analysis.

Assuming the business keeps improving and there are no sales of the VA book and the Company continues to buy back shares of up to $2.0 billion then the stock should worth closer to $60 per share or 45-50% upside to current valuations. Freed up capital will be used for capital management (both equity and debt). HIG management has expressed its desire to lower its debt to capital ratio to the low 20%’s from its current level of 26.3%. Through capital generation and scheduled debt maturities, we believe HIG can repurchase in excess of $2.7 billion of its stock through 2015 without having to tender for much additional debt. We believe these and many more catalysts (such as the complete sale of the VA book or a Group Benefits sale) which could result in dramatically more value in the stock.

Bottom Line Recommendation and Rationale

Next Steps and Catalysts

Catalyst

1) Simplified structure and story with a core focus on three established and profitable businesses “go-forward” businesses; 2) Margin expansion; 3) Stronger run-off or entire sale of Talcott; 4) Rising interest rate environment; 5) Sale of Group Benefits.