Description

Thesis: At $28.86 HCC represents an opportunity to purchase a truly franchise property and casualty insurance business at historically low valuations of ~1.1x 09E P/B and ~9.4x 09E P/E vs historical average valuations of 2.2x P/B and 13.5x forward P/E. While most financials have traded down due to concerns over 1) poor investment portfolios 2) funding / liquidity risk and 3) potential write-downs that would hurt book equity values, HCC does not have balance sheet risk with a AA+ $5Bn+ investment portfolio and enjoys an enviable AA credit rating by the credit agencies which is a meaningful competitive advantage in the current environment where companies are more concerned than ever on counterparty risk. More importantly, HCC is a very conservative insurance underwriter as historically HCC has had reserve redundancy (ie reserved more than they actually paid out in claims). The last time the Market was concerned about potential losses / future claim payments was in 1999 when HCC's ROE dipped from 18% to 6% and the stock traded down to 0.9x P/B. When HCC repriced their business and replenished reserves, its valuation increased significantly to 2x+ P/B. Using 1999 as a case study, it seems that the Market is already pricing in a punitive scenario for 2010 where HCC's ROEs and book value drops precipitously. If HCC's balance sheet and reserve levels prove to be more resilient than the Market thinks, HCC could experience significant multiple expansion. Longer-term, HCC is a business that should grow book value per share in the 10-15% area (HCC has grown BV/S by 13-14% since 1992 which is in-line with its 17 yr avg ROE of 13.7%).

Upside Case (+33%+ (incl. 1.7% div yld) / $38 ):  With the market concerned about HCC's exposure to director and officer ("D&O") liability exposure after the subprime mess of 2008 and the general "softness" of the current pricing cycle, I believe HCC is adequately reserved for potential D&O losses and will grow book value per share to $29+ by the end of 2010.  Putting a 1.3x P/B multiple on $29+ BVPS implies a ~$38 stock price (+31% from current $28.86 stock price).  Typically insurance companies that enjoy ROEs in the low teen's trade at 1.5-2.0x P/B so one could argue that my multiple assumption is arguably conservative.  Putting a 1.5x P/B multiple on a $29+ BVPS implies a $44 stock price (+51% from current levels).

Downside (-12% (incl. 1.7% div yld) / $25):  Looking down for a moment, I believe downside risk on HCC is $25.  Unlike most insurance companies, HCC provides significant disclosure on the amount and size of potential claims in their D&O book.  To refresh, director & officer (D&O) insurance (also known as executive liability insurance) covers loss from claims related to "wrongful acts."  Covered claims generally include (1) civil, criminal, regulatory or administrative proceedings and (2) written demands for damages against an insured.  Common examples of such claims are securities class actions, derivative actions, SEC or state attorney general investigations.  Covered wrongful acts include (1) actual or alleged breach of trust, breach of duty, breach of warranty of authority and (2) neglect, error or omission of fiduciary duties.  Covered losses include damages, judgments, settlements and defense costs.

Using the latest disclosures, HCC has maximum exposure of ~$856MM of potential claims in their D&O book. This maximum number is very unlikely as it is assumes 1) a 100% claims rate which is unlikely given that the whole equity market collapsed in Fall 2008- not just financials and 2) that all of the "attachment points" are exhausted. In D&O insurance, insurance is structured in "insurance towers." After satisfying a deductible (say $5mm), primary D&O insurance underwriters stomach the first $20mm of losses and then excess insurance kicks in. "Attachment points" are the points at which excess insurance kicks in and excess insurers become liable for possible claims. HCC's average attachment point is in excess of $100MM, meaning that costs have to reach $100MM on average before HCC becomes liable for any claims. Assuming a 100% claims rate and all of the claims burn through the attachment points, gets us that $856MM number on potential exposure. Based on total net written D&O premium since 2002 (when HCC entered the D&O business) through 2008 and using a recent management conversation on loss and paid loss ratios, I estimate that HCC has D&O reserves of ~$566MM, implying exposure of $290MM which after-tax (30% tax rate), implies a book equity hit of $200MM or ~$1.80/share (113MM FDS). Assuming ZERO net income from the other parts of HCC's book of business (D&O is only ~16% of their book of business), this would take book value per share to $24.50+. Putting a 0.9x P/B multiple on that number would imply a $22 absolute downside stock price. Given the low likelihood that 84% of HCC's business will have zero net income, "distressed" book value is likely to be close to $27.50 at the end of 2010 (Q309 book value of $26.46). The $27.50 2010 BVPS assumes that 100% of the $290MM of D&O exposure hits net income in 2010 while other lines of business experience higher than average loss ratios.  In this scenario, ROEs drop to 4-5% and 2009/10E book value growth is an anemic 2%. Putting a 0.9x trough P/B multiple on $27.50 implies a stock price of ~$25.

Business Background:  HCC Insurance Holdings provides property and casualty, surety, group life, accident, and health insurance coverage, as well as related agency and reinsurance brokerage services to commercial customers and individuals. It operates primarily in the United States, the United Kingdom, Spain, Bermuda, and Ireland. The company was founded in 1974 and is headquartered in Houston, Texas. HCC writes several lines of business: 1) diversified financial products (~40% of premiums) that includes Director and Officer ("D&O") and Error & Omission ("E&O") liability insurance.  D&O reimburses companies and directors  (in part or in full) for the costs resulting from law suits and judgments arising out of poor management decisions, employee dismissals, shareholder grievances, etc 2) Group Life, Accident and Health insurance (39%) which consists of mostly medical stop loss 3) Aviation insurance (7%) which covers mostly helicopters and private planes (no commercial jets) 4) Other (14%) which includes marine, property, sports, event contingency, etc. 

Investment Pros:

• Valuation - HCC is trading at historically low valuations at ~1.1x 09E P/B and 9.4x 09E P/E. Since the early 90's, HCC has, on average, traded at 2.2x P/B and 13.5x forward P/E
• Low Balance Sheet Risk - As evidenced by its AA credit rating (only Chubb has similar rating), HCC has a very strong / ironclad balance with a $5Bn investment portfolio that is 100% fixed income with a AA+ average rating. HCC's entire investment portfolio is managed by General Re (owned by Berkshire Hathaway). HCC's cumulative investment losses since 2007 represent less than 1% of current equity and HCC actually grew BVPS ~10% in 2008 while most insurers experienced negative BVPS growth due to investment losses. In addition, HCC only has $445MM of debt (vs $3.0Bn of equity) with a 13.0% debt to total capital ratio which means HCC has the balance sheet to opportunistically acquire smaller players in this environment should interesting opportunities arise
• Competitive Advantages is Cost Structure - HCC is a true specialty insurer which means they operate in verticals where there aren't as many players and can influence price. Because they operate in such specialty lines (ie pricing insurance for World War II planes or Alex Rodriguez insurance), HCC enjoys 80% renewal rates on their entire book of business and don't have to pay commissions on renewals. This explains why HCC has an expense ratio of 25% which is 5% lower than peers (consistent over last decade). In a recent meeting with mgmt, they stated that they will write insurance for major league baseball pitchers but typically will only write insurance for 30 yr old pitchers as they have found 20 yr old (think Kerry Woods) have yet to develop correct mechanics and tend to throw their arms out early - these types of anecdotes highlight the truly specialized lines of business HCC writes
• Franchise Mgmt Team with Conservative Underwriting Standards - The biggest risk with buying financials in this environment is quantifying how much book equity value is at risk. While banks have written billions of loans with lax standards over the last 5 years and were forced by the government to raise equity to ensure they had sufficient reserves to stomach future losses, HCC has demonstrated strong underwriting standards over the last decade as evidenced by the fact that HCC has actually had reserve redundancies (ie HCC reserved more than they paid out in claims) 7 of the last 11 years. On a cumulative basis, HCC has over-reserved by $73MM since 1998. While a portion of this can be tied to HCC's strong market leadership in various products, HCC compensates its underwriting teams by paying 2/3 cash (based on underwriting profit) and 1/3 in equity (vests over 4 year); depending on the actual claims paid in 3-4 years, the underwriting team's equity award is contingent on the profitability of the insurance policy
• Strong Market Share / Share Opportunities - Specifically in its group life, accident and health and aviation divisions, HCC enjoys high market as HCC is the market leader in both those markets with 15-20% and 35% market share, respectively. Having just entered the director and officer (D&O) liability business in 2002 after a significant amount of capacity left the market, HCC only has 5% market share of the D&O market. HCC believes that its strong balance sheet and high credit rating will allow it to gain share in this market environment. In a recent conversation with mgmt, HCC stated they are being shown opportunities they weren't being shown 10-15 years ago. Specifically, CEO Jon Molbeck recently had a meeting with a bottling company that stated they would not do business with AIG given the recent turmoil
• Insider Alignment with Shareholders - While insiders don't own a significant amount of stock (less than 1% of FDS), CEO Jon Molbeck recently purchased $300k of HCC stock at ~$27 and also owns 350k options with strike prices in excess of $31.92 of which 200K expire in March 2011 and 150k expire in May 2012 - in short, CEO Molbeck owns $11MM+ of HCC stock above $32 so his incentives are aligned with shareholders

Investment Cons:

• Street Likes HCC Story - Of the 9 analysts, 8 like the story so Street sentiment already is positive on HCC; however no large bulge bracket firm covers HCC
• Insurance is Historically Cyclical - The property & casualty insurance industry is notoriously cyclical as capacity enters and exits the market depending on where the industry is in the pricing cycle. When pricing is strong (typically after catastrophes), capacity enters the market and when losses hit balance sheets, capacity exits the market; the bulls would argue we are in the part of the cycle where pricing should harden/strengthen post recent balance sheet losses due to Hurricanes Gustav and Ike and the number of class action lawsuits post the significant meltdown in equity markets in 2008
• D&O Liability Risk is Not Unfounded Risk - With the credit and subprime losses, class action lawsuits are on the rise and many investors are concerned about potential losses in HCC's director and officer liability segment; while HCC believes they are well-reserved for any future claims, there are scenarios where they could experience book equity losses
• Acquisition Risk as Acquisitions Have Historically Been Part of HCC's Growth Story - Historically HCC has grown through acquisitions which is a risk; HCC targets a long-term 15% ROE and requires a 15%+ return on any potential acquisition or any use of capital for that matter; HCC only recently purchased its own stock through a $100MM share repurchase program when HCC's stock fell below book value per share
• Inflation Bad for HCC - As with any insurance company, inflation is bad as it increases the costs of future claims; one has to hope that HCC will reflect inflation in its annual repricing of insurance premiums and adjust their investment portfolio accordingly

Variant View: HCC is one of the few truly specialty public insurance companies out there and has a significant advantage in its low cost structure and high AA S&P credit rating. While the Market is very concerned about future potential D&O claims, my own analysis suggests that HCC is well-reserved for any future losses in the D&O space. When the insurance cycle turns and the Market becomes comfortable with HCC's D&O book, HCC should experience significant multiple expansion from ~1x to 1.3x+ on a likely $29 2010 book value/share.

Catalyst

While difficult to predict, many believe that we are likely at the bottom of the underwriting cycle with accident year loss ratios above 100% (loss ratios + expense ratios). While the tightening of credit spreads and the rebound of the equity markets have helped the asset sides of the balance sheets in the industry which in turn may extend the length of this "soft" pricing cycle, I would argue current valuation already reflects this. Eventually when reserve releases abate and if the interest rate environment stays low, insurers will have to look to increase prices to grow book value/share; if/when the pricing cycle turns around (HCC thinks it will in mid 2010), the entire property & casualty insurance space should benefit from P/B multiple expansion. In addition, HCC believes if AIG starts to price their business appropriately and spins out their property & casualty insurer ("Chartis"), the entire industry would enjoy "an automatic 10% price increase."  Unlike some of their peers, HCC is better positioned to gain market share from AIG given their exposure to professional liability (specifically D&O.)