I first learned about Hartford in the early 1990s, when it was a subsidiary of IT&T. At that time, a friend who was on the board of IT&T told me that Hartford was a gem with a bright future.  Hartford was then spun off from IT&T on December 17 of 1995.  In its first year as an independent company, Hartford earned $3.07 per share (recurring earnings before capital gains and losses and other one-time items) on a year-end book value of $17.72 per share, which is equal to a ROE of 17.3%.  Last year, the company earned $10.34 per share (again, before one-time items) vs. a year-end book value of $63.93, which is equivalent to a ROE of 16.2%.  Thus, one can conclude that Hartford is a very profitable company whose earnings in the 1996-2007 grew at an 11.7% average annual rate and whose book value per share grew at a 12.4% average annual rate.

 

Why is Hartford a gem?  A key consideration is management.  Two CEOs of major insurance companies told me that, in their opinion, Ramani Ayer (Hartford’s Chairman) and his co-executives are among most capable in the insurance industry.  Another key consideration is some of the actions taken by management over the past decade.  This year, property and casualty insurance will account for an estimated 40% the company’s profits.  Hartford’s property and casualty business can be divided into four segments: (1) automobile and other personal lines; (2) very small businesses; (3) medium sized businesses; and (4) other.  Hartford is emphasizing and growing the first two of these four segments and is shrinking the others.  In personal lines, Hartford has a long term contract with AARP which produces relatively steady and high earnings.  In “very small businesses”, Hartford has a high market share in a line that is less price sensitive and therefore is less cyclic and more profitable.  Thus, Hartford’s P&C segment has transitioned from being a quite competitive, cyclic business to one that is well positioned and steadier.

 

The other 60% of Harford’s current earnings come from what the company calls “life insurance”, although most of 60% actually is from annuities and “retirement products”.  A key major long-term strategy of management has been to recognize the growth potential of retirement products, such as variable annuities, mutual funds, and the management of 401K plans.  Importantly, as defined benefit plans are replaced by defined contribution plans, there is a growing need for the management of 401Ks and other retirement vehicles.  Hartford recognized this need at an early date and has a very strong position in the retirement market.  This strong position is a key reason why the company has been able to grow its “assets under management” at a 13% average annual rate over the past eleven years.  This is an exciting business that has the potential to continue to grow at a rate in excess of 10%!

 

            We project that, over the next five years, Hartford’s ROE will continue to average 15+%.  The company currently has about $1.5 billion of excess capital and has been generating roughly $1 billion of additional excess capital annually.  Thus, the company has the capital and the business opportunities to continue to grow at a rate in excess of 10%.  Because, property and casualty rates are declining from a cyclic high, we are estimating that Hartford will only earn about $10.25 this year, before any positive adjustments to reserves.  We will discuss the company’s reserves below.  Looking to next year, we will assume that property and casualty rates will stabilize at a normal or below normal level and that, under these conditions, Hartford’s EPS will increase by 10+% to an estimated $11.40 or so.

 

            Hartford and most other financial service companies have been out of favor for the past year or so – and its shares have been particularly weak in spite of the company’s strong earnings and other fundamentals.  Investors seem concerned about asset quality.  We have been told by other insurance companies that Hartford’s investment policies have been conservative.  One consideration is that, because the company has highly profitable and growing lines of business, it does not need to stretch for investment yields.  Only 2.2% of the company’s investments are in sub-prime mortgage backed securities – and the quality of these securities are such that no material losses are expected.  The attachment points on most of the RMBSs are relatively high – and, importantly, the company avoided CDOs.

 

            I expect that credit losses will increase from abnormally low levels for Hartford and most other insurance companies and banks.  But, over the past few years, credit and maturity spreads also have been abnormally low – and we expect that increased investment income from larger spreads will offset most or all (or more than all) of larger credit losses.

 

            Over the past 40 years, the average PE ratio on the shares that comprise the S&P 500 Index has been about 15X.  We believe that Hartford’s quality and growth potential are above average.  In five of the eleven years since 1996, the company’s shares have sold above 15X earnings for at least a portion of the year.  To be conservative, we will value Hartford at 14X earnings, which means that, in middle of next year, the shares would be worth an estimated $160, or more than double their present price.

 

            We believe that Hartford is materially over-reserved and that positive reserve adjustments over the next few years likely will increase reported EPS to levels that are in excess of the $10.25 and $11.40 estimated above.  Here is the logic to my thinking, which has been confirmed by the CEOs of three other insurance companies, although no management can admit that its company is over-reserved (so, Hartford has to deny my thesis).  In the late 1990s, the property and casualty industry suffered from abnormally high losses.  The reason was a spike in environmental claims and asbestos suits.  Then in 2001, 9/11 was the cause of large losses – and a few years later the industry suffered from the worst two hurricane seasons on record.  In this environment, the industry raised its rates sharply.  Loss experience since Katrina (which was in 2005) has been normal and far below the abnormally high level of the previous ten years.  Thus with rates rising sharply, one would have concluded that the earnings of the property and casualty industry should have risen particularly sharply.  For example, Hartford’s combined ratio in 2002, before prior year reserve adjustments and before catastrophes, was about 95%.  Between 2002 and 2006, prices rose by close to 50% (we can approximate this from the company’s 10Ks, which detail price increases for three of the four sub-segments).  If prices increased by close to 50%, if claims increased with volumes, and if operating expenses increased at a rate close to the price increases, then the company’s combined ratio should have declined to close to 70%.  Yet, Hartford recently has been reporting combined ratios in the range of 87-90%.  What happened is that management, which had little incentive to report abnormally high earnings, used ultra conservative assumptions when reserving for losses.  The assumptions were based on the abnormally adverse experience caused by asbestos suits, environmental claims, 9/11, and the hurricanes.  Looking ahead, as actual experience for recent accident years is much more benign than what was reserved for, Hartford will have to release reserves into reported earnings – and there were modest releases in the fourth quarter.  Based on what we know about pricing vs. recent loss experiences, we estimate that Hartford understated its reported earnings by roughly $1.50 per shares in each of the last four years.  Wall Street may not give Hartford full credit for the additional reported earnings, but the reserve releases should demonstrate that Hartford has been conservative, that its reserves are in excellent shape, and that its book value is somewhat understated.