Description

Summary

We think Kinsale Capital is one of the last remaining bubbles in the post-COVID era.  We have invested in a lot of insurance stocks over the years (long and short) but have never seen anything quite like Kinsale, a $7 billion market cap excess and surplus (E&S) insurer trading at a remarkable 12x book value and 40x earnings.  The book value multiple is at least twice any historical precedent in commercial property & casualty insurance and roughly six times the historical average.  We think the E&S insurance cycle is topping out and will likely start turning down next year, leading to a fantastic short opportunity in this highly inflated stock.

(For some additional background on the company heading into COVID, we would refer you to a January 2020 write-up here by cfavenger.)

Situation Overview

Kinsale was started in 2009 by some executives from a $900 million market cap insurer called James River.  The company went public in 2016 at $16 per share and is up almost 20x since then, recently trading at approximately $310, resulting in the highest price to book multiple of any balance sheet intensive financial company we can recall in our careers.  

The company underwrites a type of insurance called excess and surplus which are non-standard risks that most insurance companies want nothing to do with… think of insuring a gun manufacturer, a SPAC, a cannabis company or a company with a pattern of harassing employees.  Unlike admitted insurance, which is based on standard forms with regulated policies, these are bespoke policies that are unregulated by the states.

Within the E&S market, Kinsale has rapidly taken share by often providing the lowest headline premium and quoting business quickly (often within 24 hours) for risks that few other insurers want to take.  They price low and put in really strict language that allows them to avoiding paying out on many claims.  Facing escalating losses in the aftermath of the financial crisis, standard insurance carriers increasingly shed certain risks, pushing more policies to the unregulated E&S market.  This dynamic helped spark a hard/bull market that really began to take hold in 2016, perfectly timed with Kinsale’s IPO and helping the company generate mid-teens returns on equity in its initial years as a public company.

And, when COVID hit, insurance companies became very concerned about the potential of spiraling losses, particularly around COVID-driven policy uncertainty (what would be covered by business interruption insurance, etc.).  This led to significant pricing actions and even stricter underwriting, which pushed more business from the standard/admitted market into the E&S market.  This increased demand turbocharged the E&S market, which experienced massive price increases over the past couple of years.  Combined with the worst case fears about COVID-related losses not materializing, Kinsale has seen rapid growth with the pricing falling to the bottom line, resulting in current returns on equity well north of 20%.

However, we think the COVID-driven extreme price increases have run their course and the six-year old hard market is about to turn.  First, on Chubb’s most recent (third quarter) earnings call, CEO Evan Greenberg predicted that the standard market would begin to take share back from the highly profitable E&S market.  We believe competition and E&S supply is quickly ramping up after years of outsized gains, while demand is likely poised to fall.  E&S clients are generally small businesses and 2023 will likely bring more new business deaths than births as the economy slows.  While it’s not yet in the numbers, recent calls we did with insurance brokers highlighted what appears to be a changing market.  Here are some select quotes:

• “I think we are fast approaching a soft market.”

• “I’d say late July / early August first saw some market softening.”

• “Could we be in a full-fledged soft market a year from now?  100% yes.”

As the market softens and more brand name insurers begin to go after Kinsale’s clients, we think Kinsale will start to feel a significant impact, likely driving return on equity back to mid-teens levels, if not ultimately lower.  As one broker told us, “No one wakes up and says ‘I need a Kinsale policy.’  If I am quoting Kinsale, I’ve surveyed everyone else… they are the last resort.”  After taking out a Kinsale policy, one client even told this broker “the minute you can pull Kinsale [for a new insurer], pull it.”

What We Think It’s Worth

We generously see Kinsale fair value at around $100 in just over one year (down roughly 67% from current prices), which corresponds to a still-pricy 3x book and ~16x our 2024 earnings.  This assumes the company still generates an 18% return on equity, above what we believe is a more normalized target range of 14% to 15%.  If the cycle really turns hard as industry capacity overwhelms cooling demand, profitability (and the stock) could head considerably lower.

Catalyst

Weakening E&S market conditions resulting in slower growth and lower profitability.