Description

Kinsale is a relatively new Excess and Surplus line (“E&S”) midcap specialty insurer formed by a well-regarded management team out of James River.  It has generated mid-teen returns on equity at a time when most insurance peers struggle to breach high single digits. But Kinsale also has the most extreme overvaluation I have seen in nearly two decades of insurance investing, trading at nearly 7x book value versus most commercial insurance peers around 1.5x.

Insurance is ultimately a commoditized product.  Yes, there are better underwriters in better markets with better cost controls.  But insurance underwriting is not an asset-light software play with network effects, deep moats, etc… allowing theoretical hyper-profitable growth to the moon.  It is a capital intensive and replicable business which places mathematical limits on fair valuations.

Moreover, Kinsale writes long-tail casualty lines at a time when peers are reporting increasing problems for adverse development due to “social inflation”.  At this valuation Kinsale has zero margin for error to avoid a very precipitous fall.

Kinsale primarily writes smaller account E&S commercial insurance with concentrations in construction, small business, excess casualty, energy, and products liability.  

These are medium-long tail lines where claims occurrence stretch out over a decade:

Excess and Surplus lines are currently the “place to be” for insurance investors as these lines are seen as less commoditized, less regulated, and thus higher return.  This has been broadly true over the last few decades with loss ratios for E&S outperforming general P&C insurance by 4-5%. E&S is also seeing general price improvement as indicated by WR Berkley on their most recent earnings call.

Part of the excitement over KNSL has been that Kinsale offers pure-play exposure to E&S while even specialty peers are in the 30-60% range.  And Kinsale’s growth has been strong with a GPW CAGR of 16% from 2015-2017 accelerating to mid-30% in 2019 on the back of a capital raise. While KNSL still has by its estimates only around 1% market share, at some point there are diminishing returns to plucking low hanging fruit.  If it were easy to maintain long-term hyper-growth exclusively in high-return E&S business then everyone would be doing it. KNSL itself admits on its 3Q earnings call that “while we are growing at a very strong rate at the moment, investors should not expect that this extraordinary growth rate will continue forever. We don't know how long it will last. But the market moves in cycles, and at some point in the future, we expect to see a return to more normal growth rates.”

More importantly, it is easy to grow long-tail casualty lines.  Making a true profit on them is a different matter. While premiums and profits are recorded today, the true cost of selling long-tail insurance will not be known for many years.  Unfortunately for Kinsale, emerging trends are not in their favor. A phrase which has increasingly been appearing in casualty insurance results over the past several quarters is “social inflation” which refers to an increasingly plaintiff friendly legal environment.

• “There is definitely social inflation out there. And like I said, it goes in waves. We had that big spat of tort reform years ago and what's been happening since. Tort reform has been slowly but surely chipped away at, and you got other factors such as millennials and jury pools.” - Markel - Oct 30, 2019 Earnings Call

• “Over the course of this past year, our results were also impacted by headwinds from a challenging tort environment. Greg will comment on the impact in the current quarter, but I'll note that we continue to believe that social inflation is an environmental issue, driven primarily by a more aggressive plaintiffs' bar.” - Travellers - Jan 23, 2020 Earnings Call

• “With respect to our casualty and specialty reinsurance operations, these legal and social changes and their impact may not become apparent until some time after their occurrence. ... Our exposure to these uncertainties could be exacerbated by the increased willingness of some market participants to dispute insurance and reinsurance contract and policy wording and by social inflation trends, including increased litigation, expanded theories of liability and higher jury awards.” - Renaissance Re - Jan 7, 2020 Prospectus

• "Watford Holdings Ltd. announced that it expects to report a 2019 fourth quarter net loss primarily due to a strengthening of net loss reserves of approximately $28 million across the current and prior accident years. The loss reserve strengthening is in response to higher than projected reported losses in the quarter, mainly in U.S. casualty reinsurance, as well as known casualty exposures where losses are believed to have been incurred but, for the most part, have yet to be reported." - Watford Re Press Release, Jan 28, 2020

Kinsale’s nosebleed valuation leaves no room for social inflation pressure on its prior year reserve development.  Below is a table comparing Kinsale to a group of specialty insurance peers with significant E&S books:

There are a few takeaways from this comp table.  First, E&S players are not cheap as a whole. My very crude rule of thumb starting point for the fair value of a balance sheet financial company is that ROE/(P/B) should be around 10%.  At 2% this implies KNSL is around 5 times overvalued and should trade closer to 1.5x book or a price of $26. Even using this more rarified comp group, if KNSL traded to the peer mean (even after assuming it maintains an elevated ROE versus competitors)  it would be at 2.8x book value for a price of $49 versus today’s price of $115. If returns trended towards industry levels, as returns in any commoditized industry ultimately tend to do, then KNSL would trade around $40 or 65% lower.  And again, valuations around 2x book for 10% ROEs are, I believe, already expensive as a baseline.  

With any position one examines what could go right versus what could go wrong.  At current prices it is hard to see a scenario where fundamentals justify these valuations.  In a perfect world for Kinsale they continue to grow premiums at a rapid CAGR and they are able to do this in a world where competitors do not compete away margins even as Kinsale’s growing scale eats into their own premiums and profitability.  Imagine a world where Kinsale compounds book value by 14% (or 400bps above peers) a year for an entire decade before returns converge to peers and it trades to the current 2.3x P/B multiple of its comp group. Even in that theoretical case ideal case, book value a decade from now would be $65 and at 2.3x book would trade at $150 for a compound annual forward ten year return of 2.7%.  That seems like the very definition of priced for perfection. Indeed, a downward rerating seemed to be gaining steam when Kinsale reported merely inline 3Q19 earnings but the company’s subsequent inclusion into the S&P Smallcap 600 restored the stock’s upward momentum. Admittedly there is also the risk, as with any egregiously priced stock, that they are allowed to use their currency to make large secondary offerings or acquisitions.

Now consider what could go wrong.  If Kinsale sees even a hint of the averse development emerging across the overall casualty landscape then it will be punished.  If they run out of low hanging fruit as they grow and future growth is neither as abundant or profitable as in the past then it will be punished.  And at a valuation level higher than any insurance underwriter I can recall after twenty years of investing in the space, even a slight prick of the balloon could result in a violent downward rerating.  

Kinsale is not a terrible company.  But as value investors we must believe that valuation matters and today’s valuation is very wrong.

Catalyst

Adverse development hits reserving results

Returns normalize towards industry peers