Description

Kemper (KMPR) is an insurance holding company that primarily provides automotive insurance to customers across 28 states under the Kemper Auto brand, with nearly 90% of insurance premiums derived from California, Florida, and Texas. Kemper focuses on providing specialty, or “non-standard,” automotive insurance to underserved demographics who have difficulty obtaining standard insurance due to claims experiences, payment histories, or language barriers.

We believe Kemper shares represent a highly asymmetric investment opportunity from current levels. With a valuation of less than 1.4x book value, a significant discount to peers, we believe investors are far too pessimistic on Kemper’s future, largely extrapolating current trends into the future and ignoring the impact of its longer than industry average duration policies. In our view, however, as the company returns to profitable underwriting in the first half of 2024, meaningful growth in written policies and significant improvements in earnings and book value should follow in the second half of 2024, driving shares higher. Additionally, while our thesis is not dependent on it, transitioning the business to a reciprocal exchange structure – the first policies were written on the exchange in the third quarter – should lead to significant multiple expansion over time as the exchange structure reduces the capital intensity of the business, increases its tax efficiency, and significantly lowers its earnings volatility as revenue becomes increasingly fee based.

The automotive insurance cycle should inflect positively, driving a meaningful improvement in Kemper’s earnings profile. 

As pandemic-related restrictions were lifted in 2021, supply chain challenges and labor shortages created abrupt increases in used car prices and automotive repair costs, leading to dramatic cost inflation for automotive insurance companies. Making matters worse, as regulated entities, insurers face a lag between when adverse changes in loss frequency and severity, the drivers of cost inflation, are identified and when the required price increases to offset these impacts are approved, implemented, and earned in. This combination of heightened costs and little to no rate relief for an extended period led to one of the worst periods for automotive insurance companies in history as automotive insurance combined ratios rose dramatically, putting significant downward pressure on the margins, earnings, and book values of many operators. In Kemper’s case, EPS declined from $6.67 in 2020 to a loss of $1.82 in 2022. In response to these conditions, insurers like Kemper wisely restricted new policy growth, choosing to allow existing books to decline rather than pursue unprofitable business or chase market share.

While inflationary headwinds continue to weigh on many insurers, cost pressures have begun to abate as shortages of repair parts and labor at collision repair shops have been greatly reduced or eliminated and elevated used car prices have finally begun to stabilize and decline. At the same time, many insurers are finally beginning to implement price increases as the regulatory environment has become more accommodative, with many states recently approving price increases in excess of inflation in order to allow automotive insurance companies to restore profitability and continue serving their residents (e.g., in June 2023, the California Department of Insurance approved automotive insurance rate increases for Kemper of approximately 30%).

As a result, we believe the conditions are already in place for the automotive insurance industry to return to profitable underwriting and restart policy growth. This should, in turn, drive meaningful improvements in margins and earnings, which we believe will support higher equity values over time. Historical corollaries support this view, and we are already seeing early signs of positive traction from several companies in the industry this cycle:

• We believe the 2015–2017 automotive insurance cycle will prove highly analogous to the current cycle, with the industry able to address cost inflation by passing through price increases. In 2016, Allstate (ALL) had an underlying combined ratio of 96% and implemented rate increases, changed underwriting guidelines, and reduced costs to improve its combined ratio. By 2017, Allstate was able to return to a combined ratio of 91.5%. Kemper’s Alliance United subsidiary had an underlying combined ratio of 120.1% in 4Q15. Kemper filed for rate increases, onboarded additional claims staff, slowed new business growth, and took actions to improve risk selection and pricing, improving Alliance’s combined ratio to 94.7% in 2017. Kemper shares performed very well over this period, increasing 179% from the time of its disappointing 2015 full-year results through the end of 2017, significantly outperforming the 44% increase in the S&P 500 Index over the same timeframe.

• Recent updates from Kemper’s automotive insurance peers are supportive of our thesis on a pricing cycle driving improved profitability. Progressive’s (PGR) personal lines combined ratio has been on a downward trajectory since peaking in March 2023, with December 2023 monthly results showing the lowest underlying combined ratio (highest underwriting profitability) in several years. Mercury General (MCY), a peer of similar size focused primarily on California, Kemper’s largest market, reported 3Q23 results well above expectations with an underlying combined ratio below 100% for the first time since 3Q21, with management noting that results benefitted from moderating cost inflation. While peers have shown improvements in underwriting profitability more quickly, our research indicates that Kemper should see a similar trajectory in its combined ratio over the coming quarters as its longer than industry average duration policies reprice.

The market underappreciates Kemper’s growth potential in a normalized environment. 

As an important player in the specialty automotive insurance market with strong brand recognition, competing against large, unfocused insurers and less sophisticated subscale regional carriers, we believe Kemper can deliver outsized premium growth and attractive underwriting margins over time. This was clearly the case prior to and during the pandemic, when the company grew its specialty automotive insurance written premiums at a more than 30% CAGR from 2017 to 2022 (driven by a combination of organic and inorganic growth), significantly above the growth of its peers. We believe Kemper’s focus on niche markets where it can deploy its unique expertise and capabilities represents a sustainable competitive advantage. While management voluntarily pulled back on policy growth during a period in which new policies written at inadequate prices would have generated losses, we believe that growth will begin to meaningfully accelerate once the company has achieved an acceptable underlying combined ratio. We believe this happened in the fourth quarter. While policies may continue to decline over the next few quarters as a result of the slow removal of underwriting restrictions to ensure new policies are performing according to plan, we believe Kemper can exceed the peak policy count it achieved in mid-2021 over the next several years. This appears to be heavily discounted in consensus estimates which reflect muted policy and premium growth through 2027, as we believe recent policy count declines have been misunderstood as market share losses or structural issues. We believe these concerns are unfounded and that Kemper’s growth re-acceleration, something we expect to see beginning in the second half of 2024, should represent meaningful upside to current consensus expectations.

Transition to a reciprocal exchange model could drive meaningful valuation multiple expansion over time. 

In the third quarter of 2022, Kemper announced a plan to transition its business from a traditional stock insurer to a reciprocal exchange structure. Under this structure, the exchange, Kemper Reciprocal, writes the insurance policies sold to customers, while Kemper receives a management fee of up to 30% of the premiums paid to the exchange to service its operations, including underwriting policies, investing premiums, and processing claims. While this structure will take several years to fully implement as new policies written on the exchange increase in proportion to the overall business, the creation of a stable, fee-based revenue stream should greatly reduce Kemper’s earnings and cash flow volatility, while reducing capital requirements by more than 50% over time. In theory, this would then improve customer pricing competitiveness, which could drive an acceleration in policy growth. Not surprisingly, the market tends to reward these structures with meaningfully higher valuation multiples. For example, Erie Indemnity (ERIE), an insurance company with a reciprocal exchange structure that has been in operation since 1925, has traded at an average forward P/E multiple of 33x over the past five years, significantly higher than the broader property and casualty insurance sector trading closer to 13x. Importantly, while Kemper began writing new policies on the exchange in the third quarter of 2023, we have not embedded the transition to a reciprocal exchange structure into our assumptions given the uncertainty around the timing of the transition and the deployment of the capital freed up as business moves over to the exchange. That said, management plans to host a teach-in over the next few months to spotlight the transition, which could lead to additional investor focus on the opportunity in the near term.

Key risks

The past few years have taught us that trends in inflation are inherently uncertain. Higher than expected inflation across the automotive value chain could further pressure Kemper’s loss severity, causing existing approved price increases to prove inadequate. While we are encouraged by the recent trajectory of several key cost inputs and believe the company has embedded a margin of safety in its rate filings that have already been approved, unexpected increases in costs would put downward pressure on near-term results and liquidity and delay the margin and earnings recovery that we foresee. Management’s reserving practices could also prove to be inadequate, resulting in adverse reserve developments that pressure the company’s underlying combined ratio moving forward. While we believe this risk is limited given the short-tail nature of the business, we acknowledge that reserving is reliant on management’s best estimates, which could prove inaccurate.

Valuation

We believe Kemper can grow earnings and book value per share at an accelerated pace through 2027 as approved rate increases are earned in, underwriting profitability normalizes, and policy growth accelerates. On our above-consensus earnings estimates, we think shares can nearly double through the end of 2026 at conservative multiples of 11-12x forward EPS and 1.4x book value, modestly below the company’s historical average multiples prior to the COVID-19 pandemic. We believe this attractive return profile can be further supplemented, likely materially, by the transition to a reciprocal exchange model, which should result in multiple expansion over our investment horizon.

This report (the “Report”) with respect to Kemper Corporation (the “Issuer”) has been prepared by the author (the “Author”) for informational purposes only. The Report contains certain forward-looking statements and opinions which are based on the Author’s analysis of publicly available information believed to be accurate and reliable. While the Author believes that such forward-looking statements and opinions are reasonable, they are subject to unknown risks, uncertainties and other factors that could cause actual results to differ materially from those projected. The Author has no obligation to inform readers of changes in such forward-looking statements and opinions and no warranty is made with respect to the accuracy or completeness of any of the information set forth herein.

As of the date the Report is published, the Author and/or certain entities (the “Entities”) affiliated with the Author hold a long position in the securities of the Issuer and therefore have a financial interest based on changes in the price of the Issuer’s securities. The Entities may increase, decrease or otherwise change their position in the securities of the Issuer based on changes in market conditions or other analysis. Neither the Author nor the Entities undertake any responsibility to inform readers of changes in such position.

Nothing in this Report constitutes investment advice. Readers should conduct their own due diligence and research and make their own investment decisions.

Catalyst

Improvements in earnings and book value should follow in 2H'24