Investment Thesis

National General Holdings Corp (“NGHC”, “National General”, or “the Company”) is the #2 writer of non-standard auto in the United States supplemented by a book of other specialty, high-margin niche property casualty insurance products.  We think (a) secular tailwinds in the auto insurance market, (b) superior growth prospects, loss volatility, margins and capital deployment relative to competitors and (c) discounted valuation on both a book value and earnings basis relative to peers make NGHC an attractive long-term buy and hold for the next 12-24 months at current price levels.

Company Overview and History

National General is a specialty personal lines insurance holding company with a long operational history. The Company provides a variety of insurance products, including personal and small business automobile, homeowners, umbrella, recreational vehicle, motorcycle, lender-placed, supplemental health and other niche insurance products. The Company looks to underwrite profitability in attractive, underserved specialty niches where they can leverage core competencies of (a) data and analytics, (b) technology and (c) underwriting acumen which creates a technology-driven low-cost operational infrastructure.

National General was founded in 2009 by the Karfunkel family, the founders of American Stock Transfer & Trust Company, AmTrust Financial Services, Inc. (“AmTrust”) (NASDAQ: AFSI) and Maiden Holdings (“Maiden”) (NASDAQ: MHLD).  The Company was organized to acquire the private passenger auto business of Ally Financial’s (formerly General Motors Acceptance Corp or “GMAC”) property casualty insurance business.  The core GMAC business is over 75 years old. Since 2010, National General has primarily grown through 16 acquisitions of carriers and distribution, supplemented by organic growth in niche markets and fee income.

Key Value Drivers

Auto industry tailwinds

National General’s main product is auto insurance (62% of the P&C segment) and approximately two-thirds is non-standard auto, and the remainder is standard auto sold through their packaged auto and home business.  The non-standard auto market, for consumers with poor driving records, is not fully penetrated relative to the standard market by larger competitors.  Today, National General is the #2 non-standard auto writer nationally, behind Progressive.  We estimate they have a 4% share of an approximately $50 million market, which after Progressive and National General, is significantly fragmented.  Growth has been strong (25% LTM 3Q 2018 gross premiums written), and has room to run as fragmented, sub-scale non-standard auto writers will struggle to compete on price with scaled competition.  Auto insurance distribution continues to move towards a direct model, which will only accelerate this trend.

In addition to Company-specific tailwinds, we think the auto insurance industry currently is entering the most profitable period in its rate (pricing) cycle.  A prolonged soft market persisted until 2015 as safer cars provided a backdrop for a long-term decline in loss frequency.  In 2015-16, as newer cars were increasingly equipped with expensive technology (i.e. backup cameras and lane-assist in bumpers, etc.), accidents became significantly more expensive, increasing loss severity.  At the same time, oil prices declined to 10+ year lows in 1Q 2016, incentivizing more drivers onto roads and distracted driving (i.e. texting while driving) increased with the ubiquity of smartphones, both increasing loss frequency. 

As price increases since then have largely restored profitability to the industry, the ongoing hard-market rate cycle in auto insurance is likely to continue to provide runway for price increases.  The spread of price increases over loss cost inflation continues to show positive momentum in September 2018 at 2.0% according to CPI data.  If loss frequency continues to moderate and return to its long-term secular trend of decline (driven by safer cars), National General could be poised to benefit from better-than-average earnings over a multi-year period.  In its 2018 quarterly earnings calls, the Company has commented that they have observed loss frequency moderation year-to-date.

Niche product class focus supplemented by fee income

The remainder of National General’s portfolio is spread amongst niche products where they believe they have a competitive advantage by serving markets traditionally left behind by other carriers.  The majority is mass-affluent homeowners, which they entered in 2015 following dislocation in the market driven by industry consolidation.  Like non-standard auto, mass-affluent homeowners is often overlooked by larger carriers, who tend to focus on high-net worth homeowners policies, but represents approximately 75% of the $100+ billion homeowners market.  National General has shown the ability to capitalize on this opportunity, posting gross premium written growth of 29% over the last twelve months ended September 2018.

The Company’s A&H business (short-term medical and small group stop loss) was created organically following the passage of the Affordable Healthcare Act (“ACA”) in 2010.  The law spurred a meaningful increase in the use of short-term medical plans, which keep rates significantly lower than ACA plans.  The stop-loss product focuses on employers with 5-25 employees, an underserved and sizable market we estimate to be $60+ billion in premium.  The A&H segment’s gross premiums written have grown 23% over the last twelve months ended September 2018.

The market for short-term medical plans is a tailwind for the A&H business.  The Centers for Medicare & Medicaid Services (“CMS”) issued a final rule in August 2018 extending the length of time that a beneficiary can keep short-term health insurance from a 3-month plan to a 1-year plan with two 1-year renewal periods.  As a result of the 50 million Americans who do not receive health insurance through their employer, we think this market could expand by 3-4x.  National General is well-positioned for this growth, as they are the #2 largest short-term medical manufacturer behind UnitedHealth Group and own a top 3 independent medical distribution system.

Additionally, National General earns non-risk fee income from many sources.  Their A&H distribution is wholly-owned and places policies on behalf of third-parties they do not take on-balance sheet.  The Company also earns policy-servicing and other fees associated with its P&C business as well.  Since 2012, fee-related income has grown from $93 million to $553 million (43% CAGR) and only will increase as National General penetrates further into the markets described above. 

Underwriting discipline combined with scalable expense infrastructure

What really makes the growth and niche-market focus even more profitable to National General is their ability to find short-tail, low volatility loss markets and combine them with a disciplined and scalable expense base.  Since 2010, their gross premiums written have grown from ~$900mm to ~$4.4 billion (34% CAGR), but have posted an average combined ratio of 94.5% since 2011 and 93.4% since 2014.  Their technology platform, which was built in-house and owned by the company is a fixed cost.  The platform leverages one policy administrative system as well as one claims platform, a rarity in the technology-challenged insurance industry.  In-house developers rapidly integrate new acquisitions, driving expense efficiencies.  The system is flexibly constructed to add new products and allows for multiples of the volume it is currently handling today.  National General has begun to explore the deployment of some of its practices as SaaS to other insurers, and may present an opportunity to develop another fee income stream.

National General’s technology-driven operating platform should continue to provide a platform to scale premium growth without similar underwriting expense increases, creating additional free cash flow.

Low-volatility, short-tail lines of business reinsured against property cat events

National General benefits from writing short-tail business, meaning their policies and reserves are generally 6-12 months in duration.  Relatively to a longer-tail, workers’ compensation-focused business like AmTrust (which had reserve issues), National General has the ability to re-price the majority of its book in 6 months, and entirely in 12 months to correct against any reserving issues.

National General limits their earnings volatility by leveraging the quota-share reinsurance market.  The company cedes 15% of its net liability on its auto business and 42% of its net liability on its homeowners business through two separate quota-share agreements with Hannover Re.  These agreements limit the volatility on both lines of business by capping loss ratios and allowing for cession changes on a sliding scale.  The quota share agreements apply to in-force business and are in effect until 2019.  Furthermore, the quota share agreements provide capital support to National General’s business, as it increases operating leverage by reducing equity capital needed to underwrite the same premium volume on a gross basis.

National General also limits its exposure to property-related catastrophes in its auto and homeowners business.  Through their excess-of-loss treaty, from a single event, National General is exposed to the first $70 million in gross losses (58% net through the quota share), and the remainder flow to the reinsurance market, up to $575 million in total coverage.  A full retention event for National General, meaning that they experienced more than $70 million of gross losses from a single event, results in $40.6 million of net losses, and $32.1 million after tax (roughly a third of a full year of earnings, and no impact to capital metrics).  This excess-of-loss treaty program was also effective in 2017, as the many hurricane-related storms (Harvey, Irma, Jose, Maria) capped losses as earnings events for National General and did not impact their capital base. 

Capital deployment

National General has shown its ability to put free cash flow to work primarily through acquisition.  Their strategy is to buy companies with strong loss-related underwriting results but are operationally challenged (high expense ratios).  Once a company is acquired, National General rapidly integrates them into their technology platform to maximize expense synergies.  Executing this strategy, the Company has avoided price competition in auctions and limited premiums paid against their ability to extract above-average synergies.  Notable acquisitions include National Farmers’ Union for $45 million in 2018, Direct General for $162 million in 2016, QBE’s lender-placed business for $90 million in 2015, and certain lines of Assurant’s health business for $14 million in 2015.  We expect National General to continue executing their M&A strategy as their main capital deployment method, which has been historically effective and likely to support future growth.

National General also pays a $0.16 per share dividend.  The dividend, which represents an 8.25% payout ratio and 0.6% yield, is not a primary form of capital management and feels to us like a token amount.  Since 2013, the annual dividend has increased from $0.04 to $0.16, a 32% CAGR.  If National General continues to grow, and the pace of acquisitions slows, dividends may become a more meaningful contribution to capital management.

Additional upside is available if National General opts reduce its quota share, as evidenced by its equity follow-on announcement on November 13, to retain auto business currently ceded to third-party reinsurers if it deems it to be a profitable opportunity.  Managing its reinsurance profile presents another avenue to manage capital and free up additional capacity to write profitable business.

Financial performance vs. peers

National General compares favorably to its main business peers.  Primary peers are other personal lines companies with a focus on non-standard auto including Progressive (PGR), Allstate (ALL), Mercury (MCY), American National (ANAT) and Kemper (KMPR).  All of these names have relatively similar exposures to mass-market auto and homeowners, and MCY, ANAT and KMPR are of similar size.

Historical peer operating and returns comparison

1.       PGR:      93.4%

2.       ALL:        93.9%

3.       NGHC:  95.3%

4.       MCY:     99.9%

5.       ANAT:   100.0%

6.       KMPR:  100.1%

5-year Average loss ratio

1.       NGHC:  67.4%

2.       ALL:        68.3%

3.       ANAT:   68.7%

4.       PGR:      73.1%

5.       MCY:     73.6%

6.       KMPR:  75.3%

1.       NGHC:  44.8%

2.       PGR:      9.9%

3.       MCY:     4.4%

4.       ANAT:   3.9%

5.       ALL:        3.7%

6.       KMPR:  2.2%

5-year Book value per share CAGR

1.       NGHC:  12.3%

2.       PGR:      9.9%

3.       ANAT:   6.4%

4.       ALL:        6.3%

5.       KMPR:  2.1%

6.       MCY:     (1.0)%