|Shares Out. (in M):||112||P/E||13.5||10.3|
|Market Cap (in $M):||2,836||P/FCF||n/m||n/m|
|Net Debt (in $M):||675||EBIT||287||379|
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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.
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
5- year Average combined ratio
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%
5-year Net premiums earned CAGR
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)%
5-year Average operating ROE
1. PGR: 12.9%
2. ALL: 12.5%
3. NGHC: 11.5%
4. MCY: 6.2%
5. ANAT: 4.8%
6. KMPR: 4.2%
Fundamental valuation metrics for insurance carriers are price-to-book value and price-to-earnings. RoE and price-to-book value regression analysis is a commonly-used technique as it captures the key relationship between higher returns (RoE) and value (P/BV).
At a closing price of $25.29, National General trades at a 27% discount to its 2019E RoE regression-implied valuation using business peers PGR, ALL, MCY, KMPR and other trading peers STFC, HMN, SAFT. Put simply, National General’s 16.5% projected 2019 RoE is only being given credit for a multiple of 1.68x, and if fairly valued, would trade at 2.29x, implying a market cap of $3.7 billion and a share price of $34.41. This significant runway does not include any premium to fair value the Company may trade for in the future, typical for operating outperformers like PGR in the auto industry, which only adds to upside.
On an earnings basis, the Company is also cheap, trading at only 9.4x 2019E earnings. The peer group trades at 15.3x 2019E earnings, which represents a 39% discount for National General’s current share price.
As discussed above, National General has posted very high premium growth rates (34% CAGR) and earnings (17.1% CAGR) since 2010. We doubt, however, these levels will persist for the longer term. While past line-of-business growth levels (20%+) are unlikely, we think their relatively low market share and limited competition gives plenty of room to run in their targeted markets. Also, their large pipeline of accretive M&A deals, and its scalable low-cost infrastructure will drive earnings.
We think a sustainable growth case for National General is 10% and 5% annual growth in premiums and earnings, respectively. 10% premium growth, takes into account a low-single digit growth rate for the auto and property book, and low to mid-teens for the A&H book. Discounted at 8% (a middle-of-the-road view of cost of capital for a personal lines carrier), yields a share price of $34.35. Today’s share price represents a 26% discount to this level, which is a reasonable margin of safety in a slower growth environment.
We think that earnings is a good proxy for cash flow here, as at YE 2017, National General is authorized by insurance regulators to pay $387 million in dividends to their unregulated holding company, against earnings of approximately $100 million. Should earnings outpace the statutory dividend restriction / prescribed risk-based capital level, an appropriate discount should be applied to the earnings to take into account the uncertainty of regulatory approval.
Given National General’s capital deployment preference for M&A, there are limited opportunities for capital return to common shareholders and we think our capital appreciation will be achieved through a combination of earnings growth and multiple re-rating, with a higher contribution from the latter.
Key Company-specific risks
Insider ownership (Karfunkel family) and AmTrust entanglements
The Karfunkel family continues to own a ~40% stake in National General. Until June 2017, AmTrust owned 10.9 million shares (~15% stake). As a result of the ownership structure, National General was deemed a “Controlled Company” by the SEC. In June 2017, AmTrust sold its 10.9 million shares and eliminated its ownership stake, which released National General’s “Controlled Company” designation.
The Karfunkel family is intimately involved in the operations of National General. Michael Karfunkel, the founder, was CEO until his death in 2016 and was replaced by his son, Barry, who has led the Company as CEO since then along with his brother Robert as President (both men are co-Chairmen of the Board). As a result of the family ownership, the stock has low float.
The issues that persisted at AmTrust throughout the 2016-17 time period were an overhang on the National General share price. Beginning in late 2016, AmTrust experienced a number of issues including reserve deficiencies, an accounting restatement, material weakness in financial controls and an SEC investigation into actuarial and accounting policies. National General’s share price was depressed by as much as 25% during this time period.
While AmTrust experienced the above control issues, at no point did National General experience similar issues and has taken steps to further distance itself from AmTrust. In 2017, NGHC appointed E&Y as its auditor (previously audited by AmTrust’s auditor, BDO). In September 2017, NGHC acquired the policy administration system for a purchase price of $200mm that it previously licensed from AmTrust. In November 2017, they added industry veteran Jay Nichols (retired Axis Re CEO) to board. Five of eight board members are now independent, and the audit, compensation and nominating and governance committees are entirely independent. In May 2018, NGHC appointed BlackRock to manage its investment portfolio (previously managed by AmTrust).
Furthermore, ongoing issues with AmTrust will be out of the press going forward, as a take-private transaction of AmTrust, led by the Karfunkel family and StonePoint Capital, is in process. The transaction was approved by shareholders in June and expected to close later in 2018.
However, entanglements still remain with AmTrust. Barry Zyskind (CEO of AmTrust), sits on the boards of both National General and AmTrust, as well as Maiden Holdings, AmTrust’s primary reinsurer and another Karfunkel family investment. National General and AmTrust have small, joint-venture investments in real estate and life settlements contracts that are accounted for as variable-interest entities on National General’s balance sheet. Finally, National General is party to a small reinsurance treaty (<$5 million – de minimus, in our opinion) with AmTrust and Maiden Holdings.
Wells Fargo litigation
National General was the primary insurer for Wells Fargo’s force-placed (collateral protection insurance or “CPI”) business. National General provided insurance to Wells Fargo in the event borrowers did not provide proof of insurance to Wells Fargo for physical damage against the collateral for loans Wells Fargo extended to the borrower, primarily for automobiles. At no point in the policy lifecycle did National General have any interaction with, or contractual relationship with, Wells Fargo’s underlying auto loan borrowers.
Wells Fargo has paid approximately $1.0 billion in fines to settle lawsuits from several state and federal regulators related to fees Wells Fargo passed through to its underlying auto loan borrowers after obtaining a CPI policy on that borrowers underlying collateral. National General has not paid any fines related to these suits.
There is also an ongoing class action “RICO” (Racketeer Influenced and Corrupt Organizations) lawsuit related to the same set of issues, of which National General was named as a defendant on 12 counts. 11 of them have dismissed. The remaining count is expected to be resolved in December 2018.
We think this issue poses minimal risk to National General since (a) they did not interact directly with any of the consumers and did not overcharge any customers and (b) 11 of the 12 counts against them have already been dismissed, and (c) they have not been fined by any regulatory organization or judiciary. Wells Fargo is no longer a force-placed customer of National General’s business.
Reinsurance market pricing
National General relies heavily on reinsurance to protect its results from volatility. Since 2011, reinsurance prices have steadily declined. Non-traditional forms of “alternative” capital outside of traditionally regulated reinsurance carriers have meaningfully increased supply and coupled with a benign weather environment in the 2011-2017 time period, pushed down prices. An across-the-board, large scale increase in reinsurance prices would be a significantly negative event to National General, increasing their expenses if they wished to remain at the same relatively levels of reserve volatility they enjoy today.
Alternative capital seems to be here to stay, as reinsurance prices seem to have reached an equilibrium in 2017-18 time period following major cat events in 2017-18 (Harvey, Irma, Jose, Maria and multiple instances of California wildfires). At inception, many experts thought alternative capital would head to the sidelines after major catastrophes, but the opposite appears to be the case, as prices remained relatively flat after events that historically would have significantly pushed prices upward.
Credit ratings and capital structure
Today, National General is rated A- (excellent) for Insurance Financial Strength by A.M. Best. Credit ratings are very important in the insurance industry as they give intermediaries the confidence to place business with an organization that is capable of paying future claims. Maintaining an A.M. Best rating is the bare minimum for active underwriting U.S. Insurance carriers. In addition to the Best rating, most others obtain investment-grade ratings from Moody’s and S&P, which have exhaustive financial strength and capital modeling criteria, to cement their reputation in the market, as well as avail themselves access to the capital markets, which generally require ratings from both Moody’s and S&P.
National General has opted to run the business with a single A.M. Best rating, and has used the private placement and retail subordinated notes markets to raise capital. For a public insurance company, both of these choices are unorthodox. Their use of quota share reinsurance (discussed above) also reduces the amount of equity required to write its current level of business (increasing RoE) and write at a higher gross operating leverage to peers (3.8x vs. 3.2x 5-year average peer median), but penalizes the Company in the agencies’ capital adequacy models, a large factor in the ultimate rating.
Some may view this as a negative, but we think National General’s strategy here has directly contributed to its growth story. The Company’s short-tail, low-volatility liabilities are inherently stable and less prone to pricing swings and reserve development. They also do not experience the same difficulty of writing business in the insurance market as longer-tailed lines would (like AmTrust) that do not have credit ratings from Moody’s and S&P and use a +/- 40% quota share.
As the Company continues to mature and adds to its capital base and scale (the largest ratings drivers), an investment grade rating is achievable in the medium term, which will allow them to refinance their current debt profile at more attractive cost of funds. Their recent follow-on offering is a step in the right direction here.
Although there isn’t a specific catalyst like a liquidation, spin-off, re-organization or other event that will realize value, it is hard to ignore such a large discrepancy relative to peers and intrinsic value.
We think secular and company tailwinds leading to continued growth over scalable expense base will create earnings growth, driving discounted valuation to peers on both a price-to-book and price-to-earnings basis to be re-rated over next 12-24 months as market re-evaluates National General as a “standalone” company.
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