Old Republic is a $2.1 billion market cap P&C insurer that trades at 59% of TBV and has a 8.7% dividend yield. The discount stems from its mortgage guaranty insurance (“MGI”) business which produces poor GAAP numbers but which is obscuring the positive results in the company’s other insurance subsidiaries. There is an unwarranted perception that the company will face a liquidity issue if the MGI business goes into receivership and that the dividend will be cut to shareholders. I believe these fears are misplaced.

History: The company had its beginnings in 1923 and has generally focused on commercial risks, particularly workers compensation and other specialty insurance coverage. Through acquisitions and starting new businesses, the company diversified over the years. ORI started providing insurance in 1956 to the trucking industry. In 1973, it began a de novo operation to write mortgage guaranty insurance. Old Republic acquired a title insurer in the late 1970’s. ORI acquired PMA in 2010 in an all stock deal. The company also writes some consumer credit and a tiny amount of life & health (travel & occupational accident insurance).

Earnings: The bulk of the earnings are driven by the investment portfolio, which is now at $10.5 billion. The run-rate for investment income is about $340 million/year, representing a pre-tax yield of 3.26%. Earnings have been hurt over the past five years by the MGI business. However, the rest of the business is performing fairly well.

The company does generate cash from its subsidiaries. ORI is a holding company that receives cash from its subsidiaries via dividends. The March 21, 2012 presentation announcing the spin-off includes Exhibit F on the last page that details net income, dividend paying capacity and actual dividend payments of the various insurance subsidiaries:

http://www.oldrepublic.com/financial_supp_stat_exhibit_032112.pdf

The important thing is that the parent can only provide capital to the subsidiaries. Put another way, the MGI losses do not drain cash from the parent and have only depleted the capital of the MGI subsidiaries. There is no recourse to ORI holding company.

Reserves: On p. 11 of the 2011 10-K, ORI provides its loss development triangle for its General Insurance Group. It shows how the company initially set up reserves and then how the reserves changed each year. The consistent reserve redundancies are a positive, showing that management knows the business and the importance if adequate pricing.

Management & Directors: The CoB and CEO is Aldo Zucaro, 73, who has held these positions since 1993 and 1990. He joined the company in 1976 as chief financial officer.

The board of directors has 11 members, with a median age of 71 years old and the youngest being 66. I have seen similar board demographics in small banks that are about to be sold.

Institutional Ownership: 84% of the company’s shares are held by institutions, including these significant holders:

• State Street – 10.8%
• Capital Research Global Investors – 7.0%
• Franklin Resources 6.6%
• Old Republic ESOP – 5.8%
• BlackRock 5.2%

There was another large investor, Tradewinds Global Investors, that owned 10.3% of shares as of the last proxy but has since reduced its holdings below 5.0%.

Mortgage Guaranty Insurance: Most of investor angst has been focused on the MGI business, which has cumulative losses over the past five years of $1.8 billion. Due to the extraordinary circumstances surrounding the housing bust during the financial crisis of 2009, regulators gave a temporary, two-year waiver of capital requirements so insurers could continue to write new MGI business in the hopes of replenishing capital. The waiver expired last year and rather than pour more capital into MGI like Genworth did, ORI decided to put its legacy MGI business into run-off.

Earlier this year, the North Carolina Department of Insurance (“NCDOI”) took over supervision of ORI’s MGI subsidiaries. The company announced its plans in March to spin off the MGI business as a separate entity, in the hopes of being able to then recapitalize the MGI subsidiaries. Recently, the company pulled the spin-off due to objections from key stakeholders. Investors had focused on the MGI spin-off because it would have “cleaned” up ORI’s problems and facilitated a sale. That would explain why the stock dropped after announcement.

An important investor concern is a covenant in the $550 million convertible notes that were issued in 2011 that makes the notes immediately due if one of ORI’s insurance subsidiaries goes into receivership. The company recently retired $316 million in notes that came due in May, so the concern is whether the company has the liquidity to meet the put back covenant on the convertible notes. Let’s first look at the receivership issue since it is the trigger for the notes.

Since the NCDOI is supervising the MGI subsidiaries, it will have input into whether or not receivership is used. When an insurer goes bankrupt, the state insurance department where the insurer is domiciled handles the bankruptcy. All states have insurance guaranty funds to help pay claims of bankrupt insurer but none of them cover MGI (nor do they cover financial guaranty insurance). Therefore, any receivership of the MGI subsidiaries would have to be processed through a state bankruptcy court.

A receivership would clog the state courts with thousands of claimants, the existing ORI employees handling the business would be fired and then become eligible to collect state unemployment benefits, the state would then have to hire lots of consultants and lawyers to handle the receivership and all insurance contracts would become void, thus ending any and all future premium payments on those contracts. The NCDOI has no incentive for receivership, particularly since most of the mortgage guaranty insurers for Genworth and United Guaranty are also domiciled in North Carolina, and will only use it as a last resort. The aversion to receivership can be seen in the NCDOI’s creative deferred payment obligation plan that would pay 50% of claims and then use remaining 50% reserve as capital.

It is important to note that the current NCDOI supervision means that ORI retains ownership of the MGI subsidiaries. Thus, ORI would likely have advance notice of any receivership action. The one downside to the arrangement, and this is an assumption on my part, is that ORI continues to pay the overhead costs for its employees handling the MGI business. This would also explain the stakeholder, presumably the NCDOI, objection to the spin-off. Without the parent support, there would have been an increased likelihood of a bankruptcy. As the Tronox spin-off from Kerr-McGee shows, regulators do not like companies off loading their troubles via a spin-off that goes bankrupt very quickly.

What I see here is a handshake deal between ORI and the NCDOI. Neither side wants to see a bankruptcy. In return, there is no recourse to ORI and ORI is allowed to operate its other insurance subsidiaries normally. The NCDOI is willing to let the MGI subsidiaries wither on the vine so long as ORI pays the bill instead of the state. I have no idea what the overhead costs are for the MGI subsidiaries, but if it were $20 million per year, it would be better to pay that for 10 years as an expense versus making a $200 million capital contribution today that goes into a black hole and is never seen again.

Let us now examine the liquidity issue. First, if I were a note holder, I’d be happy that ORI was not putting another dime of capital into MGI because it leaves more money for me the debt holder. I would also be more than happy to waive the receivership covenant for, say, an extra 25 bps of interest. ORI should be able refinance the debt because the current debt-to-equity ratio is a modest 16%. The only real concern is if the MGI subsidiaries were placed into receivership within in a short time period. However, everyone wants to play kick the can down the road. Absent that, ORI will be able to meet its debt obligations and maintain its dividend.

Risks: Below are some of the key risks associated with ORI:

• AM Best may downgrade the ratings of individual insurance subsidiaries that could impact what business the company can write, particularly if the ratings were to fall below “A-.” Currently, all insurance subsidiaries are rated “A” or “A+.”
• The insurance industry is very competitive and cyclical.

Additional Information: This is the transcript from the company’s investor conference on June 26, 2012 explaining why the MGI spin-off would not occur:

http://seekingalpha.com/article/685431-old-republic-international-s-ceo-discuss-the-decision-to-withdraw-the-spin-off-of-its-rfig-subsidiary-s-stock-to-ori-shareholders-conference-transcript