Description

Recent market highs have pushed the “great companies at fair prices” narrative to extremes, with any above-average growth company at 30x earnings multiple labelled as compounder. But is it possible to join the “compounder-club-bro” without paying hefty prices? you get the chance to do just that with Protector Forsikring, a small Norwegian P&C insurer (Market cap 5.9B NOK) which has fallen out of investor’s favor over the past few months.

Protector gets the “compounder” title from its impressive 22.4% IRR since its Oslo IPO in May 2007. However, this IRR was much higher 3 years ago (~32%) as the share price has essentially been flat over that period (adjusted for dividends). With an historical average combined ratio of 92%, Protector was getting paid 8% a year to hold its costumers’ money; investing in this float has yielded another 7% per annum, while the entire pie has grown >20% per year. This is compounding at its best.

We believe Protector will be a multi-bagger from here over the next 5+ years. For this to come true, short-term underwriting issues will need to be proven transitory and Protector will need to strengthen its cost advantage to maintain rapid growth rates. This is far from guaranteed - but the risk/reward is highly favourable, valuation is attractive, management is well incentivized, and the business model has worked well over the past decade.  

Protector currently trades for 10.3x/8.5x P/E on 2019/2020 consensus estimates. That is very cheap and highly unusual in the current market for any company, let alone one which still grows top line 20% annually. There are legitimate questions regarding the sustainability of these estimates given that most of Protector’s earnings are investment gains coming from the managed float+equity. These tend to be very volatile and market-dependent, and hence hard to forecast. So like with any insurance company, what we wish to estimate are normalised CR, growth and investment returns. we can expect 2018 normalized earnings to look something like this:

NOK 3.5b of Net Written Premiums @ 95% Combined Ratio → NOK 175m

NOK 10b of AUM (82% fixed income and 18% equities) @4% return → NOK 400m

Interest expense of NOK 65m

=

510m Pre-tax earnings (NOK 5.9 pre-tax EPS), implying 11.7x pre-tax earnings.

Each of the assumptions embedded above is worthy of further discussion and it’s likely that 2018 earnings will in fact diverge significantly from this number. However, on a normalized basis I think they’re fairly conservative assumptions and illustrate the inexpensive valuation.  

Background

Based in Norway, but operates throughout Scandinavia and as well as the UK, Protector Forsikring tagged itself as “The Challenger” of the Scandinavian insurance industry. With a lean cost structure and internally built IT systems, the company was able to create a competitive advantage in the form of industry-leading cost ratio, despite significantly lower scale than comps. The company prides itself as the lowest cost-ratio insurer worldwide. We didn’t verify that claim - but the company certainly has a leading position among Scandinavian insurers, which as a group has cost leadership compared with most European peers.

Management likes to point out its internally developed IT systems as a major contributor to this lean cost structure, but we believe culture plays a bigger role here. Protector simply does more with less, and chooses its battles carefully. With a “build-it-right-from-start” approach, Protector has avoided the competitive spheres and concentrates its efforts on niches where management believes labour intensity is low and ROI is highest. The business model is based on serving the public sector, where Protector is already the industry leader in Norway and Sweden, and providing commercial insurance for medium and large companies (they also have a segment called Change of Ownership insurance, which is now a smaller part of the overall business). Interestingly, the company does not sell insurance directly and instead conducts business via brokers. This may surprise some who automatically drew an analogy to Geico or Admiral group, but Protector is a different breed and has developed by deploying its own strategy, rather than replicating someone else’s path.

Working solely with brokers arms the company the following abilities:

• Penetrate the public sector in new countries much quicker, putting its foot in the door for the commercial sector.
• Become the preferred insurer for most brokers (as unlike most insurance companies, they don’t compete with their own brokers).
• Keep operations lean and headcount low - concentrating recruitment to a small group of “all-stars”.

Below is a comparison of gross expenses ratio as presented by the company. I would note that by staying away from retail insurance, which is usually labor intensive and has lower claims ratio as a compensation, makes the comparison less precise:

Leveraging this cost advantage, Protector has been able to offer attractive prices, grow at very attractive rates, and handle claims swiftly. In an industry operating in a 85%-90% combined ratio, this means that even with aggressive pricing Protector can profitability underwrite most insurance products.

The company started operations in Norway in 2004, expended to Sweden in 2011 and Denmark in 2012. More recently, the company expanded to Finland and the UK in 2015-2016, where most of current growth is coming from. While the phenomenal growth in the UK increases geographical diversification, its main potential lies in scope. Just to get a sense of scale - Scandinavia has ~25m people and ~1T of GDP. UK alone has a population of 65m and a GDP of ~2.6T. The decision to choose the UK as the first expansion target outside Scandinavia wasn’t taken lightly. Management put in two years of research trying to figure out which adjacent markets are most attractive to new entrants in general, and which are most suitable to Protector’s strategy in particular. Protector entered the UK market in 2016 but only started growing aggressively last year. Over the next few years the UK is expected to be the fastest growing region for the company, and management believes that their relevant TAM in the country is as large as their current markets in Scandinavia combined (while sticking to their strategy of only targeting the public sector and commercial lines where they could relatively quickly take #1 or #2 spot). Below are some slides from the company’s 2017 capital markets day that go through the process behind the decision to enter the UK.

The following table presents Q1 gross written premiums by country and illustrates the drivers of recent growth.

Guidance for 2018 is 20% GWP growth, and management believes they can sustain 15%-20% growth for at least the medium-term (3-4 years). Over the next 10 years, the company plans to enter 3 new markets, and an internal process of identifying them is already on its way.

As you probably guessed by now, this rapid growth has also produced a growing float. Here as well Protector uses a differentiated approach compared to peers - managing its entire investment portfolio internally with a five-person team: an equity portfolio manager, fixed income portfolio manager and three analysts. Returns over the past decade have been well above benchmark indices. This is despite limited equity exposure (15%-20%), mainly due to regulatory constraints of solvency capital. The equities portfolio is concentrated - the two largest position currently account for 30% of the total equity exposure and in the past the team let their stake in NOFI grow well above 20% of the equity portfolio. Their bond portfolio has an average duration of 2.5y with rate duration of 0.29, probably as a result of holding floaters, thus creating a positive exposure to rising interest rates.

Relying on the three-legged stool of 1) lucrative insurance market 2) superior portfolio management and 3) rapid growth strategy has provided the company with a long runway. The table below presents that compounding in action.  

Why does the opportunity exists?

Despite its impressive run, public markets have never awarded Protector with premium valuation. Granted, investors have been cautious with a rapidly growing small insurer in an industry of giants. Moreover, the market generally has hard time appreciating companies with a competitive advantage in the form of “differentiated culture”. Protector has traded at a discount to the no-growth incumbents throughout its entire history, and trades at an even larger discount today, given market worries following a worse than expected quarterly report.

Relative valuation vs. publicly traded Scandinavian P&C insurers:

Protector share price is down 25% YTD on Q4 2017 and Q1 2018 earnings, which are worth expanding on. Protector has been guiding for many years now to a long-term combined ratio target of 92% (coupled with 15% GWP CAGR and 20% ROE). In Q4-17, Net CR came in at 101.5% (Q4 has seasonally higher CR, Q4-16 came in at 109.5%) - pushing net CR above guidance to 93.1% for the year. In accordance with this trend, 2018 guidance was for a slightly elevated CR of 92%-94%. However, as the company reported Q1 earnings in late April, reported net CR was 95.1% (Q1 has seasonally lower CR, Q1-17 was 87%) and guidance was revised to “higher than 94%” for 2018 - with no explanatory details. If that was not enough to scare off investors, on the earnings call CEO Sverre Bjerkeli informally walked back the 92% long-term guidance, saying that as long as Protector can grow 15%-20% per year and see opportunities to do so, he personally would settle for a higher CR to increase long-term earnings per share:

"A few percentage points lower margin than those of competitors on a volume that is twice, three times or four times as large in the future, it is obviously more profitable than to stand still at zero growth."

Given that 75% of Protectors’ earnings historically have come from investment gains, growing the float will indeed drive ROE more than growing the UW margins. It certainly spooked investors though, and even triggered negative and a sell-recommendation, based on claims that Protector should be modelled as an investment company with lower quality of future.  

Has underwriting quality been deteriorating?

This was the immediate question we asked following Q1 earnings. We had two potential issues in mind. First, that competition may be heating up, with willingness to sacrifice combined ratio points to gain market share. And second, that Protector may becoming an inferior underwriter and that UW quality has systemically deteriorated in recent years, and will continue down this route.   

The first scenario was our primary concern. Scandinavian insurers have been very disciplined for more than a decade now, with industry CR generally below 90%. Our thesis - that Protector will compound capital at high rates of return for many years – assumes UW profitability, and hence we keep alert to any hints of pricing pressures. However, our research concludes that comps. have generally remained as disciplined as ever. Gjensidige, If (#1 & #2 players) and Protector all reported weak Q1 in the commercial sector in Norway compared with last year, but Norway suffered its most severe Q1 winter since 2010, which may explain most of the claims increase. Admittedly, Tryg, another competitor, has mentioned several times in earning calls over the past year Protector’s price aggressiveness in the Norwegian commercial sector, but neither Tryg nor other big players have proactively with chasing market share, and Tryg’s management said that these pricing pressures had abated around summer of 2017, with Protector in particular turning more disciplined since then. Such statements echo Protector’s own guidance for flattish 2018 growth in Norway and with comments from Tryg, Gjensidige and Protector about taking rate increases in Q1-18:

Gjensidige Q1-18  Just to add, we had the Capital Markets Day back in 2014 and we talked about 1% to 2% claims inflation. What we are talking about today is 6%. It's lots of structural changes, electric cars, hybrid cars, leasing is a completely more dominant concept now compared to what we saw some few years behind us. We, as you heard, we will increase prices, with higher price increases going forward compared to what we have done. We are market leader. We will do this and actually we have said several times, profitability before market share. If this reduces volume a bit, we are prepared to take that as well. We think we have to increase prices to meet a completely new type of motor insurance market in Norway, with significantly higher claims inflation. And the signal is that we are in the mood of higher price increases going forward, with more [frequency] due to the new tariff system, more agile.”

Tryg signalling market stabilization after several years of rate pressure (Q2-17): “And secondly, I think, over the past 3 years, we have seen Protector be quite aggressive in Norway. And hopefully, that is coming down. That seems to be the case… The whole market starts to reprice after 3 years of rate reductions in high-end corporate Norway.”

Sverre Bjerkeli, Protector’s CEO (May 2018 interview): “Gross combined ratio has increased due to long-term price pressure in Norway, casualties, some errors in risk pricing on our part, and a little more winter. The trend will be offset by somewhat more aggressive price increases against certain customers and segments, that we continue with our good risk assessment work in Sweden as well as in other markets and that we further strengthen our position as quality and cost leader in the Nordic region. Here is our Swedish organization a model: they deliver both profitable growth and the highest quality in the Protector Group.”

To us these comments indicate that the industry isn’t engaging in a fight for market share. And to begin with, what Scandinavian insurers regard as a competitive environment is considered as very attractive anywhere else around the world.   

So Why is the industry not directly reacting to Protector? the following slides from a recent presentation by Sampo, which owns If Insurance and 47% of TopDanmark, provide the answer:

Despite a dominant position in niche segments (more than 50% market share in change-of-ownership in Norway and ~50% in Norway’s and Sweden’s public sectors), Protector is barely regarded as a challenger in the context of the broader P&C insurance market.

Note further that while an environment of increased interest rates might allow companies to raise CR targets and compete more aggressively, Protector’s bond portfolio more than compensates for such risk.

Protector’s self-indicted UW issues

If the Scandinavian market is not spiralling into irrational price wars, then the second potential scenario is that Protector is evolving into an incompetent underwriter. While an impressive 12-year record that would suggest otherwise, several recent instances are woth examining, as the combination of which has stirred the stock sideways while the market reached higher.

First, aggressive entry into Denmark in 2014-2015 pushed CR to a record high of 97% in 2016. Denmark’s insurance market is less oligopolistic than Sweden and Norway, and Protector is still having trouble turning the operations there profitable (although CR improved from 113.2% in 2016 to 108.9% in 2017). Specifically, workers’ compensation is where Protector sufferes the most - and it’s possible they will exit this line of business in 2019 if they can’t turn it profitable by then. In our view, management has handled the Denmark situation in a transparent and nimble manner, including replacing the country manager during 2017.

As the Denmark situation was stabilizing in 2017, Protector got hit from another angle. The UK subsidiary was the insurer of the Royal Borough of Kensington, owner of the Grenfell Tower where a fire broke on June 14 and resulted in 71 deaths. Protector’s estimation of gross claims was GBP 50m, out of which only GBP 2.5m should be covered from its own account and the rest by reinsurer Munich RE. However, it came out that there were some disagreements regarding part of the reinsurance contract, and there is still potential NOK 100m of liability (approx. GBP 9m) going to arbitration (final resolution expected by the end of Q3 2018). Protector maintains to have no additional liabilities beyond the GBP 2.5m already paid, a view supported by various legal opinions. However, we don’t have any insight on how this will resolve.

This brings us to Q1 2018 and the already discussed elevated CR in Norway. And so the question remains - is this just a sequence of bad luck or Protector becoming a serial screw-up? Our view is that it’s some of both. Growing an insurance business for over a decade at this pace requires some informed risk-taking. Fortunately, the cost advantage versus legacy insurance oligopoly is a sustainable advantage.  It enables both attractive pricing and efficient handling, leading to customer and broker satisfaction (ranked 1st in main regions). In addition to industry-leading cost ratio providing some cushion, the attractive Scandinavian market provides another one. I Probably wouldn’t want to put my chips on a similar company deploying a similar strategy in a market where competitors are willing to fight for the marginal client.

Sverre’s own answer to whether Protector’s underwriting ability has been impaired was this:  

“The question is that whether you'd kind of trust the underwriting competence in Protector after a poor quarter? In my opinion, you should, they are the same people who are on board, who has delivered brilliant profitability for 10 years. So it's like kind of a good [football] manager, isn't it. So brilliant for 5 years and suddenly he is totally stupid and you have to kick him out, that's not normally the situation.”

Sverre has put his money where is mouth is. In April last year he purchased 375,000 shares at a price of NOK 64.375, increasing his holding from 3.3% to 3.7%. Sverre also added the following statement to his purchase: "The family Bjerkeli "investment committee" (Mr and Mrs Bjerkeli) have unanimously decided to buy for the first time since 2008. No shares has been sold the last ten years. The family investment committee would also like to inform the market that exactly the same number of shares will be sold when the share price reaches NOK 100. You could call it an "Investment committee compromise" since Mr and Mrs Bjerkeli do have a different view on this matter."

While we can argue on the quality of his sense of humour, the purchase consideration of NOK 24m is equal to 90% of his total compensation over the last three years, and his total stake in the company is now worth NOK 217m, which we cautiously estimate to account to a considerable amount of his net worth. Also worth noting that more recently, other executives in the company made open-market purchases including the CIO, CFO and Deputy CEO. We feel that incentives are well aligned in this case, with management and board owning more than 16% of the company.

Summary

This thesis is fairly simple. A gradual return to a CR more aligned with industry peers, combined with continued growth at a 15% CAGR, and higher interest rates (pushing investment returns back to around 5%) should make Protector a multi-bagger over the next 4-5 years. As far as the downside goes, this investment isn’t without risks (discussed separately) but we think the chances for a blow-up in UW are slim given: (i) a diversified portfolio of mostly short-duration products; (ii) company culture and management’s track record, and (iii) results and commentary from peers.  

Risks

• Key Personnel Risk - CEO Sverre Bjerkeli is without a doubt a very important part of Protector’s culture and overall success. He also runs marathons, competes in iron man, extreme skier, etc. so without jinxing too much I’d just point out that the chances of anything happening to him are probably higher than the average CEO.

• Systematic deterioration of UW Quality  - as discussed
• UK & Finland Underlying Profitability - these are new markets for Protector and they are growing rapidly. While it’s still too early to tell how profitable they’d turn out to be, British insuraresinsurers are even less cost effective than Scandinavian dinasoursdinosaurs.
• Denmark Exit - Protector has been having hard time earning money in Denmark. Any decision to exit some of its lines of business there may be beneficial in the long term, but could also harm growth rates in the short term.
• Poor Investment Results

Catalyst

• Recent UW weakness proves transitory.
• Continued rapid growth of float.
• Satisfactory outcome of the Grenfell tower arbitration with reinsurer.