Value Investors Club / SEABRIGHT HOLDINGS INC (SBX)

Description

Seabright Insurance Holdings is a specialty work comp insurance carrier trading at 49% of tangible book value (TBV). They surprised the market in August by adding $30.6 million (pretax) to reserves for prior year development, which spooked investors. The stock has been falling since and has reached a point where the valuation will be compelling to a buyer.

History: SeaBright was formed in 2003 when Kemper went into run-off. A group of Kemper executives who were running the specialty work comp business paired up with a private equity firm, Summit Capital, to form SBX. (Summit sold most of their stock in 2006.) They bought a shell company, which had some legacy claims, and also bought the renewal rights and operations of the specialty work comp business. This allowed them to hit the ground running.

Niche Market: SBX targets the non-traditional, hard-to-insure blue-collar work comp insurance markets. They focus on five segments:

1. Maritime - Covers workers at sea, often referred to as "F Class" because it is governed by Federal jurisdictions.

2. Alternative Dispute Resolution (ADR) - Typically trade unions involved in construction.

3. Construction Wrap-Up - This covers one company doing multiple projects or multiple companies (owner, contractors, subcontractors, etc) on a single project.

4. Energy - This covers oil, gas and alternative energy industries.

5. Alternative Markets - This is program business with selected managing general underwriters.

From a June 2010 presentation, the business by customer mix as of 3/31/10 was:

State Act         64%
Maritime          21%
ADR                15%

The distribution by industry was as follows as of 3/31/10:

Construction                48%
Services                      15%
Manufacturing             11%

Energy & Mining 7%

Agriculture 5%
Other 5%

Distribution by top 5 states based on direct earned premium as of 6/30/10:

CA 46.4%

LA 9.1%

IL 5.5%

AK 5.4%

TX 5.1%

Reading the above lists helps to explain why SBX is cheap because they were insuring booming industries that are now in down turn. Work comp insurance is tied to economic activity because no matter what industry is covered, all rates are multiplied by payroll. However, I think investors over-reacted because there are some mitigating factors to consider. First, as long as they break even on underwriting, they will continue to collect from a $667 million investment portfolio. Work comp is a long-tail line of business, with the average claim taking about five years to settle. This is in line with their focus on high risk insureds. SBX should be able to generate net investment income before taxes of $1.00 to $1.15/sh.

Premiums: Since California represents almost half their premiums, it is important to discuss what is going on there. The California Workers Compensation Insurance Rating Bureau (WCIRB), which provides advisory loss costs for the industry, has proposed a 29.6% increase to pure premiums effective 1/1/11. This follows the rejection of last year's proposed rate increase of 22.8%, but which saw the preliminary combined ratio for accident year 2009 balloon to 122%. Commissioner Poizner is unlikely to approve such an increase prior to election day, which is November 2^nd this year. Poizner lost the Republican gubernatorial primary to Meg Whitman and is a lame duck. The commissioner's race is between Dave Jones (D) and Mike Villines (R). I can summarize the party differences as 'D' is for insureD interests and 'R' is for insureR interests. It is likely that the insurance commissioner's race will follow the governor's race, which is close at the moment.

I am not betting much on the WCIRB rate change but that does not mean that SBX premiums will be static. Some of the options available to SBX:

Submit their own rates changes. Most insurer work comp premiums are derived by applying a factor to a rating bureau's rates or loss costs. SBX can increase its bureau factors.
Experience Modifications. Most work comp policies over $10K include an experience modification factor that takes into account the actual claim experience by the insured over the past three years. However, I do not expect it to be a major influence because it is weighted more on frequency, which is down, and less on severity, which is up.
Schedule Modifications. There is some flexibility in how these are applied, so decreasing their use will increase premiums.
Rating Tiers. Most work comp insurers establish different rating tiers (preferred, standard, surcharged) and SBX can review or re-underwrite policies for rating-tier eligibility.

The result is that SBX has achieved the following overall rate increases: +8.3% in 3^rd Qtr 2009, +11.3% in 4^th Qtr 2009, +10.5% in 1^st Qtr 2010 and +12.8% in 2^nd Qtr 2010. The higher rates have helped to offset lower payrolls, allowing them to keep premiums levels flat. That may not sound like much of an accomplishment but given their business focus on high-risk, high-rate business, it is significant.

Management has been diversifying the distribution network. Their retail channel, direct brokers appointments, has been flat the past two years. These represent independent brokers who enter into contract with SBX to do business. They conduct wholesale brokering through their wholly-owned subsidiary, PointSure, which produces 19% of their direct written premium. This allows unappointed brokers to do business with SBX, without committing to a contract. Finally, they use managing general underwriters/agents to write program business. This is an area where they are seeing some growth in California, particularly in agriculture and aerospace.

Given that the ratio of premiums to statutory capital is about 80%, SBX does have the capacity to increase writings an additional 25% without jeopardizing their 'A-' rating from A.M. Best.

Unique Asset: SBX is attractive because it focuses one line of business, worker compensation, and because of its licensing footprint. They are licensed in all states to write workers comp, as well as the various Federal Acts for maritime. This would present a strategic opportunity to any commercial insurer looking to add workers comp or to expand. There are two driving forces behind this value. One is the high-cost of regulatory compliance and the other is the need to write in every state. Workers comp is probably the most regulated line of insurance, as every state requires insurers to report proof of coverage information, the collection of ratemaking data is more complex, and the claims process is regimented. Regulators strongly favor the employee, at the expense of insurers. On the states issue, employers are increasingly multi-state and need the ability to add required coverage in any state. That is why there are very few regional work comp insurers, and those that are, generally focus on small business. Starting from scratch to write workers comp is time and money consuming. Some may ask: What about the financial reform package passed this year that created the Federal Insurance Office? The FIO is an informational office and leaves regulation of insurance at the state level.

Investment Portfolio: SBX uses a registered investment advisor, Prime Advisors, which caters to insurance companies and has taken a conservative approach. The entire investment portfolio consists of fixed income securities and is valued as available for sale. The investment portfolio as of 6/30/10 was:

Investments as of 6/30/2010 (000) omitted	Cost	Gains	Losses	Fair Value	Carrying	% of Port.
Tax-exempt municipal securities	305,871	8,753	(293)	314,331	314,331	47%
Corporate securities	149,781	5,836	(62)	155,555	155,555	23%
Mortgage pass-through securities	59,515	3,449	0	62,964	62,964	9%
Asset-backed securities	58,448	1,721	0	60,169	60,169	9%
Collateralized mortgage obligations	26,214	388	(52)	26,550	26,550	4%
Government sponsored agency securities	24,135	1,258	0	25,393	25,393	4%
U.S. Treasury securities	21,202	785	0	21,987	21,987	3%
Total investment securities available for sale	645,166	22,190	(407)	666,949	666,949	100%

In total, the fair value of the fixed income portfolio was slightly above cost, which is impressive. 99% of the investment portfolio is rated "A-" or higher. 45% of the munis are insured. Pretax yield is 3.8% with duration of 4.8 years. One way to look at the investment portfolio is to compare the ratio of the investment portfolio to market cap for SBX and its peers:

Symbol	Market Cap	Portfolio	Ratio	TTM NWP	NWP/M.C.	Und. Lev.
EIHI*	100.4	202.2	201.4%	123.5	123.0%	82.1%
MIGP	115.7	410.4	354.7%	129.6	112.1%	75.5%
SBX*	172.2	669.9	389.0%	254.7	147.9%	72.0%
FMR	195.0	748.3	383.8%	227.3	116.6%	76.4%
ASI	175.9	778.6	442.6%	188.5	107.2%	62.0%
UVE	180.9	137.9	76.2%	175.9	97.2%	142.3%
HALL	177.9	405.7	229.8%	266.6	149.9%	115.3%
AMPH	221.6	248.0	228.0%	67.7	30.5%	40.6%
PMACA*	258.0	838.3	324.9%	407.3	157.9%	94.9%
AMSF*	353.7	751.6	212.5%	209.2	59.2%	66.1%
EIG*	667.9	2,012.3	301.3%	311.2	46.6%	34.5%

Since the fixed income portfolio generates most of the earnings, let's take a stab on what the investment income might look like in the future. Take the current portfolio of $667 million and assume a much lower 3.0% pre-tax return. The implied annual investment income before tax comes to $20 million or $0.91/sh. Since the portfolio is geared to lower taxes, assume a 15% tax bite and I estimate the after-tax investment income at $0.77/sh. Assume the current yield of 3.8% and I calculate after-tax investment income of $0.98/sh.

Underwriting Profit: From 2005 to 2009, the annual net combined ratio for SBX has been very good at 86.3%, 79.7%, 81.3%, 85.2% and 99.8%, respectively. There is an obvious trend line from 2006 to 2009 and the recent rate increases should help. SBX does not provide quarterly combined ratios in their Q's but from their investor presentations, the combined ratio rose from 101.1% in 1^st Qtr 2010 to 147.0% in 2^nd Qtr 2010.

Reserves: The obvious question is how good their reserves are after the big hit they took in 2^nd Quarter. First, I should note that from the conference call, the $30.6 million reserve addition was entirely incurred but not reported (IBNR) reserves, with no specific case reserve changes. That tells me that they are being pro-active in how they look at the data. If the amounts had been added to case reserves, I would be worried that they did not know what they were doing. I will ding management a little, however, because page 16 of the June 2010 Oppenheimer presentation showed a comparison by accident year of ultimate medical costs per indemnity claim for California. Below is a table summarizing the data for SBX and the industry, including the changes in the August investors' presentation:

AY Ultimate Medical Costs - California
Acc. Yr	SBX	SBX Rev.	Change	Industry
2006	19,300	20,600	6.7%	29,600
2007	19,300	22,000	14.0%	33,600
2008	22,000	24,900	13.2%	37,300
2009	20,700	24,300	17.4%	39,100
06 to 09	7.3%	18.0%		32.1%

SBX is essentially falling in line with everyone else, although at a better rate. Note that this is not unique to SBX or to CA. Work comp medical costs have been rising significantly over the past decade in all states. You can get a sense of it, and a whole lot more about the work comp industry, in the following presentation:

https://www.ncci.com/Documents/AIS-2010-SOL-Presentation.pdf

I do not see the reserve strengthening as an SBX-only problem or as a flaw in their underwriting.

Capital: Tangible book value is $15.87/sh and statutory capital is $298.9 million. There is one surplus note outstanding for $12 million. As I had indicated earlier, they have the capital to write more business, meaning they have excess capital.

Peers: There are very few pure work comp insurers that are publicly traded. Below is a comparison to similar sized P&C insurers, plus some work comp insurers:

Comparison to Peers
Symbol	Price	Shares	M/C	Equity	Intangibles	TBVPS	P/TBV	'11 EPS Est.	'11 P/E	'11 ROTE
EIHI*	$10.90	9.2		150.5	17.6	$14.44	75.5%	$0.77	14.2	5.3%
MIGP	$17.85	6.5		171.6	5.4	$25.65	69.6%	$2.18	8.2	8.5%
SBX*	$7.82	22.0		353.7	4.2	$15.87	49.3%	$0.56	14.0	3.5%
FMR	$10.98	17.8		297.4	25.5	$15.31	71.7%	$1.76	6.2	11.5%
ASI	$17.16	10.3		304.3	11.1	$28.60	60.0%	$2.15	8.0	7.5%
UVE	$4.62	39.2		123.6	0.0	$3.16	146.4%	$0.75	6.2	23.8%
HALL	$8.84	20.1		231.2	68.1	$8.11	109.1%	$0.98	9.0	12.1%
AMPH	$32.43	6.8		166.6	2.5	$24.00	135.1%	$2.83	11.5	11.8%
PMACA*	$7.54	34.2		429.2	29.3	$11.69	64.5%	$0.78	9.7	6.7%
AMSF*	$18.97	18.6		316.4	0.0	$16.97	111.8%	$2.14	8.9	12.6%
EIG*	$16.27	41.1		901.1	50.4	$20.72	78.5%	$1.38	11.8	6.7%

* primarily writes workers comp insurance

All Companies Median P/TBV: 75.1% Median P/E: 8.9

Work Comp Co's Median P/TBV: 75.5% Median P/E: 11.8

Based on the analysts' projections, SBX looks the worst. I think the $0.56/sh average estimate for SBX is low because that assumes almost a $0.40/sh, or about $9 million, loss from the insurance business. If they break-even on the underwriting side, they should earn around $0.95/sh. However, I am not going to focus too much on earnings, as that is not the catalyst.

Catalyst: SBX is trading as if it were impaired, which it is not. At the current P/TBV, I have to imagine that someone is kicking the tires on SBX because it is free money to the right buyer. A recent Reuters article penned the following:

"Insurers like SeaBright Insurance Holdings Inc (SBX.N), American Safety Insurance Holdings Ltd (ASI.N) and Infinity Property and Casualty Corp (IPCC.O) are on buyers' radar due to their niche areas of operation, strong balance sheets and compelling valuations, analysts say.

"Consolidation in P&C insurance is expected in light of continued soft premium pricing and a desire to maximize scale," said John Marra, a partner with PricewaterhouseCoopers Transaction Services.

Companies on the prowl are being choosy, focusing on specialty lines that generate better returns. Also, sellers are coming to terms over valuations, creating more room for M&A."

Source: http://www.reuters.com/article/idCASGE6660A220100802?rpc=44

With Old Republic's recent acquisition of PMA, SBX will be one of only four publicly traded insurers that focus on workers comp. Two are former mutuals that converted in the past four years: Employers Holding (EIG) and Eastern Insurance Holdings (EIHI). On the M&A side, here is where some recent deals have been valued:

- Employers Holding bought AmComp at 114% of TBV in 2008
- Tower Group bought Specialty Underwriters at 73% of TBV in 2009
- Fairfax bought Zenith National at 141% of TBV in 2010
- Old Republic bought PMA at 61% of TBV.
- Markel is buying privately held Aspen Holdings/FirstComp for $135 million. The insurance subsidiary has $53 million of statutory capital, $140 million in investments and had net written premium of $105 million in 2009. Aspen also owns two managing general agents and a wholesale operation. FirstComp has 9,300 retail agents appointed, which is significant, and may partially explain the premium being paid.

If SBX were bought out at the same TBV level as PMA, it would be worth $9.64/sh or 23% more. At the median price of all work comp insurers of 75.5%, that equates to $11.98/sh or 53% more. At a reasonable 80% of TBV, it would trade at $12.70 or 58% higher.

Links:

Earnings Transcript for 2^nd Qtr 2010:

http://seekingalpha.com/article/216874-seabright-holdings-inc-q2-2010-earnings-call-transcript?source=yahoo

August 16, 2010 Investor presentation:

http://files.shareholder.com/downloads/SEAB/985499034x0x395760/d2992d67-73b8-451a-8340-9129f9052838/Investor%20Presentation%208-9-10.pdf

Oppenheimer Presentation from June 2010:

http://files.shareholder.com/downloads/SEAB/985499034x0x380825/20501e88-a435-4970-b989-b2256be4f165/Investor%20Presentation%20Oppenheimer%206-8-10.pdf

KBW Presentation on Wednesday September 8, 2010:

http://www.kbw.com/news/conferenceInsurance2010.html

Catalyst

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			2010	2011
Price:	7.82	EPS	$0.00	$0.00
Shares Out. (in M):	22	P/E	0.0x	0.0x
Market Cap (in $M):	172	P/FCF	0.0x	0.0x
Net Debt (in $M):	12	EBIT	0	0
TEV (in $M):	0	TEV/EBIT	0.0x	0.0x