Description

BUY COMMON STOCK OF UNIVERSAL INSURANCE HOLDINGS:  UVE

• UVE trades at 5-6x earnings
• Fundamental business trends are positive
• Reasonably well defined range of outcomes
• Not an outstanding business, so not for the "coffee can portfolio"

UVE TRADES AT 5-6X EARNINGS 

Universal earned $0.84 (annualized $3.36) and $2.74 per share in the three and 12 months ended September 30, 2015.  

The P/E is 5-6x because a series of short sale presentations caused the share price to decline by ~45% from its high in October.  Business fundamentals are largely unchanged, so the P/E has re-rated from 13x to 5-6% while fundamentals have been either stable or improving.

Universal is a newish company without a long history of returns to supply context for current returns.  As discussed later, the current returns and earnings are above history and "normal" because today fundamentals are especially favorable.  

The two key drivers of returns and earnings for Universal are the company's two largest expenses:

1. cost of Florida property catastrophe reinsurance (30% of revenue), and
2. policyholder claims for residential property damage in Florida caused by catastrophic hurricanes (4% per hurricane).

FUNDAMENTAL BUSINESS TRENDS ARE POSITIVE 

Both key drivers of returns and earnings have been favorable recently.  

(1) Most importantly, the cost of Florida property catastrophe reinsurance has declined by 50% since its peak in 2006, and by 35-40% since 2012.  This is depicted in the following data reported by the broker JLT.

Oversupply of reinsurance is likely to keep Universal's largest cost in check.  A decline in the cost of reinsurance of 35-40% since 2011 (depicted above) contributed significantly to the improvement in Universal's ROE from ~15% to ~35% (also depicted above).

The decline in reinsurance rates was caused by overcapacity -- overcapacity that was exacerbated by the emergence of a new sort of reinsurance capital often referred to as "alternative" capital to distinguish it from "traditional" capital in regulated insurance companies.  The largest form of "alternative" capital is catastrophe bonds.  This emerging supply -- alternative capital -- now accounts for about 20% of total reinsurance capital.  A significant portion of this capital is supplied by sophisticated institutional investors and could be considered to be permanent.

Universal's reinsurance costs would need to increase by 50% to drive the return on equity down to ~10%.  At this point, EPS would be $0.90 (all else equal), a roughly 6% yield on the current price.

The trend in reinsurance costs for Universal is likely to remain favorable in 2016.  At the most recent annual contract renewal, around 6/1/2015, Florida property catastrophe reinsurance rates declined by 8.5% (for coverage from 6/1/2015 through 5/31/2016).  This was the fourth year in a row that rates declined, although the 8.5% decline was a bit less than the decline in the prior years.  According to a recent analysis by Willis discussed in a January 19, 2016 press release, new supply continued to enter the non-life insurance-linked securities market during 2015.  Total capital increased from $65 billion at the end of 2014 to $70 billion at the end of 2015.

(2) Concurrently, ten years have passed since a major hurricane made landfall in Florida and caused significant policyholder loss claims for property insurers.  As a result, profitability for Universal's business has improved.  This is reflected in the net loss ratio for Universal depicted below for the past ten years.    

REASONABLY DEFINED RANGE OF OUTCOMES 

UVE seems like a good target for short sellers because hurricanes seem scary and inevitable, while the company's reinsurance contracts are complicated and difficult for a non-specialist to comprehend.  But a study of Universal's reinsurance contracts reveals that the range of outcomes for Universal is reasonably well defined in most scenarios.  This conclusion is supported by the fact that two reinsurers hold shareholdings in Universal.

• Nephila is an institutional investor and the largest investor in catastrophe bonds (a type of reinsurance).  The company's affiliate, Ananke Catastrophe Investments, purchased 1 million shares of UVE for $19.00 per share on December 2, 2014 (see press release 12/2/14).  In June of 2015, Universal repurchased 200,000 shares, suggesting that Nephila holds 800,000 shares of UVE currently.  
• RenaissanceRe is a public company that supplies reinsurance and is one of the savviest as pertains to Florida property catastrophe reinsurance. According to a 13-D dated May 23, 2013, RenRe bought 1.34 million shares.  It is reasonable to conclude that these reinsurers are well informed about Universal's reinsurance contracts.          

A positive outcome for UVE owners is continued favorable bargaining power for the company with reinsurers and no catastrophe losses.  This translates into a growing stream of EPS from a $3.36 annual run rate in 3Q15.  At recent prices, this offers an 20%+ earnings yield. 

A negative outcome would entail a reversal of recent favorable trends in reinsurance prices and in losses from Florida hurricanes.  The former would ensue if Universal's bargaining power with reinsurers eroded and the company was required to retain more exposure to losses from hurricanes that make landfall in Florida.  A 50% increase in the company's reinsurance costs, all else equal, would drive Universal's ROE from 35%+ to ~10% and EPS from $3.36 to $0.90.  This is before any catastrophe losses. Under the company's existing reinsurance contracts, each catastrophe could cause after tax losses of up to $0.55-0.60 per share.  So in a pretty bad scenario, if reinsurance rates increased by 50% and the company experienced three cats and $105m of cat losses, the loss per share would be $0.85 or ~10% of book value and ~6% of the current stock price.       

Even though the total cost of insured losses from hurricanes are unpredictable, Universal's exposure is relatively well defined.  

Universal's risk to loss claims from hurricanes that make landfall in Florida varies each year based on the reinsurance Universal purchases.  For the twelve months ending May 31, 2016, the company disclosed the details of its renisurance contracts in an 8-k on June 2, 2015.  Distilling the contract: Universal retains up to $35 million of loss claims per catastrophe.  Additional gross loss claims (up to $2.0 billion for an initial event) are obligations of Universal's reinsurers, the largest of which are Fairfax Financial's Odyssey Re subsidiary and Everest Re.

According to the company: "no single hurricane event in recorded history is projected to cause losses exceeding the limits of our 2015 reinsurance program.  Modeling performed using the RMS model, which has been declared accurate and reliable by the statutorily-created Florida Commission on Hurricane Loss Projection Methodology, shows that UVE's reinsurance program is sufficient to cover an event such as Category 5 Hurricane Andrew, Category 4 Great Fort Lauderdale Hurricane, or Category 3 Hurricane Wilma, among others. In fact, given its current financial position and reinsurance program, UVE would remain profitable even if Florida were to face three storms in one season on the scale of Hurricane Andrew, which was one of the most destructive hurricanes in U.S. history."  

In the company's 6/2/15 8-k filing, it stated that "recent catastrophe modeling indicates that a repeat of Hurricane Andrew would cause approximately $600,000,000 of loss to UPCIC." As the table below illustrates, Andrew is the second most damaging hurricane to make landfall in Florida since 1900.

One study of hurricanes affecting Florida (Malmstadt, Scheitlin, Elsner of FSU) found that during the 108 years between 1900 through 2007 (no hurricanes since then) there were 67 Florida hurricanes.  In 62 of the years there was no Florida hurricane, or about half the periods.  In nearly 30 of the years, there was one hurricane.  In 15% there were two.  And there were two years with three and one year with four.   

RISKS: NOT FOR THE COFFEE CAN PORTFOLIO 

Universal does not have a meaningful competitive advantage or outstanding management.  This is more of a cigar butt good for a few puffs than a stock to buy and hold forever.  The case made by the short sellers has some basis in fact.  These points mattered more when the P/E was 14x than they do with the stock at 5-6x. 

1. Universal's rate increases are subject to regulatory review and approval

The short sellers argued that national carriers reduced exposure to homeowners insurance in Florida because it has often been an inhospitable business environment. This is not totally untrue.  National carriers and their Florida only subsidiaries had around 65% share of the homeowner market ten years ago.  Governor Crist's administration was not accomodating to rate increases.  As a result, a not-for-profit government entity, Citizens Property Insurance Corporation, gained market share, in part because in May 2007, Florida passed legislation that froze property insurance rates for Citizens' customers. 

But rates started to recover in 2010 and Citizens has reduced its influence, both factors combined to provide an opportunity for Florida specialist companies like Universal to grow and to gain share.  

2. Universal has gotten lucky because there have been no hurricanes in the past ten years

The frequency and severity of hurricanes is a key driver for Universal's returns and earnings and growth.  The study referenced above suggests there is a ~45% chance that Florida will be hit by at least one hurricane each year. Whatever data set one evaluates, it is clear that the past ten years have been benign.  This "hurricane drought" caused Universal's largest cost (Florida property catastrophe reinsurance) to decline by 45% from a peak in 2006.

3. Corporate governance is not best in class

As the shorts point out, the CEO has been well compensated and he has a record of rambunctious behavior.  Extravagent compensation tends to follow excellent results, such as the 30x increase in Universal's book value per share and the 25x increase in Universal's share price (since 2005).  And while disorderly conduct and battery are not qualities typically associated with excellence in underwriting, risk selection, or management, I have not seen any studies that show these qualities are correlated with poor underwriting or poor stock price performance.  Common sense does seem to dictate, however, that all else equal, one would prefer a CEO not to have an arrest record.   

Catalyst

Shorts get bored.  

Florida hurricane season does not begin until June 1, 2016.  So Universal is likely to report that it has earned roughly $2.50 of incremental earnings by then (roughly $0.85 for 4Q15, 1Q16, and 2Q16).  That is 14% of the current $16-17 share price.  And terms of the company's reinsurance contracts are unlikely to change meaningfully at the June 1, 2016 renewal.  So it is highly likely Universal earns another $0.45-0.50 in 2H16, another 3% of the current share price.