Description

The target security of this report is issued out of the subsidiary White Mountains RE.

The White Mountains Re segment consists of White Mountains Re Ltd., an exempted Bermuda limited liability company, and its subsidiaries. White Mountains Re offers reinsurance capacity for property, casualty, accident & health, agriculture, aviation and space, and certain other exposures on a worldwide basis.

Detail on WTM Re classes of business: Property Casualty Excess 22%, Other Porperty 30%, Casualty 10%, Accident&Health 20%, Agriculture 2%, Aviation 6%, other 9%.

Long position on: White Mountains Re Preference Shares is a $250 million Fixed/Floating Perpetual non-Cumulative Preference Shares, paid semi-annually. The Fixed Rate period will pay 7.506% until June 30, 2017, when the Floating Rate Period begins, after which, the coupon paid will be the greater of i) three month Libor + 320 bps and ii) 7.506%.

• Solvency:
  • Assets / Investment portfolio:
    • Strong franchise and excellent mgmt team: WTM senior management team have worked with Berkshire Hathaway and has maintained close relationship with Berkshire, being a partner in one of their subs called Symetra.
    • Asset Profile: Most of the assets are in fixed-income 65%, with most of t being AAA or investment grade securities.
    • Liquidity: White Mountains as a whole company, not just the White Mountains Re has had a focus on having a high part of the portfolio in cash and liquid assets, and taking the whole portfolio to have low duration. 19% of the portfolio is in short-term investments.
    • Stress Test / Capital Cushion: The total statutory capital is $4.8bn for the whole company, while for WTM Re total statutory capital is $2.8bn. The total market cap is ~2.7bn as of Sep 2010. In all stress-test analysis of write-downs for the different portfolio asset classes, the equity / stat capital was enough to support any losses.
  • Liability drivers:
    • Loss ratio / Reserving history: In peak loss years, like the years impacted by Katrina and other major cats reserves were not enough to cover losses, but in quiet years like 2008, the company had significant reserve releases. We see this as the common industry standard and the company has been profitable in the long-term.
    • Pricing: The uses models and through industry channel check, we understand the company has not been aggressive in underwriting at the WTM Re subsidiary.
• Major Catastrophe exposure: The Company has a diversified book and no unusual exposure to any single market.
• Coupon deferral: Although coupons are deferrable, the company should not defer any coupon because:
  • Impact on ability to raise money: It will be unlikely for the company to be able to raise capital in the future if they give that hit to investors.
  • Negative business impact: With the company in need of deferring a coupon, the message sent to clients is that the company is in high need of cash and can trigger a cycle of policy cancelations.
• Macro-economic risks - Long term inflation scenarios:
  • Inflation: The variable coupon protects against long term inflation, because it goes floating in 2017.
  • Deflation: Unlike most hybrid securities which just go floating at a certain point in time, this security has a floor of 7.506%, so in a deflationary (or low inflation) scenario, this hybrid would offer a very good yield. In case this hybrid is costly, the company can always buy back the securities, which would also be a positive catalyst for the investment at current prices.

• Equity like returns: Still in the high 70', has not caught up with other hybrids. At 79% of face, we believe this hybrid could be taken out at Par (21 points upside)or trade 10-15 points higher when it starts trading with fundamentals (based on current yield analysis), not just the risk-off trade we see going on now.
  • Volatility: While we find equity like returns, the volatility of this asset is much lower than the equity
• High cash yield: The current cash yield is ~10%. While the investor waits for the potential upside, they get paid 10% per year. Also, just as an investment comparables show that these hybrids pay 100-250bps more.
• Other Hybrids: Other hybrids trade at 100-250 bps tighter (XL, PRE, RE, AXS).
• Buyback / Retirement upside:
  • Regulatory purposes: The Basel III regulation and other regulations being discussed in the past year, are questioning the hybrids as an asset class and already banks have been retiring some of their hybrids. We believe that for insurance companies the same will happen and these securities may be retired in the near coming period.
  • Issuer's motivation:
    • Shareholder value creation: Buying these highly discounted securities will generate value to the stockholder since the amount of cash used to buy these back is much lower than the book value of the debt, thus accretive to shareholder. We also analyze the possibility of doing the trade for the hybrids with securities other than cash, but it does not make much sense:
      • Exchange hybrids into equity: Low stock prices make the dilutive aspect of these trades unattractive, and as such stronger companies whose equity have outperformed are likely the best candidates outside the bank space, particularly if the hybrid securities have replacement capital covenants.
      • Exchange hybrid into senior unsecured debt: This transaction does not require cash and does not result in stock dilution. However, replacing capital with debt increases leverage and will be unattractive for highly leveraged institutions.
    • Rating benefit: Depending on the price paid to retire the debt, solvency ratios can be positively affected and thus more accretive to all stakeholders.
    • Interest payment: the decrease in debt improves liquidity since the company won't have to pay the interest, which is very appropriate given the current capital markets situation.
    • Book Value of Equity - Positive: The gain on the bond buyback will increase book value by the after tax amount of the gain.
    • ROE - Near term Positive: The gain generated with the bond buyback will increase earnings and thus ROE. However this is a one-time gain and although positive in the short-run, in the long run, as equity is larger, ROE impact is to the downside. ROA impact is alwys positive though, therefore net is a healthy impact. &
• Downside: In the 08/09 market crisis, prices went to mid-to-high 30%'s of par. Since mid 09, this asset has been trading in the 70-90% of par range. We see the 08/09 crisis as an outlier situation and do not believe that scenario will happen again. Therefore on a current yield comparable basis, we see a maximum downside of 9 points (trading to 70's) but for the long-run investor this is just part of the inherent liability of this asset.

Catalyst

• Catalyst: Two main catalysts. i) a market stability (risk-on trade) pushing results and bond prices up, or ii) a take out of securities, since even at a large premium to current prices it will generate value to the equity holder. This is the lower priced security in the capital structure and thus if retired, is the one to create the larger value to shareholder.  Furthermore with new regulation standards these securities may be retired in the near-term future. And while one waits for the catalyst, they get paid ~10% yield.