A sad page for the citizens in Florida during 2004-2005 where 7 hurricanes scrapped by the coast, devastating families, local economy, and insurers alike. After that, the economy of homeowner insurance had become so terrifying that Citizens Property Insurance Corporation – the state government-owned “insurer of last resort”, had to step in and capture 20% market share just so Florida citizens can be properly insured again.
But Citizen cannot take the hit of a major hurricane really, so it created these “take-out” programs where private insurers “take” the premium receivable and potential liability in bulk, free-of-charge. HCI Group (HCI) is one of such beneficiary – it had a pact with Citizens to receive 9 installments of policies between July 2007 and December 2012. As it stands now, HCI is liable for ~150-170k Homeowner insurances w/ ~$250 mm of run-rate revenue (or ~$130 / home / month).
And look at the chart below – As of today, it marks the 8th year in Florida without a hurricane.
I don’t pray for disasters – it’s a terrible thing; but unless the climate dynamics had changed so dramatically, a hurricane is deemed to hit Florida at some point. (In fact, past 150 year’s hurricane history suggests it’s ~50% chance of >1 hurricane happening in any given year).
All while HCI is raking in profits – with a lower ceded premium for reinsurance (some believe that the reinsurance they take has no reinstatement clause – i.e. no reinsurance if the 2nd hurricane his), leaner cost structure since it does not need to pay broker in sourcing insurance policies. The firm had been running on 60-70% combined for the past few years (and 55% last year given the benign season)
And HCI is trading at 3x BV (or less now as the market pulled back).
What’s more interesting is that a clearinghouse for homeowner insurance policies is being set up and starts running a week ago (Jan 27, 2014). Basically, now all participants of the clearinghouse (private insurers) can competitively bid on the policies that come through it and if the rate is cheaper than that of Citizens by 15%, the private insurer insures the policy.
All of these developments are negative for HCI’s current business model as a take-out insurer reliant on Citizens for policy generation:
• Citizens is going to have fewer policies.
• The policies Citizens continues to hold are going to be less attractive from a price-risk perspective.
• Citizens is going to have a materially reduced need for take-outs given it can now jettison policies to the private market as they renew via the clearinghouse. Furthermore, the competition for any incremental take-outs has increased substantially over the past 24 months with the inception of multiple new take-out focused carriers.
Thus, HCI and other insurers that were reliant on the take-out process for policy generation will now either:
• shrink;
• begin to bid on policies via the competitive clearinghouse process that will drive low pricing;
• develop a costly agency network either in Florida or elsewhere; and/or
• acquire other firms.
For HCI:
• is not currently priced into the stock.
• is going to driver much higher loss ratios via lower pricing per unit of risk and higher expense ratios through the commissions that will be paid to agents. Furthermore, HCI is not yet even a participant in the clearinghouse.
• for reasons similar to above– is going to generate higher combined ratios and lower returns.
• is not attractive at current market pricing. What target is going to take stock at an unsustainable 3.1x book value? What are the cash acquisition alternatives? An attractive target will sell for cash at a material premium to book value (thus lowering HCI book value and - rationally - also lowering HCI’s book value multiple). And, any target within PNC land is not going to generate 40%+ ROEs, which should also lower HCI multiples.
At this point, I think you see what I am trying to say. The 3 drivers for HCI stock are (1) BV accretion, (2) People’s faith in their continuous BV growth to justify 3x BV, and (3) lack of catastrophic event. Let me lay out a decision tree (# in the box is P/BV)
So for example, if there is no hurricane in 2014 (I assume 80% prob, which I think is high), earnings continue to hum and grow to $21 / share (unlikely given clearing-house competition), and people still believe in the story (assuming they are, which I think is unlikely as more people understand the story), the stock could trade as high as $63/share. But if hurricane or earnings crack, there is a good bit of downside to the stock. To put that valuation in context strong specialty insurers with defensible business models like Markel and WR Berkeley are priced ~ 1.2 to 1.5x book. For further context, in 1996, Buffett paid a premium to buy the remaining 100% of GEICO (he already owned 50%). GEICO is the arguably the best PNC company in the world with a sustainable cost advantage that has enabled it to grow market share from 2.5% at the time of the deal to 9.7% now, all the while generating an underwriting profit. Over the past 13 years, GEICO has grown materially while achieving a 93.6 average combined ratio. That’s simply unfathomable and without peer. The price Buffett paid, control premium included? 2.4x TBV – less than HCI now trades.
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