P&C Insurance – Fixed Income for Cheap

by JT McGee

Improving bond returns with insurance company investments.Insurance is the most boring industry on the planet, but also one of the most necessary industries on the planet. It’s a game of mathematics, and my favorite kind of insurance, property and casualty, is one of the most competitive but also the most simple.

Bring in X dollars, pay out X-Y dollars, and accumulate investments to buffer from years where the theory of large numbers doesn’t exactly work out to your advantage. How simple.

In terms of an investment, property and casualty insurance companies are just as boring as the business itself, and that’s why I like it. One of my favorite property and casualty firms is EMC Insurance Group Inc. (EMCI).

P&C on the cheap

One of the reasons I like this company over others in the P&C space is because it is disgustingly underpriced in terms of raw price-to-book value. At the end of last year, the company had a book value of just under $370 million, and a market cap of only $266 million. Price-to-book, then, is .71—so you’re getting $1 in assets for every $.71 you pay to acquire shares.

But what are these assets? They’re fixed income products!

This is one of the things that make P&C insurance so attractive. You can buy the companies inexpensively, essentially affording the opportunity to acquire $1 of Treasuries, MBS, and corporate debt for $.71. (There is a very small equity investment portfolio, but I largely ignore it because it is such a small percentage of the total portfolio.)

Looking back through their most recent annual report we can see exactly what it is that investors will own if they own a piece of EMCI:

Insurance companies may be equity investments, but they have exposure to the fixed income markets.

We could sit here and further break this apart, but there’s very little reason to do so. The most important numbers here are the effective bond maturity dates, which have averaged between 5-6 years per issue. Management reports that they are actively seeking to reduce their total exposure to low rates and the yield curve, and has indicated that they will look to balance out their exposure to rate hikes by the Fed.

Exposure

In all reality, EMCI is nothing more than a bond fund that sells for $.71 on the dollar. The company is in the business of insurance, which means it can and does sustain some losses. However, it also has reinsurance protection to provide for complete coverage of loss beyond $3 million per event. Thus, the clustering of its business in the Midwest doesn’t present any necessarily large risk to investors. Systemic risk is nonexistent, and I can dig it.

Recently, the company reported a 1Q loss, which is largely due to the catastrophic earthquake in Japan and bad weather in the Midwest. Of course, losses are limited on each to $3 million per event, and the company expects full year 2011 earnings of $1 per share, which is excellent when compared to its other reinsurance and insurance company peers.

I fully expect that this will be one of the worst years for EMCI, so to see that the company is still generating positive net income shows me that is company and its reinsurance plan is rock solid.

The company has very little exposure to the underwriting business. EMCI has ZERO employees! Read that again—zero employees! The company’s insurance is sold through a network of independent agents paid on commission, and the parent company—the parent company is another insurance pool that owns 61% of shares outstanding—does all the dirty work. This company is just a bond portfolio, nothing else.

Earnings power

Assuming that the horrible losses this year become routine then this company sells for a forward PE of 20, which would yield investors 5% per year.

Assuming that the losses this year aren’t routine—I don’t think they will be, though I’m no weatherman—we can look at past earnings, which produce a multiple of 12. A PE of 12 means you’re getting 8.33% internally and externally (dividend!) with exposure to a nearly-pure bond portfolio with six-year maturity dates. Where else do you get that kind of return on bonds of equal maturity? You don’t. That’s the benefit of buying an insurance company below book value! (The Guggenheim BulletShares 2017 Corporate Bond ETF (BSCH) ETF, which holds corporate debt maturing in 2017 yields roughly 3.6% per year.)

The yield curve for corporate debt provides opportunity in insurance company investments. You can reference bond rates by issuer, credit quality, and maturity date at Yahoo Finance’s Composite Bond Rate page. ValuBond provides the data, including the chart at right.

In the past three years, management has reduced the total number of shares outstanding by 850,000 shares, or 6% of the float. For management, buying back shares of the company makes far more sense than acquiring new fixed-income securities on the open market, since the company sells at such a large discount to book value. There’s still room for more than $1 million in share repurchases after the company authorized a $15 million, and a later $10 million round, of buybacks in 2008.

DRIP it like it’s hot

EMCI is a small cap stock owned 61% by the parent company. The result is that 39% of the float is publicly-traded, and institutional investors own 90% of that 39%. As you can see, liquidity is limited. However, this makes the company perfect for the individual investor.

EMCI has a direct purchase program through which investors can allow their $.76 in annual dividends (current yield of 3.7%) to be reinvested into more shares of the company. The direct purchase program allows for a maximum investment of $5000 per month, per person, which should fit into most portfolios.

This company makes up the bulk of my fixed-income exposure. While it may be an equity in that it is a publicly-traded company, it is really the purest form of a bond exchange-traded fund. Sure, it’s an insurance company, but its risks are limited to $3 million per event, which shields it from most every major risk.

Possible outcomes:

  • Company is bought out either by a competitor or the parent company. Investors would get a premium, and probably walk away with the book value + a small premium, providing for upside of 50%+.
  • Company continues doing its thing – Slow but sustained growth, investors would be rewarded with 8.33% annual returns (assuming no change in interest rates and a reversion to the mean in terms of earnings) for holding debt with an average maturity of 6.25 years. That’s awesome!

This company stands in contrast to my other small cap I’ve profiled, Adam’s Golf (ADGF). (See post about Adam’s Golf.) EMCI won’t turn heads, it probably won’t surprise on earnings, and it probably won’t be the world’s best performing stock in the next ten years. However, it will continue to be one of the world’s best bond investments, and that’s exactly why I like it. Never have I found a stock with a better risk-to-reward profile than the boring business that is EMC Insurance Group (EMCI).

My only complaint is that I wish they would drop the dividend to $0 and enact a share-buyback plan for the difference. Share buybacks, unlike dividend reinvestments, do not trigger capital gains taxation. Besides, such a move would shake the income investors who are bidding this stock up. Shake ‘em! I’ll take the internal compounding. 😉

The dividend also allows credit-worthy institutions to finance their EMCI holdings with inexpensive credit facilities on the short-end of the yield curve, cover their cost of carry with the cash dividend, and take home the share buybacks plus growth in book value as pure profit on other people’s money! What a bargain!

Full Disclosure: Currently long EMCI. I do not plan to add to this position in the next thirty days except for a routine additional investment through a long-term dividend reinvestment plan.

Photo by: Stevendepolo

{ 2 comments… read them below or add one }

Norman May 9, 2011 at 15:03

What effect would it have on EMCI’s stock price if interest rates start rising?

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JT McGee May 9, 2011 at 17:17

Hi Norman,

I thought I had edited that in there, but the annual report reflects a hypothetical decrease in shareholder equity of 15.55% on a 200 basis point increase in rates. A hypothetical 100bp rate hike would reduce shareholder equity by 8.99%.

Either way, this is more than priced in. Unfortunately, much of the callable securities the company owned were called after the financial crisis, as rates went to new historic lows. Rising rates would hurt book value, but would not affect interest income going forward. How that plays into Mr. Market’s price for the stock is anyone’s best guess. 😉

Over the next two quarters, we’ll be able to see in the form 10-Ks how this company decides to fund recent storm losses. My hope is that management realizes gains on the long-end of the yield curve, and keeps cash on the shorter-end.

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