Description

Long HRTG

Thesis: Heritage is a cheap decent quality company in a defensive industry, trading well below P/B and peers. Benefits from higher rates (interest income). Biz still ~half Florida. After a brutal 2022, FL Reforms all done thx to Hurricane Ian, meanwhile policy pricing to remain favorable near term given competition has been decimated and larger players continue to reduce exposure. Multiple ways to win given HRTG is likely to re rate higher now that reforms are complete, and capital return (repurchases / div reinstated) looks increasingly likely by Q4 if 2023 goes halfway decent. Book value should also climb toward Adj BVPS as bonds come closer to maturity.

Valuation: At $3.50/share, HRTG trades at 0.7x BVPS ($5), well below its best Peer UVE at ~2.0x and HCI at closer to ~3x. Near term, HRTG should trade closer to ~$5/sh, represnting ~1.0x P/B, or ~0.7x P/Adj Book of $7/sh (ex-AOCI ie bond losses, which company doesn’t expect to sell). HRTG was run by very reputable founder until 2020 and likely has solid reserves. HRTG also seems open to strategic alternatives given depressed valuation. Mgmt recently cited the current Market cap of ~$90m and total debt ex leases of ~$129m, vs Stat surplus of ~$270m. Prior to COVID, transactions in the P&C averaged 1.5x P/B from 2016-2020 (which excludes Pure at 6.0x P/B). 

Only 2 obstacles remain now

1. Reinsurance –
   • After a brutal past few years Florida faces the hardest CAT mkt in +20yrs and harder than 2006-07 according to peer UIHC
     • This also opens up window for opportunity given multiple competitors have gone out of business or exited the HO market
   • 30-50% increases only applies to private market CAT portion of reinsurance (which is typically much less than 50% of tower)
     • HRTG deferred use of new Reinsurance to Assist Policyholders (RAP) program created by FL legislature in 2022
   • Insurers can also pass on excess reinsurance costs directly to consumers via separate rate hikes
2. Competition from state backed Citizens
   • Citizens' rates are cheaper than private market, and Citizens future rate hikes are limited by law to ~10-15% over the next few years
     • It will take several years for Citizens' competitive advantage on rates to fully go away but given Citizen’s policies are already >1.1m, its likely that the Gov and State legislators will increasingly look to limit growth and force more depopulation
     • Depopulation of Citizens could turn into industry tailwind given Citizens has massive ~15% share of the state's personal residential (ie homeowners) market (in terms of policycount), followed by State Farm at ~9% and UVE at ~8% (With no major national insurer above 4%).
       • If Citizens shed ~600-700k policies and returned to prior policycount sub 500k, this could represent a gain of ~30-60k policies for the next 10-20 largest competitors (smaller players less likely to have the capital to grow) 
         • This could represent ~20-30% growth HRTG vs their current ~170k personal residential policies  

Other Highlights

• HRTG is the 17th largest homeowners’ insurer nationwide per Bankrate, and operates in 16 states (Link)
• Florida is ~47% of Premium in force (TIV metric is misleading).
  • FL book is predominately homeowner (HO) aka personal residential.
  • HRTG also has some commercial residential exposure (~25% of total FL premium)
    • Note Commercial Resi focused companies seem to command higher multiple (UIHC at >2x P/B)
  • HRTG has top 10 market share in Florida, with ~3.4% of combined Personal & Commercial direct written premium, and ~2.5% of Homeowner  policies

• 2022 was a brutal year for FL P&C names with HRTG shares down nearly -70% for the year vs peers down -66%. This caps a brutal 7yr run for HRTG shares which ended 2022 down ~90% vs YE'2015 (as Fraud started to ramp in 2016)
  • Hurricane Ian was among the most costly weather disasters on record (ahead of Irma and behind only Katrina and Harvey). As a CAT 3 Ian was the strongest storm to hit FL since Michael (2018). 
    • Seems like most of the industry avoided real catastrophe here given a significant portion of the damage from Ian was deemed Flood not wind. 
    • The silver lining is that Ian was basically the kick in the ass needed to catalyze significant reforms, while also giving the industry a nice excuse to keep increasing rates 

• Florida Reforms done, but policy pricing remains high and likely continues to increase
  • Reforms corrected out of control fraud/litigation/abuse
    • Previously Florida accounted for 79% of all homeowners’ insurance lawsuits filed nationwide, and insurers operating in the state receive only 9% of all US homeowners’ insurance claims
      • 1 way attorney fees and 3P/AOB now banned. The impact of lawsuits from 1st parties also mitigated.
    • Industry chatter is that reforms expected to result in loss trends improving 25-40% (will take few years)
  • Average homeowners’ insurance policy annual cost > $4.2k vs $2.5k in 2020 (per Triple I) representing ~20%/yr over past 3 yrs
    • Commentary from both HRTG and peers seem to imply that rates will continue to increase near term
  • Irma litigation almost all gone, and other prior development remains tame
    • HRTG went thru private coverage on Irma, but only 50bp impact so far
  • Claim inflation stabilizing and Hurricane Ian ultimate loss estimates coming down for peers
    • Mgmt noted that Claims inflation is down recently, (still High single digits to low double digits), which is what other peers have also stated.
    • Peer HCI lowered their Ian Ultimate by 15% and peer UVE expects to see their Ian ultimate come lower over time.

• Reserves should be decent if not solid
  • HRTG has a pretty good track record on reserves
    • Company was run by very reputable founder until 2020 and thus should have pretty good reserves.
      • Note that Founder Bruce Lucas left to start ‘Slide’ a new FL HO insurer (ie strong vote of confidence in Florida market).
  • Efforts to limit growth during recent years when the industry was plagued by Fraud (AOB crisis and 1P fraud claims) likely high graded HRTG’s book and may also help them on securing reinsurance this year 

• Capital position Fine, leaves room for growth
  • Overall RBC was 330% at YE22 (vs 311% last year)
  • Gross Written Prem/Surplus looks like ~4.7x (vs 6x NAIC limit)
    • Surplus was $260m at Q3 per SNL financial, and given Q4 combined ratio of 96% its probably closer to $270m at YE’22
  • Given seasonality, HRTG should further build surplus/book value in H1’23 (assuming no extreme weather events elsewhere in US)
    • Assuming Surplus grows from $270m at YE’22 to ~$300m by Q2’23 and Gross written Prem increases 10%, the GWP/Surplus ratio stays ~4.7x

• Capital return likely once make it through 2023 storm season 
  • Dividend has been suspended last few Qs given trading below TBV ($3.19 at YE’22)
  • In terms of repurchases it wont take much to move needle here given current $90m market cap meanwhile net income could improve drastically if combined ratios return back to pre 2020 lvls (mid 90s)
    • Assuming Net earned premium increases ~10% YoY in 2023 (due to rate hikes) and combined ratio of ~96% (in-line w/Q4'22 lvls), this translates to annual Net Income of $30-40m 

• La Nina over --> good chance at favorable El Nino conditions developing
  • Unfavorable La Nina effect has finally disappeared after historic 3-pete, could lead to favorable El Nino conditions (creates windsheer which weighs on Atlantic/Caribbean storms development)
    • Note, Peak earnings for both the FL HO Industry and HRTG coincided with El Nino effect in ~2014-16 

• If Further reforms are needed it seems likely State will address
  • Gov DeSantis and FL legislature are currently looking to do more tort reform elsewhere in P&C (ie Auto, medical, etc)
  • State has $20b budget surplus, and is likely to continue to support industry if need be – FCHF and new RAP program

• Delta between Book value ($5) and Adj Book value ($7) should narrow over time  
  • Fixed income portfolio average credit rating is A+ with a duration of 3.2 years
    • YoY Decline in book due in 2022 due in part to $49m of net unrealized losses on the Company's available-for-sale fixed income securities portfolio
  • Mgmt stated that “We do not anticipate a need to sell the investments in advance of maturity. As such, we do expect the unrealized losses to roll as investments mature.”
    • Makes more sense to hold on to these given STAT accounting gives them greater credit toward capital ratios/surplus

Risks

• Reinsurance for 2023 storm season (renewal June 1) could limit growth and profitability if significantly higher than expected or less capacity available
• Another bad storm season (or unusual events elsewhere)
  • Note, Bad Hurricane Season likely kills even more competitors (see UIHC and FNHC, along with multiple non-public companies than went into receivership or were forced to merge in past few years)
• Inflation on claims and/or Litigation from prior storms (Irma, Michael, Ian) proves more costly than expected
• Competition (from Citizens or Large player re-enters FL Mkt)
  • Larger insurers such as PGR, ALL and AIG have either fully exited or significantly scaled down their exposure to FL homeowners market over the last ~20yrs. Seems unlikely that they show back up given storm losses have remain elevated and concerns around changing weather patterns due to Climate change.
• Lousy economy promotes more fraud (and Fraudsters are able to find new loophole to exploit)

Note: HRTG has not yet filed their 10k. Both Surplus and FL Marketshare Statistics based on Q3'22 Data.

Catalyst

• Better than expected reinsurance renewal
• Growth (either organically or via Citizens' takeouts)
• Re-rates to ~1.0x P/B
• Capital return (seems more likely in H2/Q4 2023 once past storm season)
  • Dividend reinstated
  • Repurchases increased
• Acquisition target (current 0.7x P/B multiple well below historical takeout multiple for the sector pre COVID of~1.5x P/B from 2016-2020 ex-Pure)