Description

Brief Company Summary
United Insurance Holding Company (UIHC) is an insurance holding company that sources, underwrites, and bears risk for residential property-casualty policies. Its trade name is UPC Insurance. UIHC’s vision is to be the premier provider of catastrophe-exposed property Insurance. UIHC purchases significant amounts of reinsurance and despite insuring catastrophe (“CAT”) risk, UIHC has avoided losses in 13 of the last 14 years, including the severe 2004 – 2005 hurricane seasons. As of year-end 2012, the business is ~91% homeowners’ policies and 87% Florida by geography. Going forward, the focus will remain on homeowners with aggressive expansion targeted inside and outside of Florida.

Key Metrics
5/30/13 Market Cap: $103mm
3/31/13 Book Value: $95.7mm
30 day avg volume: ~54k shares
Dividend yield: 1.9%
2012 Net Income / EPS: $9.7mm / $0.91 (P/2012 EPS: 7.0x)

Operating Highlights
High ROE potential:  Management’s targets a high-teens ROE in non-CAT years and a mid-teens ROE in a CAT year. 2012 ROE was 16.1%, after incurring 3 points of CAT losses.

Strong Solvency position: 12/31/12 Risk Based Capital (“RBC”) was 471%; provides runway to execute on aggressive geographic expansion plans.

Top line growth: Net premiums earned have increased 82% over the last 2 years and, impressively, large growth in insured value has come amidst declining Probable Maximum Loss (“PML”) levels.

Investing Highlights
UIHC is operating in a very positive market environment, characterized by increasing rates, regulatory momentum, and declining reinsurance costs.

Recent legislation designed to pare the size of the state-owned competitor and largest market participant in Florida provides a unique opportunity for growth within Florida. Additionally, Florida reinsurance prices are declining significantly into the upcoming June 1 renewal season, which provides primary insurers such as UIHC with an outstanding opportunity to improve margin.

UIHC is a high growth, high return company with a valuation marginally above book value, making the risk-reward highly asymmetrical. Additionally, UIHC is trading at a greater than 50% valuation discount to its nearest Florida peers, which have each seen a greater than 60% stock price increase in the last 3 months alone. Despite an equity offering in December 2012, UIHC’s trading liquidity is still rather low and may be a factor for the discounted valuation and trading underperformance relative to peers.

Further increasing its attractiveness, UIHC’s business and returns are essentially uncorrelated with broader financial markets, providing portfolio diversification.

Financial Overview

UIHC has shown the ability to generate massive returns, earning $40mm in 2007 and $26mm in 2008. However, results were challenged in the 2009 - 2010 period due to broad market difficulties related to the Florida legislature’s revision of a wind mitigation credit discount policy (which reduced UIHC’s premiums by over 30%) and increasing reinsurance costs. Adding back foregone premiums as a result of the wind credit issue to 2010, UIHC’s only loss making year, would have resulted in a $22mm profit. Neither the wind credit issue nor reinsurance costs are currently an issue for UIHC today. ROEs have been above 15% in each of the last two years.

What Happens if a Catastrophe Occurs?

In 2012, UIHC reinsured up to a 1 in 100 probability loss amount (~$528mm in 2012) for a first event catastrophe; however, the first $15mm of losses are retained by UIHC. Given this relatively small amount of retained risk and UIHC’s ongoing income potential, UIHC is likely able to sustain a 1 in 100 year first event loss without having a meaningful impact on capital levels (first quarter of 2013 net income was $4.6mm alone). Management has discussed the ability to withstand another Hurricane Andrew without posing any threat whatsoever to the company’s solvency.

However, should a 1 in 100 CAT occur and damages exceed forecasts or an even lower probability (i.e., even larger CAT) occur, UIHC could be vulnerable given it has less than $100mm of shareholders equity. Also, should a second CAT occur, UIHC stands to lose another $5mm and is then exposed to any losses above ~$150mm. (Note these figures are for the 2012 reinsurance contract and coverage is very likely to be improved after the upcoming 2013 renewal)

In conclusion, UIHC purchases high levels of reinsurance to protect itself from CATs. However, there does remain the risk of an extremely low probability event causing significant damages. However, UIHC’s growth over time and the geographic diversification of its business outside of Florida should improve its ability to withstand such a tail risk along with improving overall investor perception.

UIHC also does the best job of its Florida peers in communicating its reinsurance program; feel free to look at recent investor presentations to see more complete information.

Reinsurance Cost Opportunity

Florida wind reinsurance contracts are renegotiated annually and this year is turning out to be a very soft market for reinsurers, which is very good for primary insurers such as UIHC. On the first quarter earnings call, management cited reinsurance prices per unit of risk could be down as much as 25% and UIHC expects to be at the better end of the range. This is a big deal. Reinsurance is UIHC’s largest cost of goods sold item, as 46% of 2012 gross premiums earned were ceded (paid) to reinsurers. Taking the 2012 income statement and reducing ceded premiums by 25% results in a huge increase in earnings power:

2012 Stats Unadjusted for Reinsurance Costs:
2012 Net Income: $9.7mm
2012 Return on ending equity: ~15% (adjusted to exclude equity added in December 2012 equity offering)

2012 Stats Pro Forma for 25% reduction in reinsurance costs:
2012 PF Net Income: $25.8mm (note that attaching a  10x P/E multiple would imply a ~$16 share price)
2012 PF Return on ending equity: ~32%

It is important to note that the actual financial impact of the reinsurance cost saving opportunity will be muted as management will likely reinvest per unit cost savings to purchase even more protection. However, in this case, the value should be retained in the form of a reduced risk profile. UIHC has historically proven a responsible steward of capital and management has reinforced that they are “thinking about the decade and not the year.”

Background / Context to Reinsurance Cost Opportunity

Over the last 6 months, investors have been increasingly drawn to the insurance linked securities (“ILS”) market (including the CAT bond market). As a result, institutional investors are offering protection to Florida wind risks at significantly lower cost than last year’s pricing. The result is that the ILS market is leading down pricing for reinsurers and this is a major reason why the Florida wind market reinsurance costs may be down as much as 25% for the upcoming renewal season.

Florida Market Opportunity

UIHC targets geographies where major carriers have receded from the market leaving the opportunity for significant profitability. Following Hurricane Andrew in 1992, Florida saw several large carriers leave the market. In response, the Florida legislature established a state-regulated insurer of last resort, which eventually became Citizens. By 1999, in an effort to reduce loss exposure related to Citizens, the legislature instituted a “take-out” program to encourage private insurers to assume policies from Citizens. UIHC was initially formed to capitalize on the unique growth opportunity. Today, despite Citizens “depopulation” efforts, mandating Citizens to create programs to help return Citizens policies to the private market, Citizens market share remains at ~29%, nearly 4x its nearest competitor. Citizens policy assumptions continue to provide opportunity for private players as over 75,000 policies have been assumed by private companies so far in 2013, including ~15,000 by UPC. Such bulk take-outs generally have low acquisition costs and allow for “cherry picking,” which provides a unique opportunity for private insurers to rapidly gain high-quality policies.

Recent Florida legislation is likely to further flesh out this opportunity. Senate Bill 1770, recently passed into law, includes further measures to shrink Citizens. The bill will lower Citizens’ maximum policy limit and, importantly, provides for a private market clearinghouse, to which all new or renewing Citizens policies will be routed, to be established by 2014. Any new applicants receiving an offer of private insurance coverage within 15 percent of Citizens rates will be ineligible for Citizens. Renewing Citizens policies will be ineligible for Citizens if a private company matches or bests the Citizens’ rate. The legislation effectively removes the current agent or consumer choice provision which has allowed customers to reject an offer of coverage from a private insurer in order to remain with Citizens. Together, these mandates should continue to support rapid premium growth and rate increases for private insurers as Citizens’ influence on the market wanes.

Significant Potential for ROE Enhancement

Assuming minimal investment return over the next year, UIHC’s ROE can be viewed as a factor of its combined ratio (underwriting margin) and its growth in premiums earned. Both have great potential to improve. First, on the margin side, there is a large improvement potential consisting of:

(a) 2 – 6 points of expense ratio improvement that can be achieved by spreading GOE over higher revenue (low-end) and continuing the first quarter of 2013’s expense ratio trend (high-end)
(b) 8 incremental margin points as a consequence of the flow-through of the 9.5% rate increase that UPC was approved for in Florida beginning on 2/1/2013
(c) a 4 – 15 point incremental margin improvement based on the reinsurance cost opportunity (low end assumes only partial year benefit and partial reinvestment of cost savings into acquiring greater coverage).

Second, on the growth side, significant growth can be achieved via:

(a) a continuation of the last two years’ growth rate (35% annual NPE growth)
(b) the reduction of premiums ceded to reinsurers (as result of the reinsurance cost opportunity) itself could result in up to an incremental ~25% NPE increase (to be offset depending on how much additional coverage is purchased in 2013).

As evidence of UIHC’s growth progress, note that the first quarter of 2013 featured more than 50% growth in NPE.

As a result of the many margin and growth levers that UIHC has available, it is easy to envision a range of potential ROEs that easily exceed the 15% achieved in the last two years and could also reasonably exceed 20%.

Discussion of Florida Peer Comparables

There exists two fairly similar peer comparables to UIHC. They are Universal Insurance Holdings Inc. (Ticker: UVE) and HCI Group, Inc. (Ticker: HCI). Both peers’ share prices have increased rapidly in the last few months (over 60% since 3/1/13). By comparison, UIHC has only increased ~20% during this time and is trading at a substantial valuation discount:

UIHC P/B excl AOCI: 1.1x
HCI P/B excl AOCI: 2.8x
UVE P/B excl AOCI: 1.7x

While UVE and HCI have out-earned UIHC in recent years, given that all firms are operating in a price competitive market for homeowners insurance, the valuation gap seems much too large. Examining the business models of the peers further suggests the valuation gap should be closed. HCI appears to have no agency / distribution capabilities of its own; its business model is entirely dependent upon acquiring policies from other insurers (e.g., take-outs from Citizens). Long-term this may pose an issue as policy assumption opportunities may eventually recede and companies are forced to rely upon more traditional distribution. Moving on to UVE, UVE seems to retain a relatively large amount of risk in the event of a catastrophe loss. Under its 2012 program, UVE appears to retain first event losses amounting to ~90% of its equity, compared to only ~16% for UIHC (see the reinsurance section of the 10-K filing for more detail. Also be aware that UVE’s 2013 coverage may improve). In this way, UIHC seems to have a much more conservative risk profile. Further, UIHC’s year-end solvency position as measured by its statutory RBC ratio is 471% compared with 339% for HCI and 342% for UVE. In conclusion, it appears that UIHC’s business profile and risk management may actually be superior to the peers to which it trades at a substantially discounted valuation.

Valuation

The ROE versus P/B framework likely remains the most important valuation methodology for P&C insurers. Plotting UIHC’s P/B (y axis) and ROE (x axis) against that of both its Florida peers and nationwide P&C peers reveals UIHC to be a notable outlier, trading well below the trendline and implying potential multiple expansion easily exceeding 50% in order to close the valuation discount.

Combining the opportunity for a rapid year-over-year increase in book value (mentioned in detail in the ROE enhancement section above) along with the large multiple expansion opportunity, a range of year-end 2013 valuations can be mapped. Assuming that UIHC is able to achieve a 15% ROE (very reasonable given the above ROE discussion) and achieve multiple expansion up to ~1.6x (still well less than both its Florida peers and below the ROE vs P/B regression trendline), the resultant stock price is in excess of $10.

In conclusion, it is reasonable that UIHC can grow its book value by 30-40% over the next two years and increase its multiple by in excess of 50%, providing over 100% return potential. The downside risk appears very limited as current trading levels are only 1.1x last reported book value and UIHC maintains significant reinsurance against large catastrophe losses.

 Stock Ownership and Insider Transactions

December Equity Offering Price Signaling:  In order to raise capital to fund its expansion plans, UIHC completed a ~$28 million equity offering in December 2012. As part of the offering, the selling shareholders who were former insiders of UIHC initially offered 1 million shares for sale. As the offering was marketed, the price declined from $6.03 (red herring) to $5.15 (final prospectus). In turn, the selling shareholders reduced their shares offered to only 300,000 shares. This price sensitivity seems to suggest the selling shareholders viewed a ~$6 price as their floor valuation and provides anecdotal support to limited downside from the current share price.

In January, the selling stockholders filed a registration to sell up to ~700,000 shares, the remainder of their original 1 million offered. The registration creates a potential overhang of 0.7mm shares – ~13x the stock’s 30-day average trading volume and ~6.5% of float. While there hasn’t been any noticeable escalation in trading volumes, it is unclear to me whether this overhang still exists or whether it could pose a headwind for the stock.

Bullish Insider Activity: The ~$28mm December 2012 equity offering included $5mm of Board and Management participation. Members of the Board made $1.5 million of further purchases on 3/1/2013. There has been no recent insider selling.

Strong Insider Ownership and Trends:  UIHC is ~28% owned by insiders, including 13% of shares owned by the Chairman of the Board, who purchased more shares as recently as 3/1/2013. Wellington and Heartland Advisors purchased $10 million of the $28 million December Offering and a number of other institutional investors also participated.

However, Wellington appears to have subsequently sold down a significant portion of its stake, reducing its holdings from 827,500 shares as of 12/31/12 to just 167,413 as of 3/31/13. Given that only ~5.15 million shares were traded in the entire first quarter, assuming the Wellington share disposition amounts are correct, Wellington would have sold ~13% of the entire first quarters’ trading volume. There is no fundamental reason apparent to me why Wellington would sell its shares so quickly after participating in the December equity offering. However, given it has already sold most of its position, the removal of Wellington as a large seller of the stock could remove significant downward trading pressure on the stock.

Compared to the Florida peers, UIHC is ~25% smaller than HCI and 50% smaller than UVE on a book value basis. However, UIHC’s last 30 day trading volumes are ~65% lower than HCI and ~85% lower than UVE. The lack of liquidity may be a reason why UIHC has not yet participated in the very large (>60%) stock price increases of these peers over the last few months.

Catalyst