By RH Analytics :
This is the second of a multi-part series of RH Analytics' short thesis on the HCI Group ( HCI ). In it, we outline why we believe the company's business model is deeply flawed and the stock significantly overvalued.
In our first piece on HCI , we provided an overview of the Florida homeowners insurance market and the context that gave rise to takeout companies such as HCI. We then compared HCI's business model to peers to illustrate how terms surrounding assumptions from Citizens combined with several company specific policies make HCI appear more profitable than the group. At the same time, the underlying economics of Citizens policies suggest that the takeout model is only marginally profitable under the best of business conditions.
In this piece, we focus on financial analysis of HCI's business model. We start by illustrating how assumptions impact the P&L. The transfer of policies and cash without associated cost structures or liabilities serve as de facto subsidies. Consequently, HCI appears very profitable for a short period following the assumption. However, the benefits of the assumption are temporary and the underlying economics of the policies surface in the absence of a transaction.
To illustrate the underlying economics of HCI's book, we examine company performance in the largely assumption free period from 4Q2010 to 3Q2011. Financial results at that time were characterized by churn, escalating costs and collapsing operating margins. During the same period, the statutory insurance company experienced deepening underwriting losses as HCI's unsubsidized book 'matured', causing rapid surplus erosion. Without subsidies, HCI's business model proved grim. The company's downward spiral was halted with the acquisition of the failed Homewise Insurance in 3Q11. HCI was effectively recapitalized with a massive transfer of $43.5M from Citizens in connection with the acquisition.
We generate pro-forma results for 2013 by normalizing reinsurance costs and applying a more appropriate loss ratio. The pro-forma results show that the business model is much less profitable than commonly supposed; they also suggest that a significant portion of the state subsidy is being redirected from the company toward HCI management in the form of compensation.
HCI's business model is becoming more problematic as time passes. Efforts to make the company appear more profitable have come at the cost of cash flow. HCI is an earnings rich, but cash flow poor company - yet another troubling sign lurking below the sheen of an impressive P&L.
The Florida homeowner's insurance market is not providing HCI and other takeout companies with a 'free lunch' of easy profits. Citizens subsidizes assumptions because the policies are mispriced relative to the risk of claims, something the industry has widely acknowledged. When the highly profitable subsidized period following assumptions end the underlying economics of the policies emerges. As we illustrate, excluding subsidies, HCI's underwriting model does not generate 29% pre-tax margins as it did in 2013; rather, as our pro-forma estimates indicate, we believe the natural pre-tax margin is closer to 2% even without a major catastropic event.
HCI's 40% ROE has been a key attraction for investors and a driver of the lofty 2.4x book valuation. However, ROE is set to decline dramatically. We believe that the company will not make an assumption in 2014. Consequently, policy churn, price declines and negative sticky operating expenses will cause returns to erode. We estimate that by 1Q15, ROE will wither from currently industry leading levels of to 7%-15%. Return erosion should continue as HCI's book ages and negative operating leverage begins to take a bigger bite of income.
The Real Oz
- The Financial Impact of a Takeout
Examining HCI's financial statements at the time of an assumption illuminates how the takeout reshapes the company's operating metrics. The table below shows summary financial around the 4Q12 policy assumption from Citizens.
HCI 4Q12 Assumption Analysis
Source: Company filings and estimates.
As indicated, both the number of policies and the total value of exposure grew approximately 50% on a quarter-over-quarter basis with the assumption. Gross premiums earned increased by 36% over the same period. Reinsurance costs were virtually unchanged despite the increase in exposure. As a result of flat reinsurance costs, the entire $18.9M increase in gross premiums flowed down to the net premium line, which grew 62% quarter-over-quarter. Losses expenses were up marginally quarter-over-quarter. However, operating expenses grew at a 24%, even though policy acquisition costs declined. This likely reflects higher compensation; for the full year 2012, increases in compensation accounted for 82% of the total increase in other expenses. Underwriting income grew $15.4M or 360% sequentially as $15.3M of the $19M increase in gross premiums flowed down to the pre-tax operating line.
Examining the expense lines as a percentage of gross premiums illustrates how the subsidies drove expense ratios down. Reinsurance ceded as a percentage of gross premiums declined from 42% in 3Q12 to 31% in 4Q12, reflecting the ability to carry the assumed exposure reinsurance free. Losses and LAE declined from 28% in 3Q12 to 22% and 19%, in 4Q12 and 1Q13, respectively as the assumption of liability-free premiums diluted the flat loss expense. Policy acquisition costs also decreased, as expected. The lower costs conveyed with the assumption allowed the total expense ratio to decline from 92% in 3Q12 to 73% and 61% in 4Q12 and 1Q13, respectively.
The result of the radically reduced cost structure is that operating income skyrocketed from 8% of gross premiums in 3Q12 to 27% in the following quarter. Similarly, cash flow from operations increased over 400% to $68.9M from $13.3M with the cash transfer of unearned premiums from Citizens.
The cash infusion is a key element of the state subsidy, in our view, and represents a substantial transfer of wealth from the state to HCI.
2. Performance without Assumptions - On the Road to Bankruptcy 2010/2011
HCI's yearly assumptions from 2011-2013 have allowed the company to maintain the inflated P&L of a subsidized takeout company. The realities of the underlying book are illuminated when a period without a significant assumption is reviewed.
In 2010 HCI assumed only 8,000 policies from Citizens in the fourth quarter. That represented fewer than 10% of the total policy count at the end of the year and did not impact the financial statements significantly. The high churn rate of the takeout business becomes very visible under the no assumption scenario.
High Churn Policy Base
Source: FlOIR and estimates.
Between 3Q10 and 3Q11, HCI lost 1,623 policies for a net decline of -2.8% despite the 8,031 policy assumption in 4Q10. Removing the assumption policies reveals the natural dynamics of the book. Total policies would have declined approximately 9,654, -16.4% during the period. HCI's financial performance began to erode along with the policy base.
The table below details HCI's GAAP financial performance with and without an assumption. The 2009 financial results reflect the profitability associated with a large takeout. The four quarter period from 4Q10 to 3Q11 reflects the longer-term, underlying economics of HCI's book of business and illustrates how the cost structure increases as the benefits of the assumption pass.
HCI GAAP Financial Results With and Without Assumptions
Source: Company filings and estimates.
Premiums ceded for reinsurance increased from 41% in 2009 to 49% in 1Q10 and an average of 46% over the entire period amid falling reinsurance prices. Reinsurance expenses from 4Q10-2Q11 reflect prices negotiated in 2Q10. The lower cost in 3Q11 reflects the prices of the 2011-2012 program, which was negotiated in 2Q11 and came into effect in 3Q11.
Losses and LAE expenses increased to 33%-34% in 1Q11-3Q11, but were stable at 32% of gross premiums earned over the 4Q10-3Q11 period. However, as a percentage of net premiums earned, the loss ratio increased to 59% from 54% reflecting the higher reinsurance costs.
We suspect the results at the time were also hampered by wind mitigation credits, which reduced premiums for some policyholders. In 2011, Governor Rick Scott signed legislation that limited the credits.
Policy acquisition and underwriting expenses increased from 9% in 2009 to 12% in the 4Q10-3Q11 period. The total expense ratio increased substantially from 86.6% for 2009 to 97.4% in 4Q10-3Q11.
The lack of assumption subsidies and the subsequent increase in cost structure caused underwriting income margins to collapse from 13.4% in 2009 to 2.6% for the 4Q10-3Q11 period.
The 2009 cash flow is not suitable for comparative purposes with the assumption free period. The 4Q09 assumption increased receivables that flowed into the company in the next several quarters, which we do not show on our exhibit. To illustrate the difference in cash flow in assumption and assumption-free periods, it is more appropriate to compare the first 9-months of 2010 with the first 9-months of 2011.
For 9-months of 2010, cash flow from operations was $26.3M, but it declined -29.7% to a meager $18.5M in the same period in 2011. In HCI's 3Q11 10-Q, the company provides a simple explanation for the deterioration stating:
"Net cash provided by operating activities for the nine months ended September 30, 2010 was approximately $26.3 million, which resulted primarily from the collection of $19.5million from Citizens in connection with our December 2009 assumption transaction".
In other words, 74% of cash flow YTD through September 2010 came directly from Citizens in conjunction with the 4Q09 assumption. In the same period in 2011, without the subsidy from Citizens, cash flow withered.
As far as we can tell, HCI no longer reports cash flow received from Citizens.
The flagging financial results at the holding company level were even more acute at the statutory company. To illustrate the financial erosion, we examined year-to-date statutory results as of 3Q11 and 3Q10 filed with National Association of Insurance Commissioners (NAIC).
The table below shows summary financial results for the statutory company for the periods in question. We provide both actual and pro-forma figures adjusting for the cash infusions.
Summary Statutory Financial Results
Underwriting losses in both periods shown reflect heavy MGA fees that shift cash to the holding company. This is evident by contrasting the losses at the statutory company with the (rapidly dwindling) gains at the holding company. However, the fee burden is just one aspect. Increased costs and negative operating leverage, as illustrated at the holding company level, are the more critical drivers.
The Florida Office of Insurance Regulation (OIR) described the phenomenon of increasing costs in its 2010 Financial Examination Report on HCI, which was published in 2012. The report noted that the increase in underwriting losses in 2010 stemmed from "the Company's book of business maturing and additional losses incurred from the acquisition of policies related to the depopulation".
Underwriting losses driven by the "maturing book" necessitated capital infusions in both periods to maintain surplus levels. For the 9-months 2011, HCI injected $4M in capital to the surplus in the form of notes. This augments the $9.1M the company was required to inject in 2010. The adjusted surplus illustrates the underlying dynamics of the business.
As reported, the surplus increased 21% in 9-months of 2010 and declined -1.5% in 9-months 2011. On a pro-forma basis without capital infusions, the surplus would have declined -15% in the first 9-months of 2010 and -8.8% for the full year due to the 4Q profit. For the first 9-months of 2011 on a pro-forma basis, the surplus would have declined -20.3% from the full-year 2010 figure. Without capital infusions, the surplus would have declined from $24.1M to $17.5M, or -27% over the period in question.
The organic erosion in the surplus is further evident in HCI's deteriorating net position (adjusted for $4M capital infusion), which shows liabilities growing at almost twice the rate of assets.
Absent an assumption, HCI's maturing book of business was characterized by high churn, persistent underwriting losses and collapsing cash flow, which drove surplus erosion - all during a hurricane-free period.
3. Homewise Acquisition - Saving the Day
Both 2010 and 2011 were politically charged years for the Florida insurance industry. By 2011, 6 of the 18 takeout companies had failed without a single hurricane landing. and the press was becoming highly critical as many believed that homeowner's policies and taxpayers' funds were being transferred to financially shaky companies.
In early 2011, the troubled takeout company First Home insurance was taken over by Homewise insurance. Only 3-months after the merger, the combined entity was ordered into liquidation. Homwise's rapid post-acquisition failure gives the appearance that the deal was an attempt to prevent the failure of two troubled companies in a state-engineered "bail out".
In 3Q11, HCI acquired the failed Homewise out of liquidation. As we noted, in the first 9-months of 2011, HCI was experiencing rapidly eroding financial results with material underwriting losses. In our view, HCI's financial performance indicates it may not have been far behind Homewise in the downward spiral toward insolvency prior to the acquisition. When viewed in this context, the HCI/Homewise acquisition looks like a marriage of convenience meant to bail out the troubled HCI along with the other failed companies.
The acquisition prevented the political fallout that would likely have occurred had the 70,000 Homewise/First Home policies reverted to Citizens and it certainly helped HCI. The massive transfer of $43.5M in unearned premiums to HCI effectively recapitalized the company, perhaps even saving it from the fate of the three previous companies that held the Homewise policies.
The Homewise acquisition was structured as an assumption. Its predictable benefits provided HCI with a much needed subsidy to stem the erosion and make the business appear profitable. The table below shows the 3Q11-4Q12 results to illustrate the impact of the deal.
Source Company filings and FLOIR.
As expected, reinsurance costs declined markedly as a percentage of gross premiums. Although the value of exposure increased 140%, reinsurance costs increased only 6% on an absolute basis and declined from 42% of gross premiums in 3Q11 to 28% of gross premiums in 4Q11 and 26% in 1Q12.
The lack of reinsurance costs flowed through the P&L from 4Q11 to 2Q12. The total expense ratio declined from 97% in 3Q11 to a low of 82% in 2Q12. Underwriting profit margins increased proportionately from 3% in 3Q11 to 14% in 4Q11 and 18% for both 1Q12 and 2Q12.
As part of the acquisition, Citizens transferred $43.5M in unearned premiums to HCI. Similar to the 2009 period, the cash infusion accounted for the majority of cash generated following the assumption. The transfer accounted for 58% of the total $74.5M generated in the four quarters including the assumption.
The Homewise assumption and the associated subsidies turned around HCI's financial results, restored margins, and recapitalized the company. The resurrected business model was maintained with the 4Q12 and 4Q13 assumptions as well.
4. The Real 2013 Numbers - Adjusting for the Distortions
HCI's assumption-dependant business model masks the underlying economics of its business. Reinsurance costs are understated, losses are uncommonly low, and policy acquisition costs on high-churn assumed policies are nil until renewal.
In the exhibit below, we stripped HCI's 2013 underwriting model of assumption benefits to generate pro-forma figures. We believe our pro-forma estimates accurately reflect what HCI's 2013 results would have looked like in the absence of an assumption.
2013 Adjusted and Pro Forma Income Statement
We adjusted reinsurance costs to 47.5% of gross written, which is consistent with our previous calculation discussed in Part I. We adjusted HCI's loss ratio from the stunningly low 19.3% to 30%, inline with HCI's historical averages and those of peers.
Changing the two key cost centers drives the total expense ratio to increase from 70.1% to 98.1%, indicating that with normalized reinsurance and loss expenses, HCI's model is only marginally profitable.
HCI's adjusted total expense ratio of 98.1% is inline with those of Federated National ( FNHC ) and United Insurance ( UIHC ), which are 98.9% and 92.5%, respectively. The model is inline despite having policy acquisition expenses we estimate to be approximately $20M below normalized costs. Given the lack of policy acquisition costs, HCI should be more profitable than its competitors, even after adjusting for reinsurance and loss expenses. We believe that HCI is not more profitable despite the cost advantages because the company's compensation expenses are significantly higher than other DFIs. We estimate that HCI's compensation cost is approximately $24M compared to $10.1M and $14M for FNHC and UIHC, respectively. It would appear that a good portion of the subsidy HCI receives for taking Citizens policies go out the door as management compensation. Were policy acquisition costs to be normalized, the total expense ratio would increase to approximately 104% from the current estimate of 98.1%.
5. Earnings Rich, Cash Poor - Further Evidence of Trouble
The table below shows that while HCI's net income grew by 117% in 2013 the cash flow from operations collapsed by -48%.
The collapse was in part a function of HCI's reinsurance program, which required the company to pre-fund a large portion of its reinsurance, and the bookings of contingent profit commissions. These are non-cash, accrued profits and are booked in "other assets". Lastly, the company's unearned premium account cash cushion declined materially. We assume that is due to the assumption of shorter duration policies from Citizens, thus limiting the cash portion of the subsidy to HCI.
HCI 2013 Cash Flow Summary
The structural elements combined with the decline in unearned premiums caused cash flow to tumble from $106M to $55.5M. from 2012 to 2013. Likewise, cash flow of $55.5M is roughly even with 2011's $56M despite net income increasing over 500% and net premiums earned increasing from $88.1M to $234M over the same period. We find the cash flow comparisons deeply troubling.
HCI's debt financing also raises significant questions. The company raised $143M in debt during the period, in part to fund the $30M stock buyback at roughly 3x book value. We think that large assumptions from Citizens will become increasingly difficult; as such, we believe the company will need to take some action to perpetuate the illusion of growth and high margins. We suspect that HCI will try to fund an acquisition with the debt financing in effort to stem the organic erosion in their book.
Lastly, it is worth noting that between the $30.9M buyback and $10.9M in dividends, HCI spent $41.8M or 75% of their declining cash flow from operations "giving back" to shareholders. We view the fact that the buyback was contingent on the company's ability to raise the debt as indication the HCI could ill-afford the buyback and may be concerned with low cash generation, as they should be.
A primary characteristic of the standard insurance company business model is that companies take in more cash than they payout. The float, as it is known, arises as companies collect premiums today to pay potential losses tomorrow. It is a foundation of the business and what has allowed Warren Buffett to build his investment portfolio.
Given the float associated with the business model, cash flow from operations at a healthy company should be larger than net income, though this is not the case with HCI. It is yet another aspect of the insurance business model that is turned upside down.
Illusions always come at a cost. In HCI's case, generating the illusion of reinsurance coverage and industry leading profitability come at the expense of cash flow. In our view, HCI's cash flow generation is problematic and another indication that the business model is unsustainable over the long-term.
Assumptions contain embedded subsidies that make HCI's business appear very profitable for a short time following the takeout. Regular yearly assumptions can create the impression that a P&C insurance company such as HCI has a business model that generates software-like margins. However, the inflated P&L is an illusion. When the assumptions end, cost structures shift permanently higher and the underlying economics of the policies emerge. This phenomenon was evident in HCI's collapsing financial performance in the period just prior to the Homewise acquisition.
Evidence suggests that HCI will not make an assumption in 2014. We strongly suspect that the company will attempt an acquisition, as without the camouflage of a large transaction, policy erosion and negative operating leverage will begin to set-in as the book matures and cost structures increase. With rapidly declining operating results, we expect investors to reconsider the currently generous 2.4x book valuation.
Disclosure: The author is short HCI. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it. The author has no business relationship with any company whose stock is mentioned in this article.
See also MannKind Reality Check on seekingalpha.com
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.