Paul Hill explains how to value an insurance stock – and picks out one of the most attractive companies in the sector:
Tip of the week: Catlin (CGL), rated a BUY by UBS
Insurance companies are in the risk business and, after snapping-up rival Wellington for £591m last December, Catlin is now the largest Lloyds underwriter. It is based in Bermuda and specialises in property and casualty insurance. As well as offering cover for natural disasters, it underwrites a broad spectrum of other business – including professional indemnity, medical malpractice and directors’ liability insurance. Higher premiums and a lack of major catastrophes helped Catlin grow profits in 2006. This year, though, premiums have been flat or falling due to a relatively quiet hurricane season in the Gulf of Mexico.
This is a fairly complex sector. So how does one value an insurance stock – and how does Catlin stack up? Firstly, it’s vital to determine which operators make profits by looking at the ‘combined ratio’. This measures underlying profitability by comparing claims and costs to premiums; a ratio above 100% equates to losses. On this score, Catlin achieved 92.2% in the first half after being hit by claims from this summer’s UK floods ($30m) and integration costs ($23m) from the Wellington deal. Its prospects are set to improve to around 90.5%, though, which is about 2% better than its peers. This is driven by $100m a year cost savings from the acquisition, partly offset by further flood and integration costs in the second half of $10m and $12m respectively.
Next, in light of the credit crunch, we need to keep an eye on investment portfolios. Insurers are experts in risk assessment, rather than fund management, so it’s important to scrutinise asset quality. Catlin adopts a prudent approach. As at 30 June, it had $5.4bn of assets under management, of which 44% was in cash and 48% in bonds. Just 2% (or $105m) of the portfolio is exposed to subprime mortgages, and of this 95% is classed as ‘AAA’ with the rest ‘AA’ rated.
Finally, let’s move on to the most important factor – where Catlin ranks towards the top of its peer group at Lloyds. Joint house broker UBS is forecasting 2007 earnings per share (EPS), dividend and net tangible asset value (NTAV) to be 71.2p, 24p and 304p respectively, growing to 81.9p (up 15%), 25p and 360p (18%) in 2008. Assuming these targets are achieved, Catlin trades on 2008 multiples for p/e, dividend yield and NTAV of 5.8, 5.3% and 1.3. To my mind, this offers good value for both income seekers and growth investors. As for the future, chairman Stephen Catlin said in September: “We are on track to meet our financial targets in 2007, and see further growth opportunities in 2008 and beyond, especially in the US and through our international offices”.
So what are the risks? In the insurance industry, results can be blown apart – as they were in 2005 – owing to unexpected natural disasters (such as Hurricanes Katrina and Wilma). But Catlin has substantially reduced its exposure to catastrophe cover and is now better placed than two years ago. Another concern is that if premiums soften and competition heats up, then margins will be squeezed – although, as a larger operator, Catlin should be able to weather such storms better than most.
UBS has a 12-month price target of 610p on the stock, and three directors recently bought shares at between 455p and 462p. You should follow their lead.
Recommendation: BUY at 482.25p
• Paul Hill also writes a weekly share-tipping newsletter, Precision Guided Investments