Improved Underwriting Results
Thanks to the absence of major catastrophic losses, Travelers’ third quarter profit soared to $864 million or $2.21 a share, beating estimates. This more than doubles profits of $333 million or $0.79 a share for the same time last year and is a 73% increase over this year’s second quarter net income of $499 million. Also, compared to the second quarter’s catastrophic losses of $357 million, third quarter catastrophic losses were just $59 million. After a number of severe weather events over the last few years, the weather in the third quarter provided insurers welcome relieve.
According to Jay Fishman, Travelers CEO, premiums for business clients increased by 7.7% during the third quarter, compared to a 7.2% increase in the second quarter and a 7.5% increase in the first quarter. This is a positive trend for the company and one which will give comfort to investors concerned that rate increases would be difficult to achieve. These rate increases have, recently, had a negative impact on new business when looking at year-over-year volume for all business segments. When looking at the commercial segment, however, it still showed modest volume improvement. Going forward, with interest rates expected to stay at historically low levels, the ability to increase rates becomes more important, and should be watched closely.
Looking ahead to the fourth quarter, it is worthwhile to look at Travelers from a seasonality perspective. When looking at average fourth quarter returns of individual sectors relative to all other sectors, financial stocks tend to be good bets. Travelers has been especially strong in this regard, having posted fourth quarter gains in each of the last ten years. The continuation of this ten-year trend will likely be helped by the pattern discussed of recent large catastrophic losses leading to higher demand for coverage and increases in rates.
Return of Equity
Third quarter ROE came in at 13.6% and net investment income rose to $578 million. It is worth noting that Travelers shareholders benefit significantly from the company’s high-quality long term fixed income portfolio. From January 1995 to June 2012, ROE has averaged 12.9% with over 8.3% coming from this source of revenue. The annual contribution to ROE from the long term fixed income portfolio has been very consistent, ranging from a high of 8.9% to a low of 7.9%. Taking into consideration the interest rate environment, these results are certainly very impressive. Also, with underwriting results varying greatly due to unpredictable weather patterns, this steady stream of income makes Travelers attractive at current valuations. A trailing P/E of 10.47 and a forward P/E of 10.77 looks attractive, especially when taking into account the consistent source of the majority of its earnings. The Chubb Corporation (NYSE:CB), also attractive from a valuation perspective, sports a 13.54 trailing P/E and 13.20 forward P/E.
As noted above, Travelers shareholders are essentially owners of a high-quality bond portfolio. A contrast to this approach would be Hartford Financial Services Group Inc (NYSE:HIG), which in recent years invested their fixed income portfolio much more aggressively, but with disastrous results. Additionally, since 2009 Hartford has increased its use of derivatives including credit default swaps. MetLife Inc (NYSE:MET) is doing this as well but to a lesser extent. Credit default swaps, of course, are what led to the bailout of American International Group, Inc. (NYSE:AIG), and for Hartford, changes may be coming with respect to these risk management techniques, as they have recently shed several business lines in order to focus on their property and casualty businesses.
The challenge ahead for Travelers is if rates stay level, net investment income will steadily decline. It is estimated that net income will drop by $95 million next year, $125 million in 2014 and $145 million in 2015. Mr. Fishman spoke about this recently at a Barclay insurance conference, adding that the company will maintain its current asset class mix rather than reach for yield, which would increase the risk of default in its fixed income portfolio.
Managing Natural Disasters
Natural disasters present unique challenges that are difficult to price. Katrina was a huge financial blow to The Allstate Corporation (NYSE:ALL) due to a lack of reinsurance. From July 2012 to June 2013, Travelers will use reinsurance to cover 53.3% of losses that fall between $1.5 billion and $2.25 billion. In addition, certain losses within this range will be covered by catastrophe bonds, unique instruments that pay a high interest rate, but those in which the investor forfeits principal if the “defined risk” occurs. They will retain losses below $1.5 billion, except for those caused by an earthquake. Above $2.25 billion, the company will retain losses except for those covered by catastrophe bonds and the Northeast Catastrophe Treaty; details on this can be found in the company’s June 2012 quarterly report on its 10-Q form.
Price Targets
Short term price targets for Travelers can be tricky as analysts attempt to predict weather patterns. JPMorgan Chase recently raised its estimate to $75.00 based on an increase in estimated 2012 EPS by $.37 to $6.35. This was partly due to anticipation of the improvement in underwriting results that Travelers achieved in the third quarter. In July, S&P cut Travelers 2012 EPS estimate by $0.53 to $6.30. S&P also puts a price target of $75 on the stock assuming it will trade at 10.4X the 2013 earnings estimate of $7.18.
Dividends
The most recent quarterly dividend of $.46 paid on September 28th is the same as the first quarter, and a $.05 increase over the fourth quarter of 2011. Based on a closing price of $73.99 on October 22nd, the yield comes in at 2.50%. Since the dividend was cut in 2004, outlays have been increased by an average of 10% per year, making Travelers a very worthwhile stock to consider for rising dividend investors. For those believing that the stock has appreciation potential, getting paid in excess of a 10-year treasury while waiting for that appreciation to occur is not a bad idea. Another stock to consider would be Chubb, also a consistent dividend bull and currently generating a yield of 2.00%.
As a side note, but worth mentioning, Travelers is currently trying to avoid being included in a landmark fight between the National Football League and thousands of former players. The players are claiming that the NFL is responsible for debilitating brain injuries so severe they have led to several former players committing suicide. In August, subsidiaries of Travelers filed suit against the National Football League and other insurers to avoid sharing in the cost to defend the League. They claim that they had not provided coverage to NFL, but instead to NFL Properties, the merchandising arm of the league.
Looking ahead, although the stock has surged by nearly 40% over the past year, it still looks attractive based on many factors. The company’s P/E ratio of 10.47 is in line with peers and well below the S&P 500’s P/E ratio of 17.7. The current interest rate environment will certainly impact earnings going forward, but if management keeps its commitment to maintaining a high-quality balance sheet, Travelers is a very worthwhile financial services stock to consider. Check out the stock’s profile page on Insider Monkey here.
