UNM - Unum: Core Strength Offsets LTC Volatility

2024-01-10 23:53:49 ET

Summary

• Unum's shares have underperformed due to concerns about its long-term care exposure, but its statutory position remains strong.
• The company's core business segments are performing well, with solid premium growth and higher earnings.
• Despite the challenges in its closed block unit, Unum's capital position is strong, and its focus on its profitable new business lines should increase this year.

Shares of Unum ( UNM ) have underperformed the broader market over the past year as a recent accounting change has added to concerns about its long-term care ((LTC)) exposure. However, this does not impact its statutory position, and even assuming no value from its $5 billion of equity supporting LTC, shares do not appear particularly expensive, and as a result, I view shares as a buy.

Unum is a mid-sized insurance company with about $60 billion in assets. As you can see below, its sales are focused in disability and group life, with Unum leveraging its distribution network to target small and medium-sized businesses, in what is a profitable sector within the insurance industry. However, these sales represent where management is trying to take Unum because it also has a large legacy business of LTC exposure, where it no longer is writing policies (as such, it is classified as “closed block”). This unit houses about 55% of Unum’s assets.

In the company’s third quarter , Unum earned $1.02 with adjusted earnings of $1.94. The primary difference between the two is the one-time annual reserve adjustment Unum took, which I will explain more below. Unum is a “tale of two cities” company with solid and growing results from its new business offset by concerns about its legacy unit. UNM saw 6.1% core premium growth, and these increased premiums drove higher earnings.

Its US operation saw adjusted operating income rise by 27% to $358 million as premiums rose by 6.5% to $1.66 billion. Net investment income fell by 3% to $166 million. Group disability saw profits rise 30% to $170 million as its benefit ratio fell from 62% to 58%, a very stronger level that management expects to persist into next year.

Life and accidental death saw operating income jump 84% to $52 million. Its benefit ratio fell from 78% to 73%, as COVID-19 impacts continue to lessen. Many life insurance companies have seen unfavorable mortality trends from the spike in excess deaths in 2020-2021, but with mortality now coming back to normal trends, results are recovering. Colonial Life saw operating income rise by 13% to $103 million as premiums rose by $8 million and mortality has normalized.

Its international unit is relatively small but saw operating income rise by 48% to $37 million as premiums rose by 21%. Similar to what we have seen in the US, its UK benefit ratio fell to 67% from 79%.

On the other hand, closed block earned just $34 million. Its interest adjusted loss ratio was 105.3%. Frankly, prior to 2008, LTC insurance was dramatically underpriced, causing financial problems for Unum, Genworth (GNW), General Electric ( GE ) and others. It has been so underpriced that over the past fifteen years, UNM has secured $4 billion in rate increases to limit losses. These are only approved by regulators in extreme circumstances when an insurance offering is dramatically insolvent to ensure policyholders will still have some more protections. In 2023, Unum will have put another $800-900 million of capital into long term care, and when it reports Q4 results, its premium deficiency should be closed.

As noted above, the LTC unit has 55% of Unum’s assets, but it accounts for less than 10% of operating profits. As a result, its core operating segments had a 22% return on equity, but the total company had a consolidated ROE of 13%. This speaks to how much LTC weighs down results. Additionally, once per year, insurance companies review the actuarial assumptions underpinning their insurance reserves. Based on how policies are performing relative to expectations, these reserves have to be adjusted.

Once again, there was a material divergence. Closed block reserves rose by $368 million pre-tax, as the company has to use end of year 2020 interest rates rather than current ones. If it could use a 4.5% 30-year treasury yield, the net impact would have been zero. On net, reserves rose by a more modest $139 million due to this annual review as actuarial results in its core business were better than previously assumed.

As a result of this review, it expects its closed block to earn $30-40 million per quarter from $45-55 million previously. Now, it is important to emphasize this was a GAAP accounting review, not a statutory review, which is what regulators use to determine solvency and permit intracompany dividends. Because of this, management said the changes in “GAAP accounting does not impact views on our capital and capital deployment plans.” This review also does not impact its guidance that it can cease putting capital into the closed block unit after this year. Additionally, the company will begin a $500 million repurchase in 2024, and the share count is down by 2% over the past year with $75 million of repurchases in Q3.

As the company reports results in 2024, it will be essential for management to be able to hold to its guidance that LTC can be operated as a run-off business without further capital injections needed. That will increasingly allow the capital-rich and profitable new business lines to get investors’ focus and drive shares. In fact, because statutory and GAAP rules differ, despite these extra reserves, UNM’s risk-based capital is 470%, a very strong level, and up from 420% at the start of the year. It also has a healthy $1.2 billion of holding company liquidity. In December , Fitch raised Unum’s senior credit rating to BBB to BBB-, which is still lower than many insurers, given its LTC exposure, but on the right track.

One of the reasons the company’s position has improved is higher interest rates. Overall, net investment income rose by just under 3% to $526 million in Q3. I expect a similar increase in Q4. Now, given the move in short-term interest rates, this is a much smaller jump than some insurers have shown. A major reason for this is that UNM has long-dated liabilities, meaning it owns long-dated bonds to match them. Its fixed income portfolio has a nearly 8-year duration. It reinvests much more slowly, reducing its sensitivity to rates.

Still it has been able to invest new dollars above its 4.45% average yield. The company has also used the increase in rates to decrease its high-yield exposure, now just 4% of the portfolio. On credit quality, I would note that 58% of its $2.3 billion in mortgages have a loan-to-value below 65% with just 3% over 85%, so even if there is further weakness in commercial real estate, losses are unlikely to be high. It has also been extending about $700 million of maturities in its LTC portfolio to better match the duration of the liabilities and ensure it continues to earn this high-level of yields for a long time.

As such, UNM will not see its interest income fall much if the Fed begins cutting rates, it has just $946 million maturing over the next year. By comparison, $19.7 billion matures over 10 years from now. These yields are locked in, and these higher yields help to provide further cushion that it can over time earn itself out of any further underwriting hole in LTC.

In 2024, I believe we are positioned to see the closed block well sequestered off, which will allow investors to focus on the capital the core business generates, allowing substantial shareholder return, on top of its 3.2% yield. Now, excluding its $3.9 billion of unrealized losses, UNM has a $65.47 book value. It is important to note this book value includes $5 billion of equity supporting the closed block.

Today, its market capitalization is a bit under $9 billion. This is below its book value; however, that does not mean the market is valuing each unit at 75% of book value. Life insurance companies often trade around 1x book value, where property and casualty units can trade from 1-3x book value depending on their underwriting performance and niche. I am assuming zero value whatsoever from its closed block. In which case, the market is essentially valuing its life unit at 1x and disability insurance offerings at 1.5x book value.

Remember, the core units earn an ROE of over 22%. Being able to own these units at roughly 1.4x is attractive, as that implies an over 15% return. In 2023, UNM took advantage of the rise in rates to lock in higher yields and close the premium deficiency on an accelerated timeline in its closed book. With this unit in run-off and premiums in its core business growing, with each passing day, the composition of UNM’s business improves, which will help its consolidated ROE steadily rise.

More importantly, if management continues to guide to no more capital contributions, which I expect to happen on its next earnings call on January 30 , investors and analyst can begin to look past LTC and focus on its growing core business. With a 15+% implied return, relative resilience to Federal Reserve rate cuts, and a 10+% capital return yield, I view shares as attractive. Ultimately, I believe a sum of the parts analysis could support a 2x/book multiple on its Unum US unit vs 1.5x, or about 25% upside to Unum shares about $56. 2024 can be a year of focusing on the new Unum, which should lead shares to outperform.

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