2023-11-16 11:38:30 ET
Summary
- Mercury General faced challenges in 2022, leading to a dividend cut and loss of dividend aristocrat status.
- The company's operational performance has been lackluster, but recent results show improvement in underwriting margins.
- Investors are cautiously optimistic about the company's potential for recovery, but full benefits may not be realized until 2023.
Executive Summary
As mentioned in prior articles , Mercury General ( MCY ) faced considerable challenges in 2022, leading to a dividend cut and the loss of its dividend aristocrat status. The company's operational performance has been lackluster, negatively impacting its profitability and share price. Mercury General recently released its third-quarter results , revealing a notable improvement in its underwriting margins.
While the company has continued to incur losses, the reduction in losses is an encouraging sign. Investors appear to be excited about the ongoing changes implemented by the company to enhance the performance of its California insurance portfolio.
The stock price skyrocketed by more than 20% during the trading session following the results release. Since the beginning of the year, there has been a change in investors' perceptions of Mercury General. The company, once considered a weakened outsider in the property and casualty insurance industry, now appears to be viewed as a potential candidate for recovery.
However, the full benefits of the recovery won't be realized in 2023, as the company is still grappling with the effects of inflation.
Operational Struggles: Remediation Plan Is Ongoing
Mercury General's struggles in the past decade have been evident in its inability to consistently improve profitability. While there was a temporary improvement in 2020 due to reduced claims during the COVID-19 pandemic, the subsequent return to normalcy resulted in a sharp increase in the loss ratio, ultimately leading to a combined ratio of 108.7% in 2022.
During the third quarter, the company reduced underwriting losses, by posting a net underwriting gain of $15.8 million, resulting in a combined ratio of 98.6%.
During the third quarter, the company was adversely affected by natural events for a total cost of $36 million, or a 3.3 point impact on the loss ratio.
Excluding the effects of catastrophe losses, the loss ratio was 72.2% or a 5 point reduction from Q3 2022. The decrease in the loss ratio was primarily due to an increase in net premiums earned resulting from rate increases in the California automobile and homeowners’ lines of insurance business and in certain lines of insurance business in states outside of California, partially offset by an increase in loss severity in the automobile line of insurance business.
Furthermore, the Company continues to implement rate and non-rate actions to improve underwriting results. The insurer filed for additional rate increases for the personal auto insurance business and the homeowners’ insurance business in California and in other states.
According to the company, higher rates will continue to earn-in in the fourth quarter, which will help offset historically higher seasonal frequency and severity.
Hence, the underwriting margins might improve during the fourth quarter, although the portfolio would certainly be loss-making on a full year view, as the company recorded an underwriting loss of circa $250 million for the first nine of the months.
The improvement in underwriting margins, leading to positive cash flows from the insurance portfolio (already observed for the third quarter), should contribute to a more secure dividend.
Still An Insane Dividend Policy
In 2023, Mercury General persisted in paying a modest quarterly dividend, even in the face of operational challenges. However, questions have arisen regarding the sustainability of this approach, as it could potentially hinder the company's capacity to reinvest in initiatives aimed at bolstering profitability. Opting to reduce the dividend could have preserved more than $17 million during the third quarter.
Nevertheless, it is crucial for the management to convey confidence to shareholders by maintaining a dividend policy.
Valuation
Mercury's market capitalization is approximately $2.03 billion for a business that generates $4.0 to $4.2 billion in annual premium turnover. While its valuation at 1.48 times the book value may seem intriguing, it's essential to consider the company's profitability, underwriting performance, and dividend sustainability, which significantly differ from competitors like Chubb ( CB ) or Travelers ( TRV ) that trade at higher valuations.
The valuations of Travelers and Chubb are influenced by their superior underwriting margins over the market cycle and their attractive capital excess distribution to shareholders. For example, Chubb stands out as the top-tier property and casualty insurer, consistently outperforming its peers over the entire market cycle.
Chubb's Q3 2023 Financial Presentation
Due to its exceptional underwriting performance and resilience, investors perceive Chubb as a SWAN (Sleep Well at Night) and accord it higher multiples compared to Mercury, which has grappled with operational challenges in recent years.
Travelers is in a comparable situation to Chubb in terms of investors' perception. Apart from its dependable operating performance, characterized by an over-cycle combined ratio of around 97%, the company is viewed as dividend-oriented, boasting a history of gradual dividend increases spanning over almost two decades. Additionally, the company has engaged in share repurchases over the years, redistributing excess capital to shareholders.
Travelers' investor presentation
Final Thoughts
The efforts to reprice have begun to yield positive results in terms of operational performance.
However, due to the time lag in the impact of premium increases on profitability and the immediate adverse effect of claims inflation on the loss ratio level, it is projected that 2023 might not be a profitable year.
Yet, the fourth-quarter results are expected to demonstrate a considerable improvement in underwriting margins if there's a deceleration in claims inflation and catastrophe losses do not exceed anticipated levels.
Given Mercury General's current poor operating performance, it does not appear to be an attractive investment choice. Investors, both potential and current, should exercise caution and monitor the situation for substantial improvements, especially if pending price increases are approved by regulators in California.
For further details see:
Mercury General: From A Pariah To A Potential Candidate For Recovery