Floor takeout valuation, $450-$500mm. Conservative upside to $500-$550mm, maybe $600mm+. Valued w/ margins of safety.
Ran some numbers (I looked up statutory filing numbers and used those surplus and liabilities as these are more conservative and used by regulators; $3.3bn of admitted assets and $888mm of statutory surplus as of 12/31/12), and then I adjusted statutory liabilities of $2.4bn upwards by $600mm based on the assumption that the existing book of policies is underpriced and understated by 20%. Then I discounted the liabilities by an average duration of about 2.2 years (the average number of years the existing book of policies is in force) at a 4% (low) and 5% (high) rate. Backing out this liability from assets, my Initial take is floor takeout valuation for equity is $450-$500mm with conservative upside to $500-$550mm. This is what an acquirer could pay to comfortably achieve an IRR of 10%-15% on its investment w/ very low risk. Additional upside would come from other net assets that are not admitted in the statutory filings and any tax benefits which I haven't taken into account. This is a rough calculation, but if the hole was potentially greater than $600mm that I've assumed based on the level of underpricing by other targets that were acquired and put into runoff, then I am not sure JPM would have taken on the assignment b/c it would be borderline fraudulent accounting (which is definitely possible). But that's a risk for sure that the hole could be greater than $600mm. But being long the stock at current levels is asymmetrically skewed to the upside w/ most of the realistic downside already priced in. I wouldn't be surprised if the actual takeout happens at a $600mm valuation or higher. Only my educated guess. Also, re: the Canopius deal/liabilities, I excluded them b/c I'm considering the net effect a wash as 60% of the adverse development was said to be from the U.S. based business which also enjoy 35% tax benefits that serve as offsets.
Best analysis of underlying valuation given sensitivity around the reserve inadequacy; the unknown right now is how bad is it and is it all fully accounted for in the about to be released numbers. The smoke signals are not good given that they're putting themselves up for sale prior to the earnings release indicating that they cannot raise enough capital on their own to maintain their ratings.
They've been in very tough lines of business; ones which other carriers have a hard time with which may indicate endemic and long-term underreserving and they may be at point where they simply cannot meet their obligations.
Thank you. You are right about smoke signals. I think Howard Marks once said there were two types of investors in this world. Those that say "I know" and those that say "I don't know". He quotes Mark Twain who said, "It ain’t what you don't know that gets you into trouble. It's what you know for sure that just ain’t so." So yea, I recognize that I really don't know how big the hole is; it is unknowable. It could be massive, and I could be very wrong in my valuation. So this is extremely risky and maybe a coin flip. But my bet is that it's not fraudulently massive (i.e. 50% reserve understatement), but that's a risk that I am taking. The hole was initially guided to $110mm, and I thought to myself that about 5-6x that amount would be terrible for the company (as other companies with 100% workers' comp had that level of reserve deficiency (i.e. 25%) and were put into runoff) and would not enable capital raising nor much less ongoing new business value creation (but runoff value is still there) but anything in the 9-10x (i.e. 50% reserve deficiency) amount would wipe out book value - a very possible scenario. My assumptions are too arbitrary and put too much faith in human beings. The risk for me is that the i-banks took on the hopeless assignment to sell the company b/c there's no downside for them if they can't. Another risk that I failed to account for enough was the reinsurance/cat loss risk from Hurricane Sandy. I thought that the company had as of Feb. 8 closed 89% of the 24,000 claims that its stock companies received as a result of the superstorm, which hit the Northeast and Mid-Atlantic in late October. But all of this could be misrepresentations by the company. Having said all that, I am still long!
First time I am seeing a realistic valuation. Insurance business is run against tangible assets. The amount of $600M is close to realistic. This is why they appointed JPM to find a Buyer. Also the buyer gets all these clients for free. With zero acquisition costs. 53Million shares gives a valuation of $10 per share. Les see who bites/
The value lies in the value of the investment portfolio backing the reserves. So what price to you put on a low-yielding investment portfolio in order to meet your hurdle ROI? Next, you need assurances that the reserves are in fact finally adequate -- any expected reserve deficiency simply reduces the price you put on the investment portfolio because, again, you are looking to meet or beat your hurdle ROI. Wall Street is not a bunch of sharks circling the wounded body in the water looking to lower the price; but then again it is not an altruistic charity focused on the welfare of that body's shareholders.