Regionals: Catching up to nationals in the value creation marathon
The starting pistol was cocked. The timing was following the 9/11 tragedy. On one side of the track were the nationals and the E&S carriers who knew how the playbook was to be used. On the other side were the regionals, a scrappier group of players who knew this was going to be a once in a multi-decade opportunity.
The pistol was fired and the race began. But, unlike a marathon where the favorite takes an early lead to win, something interesting happened over time. This regionals group stumbled initially in balancing growth vs. underwriting and even being able to balance different business segments.
However, it got its stride straight, caught a second wind and managed to not only catch up but also outpace several well-known companies in the process.
Looking at the landscape of property-casualty insurance, regionals have been the true come-from-behind group. The small/middle (smiddle!) end of the market has worked out in this group’s favor.
For the purposes of this piece, we will focus on Selective Insurance Group, The Hanover Group, Cincinnati Financial and Donegal Group.
Initially this cohort moved on from regionals to so-called super regionals, although since then, the lines between regionals and specialty carriers have been blurred. But even though the nomenclature has been blurred, the true test lies in value creation over time.
The two charts below illustrate this shift. The first chart shows value creation for major carriers and regionals, with the regional group mostly in the bottom half for the post 9/11 years.
As results improved, these rankings have evolved materially with two of the regionals moving to the top end of the leaderboard as shown below, for the 5 years since 2017.
The recent earnings cycle has proven to be an interesting pivot for the commercial insurance space, as debate continues on whether the pricing cycle has legs into 2023.
For the regionals, as we show later in the note, the business mix evolution has helped them lessen the noise seen in the personal auto space. Yes, personal auto and homeowners provide diversification, but loss cost trends can be tough to get ahead of, as shown over the past few quarters.
Beyond diversification, underwriting is the one area where this group has struggled a lot in getting this right.
These efforts seem to be paying dividends, as we show later in our note, with the loss picks and loss development numbers stabilizing in recent years. With an uncertain loss cost climate, getting this right will differentiate them during the next turn.
The growth and loss picks are closely interlinked with expense management where the regionals have the added possibility to continue improving. As the current cycle plateaus and the gap between loss costs and earned pricing narrows, this is an additional arrow which can be fired to make up for the margin gap.
The note below looks at diversification, underwriting, and expense ratio shift over time.
Firstly, the business mix has gotten more commercial predominant
If we go back 20-25 years or so, many carriers were trying to be all things to all people.
The concepts of cross-selling and even owning life insurance franchises were seen as ways to insulate from business cycles. Much of this thinking has proven to be problematic, and both regionals and nationals are pared-down versions of themselves.
The research team thought it would be interesting to see how the regionals have changed their business mix compared to nationals over the past 15 years or so.
Selective and Cincinnati have mostly remained stable with a predominant commercial leaning while Donegal and The Hanover Group have shifted towards commercial over the years.
This makes sense. Taking a step back, companies which have been auto specialists (direct and agency), even after collecting mountains of data, were blindsided by the uptick in loss cost trends in recent years.
A smaller regional player distributing through an independent agency network would have faced similar or even worse trends; so, the pivot has somewhat insulated regionals.
On the other hand, as we discuss later, longer-tail lines carry meaningful reserving risks compared to auto/homeowners reserving variability.
Secondly, improved underwriting has resulted in higher value creation
The chart shows the past 10 years of loss and LAE of the regionals vs. their commercial counterparts. Note the gap narrowing over time.
In other words, regionals exhibited a bigger volatility over the last decade. As underwriting has improved, the loss picks have settled in a tighter range, which is often indicative of improved reserving practices.
The charts below show the initial loss picks of the major commercial writers vs. the commercial lines of the regionals. Again, these loss picks need to be evaluated with the development that comes with them, as well as the subsegment, which can materially alter these numbers.
With this caveat in mind, we would highlight the stability of loss picks compared to movement year to year.
Ideally, a company’s reserving actuaries pick the losses exactly, and the PPD table is a row of zeroes. However, this doesn’t happen in reality, and the true measure of success is lowering variability with potential favorable development over the long-term.
Note the minimum and maximum beginning to narrow for the regionals over time.
The personal lines mix is, of course, skewed if a carrier has more personal auto vs. homeowners. But the net takeaway in the chart below is again the narrowing of loss picks over time vs. material movement year over year.
On a development basis, both larger and smaller carriers have seen noise, although the median numbers for regionals have narrowed if one were to exclude Donegal from the mix.
Thirdly, regionals have headroom for expense ratio improvement
In looking at the regionals’ expenses, it’s possible there’s an opportunity for more margin improvement. The following chart illustrates the expense ratios for the regionals vs. nationals.
Many regionals, over the years, have talked about narrowing this gap and this is another lever for the group to pull. Taking a step back, the table below shows a gap of 300-400 basis points.
Typically, during any pricing cycle, the gap between earned pricing and loss cost inflation narrows or expands. However, chipping away at the expenses can provide a lasting impact over cycles.
So, how does this all add up? The chart below shows the price to forward book vs. 2023 ROE based on consensus analyst estimates.
Excluding Cincinnati, which is more of a total return carrier, both Selective and Hanover have nearly closed the gap with larger nationals.
Yes, there is some deserved consolidation multiple built into the stocks, but their multiples also reflect their improving ROE profile over time.
In our prior note we have noted that often acquisitions end up dealing with asymmetric information for the buyer. However, as the cycle begins to plateau, and if the recent balance sheet marks from interest rate change reverse, potential acquirers could end up returning to the table.
The table below shows select regionals and specialty acquisitions (domestic-predominant). We would not be surprised to see some of these regional companies able to command a premium to the current multiple.
In summary, regionals have been able to successfully navigate the market cycles and close the return gap vs. several well-known carriers.
We are at an interesting inflection point where meaningful uncertainty remains over current economic conditions and any potential changes in the loss cost environment. Regionals have to remain vigilant against any rapid shifts and continuing to chip away at the smiddle space.