2 for Tuesday: As It Falls, HCC Gets More Attractive

Oct. 18, I wrote a column in which I was bullish on the insurance stocks, highlighting two names in particular: Navigators Group(NAVG) and HCC Insurance (HCC). Since then, Navigators has returned a handsome 20%, but HCC is down about 12%. I still like the sector, and at these prices, HCC is particularly attractive.

Several factors are behind the decline in HCC's shares, none of which change my view of the company's solid long-term outlook. The first issue has to do with fourth-quarter results, which (for the industry in general, including HCC) are not a whole lot prettier than the third quarter's, which reflected the toll of the World Trade Center catastrophe.

As if the losses from Sept. 11 -- both personal and financial -- weren't traumatic enough, another plane went down just two months later -- American Airlines Flight 587. Then there was the Enron debacle and the Kmart bankruptcy, followed by a renewed fear of asbestos liabilities, and even more bankruptcies.

Those severe losses, however, although painful to the industry in the short run, should serve only to strengthen pricing in an insurance market that was already firming. That raises issue No. 2: Although the pricing outlook has strengthened, some investors are concerned that this only attracts more capital into the insurance market, which will in turn force pricing down.

Indeed, billions -- perhaps as much as $26 billion to $27 billion in new capital -- have been raised globally since Sept. 11. But that still doesn't cover the $35 billion to $65 billion in estimated losses sustained by the World Trade Center devastation alone. And much of that new capital is focused on pursuing business in market segments that are the most capacity-constrained -- namely: aviation, property and marine.

So, although premium price increases in the property catastrophe reinsurance area may not be up in the 60% to 100%-plus range (as hoped by many right after Sept. 11), they still will likely be up between 30% to 50%, says Mark Lane, insurance analyst at William Blair. "That's still high enough to support strong top-line growth and better margins," says Lane. (Lane has a long-term buy rating for HCC, and William Blair has provided underwriting services for HCC during the past three years.)

The Stock HCC Insurance Holdings (HCC:NYSE)
Recent Stock Price:	$25.90
52-Week Range:	$21.20-$29.65
P/E Ratio:	25.84
Market Capitalization:	$1.58 billion
Float:	36.4 million shares
Short Interest Ratio:	17.98
Institutional Ownership:	87%
Source: Yahoo! Finance

HCC looks good in both the near term and the long run. The company absorbed its losses associated with the World Trade Center in the third quarter of 2001, and it has no Enron-related or asbestos-loss exposure to speak of. Now with that out of the way, I think the shares are poised to move higher. On Monday the company updated its guidance for the fourth quarter of 2001 (those earnings will be released Feb. 21) and for 2002, validating what the shares' recent decline already reflected.

The insurer said its fourth-quarter earnings would be in a range of 37 cents to 39 cents a share, below analyst estimates of 44 cents but still ahead of the prior year's fourth quarter. HCC attributed the shortfall to a number of issues, all of which seem like one-time events: a slowdown in business right after Sept. 11, exiting the workers' compensation business, restructuring its accident and health operations, and dilution from equity and convertible offerings. Its earnings guidance for this year (between $1.75 and $1.95 a share) falls right in line with analysts' estimates of $1.85.

HCC is a market leader in the insurance niches it serves, such as medical stop-loss and general aviation (excluding large commercial aircraft). The firm is very well-run and disciplined in its approach to underwriting, with conservative loss reserves, good cash flow and a strong balance sheet (it has a debt-to-capital ratio of about 20%). HCC has an excellent track record, posting compound annual growth in book value per share and revenue of 12% and 16%, respectively, over the past four years.

The Stats
Year	Revenue (in millions)	EPS
1999	$345.565	$1.20
2000	473.603	1.25
2001*	517.50	1.07
2002*	650.00	1.85
*Thomson Financial/First Call estimates. Source: Company reports

The company should be able to grow earnings in the midteens going forward, largely because of a strong pricing environment. The trends in medical stop-loss insurance, which accounts for 40% to 45% of the company's earnings, are very strong. Lane says 2002 should be the third-straight year of 20%-plus increases in stop-loss insurance rates. General aviation insurance, which represents 20% to 25% of earnings, is enjoying an accelerated pace of rate increases after last fall's commercial plane disasters.

So, although nothing has really changed in the fundamental outlook for HCC since my October column, the share price certainly has gotten much more attractive. At $25, HCC is trading at a price-to-book-value ratio of about 2.2 times -- well below its 1997 high of 4.0 times, and slightly below its historical average of 2.5. Sloppy quarters may be painful in the near term, but over the long run, they can present great buying opportunities.

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