Bilanol
I last covered United Fire Group (NASDAQ:UFCS) almost a year ago. At the time, I was concerned about poor underwriting results after a period of fundamental improvement, potentially pushing out a positive re-rating of the stock. Furthermore, with soaring inflation, I was concerned inflation would translate into higher loss ratios for United Fire.
Since my downgrade, UFCS has plunged 27%, justifying my cautious stance (Figure 1).
Figure 1 – UFCS stock price has plunged since my last article (Seeking Alpha)
With UFCS recently reporting Q2/2023 earnings results, I thought it would be timely to review the company’s operating results and update my thesis.
Brief Company Overview
United Fire Group is a small-cap Property and Casualty (“P&C”) insurer that primarily provides commercial lines of insurance including Commercial Property, Liability, Inland Marine and Workers Compensation insurance. Commercial insurance accounted for 88% of Net Premiums Earned in 2021, with Fire and Allied Lines and Commercial Auto being the two biggest lines of insurance written by UFCS (see Figure 1).
Figure 2 – UFCS NPE by lines of business (Author created with data from UFCS 10K report)
Underwriting Back To The Red
After a string a bad underwriting years, United Fire had actually swung into underwriting profits with sub 90% combined ratios in Q4/2021 and Q1/2022, piquing my interest to launch coverage last year.
However, UFCS fell back into an underwriting loss in Q2/2022 (leading to my downgrade), and ultimately ended 2022 with a combined ratio of 101.4%, essentially breakeven (Figure 2).
Figure 2 – UFCS historical combined ratios (Author created with data from company reports)
So far in 2023, UFCS’s combined ratio has continued to worsen, coming in with YTD 2023 combined ratios of 118%, mostly due to Q2/2023’s disastrous 133% combined ratio (Figure 3).
Figure 3 – UFCS underwriting has turned for the worse in 2023 (UFCS Q2/23 investor presentation)
High Loss Ratio Driven By Negative Reserve Developments
A large part of the ugly 98.4% loss ratio in Q2/23 was due to 20.8% in negative reserve developments that the company recognized in the quarter. Negative reserve developments is industry jargon for when an insurer had done a poor job of estimating losses initially and now must take additional charges to ‘true up’ to the actual losses paid out.
Reading through the company’s 10Q report, we learn that the significant driver of reserve strengthening was due to an “increase in long-tailed other liability reserves primarily due to increased loss cost trends related to economic and social inflation.” Commercial Auto also experienced negative reserve developments, particularly related to “loss trends in post-2020 accident years.”
Readers may recall in my initiation article, I warned that high inflation could be a key risk to a P&C insurer like United Fire:
Insurers take on insurance policies in today’s dollars and pay out claims at a future date. If inflation is very high (for example the material and labor costs to fix a car) and the insurer did not take that into consideration when setting the policy rate, then actual loss ratios could be higher than expected.
At the time, management claimed that the rates they were getting on their insurance policies were adequate to cover losses. We now learn that those rates were not adequate, and the company must take additional reserve charges.
Of course, the CEO who was in charge at the time, Randy Ramlo, have long since retired, and have left the mess for his successors to resolve.
Premiums Written Starting To Grow
On the positive side, premiums written at United Fire continues to show growth, recording 5 consecutive quarters of YoY growth in Q2/2023 (Figure 4).
Figure 4 – Premiums written back in growth mode (UFCS Q2/23 investor presentation)
However, growth for the sake of growth for an insurer is not very valuable. What United Fire needs to do is improve underwriting standards such that the company can bring combined ratios to under 100%. Only then will profitability improve and shareholder value be created. For now, this is still a work in progress.
Financials A Mess So Far In 2023
Overall, United Fire’s financials have been a mess in 2023, as a 118% combined ratio have led to UFCS recording -$2.21 / share in diluted EPS per share in H1/23 and a -16% ROE (Figure 5). Book value decreased YoY to $26.77 / share.
Figure 5 – UFCS financials a mess (UFCS Q2/23 investor presentation)
Valuation Remains In The Penalty Box
With poor underwriting results and a YTD ROE of -16%, it is not surprising that United Fire’s valuation continues to be in the penalty box, with the company trading at a discounted 0.74x Price to Book (“P/B”) ratio (Figure 6).
Figure 6 – UFCS valuation in the penalty box (Seeking Alpha)
Given UFCS’s poor profitability, with a 5Yr average ROE of -0.16%, I believe a 0.74x P/B ratio is appropriate. Looking at P&C peers, those that can generate higher ROEs are generally valued with higher multiples (Figure 7).
Figure 7 – P&C insurer valuations are tied to ROEs (Author created with data from Seeking Alpha and tikr.com)
UFCS’s poor profitability is most similar to ProAssurance Corp (PRA) with a 5Yr average ROE of -0.03% and currently valued at 0.8x P/B (Figure 8).
Figure 8 – P&C peer valuations (Author created with data from Seeking Alpha and tikr.com)
Risk To Cautious View
The biggest risk to my cautious view is that United Fire is trading at a discounted 0.74x P/B valuation, so it may appeal to another company that can acquire UFCS’s book of business and try to close the valuation gap.
However, I believe this probability is remote because insurers are like giant cruise ships; turnarounds take a long time to come to fruition because bad business written in the past may take years to work through and ultimately pay out. UFCS’s negative reserve developments may give potential acquirers pause, since it will be challenging to figure out whether additional reserves will need to be taken.
Conclusion
Overall, United Fire’s operating performance in the past 12 months have justified my downgrade of the stock, as underwriting performance have regressed, especially with a 133% combined ratio in the recent Q2/23 quarter.
While the stock may look cheap at 0.74x P/B, a peer analysis suggests this valuation is appropriate for United Fire’s poor profitability. Until UFCS can improve ROE, the stock will continue to languish and trade at a discount to liquidation value. I continue to rate UFCS a hold (or avoid).
