Intact Financial — Dominant In Canada, Growing In U.S. And U.K. (TSX:IFC:CA)

Intact Financial Corporation (TSX:IFC:CA) is the dominant Property & Casualty Insurer in Canada. After reaching market dominance in Canada by acquisition, the company has expanded into the U.S. and U.K. by further acquisitions in recent years.

Property & Casualty Insurance has been through a tough few years, but the industry has regained pricing power, and results have been strong. Intact has grown rapidly, and the share price has followed suit – up 250% over ten years and 120% in the last five.

In this article, I will examine the key operating businesses, consider recent performance and the outlook for the company, and determine whether the valuation is justified. I will also look at some alternative positions in the IFC preferred shares.

The key business segments

IFC operates in three segments, Canada P&C, US, and UK & International (UK&I). The three regional segments have very different business profiles, spanning personal lines, commercial lines, and specialty lines. For an explanation of the main lines of insurance business, and what it takes to be successful in each, readers new to the insurance industry might like to click here to refer to this piece.

As can be seen from the excerpt below from the management Q4 presentation, the business is still dominated by the Canadian business, which accounts for roughly 66% of the written premiums, with UK&I accounting for about 21%, and the smallest business in the US making up the balance.

Canadian Property & Casualty

With $15bn in premiums, Intact Canada has a leading market share of around 20%. The Canadian P&C market is highly consolidated, with the top 5 insurers sharing nearly half of the premiums available.

The Canadian market is heavily regulated, especially in personal lines, and highly competitive. Industry results in the post-Covid era were very strong with a sub 90% combined ratio, generating a return on equity of 18%, as per this report from the industry journal Canadian Underwriter. 2023 market results are not yet available.

Intact Canada, like the Canadian market, is dominated by the personal lines of homeowners and motor insurance, with 60% of premiums in the personal lines space (PA and PP in the chart below). The 40% of commercial premiums is much higher than the market average of 23%, which should drive a lower combined ratio overall. As a market leader, the regional split basically follows the population distribution.

Business performance for 2023 was not great, with a deterioration in the combined ratio of 4.3%, albeit to a still profitable 94.3%. This was driven by an increase in catastrophe losses.

Catastrophe claims in 2023 included Wildfires, Floods, Hailstorms, and Ice Storms. According to this report in Reinsurance News, 2023 cat losses for the market were the fourth-worst on record, reflecting a global trend for increased climate and weather related cat losses. Cat losses accounted for 7.5% of premiums, nearly double the 4.1% of the previous 12 months, and pushed the personal property combined ratio over 100%. The cat loss ratio of over 18% for personal property was 11% above the expected 7% allowance for the segment.

What is not highlighted is that, with the hard reinsurance market that started in 2022, Intact changed the structure of their reinsurance protection, so they carry a bigger proportion of cat losses before reinsurance protections kick in. I couldn’t find details of the impact of this change. All in all, this represents a deteriorating underwriting performance for 2023.

As I have discussed in previous articles, global insured catastrophe losses have been increasing, especially climate and weather related losses. This has created a shortage of supply in the reinsurance market, with prices increasing, and more risk passing to insurers to hold themselves. It is unlikely that this trend will reverse in the coming years.

UK & International

The UK&I business was acquired in 2021, when IFC purchased part of the legacy business of Royal Sun Alliance (RSA), an iconic British insurance company, which traces its roots back to Sun Insurance, one of the first ever insurance companies, founded in 1710 (not a typo!).

In a complex transaction, Intact partnered with Danish insurer Trygg, to split up the company, with Intact keeping the Canadian and UK business, while Trygg got the European business.

The history of RSA is one of decline and fall, with the once prominent global insurance icon suffering repeated performance issues, and divesting much of its global footprint in a series of restructurings. This process continued post acquisition as IFC shut down the UK personal lines business, and sold off the Middle East unit.

The results presented include the UK personal lines business. However, management also provided a ‘pro forma’ breakout of the ongoing commercial lines business.

CL is commercial lines, accounting for 61% of the ongoing premiums. SL is Specialty lines, 33% going forward, and a small intermediated personal lines business will only account for 6% of ongoing premiums.

The commercial lines segment was boosted by the acquisition of an intermediated commercial lines business from Direct Line (DLG.UK), a predominantly direct sales personal lines insurer. The STG 530m of premiums represent nearly 30% of the ongoing business. Intermediated commercial business was a strange fit for DLG. Combined ratio of the DLG book was 96% in 2021/22. I imagine that integrating this portfolio will not be simple for RSA.

2023 was not a great year for the UK&I, with a 6% deterioration on the combined ratio to 96.4%. The ‘pro forma’ view of the ongoing business would have printed better, with a 94.3% combined ratio, a 4.6% deterioration on 2023. The cat losses were a culprit again, with 1.9% deterioration on the pro forma view. A 4% unfavourable development on prior year’s business, which followed a 5.9% reserve charge in 2022 and a 1% deterioration on current year’s underlying loss ratio accounts for the rest.

These are not good signs for the business, as the implication is that, even absent cat, there is a consistent poor track record in pricing its risks.

Management guidance is for a ‘low 90s’ combined ratio going forward, which implies a material improvement. For the London market specialty business, pricing trends are positive, but this is the smallest piece of the pie. UK general commercial risk has a less positive pricing outlook.

I am skeptical of the ability of RSA to deliver on its positive outlook in 2024, especially with the integration of the DLG portfolio.

US

The US business has a different profile again. Intact started this business with the acquisition of Specialty carrier One Beacon in 2017. This was both a geographical and product expertise expansion, and has enabled IFC to grow its Specialty footprint in Canada as a result. This looks like it has been a strategic win for IFC.

Business lines include Accident and Health, Inland Marine, and Surety. A number of smaller lines of business make up the USD $2.1bn of premiums.

The distribution model is noteworthy. While the bulk of the business is via brokers, about 1/4 is written via Managing General Agents (MGAs). The MGA model is growing in popularity in the US. It involves outsourcing the core risk-taking process to third-party agents, who take little or no risk themselves, but make the risk decisions. There are some great MGAs in the market, but the underwriting and operational risks are enhanced compared to the classic underwriting model.

US specialty brings a low sub 90% combined ratio to the IFC results, which is a real positive. The business is growing fast, at 9% in USD terms. 2023 here again showed some deterioration from 2022.

Cat contributed here again, with a doubling of the cat loss ratio to 3%. As with RSA, there was a negative prior year reserve development of 1%, following a 1.4% negative in 2022.

The underlying current year loss ratio improved by 2.5%. Until the Prior year track record improves, it would be appropriate to discount that by the running 1% negative prior year’s impact.

All in all, the combined ratio deteriorated by 1%. An 88.7% combined ratio still reflects a very healthy underwriting result. The point to note is that again, 2023 showed a deterioration year-on-year from various parts of the scorecard.

The results combined

This all results in a performance snapshot which is solid, but deteriorating in the underlying business. The business is growing at around 5%, with a 2.4% deterioration in the nominal combined ratio to a respectable 94.2%. With increased interest rates, the discount impact covers the deterioration, leaving the discounted combined ratio a flat 89.5% year-on-year. In this phase of the market, investors should expect an improving combined ratio, and enhanced investment performance flowing through to an improved bottom line. In the context of the market – a flat performance is underwhelming.

In all three businesses, a key driver of this has been the cat loss ratio. On the earnings call, management shared an increase in the cat provision to 4.3%, compared to an actual 7.5% in 2023, and 4.1% in 2022. My expectation is that this cat loss provision will prove to be inadequate given underlying loss trends and less reinsurance protection in place. This leads me to believe that the margins of IFC’s business are as good as they will get. With large market shares in the two largest businesses, growth exceeding the current levels seems unlikely.

So how is IFC priced?

In a word, IFC is expensive by comparison to peers. On a price/earnings basis, IFC is 33% more expensive than The Travelers Companies, Inc. (TRV) and Chubb Limited (CB) and 60% more expensive than Fairfax Financial Holdings Limited (FFH:CA) and American International Group, Inc. (AIG).

On a price/book basis, the valuation gap is similar. 145% of TRV, 165% of CB, and more than double the valuation of FFH and AIG.

Why this valuation gap isn’t justified

• Peers like CB and TRV are best-in-class global carriers.
• FFH has shown great performance and is positioned better in the business mix. (read this article for details).
• IFC has a big concentration risk in Canada, a competitive market facing challenges.
• Cat loss expectations seem to understate the climate risk.
• RSA faces integration risk with the portfolio acquired.

Summary and how I will manage my position

• IFC has been a great consolidator in the Canadian market.
• Expansion into the US since 2017 has worked well.
• The RSA acquisition seems more complex.
• Valuation has become stretched.
• The performance outlook is for stagnating margins and unexciting growth.
• Climate risk might be understated.

Pulling this all together, I have to rate the IFC common as a sell based on valuation. This is not the conclusion I expected when I started the analysis, as I think IFC is a great insurance company, especially in Canada. In my personal account, I am long IFC with a 55% price gain.

IFC preferred shares

I think that it is time to switch to the preferred shares. If, as I expect, midterm share price growth will be limited, the downside of the preferreds is mitigated. IFC has a number of preferred offerings.

Two look interesting to me:

(IFC.PR.C)

This is a non-cumulative floating rate share, with dividends at the 5-year Canada Bond rate +2.66%. The current yield is 4.5%, with the next reset due September 26. The current price is $19.22 on a nominal price of $25. The current 5-year rate is 3.67%. Assuming the rate drops to 2% by the reset date, the yield on reset would be 6.9% If rates stay higher for longer, the yield will improve. With the current price 25% below the call price, there is good protection against the share being called.

(IFC.PR.G)

Also offering a non-cumulative floating rate, this preferred is a lower-risk alternative.

If you don’t like the reset uncertainty, this one just reset in May ’23 at the 5-year plus 2.55%. The reset rate was 6.05%, with the current price, the yield is 6.87%.

My personal strategy is to sell my common shares, and switch my position into the preferred shares. I will choose the one that just reset. I will consider using some dividends to buy call options on the common, to capture price upside if I prove wrong on the valuation call.

Editor’s Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.