State Auto Financial Corp. (NGS: STFC), a mid-cap P/C insurance company, is HOLD. The company is a regional player that has struggled in recent years to post consistent results. In 3Q20, continuing catastrophic weather events, COVID-19, and civil unrest led to higher-than-usual losses. We also note the recent deterioration in combined ratios. However, we have a favorable view of the company’s recently completed digital platform, efforts to attract low-risk drivers, and exit from unprofitable business lines.
On November 5, State Auto posted a 3Q20 net loss from operations of 0.10 per share.
The 3Q combined ratio worsened to 106.0 from 99.5.
Revenue was changed at $1.04 billion. The nine-month combined ratio worsened to 109.3 from 103.6 a year earlier.
State Auto reports operating results for two divisions: SAP Personal Insurance (66% of net premiums written) and SAP Commercial Insurance (34%). Fiscal 2Q20 results for these segments are summarized below:
In Personal Insurance, net written premiums rose 10% due to new business growth and higher rates in Homeowners offset by lower auto rates. The combined ratio rose 10.9 points to 111.5. The Homeowners combined ratio rose to 123.1 from 99.9 due to weather-related claims in the South and Midwest. The catastrophe loss ratio for the segment was 15 points above the five-year average due in part to the impact of the pandemic.
In Commercial Lines, net written premiums grew 8.3% and the combined ratio improved to 88.9 from 95.9. The combined ratio improved in the commercial auto, small commercial, middle market and farm & ranch segments, but worsened in the workers’ comp segment.
State Auto has reserved $2.9 million for anticipated costs pertaining to its legal defense for business interruption claims related to the pandemic. Management believes that the company is not liable for most of these claims. Fifteen cases are currently open, including four class-action suits.
State Auto has updated its personal auto pricing model in 14 states, lowering rates for ultra-preferred and preferred risk customers and raising rates for higher-risk customers. Management noted that approximately 20% of auto policy holders use telematics, a vehicle tracking device that records driving data, including location, speed, and sudden acceleration or braking. The company then prices individual renewal premiums based on its evaluation of this data, with discounts of up to 50% and surcharges of up to 25% depending on the quality of the driving. STFC provides a 10% discount for new customers using the technology.
EARNINGS & GROWTH ANALYSIS
To build models for insurance companies, we typically focus on ROE. The top companies in the industry, operating at optimum efficiency, can generate ROEs in the high teens. The average is in the 8%-12% range. We are lowering our 2020 estimate to a loss of $0.34 per share from earnings of $0.09 per share based on the 3Q net loss and uncertainty related to the coronavirus and civil unrest.
We are also lowering our 2021 EPS forecast to $0.97 from $1.00.
FINANCIAL STRENGTH & DIVIDEND
As the company posted a 3Q operating loss, it was unable to cover interest payments, while peers covered interest expense on average by a factor of 1.1. Similarly, STFC’s ROE was negative 3.8% in the trailing 12-month period, compared to an average of positive 9.0% for peers.
State Auto declared a quarterly dividend of $0.10 per share, payable on December 29 to shareholders of record at the close of business on December 16. The dividend has remained unchanged over the past five years. We expect the payout to remain at $0.40 per share.
MANAGEMENT & RISKS
Michael LaRocco, the CEO of State Auto, has more than 38 years of experience in the insurance industry, including roles as COO at Safeco Insurance Companies and CEO at Fireman’s Fund Insurance. Mr. LaRocco most recently served as president and CEO of AssureStart, a technology startup selling insurance to small businesses online.
Mr. LaRocco joined the company in 2015 with the goal of helping it to emerge from several years of weak results. Indeed, results have been so erratic that in April 2015 the insurance rating company A.M. Best lowered State Auto’s financial strength rating to ‘bbb-‘ from ‘bbb.’ The downgrade was due to poor underwriting and operating results relative to the private passenger standard auto and homeowners’ composite, weak 2014 results due to adverse run-off development in large commercial trucking and restaurant specialty lines programs, and the potential for continued adverse development in these programs.
The most significant risk for State Auto is underwriting eterioration in the property casualty market. Management is addressing this risk through aggressive pricing. Other risks to earnings and the balance sheet include insured losses from major property catastrophe events.
State Auto Financial Corp., based in Columbus, Ohio, writes personal (66%) and business (34%) insurance. Products include personal and commercial automobile, homeowners, farm owners, multiple-peril, workers’ compensation, and other lines. The company sells products and services through a network of 3,400 independent insurance agencies in the central and eastern United States. The company is 62%-owned by State Automobile Mutual Insurance Co.
The stock also trades at 0.7-times book value, below the average of 1.4 for peers.
On November 30 at midday, HOLD-rated STFC traded at $15.22, down $0.22.