Enstar Group Deepdive

Enstar Group Ltd (NASDAQ:ESGR):

ESGR is the leading insurance run-off company. An insurance run-off company acquires portfolios of discontinued insurance lines, taking on both insurance liabilities and the related investable assets. It seeks to profit by effectively managing insurance loss claims while investing the assets (float). The predecessor to ESGR (run by the same management team) was formed in 1993, and the company went public in 2007.

Currently, ESGR trades at <90% of GAAP tangible book value, <60% our estimate of economic TBV, and approximately 5x run-rate net income. In our view, this is an exceptionally compelling valuation for a high-quality business that generates strong ROEs, has large insider ownership, has repurchased approximately 30% of shares outstanding over the last 3 years, and whose results are almost wholly uncorrelated to the macro environment.

Our thesis for ESGR is based on five key considerations:

ESGR operates a structurally attractive business
ESGR is underfollowed and misunderstood
ESGR management is strong and aligned
ESGR is materially undervalued
ESGR is better positioned for earnings growth and multiple expansion than it has ever been

Business model:

An insurance portfolio is put into run-off when an insurance company discontinues writing a line of business (i.e., the insurer stops underwriting new business in a category, and will no longer renew existing policies). While various reasons may be cited for putting a line of business into run-off, capital needs and lack of profitability are the most common. In other words, insurance companies generally put into run-off and sell business lines which they are unenthusiastic about, and which they actively want off their balance sheet. Accordingly, companies acquiring run-off portfolios tend to be buying assets from motivated sellers, a structurally attractive position. The question, of course, is why does ESGR want to buy run-off portfolios which traditional insurance companies want to sell?

At a basic level, ESGR is a ‘better’ owner of run-off portfolios than traditional insurance and reinsurance companies. Traditional insurers consider either insurance underwriting or investment asset management their core competencies. By contrast, claims management is ESGR’s core competency, and the company’s central focus is to reduce the amount of money it spends to settle claims. More specifically, ESGR is advantaged in two significant ways vs. traditional insurers vis-à-vis claims management:

ESGR manages the claims management process more efficiently – for traditional insurers, claims management is viewed as a back-office function and cost center. Talent and investment dollars do not flow towards it. In contrast, ESGR is run by claims management specialists and effective claims management is the primary profit center for ESGR.
ESGR can (and does) manage the claims management process more aggressively – traditional insurers are wary to pursue aggressive negotiations with claimants out of fear of impairing client relationships and jeopardizing future business. For run-off specialists like ESGR, ongoing client relationships need not be considered to the same degree.

ESGR’s business model works as follows: the company acquires a run-off portfolio containing $1000 of investment assets, together with “claims reserves” liabilities that the selling insurer believes will total $1000. ESGR uses its superior claims management processes to reduce the ultimate amount paid to settle the claims reserves liabilities to $850.

In other words, ESGR’s earnings come from the reduction of liabilities over time (as claims are settled for less than book value), and the company’s business model and financials look very different from those of a traditional insurer. Simplified, most insurance companies are modeled on the basis of: earnings = (net premiums earned + net investment income) – (insurance loss expenses + other operating expenses). ESGR’s run-off business differs in two fundamental ways:

Net premiums earned is an immaterial number (new premiums arise for ESGR only as an incidental consequence of policies which the company is obligated to renew).
ESGR’s insurance loss expense (‘Net incurred losses and loss adjustment expenses’) is negative, or a contra-expense. That is because, as discussed, ESGR’s business model is focused on the reduction of claims reserves liabilities (which are effectively over-provisioned at the time of ESGR’s portfolio acquisitions).

We believe that because ESGR’s business model and financials look so different from traditional insurers’, the company tends to be overlooked by insurance-focused investors and analysts.

Management strength and alignment:

Since 2003, ESGR has compounded fully diluted book value per share by 15.7%, almost the highest rate of any insurance company over that time frame. ESGR has achieved its success while remaining highly disciplined in its acquisition of run-off portfolios – a view supported by our analysis of ESGR’s financials, discussions with the company, and discussions with industry participants.

Our view – shared by the company – is that the most significant risk to ESGR is a bad acquisition of a run-off portfolio. A bad acquisition would be one where ESGR estimates that the cost to settle all claims will be $X but the cost ends up being substantially more than that.

Based on our analysis of ESGR’s SEC and insurance commission filings, the company has an unparalleled track record of positive reserve development, meaning the company has been executing its strategy of reducing claims reserves liabilities over time.

Furthermore, we believe that the very high level of insider ownership significantly aligns management and the board of directors with shareholders and diminishes the risk that management will consummate an imprudent transaction driven by short-term aims. Total insider ownership – including management and board members – totals ≈35% of shares outstanding. Moreover, much of the company’s executive compensation is structured as long-term equity-based incentive compensation.

Valuation:

ESGR trades at <90% of GAAP TBV.

Over its history ESGR has generated very strong returns on equity and for that reason, we believe TBV is the starting point for valuation. Moreover, we believe that reported TBV materially understates ESGR’s intrinsic value for two reasons:

Reported TBV understates economic TBV by $140-$200/share.
Reported TBV assigns no value to ESGR’s business platform, which allows it to efficiently acquire and manage new portfolios each year, generating significant value.

Economic TBV:

Perhaps surprisingly, other than a single small exception, ESGR has never recognized a gain on the acquisition of a run-off portfolio (i.e., the accounting entry of ‘Gain on bargain purchase’).

Simplified, a typical acquisition for ESGR works as follows: ESGR acquires a run-off portfolio that contains $2000 in investment assets and for which the claims reserves – based on the seller’s financial reports – stand at $2000. At the same time, ESGR’s internal analysis indicates that it will ultimately settle all the claims for a cost of $1700. In contrast, however, ESGR’s auditors will require that the company book the claims reserves up to the fair value of the assets acquired, or $2000. From that point, ESGR will be able to recognize reductions in claims reserves over time, as claims are settled at levels below their cost at acquisition.

As a result of the above, a few things become clear:

Given the company’s expertise in subsequently managing claims, a lot of ESGR’s money really is made from the acquisition itself. (In the example above, at the time of the transaction, ESGR believes that it has acquired $300 of net economic value).
At any given point in time, ESGR’s book value will not reflect a substantial amount of the value embedded in its balance sheet in the form of future claims reserves reductions (that will be realized through the company’s normal-course claims management). In the above example, if ESGR were to present a balance sheet using its expectation of the cost to resolve the claims liabilities, that balance sheet would reflect $2000 in assets, $1700 in claims reserves liabilities, and $300 in equity. As reported, that transaction would look like $2000 in assets, $2000 in liabilities, and zero equity value.

Based on our analysis and discussions with the company, we conservatively estimate that claims reserves are overstated (relative to what payout will ultimately be) by ≈$60 per share. That value is not reflected in ESGR’s financials.

There is a separate and even clearer reason GAAP TBV understates economic reality – per GAAP accounting, ESGR’s investment assets are marked-to-market, while its liabilities are not. Accordingly, as interest rates rose over the course of the last year, ESGR had to take large write-downs on the mark-to-market value of its bond and equity portfolios, resulting in a ≈$100 decline of TBV/share. However, despite the rise in interest rates and associated discount rates, GAAP accounting does not allow for the reevaluation of liabilities, irrespective of whether such liabilities will be paid in 6 months or 6 years. But just as higher interest rates cause the present value of the cash inflows associated with ESGR’s investment assets to decline, higher interest rates also reduce the economic present value of the cash outflows associated with ESGR’s liabilities.

In contrast, for insurance industry regulatory accounting (used by insurance commissions for the calculation of capital requirements), liabilities are discounted as interest rates change. Based on those regulatory calculations, ESGR’s regulatory liabilities are $1.3bn-$2.2bn less than the liabilities reported under GAAP. This represents incremental TBV equal to 30%-50% of the current share price.

Taking the two sources of latent economic value into account, a fair estimate of ESGR’s economic TBV is 70%-90% higher than ESGR’s share price.

Platform value:

As highlighted above, ESGR’s acquisition activity is the source of future profits. Book value plus the economic adjustments thereto is what exists now.

Based on historical data, management commentary, and discussions with industry participants, we believe that ESGR can acquire >$2bn of run-off portfolios per year. ESGR is substantially overcapitalized and foresees no need to raise equity capital to fund additional portfolio acquisitions. Accordingly, to the extent that an acquisition requires capital, ESGR has excess equity capital and ample access to debt capital to fund the transaction.

Why now? And conclusion.

We previously owned ESGR from 2015-2019. So, why did we exit and why did we re-enter? More pointedly, why do we think ESGR’s stock will rise from either (or a combination of) much higher earnings or a higher valuation multiple?

We exited for the following reasons:

Fatigue with low interest rates: low interest rates depress ESGR’s ROE because their asset portfolio (largely bonds, levered 3x-4x against ESGR’s equity) earns little money.
Fatigue with a soft insurance market and associated risks: over the second half of the 2010’s and into the early parts of the 2020’s, insurance markets were indefatigably ‘soft’, meaning pricing was too low due to industry overcapitalization. Soft markets result in weakened underwriting, which introduces the risk that actual losses will prove worse than expected.
Concerns with competition: inspired by ESGR’s success, many ESGR clones were launched by inexperienced and aggressive entities, creating heightened (and sometimes irrational) competition for deals.
Fatigue with ESGR’s lack of corporate communication: while we respect ESGR’s low-key and heads-down culture, ESGR engaged in essentially zero investor relations. This made a situation already difficult for investors to understand into something close to impossible.

With shares then trading at a premium to reported TBV and the delta of reported vs. economic TBV not nearly what it is today, we decided to exit.

What has changed?

Interest rates are much higher: ESGR’s increased earning power from higher rates is enormous – simply, with $1 of equity and $4 of investable assets per share, 2% interest rates generate an 8% ROE while 5% interest rates generate a 20% ROE. Moreover, ESGR’s bond portfolio has been fully marked down to reflect the current rate environment.
The insurance market has hardened dramatically: there are various reasons for this, but it basically boils down to insurance industry rationalization following a string of heavy loss years. In a hard market, primary insurers and reinsurers often look to sell run-off portfolios to free up capital to take advantage of improved primary pricing. Moreover, insurers are more likely to be appropriately reserving for losses, reducing the risk to ESGR that the reserves are undermarked when it acquires a portfolio. In short, there is now a greater supply of lower risk and higher return portfolios for ESGR to buy.
Competition has retreated: the main ESGR clones (e.g., Catalina, Armour, Axa LM, R&Q, Darag) have either called it quits or substantially rolled back their ambitions. We think new capital formation in the market will be difficult given the lousy returns the upstarts generated. ESGR’s competitive position hasn’t been this strong in years.
The company has significantly improved its investor communication: in April 2020, ESGR hired a new treasurer with deep insurance industry and capital markets experience. He also became the (first ever) point person for ESGR’s investor relations. Shortly thereafter, the company began doing quarterly update calls/videos. In March 2023, that individual was promoted to CFO.
Much improved prospects for a higher multiple: over the last few years, ESGR has demonstrated its ability to perform well in extremely challenging market conditions. Moreover, the company is, for the first time, expressly interested in ramping up asset management for 3^rd party capital. Those efforts (which we believe the company is well suited to pursue) could result in meaningful capital-light fees, further boosting ROE.

We expect ESGR to generate earnings of more than 60% of its current tangible book value over the next three years, and to compound at a high rate for a long time thereafter. The company has capacity for further share repurchases, which we expect will continue so long as shares trade at a deep discount to fair value. ESGR’s prospects for earnings growth are better than ever. And ESGR is cheaper than ever.

Presented below is our estimate of normalized run-rate earnings for ESGR:

At 1.5x GAAP TBV – which would be in line with industry median levels despite ESGR’s far superior ROE, economically understated GAAP TBV, differentiated and valuable platform, etc. – the stock would trade at >2.5x current levels in 3 years.