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Scottish Re Group

George C. Fisher

There have been many articles written about the current flat US Treasury bond yields and rising interest rates, mine included. As no trend lasts forever, I have started searching for companies whose fortunes maybe negatively impacted, but should improve with the pending “normalization” of the yield curve. The “normalization” will occur by either short rates dropping or long rates rising – or both.

As short-term rates continue to head higher without corresponding increases in long-term rates, some of the pain is felt in the financial sector, especially firms that rely heavily on bond investment income. Yields have flattened to the extent that expected income from a 10-year US Treasury Note is just a hair below their 30-year cousins. That creates a 20-year differential in maturity risk with virtually no additional return for the increased time exposure. Large institutional bond investors, such as insurance companies and pension funds, usually experience underperforming investment income in times of flat yields. Based on the recent Fed increases in short rates, and a “normalization” of the yield curve to reflect a 2.5 to 3.0 spread from short duration to long duration, long bond yields could/should be much higher. Currently, 30-yr bonds yield 4.90%, and under a “normal” bond curve based on the current short rates, the long duration yield could/should be somewhere north of 6.4%. If the curve was “normal”, new capital in the bond market would generate substantially higher investment income. Companies that convert ongoing revenue streams into investment income, and rely on investment income as a large portion of overall net income, are feeling the pinch.

As most of us know, the theory behind a basic life insurance company is quite simple. A policyholder pays an insurance premium to a company that invests the proceeds. When the policyholder dies, the insurance company agrees to pay a specific amount stipulated in the policy. Premiums are determined by risks associated with the policy holder and the anticipated income generated from the premium revenue stream. In flat yield environments, life insurance companies usually don’t generate as much investment income from the ongoing premium revenue stream as in “normal” yield environments. This translates to slowing corporate earnings growth as insurance company investment income opportunities diminish, and stock investors don’t usually like slowing earnings growth. The economics of flat yields affects all insurance firms, including the life re-insurance industry.

Many times, life insurance companies will offer to split a policy that is on the books with another insurance company. In this arrangement, the two companies share the policy risk and the ongoing revenue stream. This is called “re-insurance”. Re-insurance aids the primary underwriting firm by freeing up capital reserves to write additional business and by spreading the claim risk with others. The re-insurer does not usually market their products directly to consumers and deals mainly with other insurance companies. This saves on marketing and individual underwriting costs, greatly reducing overhead. There are many large re-insurers with the best known being General Re, part of Berkshire Hathaway. Within the re-insurance business, some firms specialize in niche markets.

Since 1995, the overall US market for life insurance has grown by a compounded rate of 7% annually. As more primary insurers turn to re-insurers as partners, growth in the life re-insurance market has expanded at twice the underlying growth rate of policies. Over the last 10 years, the market for life re-insurance has grown by a compounded rate of 15% annually. Industry followers believe this trend will continue.

Although possibly a bit long winded, I think the above explanation is important as flat yields never last forever. Stocks in life re-insurance companies have under-performed the market and, as a group, current trade at around a PE of 12 compared to the S&P 500 PE ratio of around 16. I believe yields will eventually “normalize”, generating higher paying fixed income investment opportunities. Insurance companies, in general, should experience improving investment income, improving investor attention, and improving stock prices.

Scottish Re Group (SCT $24, Financial, Insurance) is the third largest life re-insurer in North America. Scottish Re focuses on life insurance, annuities and annuity-like products. I believe this niche is a less volatile sector of the overall re-insurance industry, especially compared to property/casualty. To a much smaller degree, SCT offers life insurance and financial products directly to high net worth individuals. Headquartered in Bermuda, SCT generates 83% of its revenues in the North America, and is expanding its business in Europe and recently in Asia.

Scottish RE was formed in 1998 and has fueled growth through in-place policy portfolio acquisitions and internal expansion. For example, in 2004, SCT purchased a large portfolio of life re-insurance policies from General Electric during the realignment of GE Financial. The largest acquisition was in December 2004 when SCT purchased ING Re's U.S. Individual Life Re-insurance Business. ING wanted to exit the life re-insurance business to focus on other opportunities. This acquisition catapulted Scottish RE to the third spot in North America and more than doubled annual revenues. Due to issuing new shares of stock to acquire the ING portfolio, per share earnings increased in 2005 by 39%. It is noteworthy that annual revenues increased from $811 million in 2004 to $2.29 billion in 2005, reflecting the ING acquisition. EPS also shot up from $1.91 to $2.64. If you are into big numbers, Scottish RE has over $12.0 billion in consolidated assets, $1.0 trillion in gross re-insurance policies in force covering 13.9 million policyholders in North America with an average policy benefit of $76,000.

I like Scottish Re for several reasons. The current stock price of $24 is way undervalued, even for the out-of-favor insurance business. For starters, it is trading at a PE of 9.2 while its peers trade a PE of 12.8. Listed below are other fundamental valuations, as of March 23, 2006, comparing Scottish Re’s to its peers and an approximate SCT stock price equal to the peer average ratio:

  Scottish RE Peer Average Price of SCT Stock
At Peer Average
PE Ratio 9.2 12.8 $33
Price to Sales 0.6 1.3 $52
Price to Book Value 1.1 1.8 $39
Price to Cash Flow 9.2 10.3 $27
Price to Free Cash Flow 3.6 9.0 $60

Institutional investors, such as mutual funds, own an incredible 95% of the 53 million shares outstanding. This leaves very little float for the individual investor, but it also provides a huge base of presumably long-term shareholders. The downside to such a large institutional ownership is in the extremely unlikely event all the fund managers want to unload their shares at the same time, things could turn ugly.

Revenue and earnings per share growth in 2006 will be affected by the continuing structural integration of the ING portfolio along with sluggish investment income. According to Wall Street consensus, revenues should expand from $2.29 bil in 2005 to $2.61 bil in 2006, and $2.76 bil in 2007. Earnings per share are expected to grow from $2.64 last year to $2.81 this year, and $3.14 in 07. Earnings estimates for this year and next year have declined slightly over the past 90 days. Some analysts believe Scottish Re has the potential to post earnings gains close to 20% over time. While short-term EPS growth is a bit anemic at only 6.4% in 06 and 11.7% in 07, SCT seems to be well positioned for the future.

Historically, Scottish Re has deployed the vast majority of its investment assets in the bond market, and investment income constituted 17% of last year’s annual revenues. Earnings growth going forward will be augmented by additional investment income that will accompany a “normalization” of the bond yield curve. According to recent SEC filings, as of Dec 31, 2005, the company had consolidated assets of $12.0 bil. Of that amount, $9.5 bil is categorized as “investments” with $5.0 bil in fixed maturity bonds and $1.5 billion in cash. Investment income totaled $355 million. In 2005, SCT took in about $1.9 bil in premiums, paid out $1.4 bil in claims and generated net income before interest, taxes, and depreciation of $113 million. As bond yields inch upwards, so should SCT’s investment income. With only 53 million shares outstanding, it should not take much increase to positively affect earnings per share.

The company is also expanding its footprint into the growing Asian market. Scottish Re has serviced the Japan market for several years and is looking to capitalize on the favorable Asian insurance trends through its recently opened Singapore office. It seems Scottish Re likes to acquire large blocks of business from other financial companies seeking to divest assets, such as GE and ING. I believe management will duplicate their North American success overseas.

Another factor to review when researching insurance companies is to evaluate their credit ratings. Ratings directly impact the desirability of their products, along with the cost of their capital. Investors should search for firms with top credit ratings, and the ability to sustain top ratings. Scottish Re has high credit ratings, as described on their website: “Scottish Re is rated “A-” (excellent) for financial strength by A.M. Best Company, which is the fourth highest of sixteen rating levels; “A” (strong) for financial strength by Fitch Ratings, which is sixth highest of twenty-two rating levels; and “A-” (strong) for financial strength by Standard & Poor’s, which is seventh highest of twenty-two rating levels. Scottish Re (U.S.), Inc. is also rated “A3” (good) for financial strength by Moody’s, which is seventh highest of twenty-one rating levels.”

However, not all is rosy at Scottish Re. Management effectiveness is short in generating gross and net margins. In 2005, both were below industry average. While industry trends favor margin expansion, SCT’s margins have contracted both year-over-year and their 5-year average. I believe this reflects assimilation of the large 2004 acquisitions, and over time, management will improve their efficiencies. For example, SCT generates six times the revenues and three times the gross profit per employee as its peers. Over time, I am looking for higher earnings in part due to better margins.

In addition, 1st quarter 06 earnings are expected to be around 5% below last year. SCT is anticipated to earn $1.17 in the first half of 06, up 11% from last year. Second half results are expected to be $1.64, down 4% from 2005. Wall Street media likes to focus on prior year comparisons, seeking signs of consistency, and SCT’s comparisons will be all over the place in 2006. An advantage of being owned by large institutional investors is professionals may have more patience to ride out these short-term earnings comparisons than fickle retail investors.

One aspect of Scottish Re I find intriguing is their technical stock chart. Since making an impressive run from $16 in late 2002 to $24 in the fall of 2003, SCT has been trading between $20 and $26. Going back to Oct 2003, SCT’s successive intermediate highs in April 04, Jan 05, July 05, and Dec 05 form the top end of a trading channel, or the resistance line. The lows of July 04, May 05, Nov 05, and Feb 06 form the bottom of the same channel, or the support line. However, these two lines are converging, and are only a few points apart. Technical analysis would call this formation a consolidation “pendant”. Although usually a short-term trading tool, I find the long-term formation interesting. As the trading channel lines narrow, the stock eventually exits the trading range, breaking either to the upside or down. Most of the time, the breakout movement is a continuation of the trend in place before the pendant, and in this case it should be to the upside.

The ING acquisition has provided SCT with a substantially larger base to expand its core business, both in North America and overseas. For the 5 years before the ING purchase, management succeeded in doubling earnings per share. I believe management is up to the task of improving efficiencies, expanding their business model internationally, and achieving annual earnings growth in the 15% to 18% range.

As I see it, if Scottish Re earns $3.14 next year and even if there is no expansion of its undervalued PE ratio, the stock could rise to around $29, or 20% above its present price.

I think Scottish Re could climb into the mid-$30 as the bond yield curve “normalizes” and individual investors return to insurance companies. Over time, if Scottish Re were to generate earnings expansion matching the underlying industry growth trend, there could be reasonable potential for share prices over $45.

Due to a small share float available for retail trading, don’t expect the big Wall Street brokerage houses to start recommending SCT. While Scottish Re may be undervalued, investor patience may also be required. SCT has a low dividend payout ratio, and management does not seem inclined to raise it distribution above a token amount. I started nibbling at $24.50 in March, 2006.

George C. Fisher is a 30-year veteran in DSP/DRIP investing. He is author of All About DRIPs and DSPs (McGraw Hill, 2001) and The StreetSmart Guide to Overlooked Stocks (McGraw Hill, 2002). Mr Fisher is an avid dividend reinvestment advocate and utilizes the strategy with all dividend paying stocks, both at the broker and direct with the companies using their DRIP programs.