HGIC Harleysville Grp. Inc. (MM)

We are reiterating our Neutral recommendation on the shares of Delphi Financial Group Inc. (DFG) following its second quarter 2011 earnings release.

Delphi’s second quarter core operating income of 86 cents per share missed the Zacks consensus Estimate of 91 cents but compared favorably with 79 cents reported in the prior-year quarter.

The earnings miss was driven by lower operating income at Delphi’s Asset Accumulation segment, which was partly offset by higher operating income at its Group Employee Benefit segment.

Delphi is trying to mitigate the top-line pressure at Reliance Standard by selling excess workers’ compensation products through Safety National. The subsidiary is expanding its leading market share in providing coverage to self-insureds. Its market share increased to 27% in 2010 from 25% in 2009 and 22% in 2008. Also, the company increased premiums at a CAGR of 6% between 2006 and 2010.

Management expects an attractive market for the Excess Workers’ Compensation considering the positive trends in January 2011 renewals, with a 3% improvement in average rates and a hike in average self-insured retention (Safety typically writes 25% to 30% of its business in January and the pricing on these renewals generally set the tone for the year). Again during the July 2011 renewal season, rates on excess workers’ compensation policies increased 4% and SIRs on average upped 3% owing to new and renewed policies.

The company’s retention of its existing excess workers’ compensation customers remained strong during the first half of 2011. Moreover, the long tail nature of this business with average duration of 15+ years implies a large investable float. But, along with it, comes a long-tail risk related to the uncertainty of claim payments. Nevertheless, given the company’s use of reinsurance and the increase in self-insured retentions, we believe the company can effectively manage the long-tail claims exposure that provides it with free cash to invest for long term. Management anticipates a stronger growth at Safety, which continues to benefit from its leadership position in excess workers' compensation and growing contributions from assumed reinsurance.

At Reliance Standard, Delphi’s life insurance unit, second quarter core premiums increased 5.9% year over year, while core production declined 7.9%. The segment’s modest premium growth and lower production in the quarter reflected management’s ongoing commitment to pricing and underwriting discipline. The unit is gradually benefiting from its strong position in the small case market and its differentiated offering for larger cases with its integrated employee benefit (IEB) program. The unit is expected to gain from its niche focus on the small case segment (companies with less than 500 employees).

Moreover, at Reliance Standard, voluntary products continue to be a major growth driver as employers seek to control costs. Thus, after declines of 1.6% and 1.1% in core premiums in 2010 and 2009, respectively, the unit’s business modestly improved during the first half of the year. Though we expect business growth, we believe it will be somewhat offset by competitive pressures on group employee benefits and an uncertain employment scenario. Besides, high long-term disability claims incidence would act as another headwind.

Net investment income in the first half of 2011 was $175.5 million, an increase of 8% from the comparable period last year. This increase reflects a 14% improvement in average invested assets to $6,678.0 million in 2011 from $5,852.3 million in 2010, a higher level of investment income from the company’s fixed maturity security portfolio, and a better performance of the company’s investments in investment funds organized as limited partnerships and limited liability companies as well as trading account securities. The tax equivalent weighted average annualized yield on invested assets was 5.7% and 6.0% in for the first half of 2011 and 2010, respectively. We, however, expect net investment income to be suppressed for 2011 given low investment yields.

Combined ratio at Delphi inched up to 94.8% in 2010 from 93.3% in 2009 and 92.2% in 2008. Given the expectations for a restricted premium growth and a higher long-term claims disability incidence, combined ratio is unlikely to trend down from the current levels. Management expects combined ratio for 2011 to be in line with the 2010 level.

Delphi has been consistently returning value to its shareholders via dividend payments and share repurchases. It has increased dividend every year since 2001, when it initiated its dividend payout. In May 2011, the company announced a 9% hike in its quarterly dividend. The dividend growth rate averaged 16.7% over the past five years, reflecting a solid balance sheet. Besides, the reduction of debt-to-capital ratio to18% at 2010 end from 19% at 2009 end and 26% at 2008 end also contributed to the solidarity of balance sheet.

Delphi, closely competing with FBL Financial Group Inc. (FFG), Harleysville Group Inc. (HGIC), HCC Insurance Holdings (HCC), and Markel Corp.(MKL), carries strong ratings. Its subsidiaries, Reliance Standard and Safety National, carry financial strength ratings of "A”, “A-”, “A3” and “A” by A.M. Best, Fitch, Moody’s, and Standard & Poor’s, respectively.

 
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