Mortgage Insurers Make Headlines, Title Insurers Make Money
Uncertainty surrounds specialty insurance, but there's one overlooked opportunity.
While there has been a great deal of publicity on issues affecting stocks in the specialty insurance industry--mortgage, bond, and title insurance--not much of substance has changed our view over the past year. Foreclosures continue to build, as we expected, but currently at a slower pace due to the "robo-signing" controversy and other processing issues. The economy is improving, albeit slowly, and new job formation, a factor that could limit foreclosures, is still meager. A growing inventory of distressed homes continues to pressure home prices, leading to more and deeper underwater mortgages. All in all, the outlook remains generally depressed for most of the stocks we cover in these industries. However, we adhere to our view that there is opportunity in one sector of this group.
Our take on the mortgage insurers has been and still is that they have yet to see the worst levels of actual paid claims hit their reserves. The average time from initial delinquency to foreclosure has lengthened dramatically, first from attempts to modify nonperforming loans and more recently from the delay arising from faulty foreclosure proceedings. Mortgage insurers that have already reported fourth-quarter earnings have stated that paid claims in 2011 will rise, in some cases substantially. Assuming the market doesn't weaken further, we think the mortgage insurers will survive but will likely have to raise more capital in order to be adequately reserved. On the other hand, a stagnating economy with no job growth could bring these firms to the brink if foreclosures accelerate beyond our expectations. Because of the extreme range of outcomes in this line of business we think investors are best advised to avoid the monoline mortgage insurers we cover, MGIC (MTG), Radian Group (RDN), and PMI Group (PMI). Old Republic International (ORI), a multiline insurer with other lines of business that are performing adequately, is less uncertain and could be considered for investment with a wide margin of safety.
Financial guarantors (bond insurers) are in even worse shape than the mortgage insurers. Ambac has declared bankruptcy, and MBIA (MBI) is in limbo without the ability to write new business because of legal proceedings from a variety of sources. However, MBIA has also filed suit against some of the major mortgage lenders, seeking reimbursement for claims paid on insured mortgages that violated representations and warranties. If MBIA were to succeed in this effort, billions could be returned to their coffers and the company's capital position would change dramatically. But predicting how courts will rule on complex business issues is a tenuous exercise, in our view. We believe extreme uncertainty still surrounds the value of MBIA, although the legal case finally presents some possibility of an upside. The only remaining guarantor that is still active in writing new business is Assured Guaranty (AGO). Still, even Assured has claims liability from its large municipal bond insurance portfolio, and the firm is currently under review by Standard & Poor's (MHP) for a possible ratings downgrade, which would have detrimental effects on its ability to write new business.
We still think that title insurers are the one specialty insurance opportunity worth investigating. Unlike mortgage insurers and guarantors, title insurers have no major liabilities threatening their survival, and the business is relatively straightforward and driven by fees generated by real estate sales and refinancings. Obviously, this is not without its impact in the current environment, as the volume of real estate transactions has fallen significantly in recent years and has yet to really rebound. But the title insurers have historically adjusted to real estate downturns by cutting costs, which sets up underwriting margin expansion in subsequent years. For example, the title insurance industry's combined ratio--insurance expense divided by premiums--averaged 108% in the recession years of 1980-82, which fell to an average of 98% in the four years after the recession. Similarly, the real estate downturn of the late 1980s and early 1990s caused the industry's combined ratio to average about 104%. In the four years after that the combined ratio averaged 97%. We think the same margin expansion will occur once the housing market gets back on its feet, but even more so due to industry consolidation that has softened the degree of competition.
Despite operating in one of the worst real estate markets ever, the two title insurers we cover, which collectively insure about 65% of the total market in the U.S., were both profitable in 2010. Fidelity National Financial (FNF), the largest title insurer with a market share of about 38%, reported an 8% title insurance operating margin (excluding realized investment gains and losses) for the full year 2010. First American Financial (FAF), which will report fourth-quarter earnings in late February, reported a 6% title insurance operating margin for the first nine months of last year. Both companies experienced title insurance operating losses beginning in 2008 and took expense management actions, slashing costs through staff cutbacks, office consolidation, review of unprofitable agents, and a variety of other measures. Further, on the revenue side, title insurers will benefit from a shift in the mix of policies going forward. Business in the last two years was dominated by residential refinancing, the product with the lowest profit margin. As real estate markets begin to recover, more business will be residential resale and commercial transactions, both of which carry far greater profit margins. In the beginning stages of this recovery we think title insurers will see premiums increase as the result of distressed residential property sales and workouts in the commercial real estate sector. The combination of higher transaction volumes, higher profitability per order, and expense reduction actions taken over the past two years should set the stage for significant positive operating leverage once real estate markets normalize.
We don't expect this process to happen quickly, and 2011 could be another tough year for the industry--the refinancing boom of 2010 is receding, and sales transactions have yet to show any real traction. However, the patient investor could find a lot to like with these moaty but cyclical companies at the current market valuation.
Our pick of the two title insurers is First American. We think First American has built a stickier customer base as the firm has almost doubled its market share since 1990, primarily through organic growth. In contrast, Fidelity has increased its share over the years mainly through acquisitions, which have led to market share declines in the years immediately after each acquisition as competitors have picked off dissatisfied customers and agents. While we think Fidelity has made wise acquisitions at attractive prices over the years, it has not demonstrated the ability to ring fence acquired customers and agents, which diminishes at least part of the deal's expected value. Over time we expect First American's organic growth strategy to add more value than Fidelity's acquisition approach. Now that the industry has consolidated to the extent that four companies write about 90% of the business, we doubt there are any acquisition opportunities left due to legal obstacles.
Jim Ryan does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.