Chubb (CB): A Conservative Dividend Grower in the Insurance Industry

Chubb (CB) is one of the best managed insurance companies in the world. Prior to the merger of CB and ACE, these companies had raised their dividends for 33 and 22 consecutive years, respectively. With a forward-looking payout ratio below 30%, we expect the combined company’s dividend growth to continue for many more years.

While a merger the size of ACE and CB’s should naturally raise some concerns, we believe the deal is in good hands with ACE’s experienced CEO and think it will make CB even more competitive and profitable once the integration is complete.

We like CB for our Top 20 Dividend Stocks portfolio and are optimistic about the company’s long-term future.

Business Overview

ACE announced it was acquiring CB for $29.5 billion in July 2015, and the deal closed in January 2016. This deal created the sixth-largest U.S. property / casualty (P&C) insurer by premiums and brought together two conservative insurers with highly complementary business lines – ACE is more international and focused on large commercial accounts, and CB is stronger with middle-market companies and personal lines businesses. Insurance companies make money by writing premiums and investing proceeds for income before costs and claims need to be paid out.

By product line, the combined company generates 54% of its premiums from commercial P&C, 21% from personal lines, 17% from global accident & health and life, 5% from agriculture, and 3% from global reinsurance.

By geography, the combined company writes approximately 63% of its net premiums in the U.S., 14% in Europe and Africa, 10% in Asia, 8% in Latin America, and 5% in Bermuda and Canada.

Business Analysis

The combination of ACE and CB will provide the company with several competitive advantages, beginning with the size of the business. Insurance policies generally have little differentiation, which makes price an important selling factor.

ACE and CB combined to write over $30 billion in global net premiums last year, making them one of the largest players in their markets. With its massive base of premiums, the company can spread its operating costs over wider pool of customers to lower its policy costs, diversify its risks, and offer customers packaged policies that cover a number of types of insurance (CB now has one of the largest product portfolios in the global insurance industry).

Both of these companies have done an excellent job underwriting conservative policies. From 2010-2014, ACE and CB’s average combined ratio was 90%, and it never ran at a loss (see below). The combined ratio measures an insurer’s costs and claims as a percentage of the total premiums it has written. A ratio below 100% means that the insurance company is generating a profit from its policies and has been smart (or consistently lucky) about the risks it is willing to write policies for.

Source: Chubb Limited

As seen below, ACE’s combined ratio over the past five years has averaged 6.2 percentage points lower than that of any major insurer in the world, underscoring the company’s skill in understanding and appropriately pricing risk.

Source: Chubb Investor Presentation

Additionally, ACE and CB are both very conservative with their investment portfolios. Fixed-income securities represent over 90% of both companies’ portfolios and are less volatile than equity investments. The bonds each company is invested in have relatively short durations, making them somewhat less sensitive to interest rate movements, and high quality credit ratings.

There’s also a lot to like about ACE’s CEO Evan Greenberg, who orchestrated the deal. The combined company will be named Chubb, not ACE. The CEO said, “I don’t know any other way to show respect to somebody to begin with than to say we’re going to take your name.” How often does a CEO take that approach? It probably didn’t hurt that CB’s was founded in 1882 and has more brand recognition, too.

The merger’s main benefits are the cost synergies that can be obtained. The transaction is expected to immediately add to CB’s earnings per share and increase profits by over 10% beginning in the third year after the deal closes. CB expects to generate $650 million in annual cost savings by 2018 and generate strong growth from cross-selling opportunities.

Besides the merger and both companies’ conservatism, CB’s business is advantaged due to its established distribution networks and massive number of field agents to sell its policies. CB’s history dates back to the late 19^th century, which has provided it with over 130 years to build its network and establish a well-known brand recognized for quality service. New competitors would need years of time and millions of dollars to catch up.

Chubb’s Key Risks

Whenever a large acquisition is made, numerous risks present themselves – poor strategic fit, difficult integration work, overestimated synergies, employee turnover, cultural challenges, and more.

While ACE’s acquisition of CB was a huge deal, this also isn’t ACE’s first rodeo. The company has successfully acquired and integrated over 15 businesses in the past, including numerous multi-billion dollar deals, which hopefully helps mitigate some of the risk associated with this merger. However, we believe this is the largest risk to CB’s long-term earnings potential and will continue watching it closely.

Beyond the merger, the insurance industry poses several risks that can impact the company’s near-term results. More specifically, insurance pricing runs in cycles. As seen below, courtesy of Ernst & Young, the P&C industry’s combined ratio has been volatile over the past decade, ranging from a low of 92.6% in 2006 to a high of 107.7% in 2011.

When the combined ratio is low, it usually means that the industry has enjoyed a period with few catastrophe events, allowing insurers to rebuild their balance sheets and capital. With excess capital, there is more competition to write policies, which results in pricing pressure.

On the other hand, when several catastrophe events occur and/or investment income is very poor, there is less capital in the industry and pricing trends can turn more favorable. The industry has seen modest claims over the past three years as evidenced by the combined ratio remaining below 100%. In other words, pricing could be squeezed a bit over the coming years. Advances in data analytics could also result in more efficient pricing of policies, although we would expect CB to remain at the forefront of change in this area.

Source: Ernst & Young

In addition to industry pricing cycles, catastrophe events such as hurricanes can obviously have a severe impact on near-term financial results. They are as unpleasant as they are inevitable, but CB has the financial health to weather just about any storm. It is also one of the most conservative underwriters of any insurer.

Finally, it’s worth mentioning the impact that low interest rates are having on the investment income that CB can generate. Investment income is a key driver of an insurance company’s profits, and over 90% of CB’s investment portfolio is in fixed-income securities. With interest rates appearing like they could be lower for longer, investors could be disappointed with the investment income CB can generate over the coming years.

Dividend Analysis: Chubb

We analyze 25+ years of dividend data and 10+ years of fundamental data to understand the safety and growth prospects of a dividend. CB’s long-term dividend and fundamental data charts can all be seen by clicking here, but note that it does not include both companies’ combined operations.

Dividend Safety Score

Our Safety Score answers the question, “Is the current dividend payment safe?” We look at factors such as current and historical EPS and FCF payout ratios, debt levels, free cash flow generation, industry cyclicality, ROIC trends, and more. Scores of 50 are average, 75 or higher is very good, and 25 or lower is considered weak.

Prior to the merger, CB had a Dividend Safety Score of 84, suggesting that its dividend is extremely safe. Prior to the merger, both companies had earnings payout ratios close to 30%. The combined company currently pays annual dividends of $2.68 per share, which results in a 27% payout ratio when using CB’s 2016 consensus earnings estimate of $9.90 per share. This is a very healthy payout ratio that provides plenty of room for unexpected catastrophe events and offers nice room for dividend growth.

As seen below, legacy CB’s payout ratios were always low and steady.

Source: Simply Safe Dividends

Source: Simply Safe Dividends

Another factor boosting CB’s Dividend Safety Score is the non-discretionary nature of most insurance policies. Regardless of how the economy is performing, buildings still need to be insured, protection is required from unexpected illnesses, and lives must be cared for. As a result, ACE and CB’s sales fell by just 4% and 6%, respectively, during fiscal year 2008.

Source: Simply Safe Dividends

Both companies continued generating excellent free cash flow during the recession, even despite the drop in value of their investment portfolios. The conservative approach CB takes to managing risk with its underwriting and investment portfolio helps the company endure tough times. While the insurance business requires a lot of financial capital to get started, it requires little in the way of tangible assets, resulting in great free cash flow generation.

Source: Simply Safe Dividends

CB has earned commendable returns on capital for shareholders over the last decade, generating a double-digit return most years. While insurance is a commodity, CB’s economies of scale and risk management skill have helped it outperform many of its competitors.

Source: Simply Safe Dividends

Regarding the balance sheet, ACE did take on around $5 billion in debt to finance its acquisition of CB. However, S&P has issued CB an AA credit rating and the company’s overall financial health continues to look very good.

All things considered, CB’s dividend is extremely safe due to the company’s low payout ratios, excellent free cash flow generation, non-discretionary services, and healthy balance sheet.

Dividend Growth Score

Our Growth Score answers the question, “How fast is the dividend likely to grow?” It considers many of the same fundamental factors as the Safety Score but places more weight on growth-centric metrics like sales and earnings growth and payout ratios. Scores of 50 are average, 75 or higher is very good, and 25 or lower is considered weak.

Prior to the merger, CB had above average dividend growth potential with a Dividend Growth Score of 69. Prior to acquiring CB, ACE had increased its dividend for 22 consecutive years, and CB was already a dividend aristocrat with 33 consecutive dividend raises.

While the company will be busy with integration work over the next several years, the merger is expected to add to the company’s earnings immediately. We expect another dividend increase in 2016 and believe it will be at a low- to mid-single digit rate. Before the deal, ACE had been growing its dividend at a low-single digit rate, choosing to invest most of its cash in acquisitions. CB had grown its dividend at a double-digit clip in recent years.

Valuation

CB trades at 11x forward earnings and has a dividend yield of 2.4%. We believe this business can grow sales at a low-single digit rate (legacy ACE compounded sales by 3.5% per year over the last five years) with earnings per share growing by 6-8% per year driven by cost synergies and operating leverage.

Under these assumptions, CB’s stock appears to offer annual total return potential of 8-10% per year. We believe the company is reasonably valued, especially given its high business quality. However, a lot of the company’s value admittedly rests on the long-term outcome of the merger.

Conclusion

ACE’s merger with CB comes with numerous integration risks, but it also creates opportunity for two blue chip dividend stocks to become an even greater force in the P&C insurance market for years to come. We expect the combined company to generate consistent dividend growth for many years and are happy to bet on such a disciplined, conservative management team.

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