The Jekyll And Hyde Of The Specialty Insurance Sector

(By Jim Ryan)

While both the title and mortgage insurance industries are tied to decimated real estate markets, we think their prospects are as different as Dr. Jekyll and Mr. Hyde. Title insurers have remained profitable, a direct result of their ability to adjust to an ever-weakening market, while mortgage insurers continue to drop like flies. We think the major title insurers can continue to profit while waiting for a real estate recovery, but it's an entirely different story for the mortgage insurers.

First American?(FAF) and Fidelity National?(FNF), the two leaders in the title insurance industry, have kept a lid on costs, increased prices, and benefited from a shift to more-profitable lines of business. The combined ratios (title insurance expense divided by title insurance premiums) of the two firms have remained relatively stable, producing underwriting margins that have averaged about 96% since the beginning of 2009.

This has been accomplished despite a near collapse in existing home sales, which have been on the decline since reaching a peak in 2005, aided only by occasional government incentive programs that increased sales for a short period. After commercial real estate transactions, existing home sales are the most profitable segment, and the lack of recovery has weighed on margin expansion in the industry. In 2011, home resale activity has fallen in most months and is off significantly, as evidenced by purchase mortgage activity.

Commercial real estate activity has become a lifesaver for the title insurers. As the number-one and -two industry leaders, Fidelity and First American have an even greater share of all commercial real estate transactions, with a combined share that is probably greater than 80% (exact market share figures in this segment are not reported). The two insurers reported increased commercial real estate transactions beginning in the middle of 2010 and continuing to climb this year. For the?third quarter, Fidelity reported that closed commercia! l revenu e from its national commercial division rose 46% on a year-over-year basis. First American saw similar results in the second quarter, with an increase of 28% in the same time frame. Commercial revenue per order is about 5 times greater than home resale, and while the title work is a bit more complicated and time-consuming, the margins are still much higher.

We think First American and Fidelity are undervalued and capable of producing earnings per share much higher than what they've reported during the past two years.

We think First American could see annual earnings per share around $3 once the market normalizes, and we forecast Fidelity to average about $1.75. At the current market price, we think First American in particular is very attractively valued relative to its normalized earnings power, and it is one of our best ideas for the patient, long-term investor.

The mortgage insurance industry, on the other hand, is in deep trouble. In the past three months, two major U.S. mortgage insurance companies, PMI Group?(PMI) and the flagship subsidiary of Old Republic?(ORI), have entered runoff. In runoff, insurance companies cease writing new policies and attempt to settle the remaining policy obligations with existing reserves under the direction of regulators. The mortgage insurance industry is staggering from foreclosure claims brought by mortgage lenders it insured, and although the hits it has taken so far are substantial, it could be just the tip of the iceberg.

The two remaining mortgage insurers we cover, MGIC Investment Corporation?(MTG) and Radian Group?(RDN), are struggling to survive the onslaught of foreclosure claims. While the firms have been accumulating reserves during the past three years in anticipation of eventual payouts, we?don't know?whether the buildup is enough. The number of claims has continued to rise, which threatens the ability of the firms to continue paying them.

Without some sort of improvement in the housing sector, we think the mortgage insurance indu! stry wal ks a fine line between survival and collapse. In our view, an investment in this industry should be avoided until signs of a turnaround are confirmed.

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