Risk/Reward Favors Old Republic International

We believe that  Old Republic International's (ORI) dividend, currently yielding 6.7%, is sustainable on an economic basis and that management is fully committed to maintaining it. There is a low-probability threat, extraneous to business performance, that could force the multiline insurer to cut the dividend. However, even if this were to occur, we think the stock offers compelling long-term value to investors willing to endure headline risk in return for potential reward. The market is overlooking the underlying value of Old Republic's legacy insurance operations, in our opinion.

We think Old Republic has a narrow economic moat. The general insurance segment targets specialized coverage with niche characteristics, while the title insurance business has significant barriers to entry. Most insurers have to rely on investment income to produce a profit, but Old Republic has better-than-average underwriting income. However, the stock currently trades at only 0.73 times book value and 70% of our fair value estimate.

While Challenges Remain, Old Republic Has Put the Worst Behind It
Over the past year, Old Republic has confronted numerous obstacles raised as a result of its mortgage insurance operations. In August 2011, the mortgage insurance subsidiary violated the maximum risk/capital ratio imposed by various authorities and was put into runoff under the supervision of its chief regulator, the North Carolina Department of Insurance. In the spring of this year, Old Republic attempted to spin off the business, along with another housing-related line that was part of the general insurance segment, to investors and shareholders. We thought this was a smart tactical move by management, as it would have put to rest the possibility that current convertible debt holders would be able to exercise a covenant of the bond that allowed for accelerated payment if the NCDOI were to declare the mortgage insurance company insolvent. Further, this move would have cleaned up the company's financial statements and made its economic value more clear. However, that plan was shelved after certain stakeholders of the mortgage insurer objected to the transaction. It is worth noting that Old Republic is not required to provide further support to this subsidiary and management has clearly stated that it has no intention of doing so. So while the mortgage subsidiary remains a part of the company and is included in its consolidated statements, Old Republic is shielded from further losses at this unit.

However, as a result of the cancellation of the spin-off, Old Republic retains the risk that the NCDOI declares the mortgage insurance subsidiary insolvent. If this action is taken, the holders of the existing $550 million convertible bond have the right to demand immediate payment. As this is almost all of the debt owed by Old Republic, we think the debt could be refinanced without much difficulty, unless the event were to occur in times of economic financial stress. A much more likely scenario is that the new lender would require a cut in the dividend as a condition to the new loan. We think this is a low-probability risk given the NCDOI's actions to date, and there have been no signs that the regulator intends to declare the unit insolvent, but it cannot be ruled out. While this is a noneconomic concern and would have no impact on our fair value estimate, the concept of perception trumping reality should be considered in the short term and may be a factor in the timing of share purchases.

General Insurance Has Solid Underwriting Margins
Old Republic's general insurance subsidiary is a property-casualty insurer, specializing in commercial auto, workers' compensation, and other commercial lines. Since 1996, general insurance lines have been profitable, generating a 2% underwriting margin over this time frame. Versus the P&C industry, general insurance has outperformed almost every year since 1996, averaging a combined ratio (expense divided by earned premium) of 98%, 5 percentage points better than the industry combined ratio of 102%.

Included in the above Old Republic combined ratio is the one insurance line that has experienced outsize losses since the beginning of the financial crisis: consumer credit indemnity. This product, which insures pools of home equity loans, was first issued in the late 1950s and for most of its history was profitable. However, the financial crisis hit homeowners hard, causing property values to crash and unemployment to rise sharply. As a result, home equity lines began to default, increasing claims dramatically. In 2009 and 2010, CCI claims drove Old Republic's combined ratio to industry levels, putting a major dent in underwriting income.

CCI claims are still being paid out, and there are legal actions pending against Old Republic from lenders on claims denials. In the second quarter, Old Republic established a higher reserve for litigation expense in anticipation of the legal actions, which will lead to a higher combined ratio in 2012 over 2011. However, in terms of the future impact on general insurance, we think even a spike in CCI claims will not have much of an effect on operating income.

Title Insurance Revenue and Margins Are Improving
Title insurance is a transaction business; title insurers earn premium on practically all real estate transactions in the United States. The industry has bounced back over the past three years primarily as a result of residential refinance transactions, foreclosures, and a gradual recovery in commercial real estate markets. Over time, as economic conditions improve, we expect title insurance underwriting margins to improve further as the business mix favors more profitable residential resale and commercial business.

Old Republic took advantage of title insurance industry consolidation and aggressively increased its market share over the past four years. While other title insurers were cutting costs to boost margins, Old Republic was picking up share, primarily by signing agents.

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Gaining market share doesn't come without a cost, as Old Republic's recent results confirm. The firm incurred significant short-term marketing expense in exchange for gaining share. Old Republic, however, has the advantage of its large and profitable general insurance lines to help offset these costs. The larger title insurance peers of Old Republic are essentially monoline and heavily dependent on income from this line for survival. As a consequence Old Republic was able to expand while its competitors were slashing costs that cost them business.

In our opinion, Old Republic's investment in the long-term success of its title insurance business is a sound strategy. We think Old Republic will retain most, if not all, of these gains, which will result in greater profitability as the firm reverts to its historical profit margins. Because the business strategy depends heavily on agents, we don't think it can produce underwriting margins as large as the direct issuing competitors in good times. However, because it will not have to support the fixed costs of direct issuing competitors, it will be less likely to show underwriting losses in downturns. In our explicit forecasts over the next seven years, we think Old Republic's title insurance underwriting margins will average about 4%, lower than the 8% or so we forecast for larger peers but also less prone to underwriting loss.

On an Economic Basis, We Think Old Republic's Shareholder Dividend Is Sustainable
As an insurance holding company, Old Republic relies on dividends from its insurance operating subsidiaries to fund corporate obligations. Having satisfied a $316 million high-cost convertible debt obligation in May, the holding company annual expense run rate has been reduced to just over $200 million (which includes debt payments, shareholder dividends, and a relatively small home office expense). At the end of 2011, Old Republic had $361 million in capital available from its general and title insurance subsidiaries to upstream to the holding company in 2012. At the end of 2010 and 2009, the capital available to the holding company was $307 million and $296 million, respectively. In each of these years, the dividend available to the holding company the following year was well below the amount needed to fund corporate obligations. Because of this, excess capital available to the holding company is being held at the insurance subsidiaries.

We think it's also important that management is fully committed to the shareholder dividend as the preferred method of returning capital to equityholders. Old Republic has made cash dividend payments to shareholders uninterrupted for 72 years and has increased the cash dividend in each of the past 25 years. The earnings power of Old Republic insurance subsidiaries provides capital in excess of that needed to fund corporate expense, and management is dedicated to returning capital to shareholders. As a result, we think the dividend would be cut only if management was forced to do so, and avoiding this situation is a top priority for the company. However, in the slight chance of this event occurring, we think it would result in an even better buying opportunity.