Grupo Catalana Occidente (GCO:SM) is a 150-years old Spanish insurance company operating across two lines of business: traditional insurance (P&C and life) and credit insurance (the coverage of commercial credit risks).
GCO is the fifth largest insurers in Spain (~5% market share), but by far the #1 domestically in credit insurance and #2 at the global level (with a 26% global market share).
Traditional insurance business
The classic “bread-and-butter” of insurance companies, GCO primarily provides short tail P&C insurance and life/savings products. This division is comprised of four sub-segments almost equally split: Multi-risk (including property insurance: 25% of premiums), Motor (23%), Life (29%) and Others (such as industrial or liability insurance: 22% of premiums).
This is essentially a mature business that shows low organic growth (3.5% annualised over the last 5 years). However, with the domestic market still very fragmented, there is a lot of scope for market share gains through both organic and inorganic growth. And the company has indeed been continuously pursuing bolt-on opportunities that have arisen by acquiring other smaller entities.
While not all the acquisitions came in cheaply (Seguros Bilbao at a P/BV of 3x and P/E of 16x; Antares at P/BV of 1.3x and P/E of 15x), GCO has been able to maintain a 12% ROE because of the value creation post-acquisition through cost synergies and better operations. This strong operational experience will be a tremendous asset for future acquisitions as well.
A focus on profitability
Similar to banks, the nature of the insurance business makes it quite easy to growth, especially in the short-term: all you have to do is to get careless about underwriting. The key for investors is therefore to look for companies that do not chose to grow at any price, but rather prioritise profitability.
GCO is not the largest company in Spain, but it's one of the most profitable because of good cost discipline. Its strategy is clearly spelled on 3 pillars:
Growth: development of appropriate products and services and establishment of adequate distribution channels in order to reach customers
Profitability: recurring and sustained profitability through technical-actuarial rigour, diversification in investments and processes that allow for adjusted cost ratios and quality service
Solvency: prioritising the generation and continuous growth of own resources in order to fund the expansion and ensure adequate returns to shareholders.
The firm has indeed a long history of strong profitability as can be seen in the chart below with the combined ratio being consistently below 100% for the non-life traditional segments. (In simple terms: if the combined ratio is below 100% the company is earning money at the operating level; if it is above, it is losing money and has to rely in investment income.)
Going further back, I found this slide showing that the traditional insurance segment has been profitable also during the more challenging macroeconomic conditions of the 2008-2009 credit crisis.
GCO has also consistently outperformed its peers, with its moat coming from an established distribution channel of loyal agent partners who have been associated with the company for a long time. The customer “satisfaction & retention” rates are very high at 90%+ levels. Strong brand and lean operations help in lower customer acquisition costs. In Saas terms, the CAC/LTV metric for GCO would be healthy with low churn rates and higher profitability as customers cohorts mature.
This ~3% difference in combined ratios vs peers might seem marginal, but it means that GCO can continue to generate a healthy ROE for shareholders even when peers are earning below their cost of equity. GCO does not have to rely on investment income from its float to generate healthy profits, and therefore does not have to take unduly risks to earn its cost of capital.
A deeper dive into Trade Credit Insurance
Credit insurance at GCO is provided by Netherlands-based Atradius, a well-diversified global insurance operation which is #2 worldwide in this niche space (#1 is Euler Hermes, now fully owned by Allianz).
GCO first bought a 5% stake in 2003 and in 2007, taking advantage of the crisis, it bought out other shareholders such as Swiss Re, Deutsche Bank and Sal Oppenheim. Today it has an 83% economic interest, both directly (36%) and indirectly via Grupo Compañía Espanõla de Crédito y Caución (of which it has 74% with the rest owned by other Spanish insurers).
In trade (commercial) credit insurance, a company insures third parties against the potential non-payment by their clients: it is a way to help customers worldwide to trade wisely and develop their business safely, providing companies of all sizes with the domestic and export market knowledge and support they need to successfully manage their trade receivables.
The business is pretty straightforward: 1) a company (seller) sells and ships goods to the buyer, extending a short-term loan (a trade receivable); 2) the buyer typically pays the seller 30-120 days after shipment (a trade payable); 3) for a premium, a credit insurer acts as intermediary protecting the seller by covering default risk.
The trade seller pays a premium / fee to the credit insurer based on its level of turnover. The insurer offers a “limit” per invoice to the seller depending on the credit risk of the buyer, but no contractual agreement exists between the insurer and the end buyer.
The typical premium paid by sellers vary between 0.25% to 0.35% of the total receivables of the insured firm. This cost is paid back to the firm through lower financing/factoring costs and increased sales potential: hence, there is a tremendous advantage to clients through credit insurance, which add value through risk monitoring, bad debt collection and informational services.
Atradius also helps its clients with its expertise in management and debt-collection through a full range of services. In the event that a receivable is not paid by the debtor, Atradius generally handles the recovery process in order to limit the loss and release the policyholder from managing the dispute, allowing it to preserve its commercial relations with the debtor. Should these procedures fail, and once a specific period has elapsed, credit insurers typically pay the policyholder a portion of the unpaid covered receivable (generally 85% to 90%), with this risk sharing contributing to a community of interests between the insurer and the policyholders in order to encourage a prudent risk management.
Despite the currently problematic situation, trade credit insurance is still a very attractive business, with significant barriers to entry, network effects and little exposure to interest rates.
As trade credit insurers insures against defaults in a third company’s receivables, “claims” come up when a customer of the insured company gets into trouble, not the insured company itself. In general, credit insurers do not insure single risks but a whole receivable portfolio: and different to banks, the underlying exposures are very short-term. Underwriting a trade credit policy therefore is different from “normal” insurance. For traditional insurance policies the company “only” has to assess the risk of its contractual partner and match this to a historical pattern. In a typical trade credit insurance contract however, the insurer needs to understand and price hundreds of different potential risks on a global basis. Starting from scratch and trying to analyse every single counterparty makes the costs for the first contracts prohibitively high; but when you already have all the names in your database, the marginal cost is negligible. Credit insurance is basically an information network business and the amount of data that companies are forced to open to them provides them with unique insights, making the whole system safer. On a normal day, Atradius takes around 30.000 credit limit decisions: replicating this database or information network for a new entrant is extremely difficult.
Diversification and investment risk are the key drivers of profitability: the two tables below show Atradius’ exposure by country and sector.
The market naturally tends to favour larger players, as there are significant economies of scale and scope: brand and customer relationships, customer database for risk assessment, sales network. Only few companies can provide in-house risk monitoring as well as debt collection services on a global basis, and global corporations need strong global insurance partners.
As a consequence, it is one of the most oligopolistic markets and, more important, is getting more concentrated over time. The “free” market is dominated by three European players with a cumulative share well over 80%: Euler Hermes (estimated 36% market share), Atradius (26%) and Coface (20%). A large portion of global credit insurance is actually handled by government-controlled institutions, in a form of export subsidies. In the US, the dominant force is EXIM (Export-Import Bank of the United States). China is dominated by two local players: China Exim Bank (Export-Import Bank of China) and Sinosure (China Export & Credit Insurance Corporation). In Japan, until 2005 there was effectively a monopoly of the state insurer NEXI (Nippon Export and Investment Insurance), which today still retains an 80%-90% market share. However, all the big Japanese insurers have formed strategic alliances with foreign credit specialists: Mitsui Sumitomo with Coface, Tokio Marine with Atradius, Sompo Insurance with Euler Hermes.
There is – however - another factor specific to the business. In the traditional P&C insurance, claims are independent from movements in capital markets, so that insurers can invest the money backing their reserves (float) into riskier type of assets. This is different for trade credit insurers: claims increase when defaults are plenty (recession), which at the same time could hurt the investment portfolio. Therefore, trade credit insurers have only a limited capacity to take investment risk - especially credit risk - as they are already exposed on the insurance side.
This is exemplified by Atradius’ investment portfolio, which is comprised for ~83% by fixed income and cash equivalent instruments.
Not only: the average maturity of the fixed income portfolio is below 3 years. Therefore, a sudden rise in interest rates would certainly cause short-term mark-to-market losses, but with little impact on cash returns if held to maturity, and it could quickly shift into higher yielding bonds.
This “lower diversification of claims” (relative, for example, to insuring big catastrophes) means that credit insurance is relatively capital-intensive: both Atradius and Euler Hermes have equity that is around 2x their net earned premiums, where a “traditional” P&C insurance company would have a ratio of less than 1x (for the entire GCO group it is indeed at 1.1x). This combination of restricted investment activities and large capital requirement is the main reason why trade credit insurance is structurally much more profitable than most other insurance sectors: trade credit insurers could never rely on making most of their profits from investments, they always had to make sure that they earn money in day-to-day operations. This is evidenced by the combined ratio for GCO’s credit insurance business alone: it only increased in the pandemic year 2020 (claims went up a lot), but it has historically been well below the 100% hurdle rate.
Euler Hermes (which used to be publicly listed and is now a subsidiary of Allianz) has the longest available data history on this metric, where a similar trend is evident: Coface’s CR has been more “volatile” (in particular in 2016, driven by higher-than-expected losses in its emerging markets division) but on average it’s around 80%-85% for the entire sector.
Atradius did perform much worse during the great financial crisis, when CR shot to 135% in Q1 2009: however, it was already below 100% by the end of that year, and it didn’t need any capital support from the rest of the group to return to the path of profitability and earnings growth. In addition, Atradius currently transfers ~50% of premiums to reinsurance companies (much more than peers): this is basically a spread business and in good times or in a soft cycle as premiums are under pressure, there is some buffer for margins as reinsurance premiums shrink as well. The risk is that the current global “uncertainty” wreaks havoc on global supply chains, but Atradius should not have particular problems in weathering the storm.
Last but not least, the correlation of technical results with capital markets performance makes the sector less attractive for “alternative sources of capital”, which is a big issue for traditional P&C insurance.
On a normalised basis, Atradius can easily generate a post-tax ROA of 4%, which allows it to deliver healthy ROE of 12% with just 3x leverage. On the other hand, well run diversified insurance firms like Allianz generate ROAs of 1%-2% and hence need to increase leverage risk to generate healthy ROEs. Credit insurance businesses are also more global in nature with a large fee/ service income component, making them more durable.
Capital allocation and financial strength
This is the third pillar of the company’s strategy: GCO is a well-run family-owned business (65% insider ownership by the Serra family) with strong track record of organic & inorganic growth since its listing 25 years back.
The Serra family have built a conservative and long-term thinking culture within the firm (the next generation of the family is already involved) and has grown the business without diluting existing shareholders. Total outstanding shares in 1994 at the time of the IPO were 118.4 million; the current share count is 118 million. Total insider ownership was 76.8 million shares in 1994 and is 77 million shares currently. The family hasn’t sold a single share throughout this wealth creation period, indicating their long-term commitment.
This is also evident in the dividend policy: the group retains a big portion of profits to use it for accretive acquisitions. These have led GCO’s total turnover to grow at 4.5% CAGR over the last decade (characterised by extremely low interest rates) but its equity per share at 13% annualised rate since 2011.
The group has a very low debt ratio (less than 5% of capital employed) and credit ratings are also particularly strong, with Moody's affirming in 2021 its A2 rating of the operating entities in the credit insurance business under the Atradius brand and upgrading the outlook to stable even in situations of economic uncertainty such as that generated by COVID-19. In addition, A.M. Best (which provides credit ratings and services specifically for the insurance industry) confirmed last year the financial strength rating of A (excellent) with a stable outlook for the group's main operating entities, both in traditional business and credit insurance business.
Furthermore, the estimated Solvency II ratio applying the transitory measure for technical provisions is 220%.
This prudent capital management has allowed the company to grow its permanent resources each single year in the last 25 years (with the lone exception of 2009 but not 2020).
Valuation
This is where things get more interesting: despite all the nice things just said about the company and the value created since the IPO in 1994, the stock performance has recently not been as good.
Even among depressed European insurers, GCO stands out for how cheap it is:
P/E: 7.5x
P/E (5Y): 9x
P/BV: 0.8x
P/TBV: 1x
Div yield: 3.5%
As discussed above, the credit insurance division is probably the one currently (over)penalised by investors: in the current macroeconomic environment, there is a justified fear of a significant deterioration in the payment likelihood of the policyholders' clients and therefore of a rise in the number of claims filed. That was probably more relevant in 2020 than today: the current “excuse” could be fears of deceleration in global economic activity.
Just to be clear, this is a €3.2 billion market cap company that in 2021 generated €425m in net profits with a 14% ROTE on an extremely solid capital position (and even in 2020 it generated €260m in profits and 10% ROTE). [Note: due to the many acquisitions, there are c.€800m in goodwill on the balance sheet: ROTE is a better metric from an incremental ROE perspective.]
Even during the financial crisis, GCO had to pay 1.5x book value to acquire Atradius, and in 2016 Allianz took out Euler Hermes at 16x earnings and almost 2x book value. The reasons for these premium valuations are exactly their oligopolistic characteristics and growth opportunities.
With equity of €2.2bn and earnings of €240m, at the lower end of these comparable transaction multiples Atradius could be worth today between €3.2bn and €3.8bn: that is €2.7bn to €3.2bn directly attributable to GCO from credit insurance alone! And while the traditional business is mature, it is not in secular decline or losing gobs of money: on the contrary, it is growing more or less at GDP and is more than sufficiently profitable.
Another way to look at the cheap valuation: with a Solvency ratio of 220% and a minimum required under adverse scenarios of 175%, there is approximately €1bn of excess reserves accumulated on the balance sheet that could be distributed as a dividend at any time. Removing this from market cap, it puts the traditional insurance business on a P/E of less than 10x and P/BV of 0.9x while at the same time assigning zero value in perpetuity to the credit insurance business. [There is likely a zero chance that this “special dividend distribution” will ever happen, as GCO prefers a prudent capital management: but it just highlights further how cheap the current market cap is currently relative to the underlying operating profits and strong capital base.]
Potential risks
Capital allocation is the main risk in this business. Since GCO operates with excess capital, it might be tempted to acquire/diversify at uneconomic valuation multiples in a continued low interest rate scenario, which could deteriorate future value creation. The high skin in the game and the management’s disciplined track record should mitigate this risk to a large extent.
As for any financial company, long sustained low interest rates would also mean that the management might be forced to take undue risks on its investment book. The firm has been running a fairly conservative portfolio that is diversified by sector, geography and security. Undue blow up in credit markets through higher delinquencies or rising interest rates is a meaningful risk.
In 2021 GCO earned approximately €350m in “income” on its €15.7bn portfolio for a 2.2% return: it is difficult to see it evaporate completely even if rates in Europe remain low and equity markets do not perform as the last decade. Further, the fixed income portion has a relative short duration of just 4 years: it could take a short-term mark-to-market hit if rates were to rise, but since most of the insurance segments of GCO are dependent on combined ratios for profits and not investment income, they are far better positioned to mitigate this risk than peers with long tail books or in commoditised insurance segments.
Final thoughts
It is not common to see insurance companies or financial institutions with such strong insider ownership and tremendous skin-in-the game. This is a business that has been instilled with a conservative culture and a long-term orientation without dampening the growth ambitions. With a 25 year+ track record of durability and healthy shareholder returns, GCO is a compounder that is trading at an outright cheap valuation at the current market price.
Thanks to a strong balance sheet, it can be expected to grow both organically and inorganically: excess capital can be deployed to prudent acquisitions should the right targets present themselves.
It is understandable that Mr. Market might fear the current macroeconomic uncertainty, but despite its cyclical natural, trade credit insurance is a quite interesting niche market with significant barriers to entry and attractive economics despite the inherent volatility. At a broader level, the traditional Spanish business is probably less moaty but is also less cyclical.
Even in a repeat of a 2008 kind of economic crisis (when both insurance segments continued to be profitable) GCO should still earn decent profits. And with many regions dominated by state entities, “pure” credit insurance is still very much underpenetrated outside of Europe, and can be a GDP+ growth business for many more years to come.
great write up, shared with my Spanish investment friends.
Great writeup!
You've mentioned in the article that "In 2021 GCO earned approximately €350m in “income” on its €15.7bn portfolio" , how did you get this number?
I've been looking at the annual report unsuccessfully, I'm not sure if they disclose it directly.