In our prior notes on regionals, we discussed the historical differences between regionals and non-regionals as well as their development to super-regionals as they grow in accounts, classes, and state footprints.
As their results stabilized versus their historical catastrophe volatility, these companies have been rewarded with better stock multiples. In some cases, they have even exceeded better-known and better-run franchises, factoring in an expectation of eventual takeout.
The small-to-mid-market segment has proven to be lucrative for regionals, as larger account companies struggle to step down in this space due to higher fixed and variable expenses, low overall premiums, and historic distribution relationships.
At the same time, we have warned about the challenges these franchises will face as they begin to resemble versions of larger primary or national carriers.
Last week, along with its second-quarter earnings, Selective Insurance announced another charge that caused the stock to drop 17% and reignited concerns about the company's reserving practices. The first of the more recent charges occurred in Q2 2024, when the company pre-announced a $176mn reserve charge, primarily driven by adverse development in its casualty lines.
The total adverse development over the last two years now stands at $320mn against a reserve base of $6.6bn as of year-end 2024.
The chart below illustrates the stock's performance over time. The company now trades at 1.4x book value, compared to 1.8x prior to the second-quarter earnings, and down from an all-time high of 2.4x.
This charge has once again brought to the forefront the historical differences between regionals, nationals, and specialty franchises.
Are these regional franchises truly good enough? Are they small and nimble enough to operate on the edge of specialty and larger primary insurers and react quickly to the changing landscape?
Or are they suffering growing pains, causing them not only to be slow in reacting to changes but also overstretched in their reporting lines, depriving management of good information on what is happening at the frontlines?
There are a number of questions that management, the board, investors and potential consolidation partners will need to try and answer as the path forward is charted for Selective.
Is this reserve charge reflective of the company reacting early or late to recent accident year problems? Could there be additional charges from older accident years, as seen at several other franchises?
Has the company completely mistimed its strategy post-2020, and are these issues near-term fixable? With the significant decline in the stock multiple, does this make the company vulnerable to a potential takeover? Are investors losing confidence in management and impatient for a change?
Our note assesses some of these questions and examines three key areas.
First, Selective’s ability to withstand the pain from its missteps around its business mix. The company's business mix leans more toward other liability (OLO) and commercial auto, with a small workers' compensation book of business – with this mix becoming more pronounced over the years.
In hindsight, Selective took the wrong side of these bets, as the trends in OLO and commercial auto have worsened, with a small workers' compensation portfolio not generating enough reserve releases to offset the negative news.
Second, the way Selective handles its adverse development will be consequential. Once adverse reserve development begins in P&C, it tends to persist. The charges have been centered on recent years, which shows the company figuring its way out as the social inflation picture remains nebulous.
Third, Selective’s future will be determined by its board’s willingness to entertain takeover interest, as well as potential acquirers’ willingness to look past the reserving noise to the value of the platform.
Regional insurers, including Selective, have been perceived as likely takeout targets, which means that the multiples carry in-built control premiums. With this reserve charge, bidders are more likely to end up waiting several quarters to gain confidence.
Our analysis indicates that, although the industry remains affected by social inflation challenges, Selective’s issues stem from its business mix, expansion, and a delayed recognition of loss trends compared to its peers.
We do not view the franchise as necessarily broken, but management needs to get quickly to finality, either through a one-and-done clean-up charge or an ADC. An annual drip-drip of reserve deterioration would destroy confidence.
We discuss these issues below.
Selective leans more heavily into social inflation-impacted lines compared to its peers
The chart below illustrates shifts in the business mix over time and compares the company to other regional companies. Commercial auto liability and other liability occurrence (OLO) are key lines that have driven heightened reserve charges among many exposed insurers due to social inflation, as discussed in prior notes.
(For a complete list of all companies included in each cohort – and the overall top 10 – refer to the appendix.)
Notably, Selective’s mix has shifted away from workers’ compensation and toward commercial auto, as well as OLO. The company also continues to write comparatively more premiums as a percentage of its total written premiums in both commercial auto and OLO when compared to its other peer groups.
Another way to think about the analysis above is that Selective is one of the few names that has seen double-digit growth in OLO and commercial auto over the past several years.
Taking a step back, we would reiterate the point that business written in these casualty lines after 2020 has faced additional scrutiny from us and other industry observers. Carriers have faced a troubling social and loss-cost inflation environment in recent years, making the cost of risk exceedingly difficult to gauge accurately.
Although the company acknowledged these business mix challenges, they also coincide with a broader slowdown in other parts of the commercial insurance space, as discussed in our Travelers note. This makes it difficult for a franchise to alter course and redeploy capital as management attempts to dissect whether it's dealing with a company or an industry issue.
Selective’s reserving patterns illustrate causes for adverse loss emergence versus its peers and the industry
The following three charts illustrate reserve development for three key lines of business at Selective, which the company also discussed during its second-quarter earnings call.
Although the earnings presentation used the broader industry as a comparison, we chose other regional companies instead, allowing us to benchmark the evolution of reserving patterns more effectively.
We also compared these numbers against those of larger and smaller peers, which are listed in the appendix.
Starting with OLO, it’s immediately apparent that most of Selective’s recent reserve charges have come from recent accident years. This contrasts with other regionals as well as top 10 carriers, whose reserve strengthening actions were focused on the soft market accident years of the late 2010s.
We also note that Selective’s initial loss picks were consistently in the 50s over the last 10 years or so. This compares with other regionals who started in the 50s as well but started raising them in 2022 materially.
The same difference exists on the adverse development front as well, where Selective’s adverse is focused on recent accident years, while the regional peers are focused on 2019, 2021, and 2022.
The company claims its lower loss picks are reflective of small and middle-market accounts, and its business mix remains unchanged.
But this gives you the anomaly that Selective’s ultimate loss ratios are much worse in 2022 and 2023 years – relatively better years for the industry – than ugly years like 2016-19. For this to hold you would need a strong conviction that social inflation was a very slow burn for the small account space, only really showing up in the last few years, with Selective then moving faster than others on charges.
We are not fully convinced that the older accident years are out of the woods.
Moving on to commercial auto liability, Selective’s reserve development patterns are mostly similar to those of the regionals and the top 10 carriers shown in the appendix. However, the 2023 accident year has developed unfavorably compared to the improvement of its regional peers.
As noted above, we would also highlight that Selective’s commercial auto book has grown multiple times what it was in 2014, similar to other liability lines.
We have repeatedly called attention to the continuing industry practice of releasing reserves from workers’ compensation in order to offset adverse development in other lines of business. Selective is no outlier in this regard and has in fact had more favorable reserve development than the aggregate shown below.
However, in Selective’s case, this has still been insufficient in offsetting the reserve charges taken in other lines of business. Workers’ comp has consistently declined as a percentage of the company’s total direct written premiums over the last decade, falling from 13% in 2015 to less than 7% in 2024.
By contrast, other liability and commercial auto each make up roughly 30% and 20% of the company’s book, respectively.
On the workers' compensation side, loss ratio development patterns are generally similar to those of the other regionals.
If being consolidated was an option, that is likely off the table for now.
The table below shows select regional and specialty acquisitions over the years. These included names such as Ohio Casualty, which was acquired by Liberty Mutual in 2007, and Harleysville by Nationwide in 2011.
The current crop of relevant publicly traded regionals includes Selective, The Hanover Group, and Cincinnati Financial. It is highly likely that Selective and others have been evaluated as potential consolidation targets by larger national or international insurers as we approach the start of the next consolidation cycle.
However, Selective’s reserve charges will likely dampen any interest, as buyers move to the sidelines and wait to see how these challenges play out before regaining confidence in the franchise. Potential buyers, in some cases, will completely move on as well.
In summary, although broader social and economic inflation has impacted Selective’s reserve development, our analysis shows that it's mostly a combination of business mix and belated acceptance of loss trends.
Appendix
