Delphi Reiterated at Neutral

We are maintaining our Neutral recommendation on the shares of Delphi Financial Inc. (DFG) following the release of fourth quarter 2010 results.

Delphi’s fourth quarter earnings were a dime ahead of the Zacks Consensus Estimate, aided by favorable underwriting and investment results.

We believe its subsidiary Safety National, a leader in Excess Workers’ Compensation, will show a strong growth going forward, based on rates hike and self-insured retention increase at the outset of the year.

Safety National is expanding its leading position in providing coverage to self-insureds. Its market share increased to 25% in 2009 from 22% in 2008. It has increased premiums at a CAGR of 6% from 2006 to 2010. Management expects an attractive market for the Excess Workers’ Compensation based on positive trends in January 2011 renewals, 2% hike in average rates and 2% increase in average self-insured retention. Safety typically writes 25% to 30% of its business in January and the pricing on these renewals generally set the tone for the year. An average of 1% increase in payrolls, along with growth in healthcare, schools, and public entities balancing a decline in other areas, provides room for further business growth.

Although the long-tail nature of this business, with average duration of 15+ years indicates large investable float, the long-tail risk related to the uncertainty of the claim payments cannot be disregarded. However, given the company’s use of reinsurance and the increase in self-insured retentions, we believe Safety National can effectively manage the long-tail claims exposure and secure free cash to invest in the long term. During the fourth quarter conference call, management stated that it expects a stronger growth at Safety, which continues to benefit from its leadership position in excess workers' compensation and growing contributions from assumed reinsurance.

On the other hand, Delphi’s another unit Reliance Standard is expected to show restricted growth due to competitive pressures on group employee benefits and uncertain employment scenario. The business condition, however, is gradually improving, with 1% spike in core premiums in fourth quarter 2010, quite like the hike witnessed in third quarter. Core production rose 9% owing to the unit’s strong position in small case market and its differentiated offering for larger cases with its integrated employee benefit program. The unit will expectedly benefit from its niche focus on the small case segment (companies with less than 500 employees), which reportedly witnessed 400,000 jobs addition in December and January and accounted for almost 90% of total job growth during the period. Moreover, at Reliance Standard, voluntary products continue to be a major growth driver as employers seek to control costs (voluntary premiums were up 9% in the quarter). Thus, even after 1.6% and 1.1% drops in core premiums in 2010 and 2009 respectively, the unit is gradually experiencing improvement in business. However, higher-than-expected long-term disability claims will likely keep earnings under pressure during the first half of the year.

As far as investors’ wealth creation is concerned, Delphi has performed favorably on this front. It has increased dividend every year since 2001, when it initiated its dividend payment. In August 2010, the company announced a 10% hike in its quarterly dividend. The dividend growth rate averaged 16.7% over the past five years, reflecting a solid balance sheet. Delphi has improved its balance sheet further by reducing debt-to-capital ratio to17% at 2010 end from 19% at 2009 end and 26% at 2008 end. Although management did not seem much enthusiastic about share buybacks during the fourth quarter conference call, it contemplated strategic acquisitions or investing more money into business.

Looking at investment income, Delphi is neither expecting interest rate hike in 2011 nor assuming as much return on alternative investments as achieved last year. The returns from alternatives assets, which account for 4–5% of total assets, were around 15% for the full year 2010 compared with 13% for 2009.

Over the mid to long term, we expect Delphi to perform well, given its historically favorable operating performance, its niche in excess workers’ compensation market, and above adequate capitalization.

Delphi, with current market capitalization of $1.6 billion, competes with both life and property-casualty companies. Some of its life insurance peers are Reinsurance Group of America Inc. (RGA - Analyst Report), StanCorp Financial Group Inc., (SFG - Analyst Report), Torchmark Corp. (TMK - Analyst Report), and Unum Group (UNM - Analyst Report), while its property and casualty competitors are American Financial Group Inc. (AFG - Snapshot Report), American Safety Insurance Holdings Ltd. (ASI - Snapshot Report), and W.R. Berkley Corp. (WRB - Analyst Report).