We are downgrading our recommendation on Delphi Financial Group (DFG) to Underperform on concerns of lower production from its two main subsidiaries – Reliance Standard Life Insurance Co. (“RSLIC”) and Safety National Casualty Corp. (“SNCC”).
RSLIC, Delphi’s life insurance unit, has been recording lower premium production for several quarters. We believe that RSLIC’s core small-case group disability and life products will likely encounter increasing competition as more carriers are beginning to focus on this market niche.
Additionally, the company might experience deterioration in its short-term and long-term disability income products in the near term due to the continued impact of high unemployment levels and the weak economy on payrolls.
Delphi is trying to offset top-line pressure at RSLIC by selling excess workers’ compensation products through SNCC. However, due to improvements in the primary workers’ compensation market with lower premium rates, conditions relating to new business production and growth in premiums for these products are less favorable at present. As such, production at SNCC was weak compared with year-ago levels. Given the intense competition, we do not see a trend reversal any time soon.
After recording a low investment income in 2008, management undertook portfolio repositioning aimed at reducing its exposure to alternative assets. This effort led to a 35% year-over-year improvement in net investment income to $84.1 million in 2009. We believe that the investment portfolio restructuring will further reduce volatility while helping Delphi to earn attractive returns. Management expects high single-digit growth in invested assets, which will culminate in an increased investment income.
Operating cash flow at Delphi has been on an increasing trend. It has sufficient financial flexibility with $472 million of cash and short term investment at the end of 2009 and no debt maturing till 2020. It has also improved its balance sheet with debt-to-capital ratio declining to 19% in 2009 from 26% in 2008. Delphi also has been consistently increasing dividends since 2001 (when dividend payment was initiated).
Though Delphi has restructured its investment portfolio, we remain concerned over residential mortgage-backed securities (RMBS) and asset-backed securities (ABS) held primarily at RSLIC, which includes some exposure to highly subordinated tranches. These structured securities are expected to report additional losses that would adversely affect capitalization.
Moreover, combined ratio at Delphi has increased, though modestly, to 93.3% in 2009 from 92.2% in 2008 and 92.4% in 2007. However, given the expectation of restricted premium, combined ratio would trend higher for the remainder of 2010.
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