Property and casualty insurance provider Safeco Corp. (SAF) agreed on Apr. 23 to be acquired by Liberty Mutual Group in a deal valued at $6.2 billion. Safeco shareholders would receive $68.25 per share for each share held, a nearly 51% premium to Safeco’s closing price of $45.23 on Apr. 22.

News of the proposed acquisition lit a charge under Safeco shares, pushing them up 46% to $65.94 on Apr. 23.

The acquisition would make Boston-based Liberty Mutual the fifth-largest property and casualty insurer in the U.S. and the second-largest surety insurer. After the deal closes, Safeco, which sells insurance to drivers, home owners and owners of small- and mid-sized businesses, will become part of Liberty’s Agency Markets business unit, which had revenue of $5.6 billion in 2007. Combined, the organization will have about 15,000 independent agencies. (The deal is expected to close by the end of the third quarter, after getting customary approvals.)

Analysts think the deal could spark more M&A in the insurance industry. "Liberty is building scale, so that might get other companies thinking about it," says J. Paul Newsome, an analyst at Sandler O’Neill & Partners in Chicago. "There’s a big question as to whether there are a bunch of other buyers out there looking around."

Cathy Seifert at Standard & Poor’s Equity Research, who said in an Apr. 17 note that Safeco could be an attractive takeover candidate if the industry consolidates, called Liberty Mutual's offer generous at more than two times Safeco’s book value at the end of 2007 and said it would likely serve as a catalyst to shares of other property casualty insurers. She considers Safeco a "mediocre underwriter," but conceded that its West Coast business would be complementary to Liberty Mutual’s existing markets. Seifert kept her hold recommendation on the stock on Apr. 23, but hiked her price target to 68 from 50. (S&P, like BusinessWeek, is owned by McGraw-Hill Companies (MHP).)

The premium that Liberty is willing to pay, while enormous and astounding to some investors, makes sense in that it’s being offered by a mutual insurance company, which is owned collectively by its policy holders, as opposed to shareholders, who presumably would demand more thriftiness in an acquisition.

While he finds the premium surprising, Newsome at Sandler O’Neill says he can understand it given that ratings agencies treat mutuals differently than stockholder-owned companies and have lower expectations for mutuals' return on equity. "If your expected return is lower than a stock company’s, then you’ll be able to pay more for an acquisition than a comparable stock company," he says.

Meyer Shields, an analyst at Stifel Nicolaus & Co. in Baltimore, sees the premium as justified for a few reasons. First, a mutually-owned company has more latitude to pay what it wants as long as it thinks it can earn it back over the next three to four years. Liberty also may think it can improve Safeco’s personal auto insurance business, which has been underperforming for a couple of years, says Shields. "If that can be run more successfully by a different management, then there’s more value available to a new owner," he says. "So they’re not overpaying as drastically as it looks."

In January, Seattle-based Safeco reported a 33% decline in earnings for the fourth quarter of 2007, partly due to a pretax underwriting loss of $19.0 million in its auto business, compared with a pretax underwriting profit of $48.5 million a year earlier. Safeco Auto’s combined ratio – the percentage of each premium dollar spent on claims and expenses – climbed to 102.9% in the fourth quarter from 92.7% the year before, reflecting higher average bodily injury losses per claim.

"Safeco has struggled to see how underpriced [its auto insurance rates] are and to figure out the best way of addressing the problem," says Shields. He expects Safeco to generate a combined ratio of just under 109% this year. If Liberty can improve that by 400 basis points, he estimates that would translate to 77 cents per share in additional earnings, a 15% increase over analysts’ consensus forecast of $5.90 for 2008.

Adding 77 cents to his earnings estimate this year would enable Safeco to increase its return on equity from the mid-teens to 17%, which would be one of the better ROEs in the industry this year, Shields says.

"It’s a question of raising rates intelligently. For the losses and expenses they have, the rates are just too low," he says. "If [Liberty] can figure out how to raise rates without completely disrupting [the] current group of policyholders, it’s achievable over a two-year period."

One benefit of personal auto policies is that the coverage lasts for just six months, which means that when a company raises rates, it takes only six months for it to flow into earnings rather than an entire year, he says.

However, Liberty Mutual might have trouble raising auto insurance rates, says Newsome at Sandler O’Neill. "It is a difficult competitive environment," he says. "A lot of really big auto and home insurance companies are really sophisticated."

Meanwhile, the cost of claims is starting to rise at a modestly faster rate than in the past, mostly due to higher medical claims, Newsome says. And while there had been a consistent decline in the number of auto accidents for several years, that trend seems to have ended, he adds.

In an April report on the insurance industry, Friedman Billings Ramsey acknowledged that Safeco’s auto insurance results were disappointing, but said it felt "that management is proactively addressing these problems by filing for additional rate increases and refining business processes."

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by David Bogoslaw

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