Wednesday, July 16, 2008

A Find in Fremont

This is an analysis by my friend and colleague, Matt Miller, on Fremont Michigan Insuracorp (FMMH.OB):
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A Find in Fremont

Fremont Michigan Insuracorp Inc. (FMMH.OB), headquartered in Fremont, MI, the “Baby Food Capital of the World,” underwrites multiple lines of personal and commercial insurance, including homeowners and automobile, exclusively in the state of Michigan. The company dates its founding back to 1876, though it only recently came public via a demutualization in 2004. The company struggled in the early to mid nineties with inadequate rates and was nearly forced out of business by state regulators. Fortunately, Dick Dunning, a former Gerber financial executive came in as CEO and turned the company around.

Discount to Book Value

The company currently trades at a significant discount to stated book value. The reported balance sheet book value per share is $21.64 (adjusted for recent stock dividend, as are all numbers that follow) and the company is currently trading at $18.34 [Note - it is actually at $16.50-$17.00 today, but $18.34 was the price when the numbers were pulled together for the analysis], which means its shares can be purchased for approximately 84.8% of book value.

Hidden Asset

Included in book value per share is the company’s owned headquarters building in the town of Fremont. It is large brick building which provides adequate room for growth, as within the last ten years it housed nearly 100 employees, but now currently hosts approximately 60. According to the company’s statutory financial statements filed with the state of Michigan, the book carrying value at December 31, 2006 was approximately $760,000 while the fair value of the property as appraised in 2005 was approximately $3,400,000. Given that the building has been further depreciated since that time and that there are approximately 1.83 mm shares outstanding, the book value of the company is being understated by at least $1.45 per share. Adjusting book value for this asset leads to an adjusted value of approximately $23.09 per share, which means shares in the company can be purchased in the open market at 79.4% of adjusted book value.

Insurance Operations and Underwriting

The company is a single state indirect writer in Michigan of both personal (70% of DPW) and commercial lines (30% of DPW), including its two largest lines of business, personal auto (33% of DPW) and homeowners (31% of DPW). Its other significant lines of business include business owners, commercial package, workers comp, farm and marine. For the most part, the company writes its business in rural and western Michigan, preferring to stay away from more litigious areas like Detroit. It focuses on insuring good risks, typically with higher insurance credit scores of 700 or higher. The company’s agent base consists of approximately 180 agents in its target markets, a number which has purposefully been trimmed over the last several years from about 220. The company has made a conscious effort to eliminate poor performing agents and create an atmosphere of “franchise-like” territories for its agents.

Despite the current soft market in insurance, the company has been prudently expanding its book of business by growing its auto coverage, a feat made possible by its investments in technology (detailed below). Most of the growth has been achieved by pairing auto policies with its traditionally larger book of homeowners policies. The company would like to be more aggressive with its expansion of its commercial lines, but given the current soft market and the greater price sensitivity in the commercial lines, it has been unwilling to sacrifice the quality of its commercial book for growth in its commercial book.

None of these numbers would mean very much if the company ran a poor insurance operation, but fortunately, the team at FMMH runs a fine book of business. The company’s reserves for claims tend to be conservative, and in fact the company has been redundant in six of the last ten years. Per the company’s most recent 10-k below is the cumulative net of reinsurance redundancies (deficiencies) over the last ten years.

Year..........Net Cumulative Redundancy
........................(Deficiency) (mm)

1997....................682
1998....................866
1999...................-407
2000...................-1,843
2001...................-256
2002...................-477
2003....................2,765
2004....................5,597
2005....................6,584
2006....................4,132

The company’s new CFO, Kevin Kaastra, joined the company in 2003. His stated desire or philosophy when it comes to reserving is to not have to go back to shareholders with deficiencies. There may be some additional upside to the company’s book value given the most recent reserving and this philosophy, but we do not build it into our valuation. At the very least this suggests that the company’s adjusted book value is not overstated because of reserving deficiencies. Stated book value and adjusted book value ought to be fairly representative of the company's true economic position.

Also provided below is a table, from the most recent 10-k of the company’s underwriting results over the last eight years. It highlights two important points. First the significant decline in loss experience, driven partly by the release of reserves and partly by some exceptional underwriting results in 2005 and 2006 (calm weather years). Second, it shows a more recent spike in the expense ratio, something the company is working on improving. All of the company’s investment in technology has taken place in the last three years and those cost of internal technology development are being amortized over three years, which is much shorter than the true useful life of the technology. It is admittedly an area the company needs to improve upon to remain competitive. The company’s target is a 34 expense ratio (as a note its target combined ratio is 94).


.......................................2000.....2001.....2002.....2003.....2004.....2005.....2006.....2007
Net loss and LAE ratio....65.60....86.70....64.80....62.80....62.70....53.40.....44.80.....57.10
Expense ratio....................35.50....33.10....39.40....38.10....35.40....32.30.....34.60.....37.20
GAAP combined ratio....101.10..119.80..104.20..100.90...98.10....85.70.....79.40.....94.30

The company runs a very conservative, perhaps too conservative, reinsurance program. Its maximum exposure on any one risk is $150,000 and on any one catastrophe event is $1,250,000. These low “deductibles” also play a part in the company’s higher expense ratio. As the company is now in a much stronger financial position, it has indicated its willingness to retain some additional risk. While such a decision may add additional risk to the balance sheet and result in a more volatile earnings stream, given the history of the company’s underwriting and the current cost of maintaining its reinsurance coverage, the long-term economics of the business should improve.

Balance Sheet

The company currently runs a conservative investment balance sheet. FMMH has no toxic investments, like those coming to light on a number of other insurers balance sheets. Below is the investment profile of the company’s balance sheet at December 31, 2007. The company’s mortgage-backed securities are all GSE securities.


.........................................................................................2007
...............................................................Fair Value........................Allocation
Fixed maturities:

U.S. Treasury securities and
Obligations of U.S. government
corporations and agencies..................................................3,198,181.............................5.40%
States and political subdivisions..................................... ...25,761,183...........................43.80%
Corporate securities..............................6,833,902...........................11.60%
Mortgage-backed securities..... ........................................14,735,608............................25.10%

Equity Securities:

Common Stocks.....................................8,305,133.............................14.10%
Preferred Stocks...................................................0...............................0.00%

Total investments.............................$ 58,834,007..........................100.00%


Investments in Technology

As the company has strengthened its capital position over the last several years, it has made significant investments in technology. An internally developed system known as Fremont Complete, positions them well in the agency community and for growth in the future. The company has spent approximately $2.5 mm over the last three years developing this automation platform.

Miscellaneous

- the company’s A.M. Best rating was reaffirmed in January of this year at B++ (company is targeting an A- to better position itself in commercial lines of business)
- 13.2% of the company is owned by management, the board and the company’s 401(k)
- the company recently announced a buy-back of 100,000 shares, representing approximately 5.6% of the outstanding shares
- company recently announced a 3% share dividend in conjunction with share repurchase (numbers in this write-up have been adjusted accordingly)
- very little to no institutional holdings

Risks

Local Catastrophes and Weather

The company is a single-state writer of homeowners insurance, which amplifies its risk on localized catastrophes. Though the risk is mitigated somewhat by the nature and frequencies of the risks in Michigan and its current reinsurance policies, expanding to additional states over time would broaden their geographic exposure and provide opportunities for significant growth. The major weather risks faced by the company are the impact of extreme cold weather in the winter (causing fires, frozen pipes, melting water, additional auto accidents, etc.) and thunderstorms in the summer (causing wind, rain damage, etc.). Though there are occasionally tornados in the state, their frequency is far below that of other states in the Midwest. The chart below, generated from NOAA Satellite and Information Services data, puts this storm type in perspective.


.................................................Number of Tornados (1998 through 2007)

State..................................Total Tornados..........F1 or Higher..........F2 or Higer
Michigan...................................178.............................77...........................14
Iowa...........................................643...........................237...........................77
Oklahoma..................................672...........................284...........................93
California...................................102.............................17.............................1
North Carolina..........................326...........................116...........................26

Michigan Economy

Also, as a single state writer in Michigan, the company faces a difficult local economy as industrial jobs have migrated elsewhere. Though something to keep an eye, the company’s focus on western, rural Michigan as opposed to the heavily industrialized areas of the eastern part of the state helps mitigate this risk to some degree.

Michigan Regulation

As a single state writer of insurance, which is heavily regulated by the state, the company will face the threat of adverse regulatory changes in Michigan. Michigan is currently a modified no-fault auto state (suits are permitted only when an injured person suffers death, serious disfigurement or serious impairment of a bodily function) and it requires unlimited medical coverage to auto accident victims. The state run MCCA fund provides mandatory reinsurance for claims over $325k. Currently the state allows the use of credit scoring in insurance underwriting, though this is now being challenged in the state courts. A change in any of these policies or other state regulations could have a significant impact on the company’s operations.

Dependence on Underwriting Results

One of the drawbacks to the current state of the company is the lack of investment leverage (see chart below). The significant growth in equity over the last several years has outpaced the growth in company’s investment portfolio. The result is that future growth in book value is almost completely dependent on sound underwriting results. It certainly necessitates discipline, something we believe the management to have, but it does need to be considered a risk and recognized as a diminishing factor in the company’s valuation profile.


..........................................2002.....2003.....2004.....2005.....2006.....2007
Investment Leverage......3.17.......4.22.......2.66.......2.05.......1.79.......1.60

Valuation

So considering the risks, nature of the business, and economics, what do we think the company is worth? Given the company specific risks, nature of its underwriting and reserving, its prospects for additional market share accumulation in the state of Michigan and possible expansion into other states we believe a multiple to book of 1.3 to 1.4 times is appropriate. The overall price to tangible book value of the property and casualty industry is 1.7 (FMMH book value is all tangible). Allowing for a discount of .4 to .3 times book value due to the single state nature of its business and the fact that it is a micro cap company, we derive a value, per share, of $30.02 to $32.33. That would result in a discount to intrinsic value of between approximately 39.5% and 43.3%, and since we are buying below an understated book value, we see very little downside to a long-term holder at these prices. Believing that the company has the infrastructure and management expertise to grow its intrinsic value in the range of 10-14% per year over the next several years, we find such a discount to be quite attractive. Given these parameters we expect a greater than 20% per year return over the next five years.

Potential Catalysts
- the company was demutualized in 2004 and as part of that process no individual entity could own more than 5% of the company’s outstanding shares for five years; this period ends next fall (there are a couple holders of more than 5% currently which had to go through exhaustive processes with the state of MI after inadvertently going over the 5% limit)
- share buy-back
- further leveraging of expense ratio
- continued growth in BV per share
- change in reinsurance program to add additional risk to balance sheet
- increase investor awareness of a small-cap bulletin board stock
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*This is not a recommendation to buy or sell a security. Please do your own research before making an investment decision. We own shares of the company, either directly or indirectly, and we may buy or sell shares at any time without updating this post.