Federated National – Part 2

A reader Jeff S. sent me a good write up about potential risks about insurance companies in general. In the rush of posting this article yesterday, I should have mentioned them as they are important:

Book Value

Insurance companies hold a lot of assets, mainly bonds. The value of those assets shift dramatically depending on market conditions and thus, book value can go up and down dramatically. For example, Federated holds $150 million in cash and investments and the majority of it is in bonds. If the value of those bonds goes down say 10%, we are talking about a $15 million hit to book value or about $2/share. 

When you are investing in insurance companies, you are investing in bonds. Right now, it is not a great time to be an investor in bonds (especially, long term bonds) because of the low interest rates. About 16% of Federated’s portfolio bond portfolio, is in bonds that mature after 10 years. Another point is that any extra cash flow that the company gets will be invested in more bonds at the current anemic rates. 

Loss and loss adjustment expenses

Insurance companies not only have to expense actual paid losses, but also losses they expect to pay in the future. As a result, an overly optimistic management team could increase earnings by underestimating losses they may have to pay in the future.

It is worth noting that losses this year for Federated were stable even with a 20%+ new business. Also, unpaid losses and LAE has gone down $10 million year over year from $59 to $49 million.

Management attributed it to “primarily to a reassessment of our losses by line and increased underwriting procedures to manage our risks.” Federated has been focusing on writing more profitable policies. This has resulted in lower reinsurance premium rates and obviously lower losses. However, I am not a huge fan of the first reason (reassessment of our losses). 

Takeout

One thing I like about Federated is that they have grown organically and not from takeouts (taking business/premiums from other insurance companies). Takeouts result in instant premium growth and a boost to earnings. Homeowners Choice, Inc. (HCI), an another florida insurer, has growth this way, but the Federated CEO is not a fan of this approach and is adding business policy by policy.

Management

You need a good management team to manage risk. In regards to Federated, I can’t say either way they are good or bad, but I do like that they are saying the right things in the conference call.

Conclusion

With any investment, there is risk, but insurance companies are riskier. Federated is still a buy for me as I wrote in my previous article, but  investors should invest with caution.

Disclosure: I own FNHC

8 thoughts on “Federated National – Part 2

  1. Book Value

    Regarding bonds held by insurers, they only need to be marked to market if they are classified as available-for-sale. If they are classified as held-to-maturity, then no mark to market adjustment is needed. Thus, most insurance companies hold to maturity. And when they receive the principal back at maturity, now they are rolling them into lower yielding bonds. So the risk isn’t necessarily large swings in unrealized gains from bonds, but rather an overall investment yield that will likely slowly tick down over time. I would be curious as to what caused the large unrealized gains in 2012. Need to look at stat blanks Schedule D. Is their equity portfolio invested aggressively? I suppose it is more likely they sold some bonds for gains before maturity. But again, the proceeds would be reinvested in lower yielding assets.

    Loss & LAE

    Not sure where you are seeing losses being stable as it appears to me that their loss ratio is ticking down quickly. That is concerning. But have to back out CAT and reserve development from past loss ratios to get a better sense of what is going on. That’s the only way you can tell if they are being too aggressive or not. Unpaid loss & LAE reserves on the balance sheet are going down despite the growth, which leads me to believe that they are being aggressive. Although when they write new premium, it starts in the unearned premium reserve and then the majority rolls into the loss & LAE reserve as the premium is earned. Regarding mgmt comments, of course they will say that. And my guess is reinsurance rates are going down because they are buying less of it, so risk is increasing. Would have to look though.

    Takeout

    Takeouts can be good or bad. They are great if you have a really good mgmt team with effective risk models because they can just pull the best premium out. In terms of growing organically, it is always easy for an insurer to grow if they just underprice the market. This is how insurance companies blow up down the road. Buffett harps about this lack of discipline in his letter every year. And both takeouts and growing organically result in instant premium growth and a boost to earnings.

    Mgmt

    Their resumes do not look good. They will say what they say. I never give it much weight. For insurance companies, I could show you a very long list of ones that have blown up where the mgmt team said very rosy things right up until the end. It’s simple: underprice the risk, bad things will come. Optimism won’t change that.

  2. Loss ratio has decreased dramatically. This could be due to rate hikes, and better underwriting. When I said flat i meant it is exactly the same in terms of dollar amounts even though premiums have gone up. Thus, a lower ratio.

    What specifically stands out about their resume that does not look good?

  3. Rate hikes would have some lowering effect on loss ratios, but I am always skeptical of the better underwriting claim. Increasing premiums by 20% and also employing better underwriting is an oxymoron in my mind. How much were the rate hikes relative to the 20%? If it was all rate hikes, then ok. But the loss ratio has dropped from 76% in Q1’11 to 53% in Q3’12. That is a big drop. There was actually favorable development in the 2011 loss ratio, so without it the ratio would be over 76%. Was there any CAT in it? I doubt it. So that’s a pretty big drop in my book. Not sure a rate hike could account for it all. I actually don’t even know how much the rate hike was.

    Regarding the mgmt team, the CEO has been with the company since 1998. Before that, he ran some insurance agencies. He doesn’t have any experience running an insurance company beyond running FNHC. So his track record needs to be analyzed by looking at the expense ratio and reserve development among other things. The CFO also doesn’t have experience with an insurance company other than at FNHC. Spent some time at American Express’s bank and only a couple years at major accounting firms. They just don’t strike me as very impressive.

    Regarding the bond portfolio, it does look like a majority of their bonds are held as available-for-sale. I guess that makes sense given interest rates have been so low and they want to be able to potentially sell bonds at a moment’s notice. But you are right in that it does create a larger risk for book value given that the bonds have to be marked to market each quarter. If interest rates move up much for some reason, book value will really get hit.

    Regarding reserve development, it can be found on pg. 30 in the Q3’12. This is one of the most important numbers to look at for an insurer by the way. ‘Incurred related to prior years’ (this is reserve development) of $1.6m for YTD 9/30/12. The negative amount means they released reserves, also called favorable development. So of the $3.2m of net income for YTD 9/30/12, half was from releasing reserves. This is where mgmt can play with earnings. Not saying they are; the release could be justified. Need to look at reserve development historically though. Has there been any major adverse development, meaning they didn’t do a good job underwriting the business and had to add to reserves? How much of earnings are made up of favorable or adverse development each year?

    I just took a closer look at reserve development:

    In 2011, they lost $430k and had a $1m release, meaning they would have lost $1.4m without it. In 2010, they had $2.8m of adverse (not favorable) development, $1.7m in 2009, $4.5m in 2008, $9.2m in 2007 and $9.3m in 2006. So it looks like they aren’t the best of underwriters. Much of that adverse development was probably due to the hurricanes in 2004 and 2005 (need to back CAT out of loss ratios by the way), but this all needs to be looked at. How was development before that? Need the stat blanks. Have they ever had positive development before the last 2 years? If not, I would guess they are juicing earnings now. I would need to do more work to figure this all out though.

  4. This was their rate increases over last 2 years according to CEO: “So we did have two years of big rate increases, one was 20% and one was 19%.”

  5. I don’t mean to be too critical here, just pointing out things to consider. FL homeowners’ insurers need to make hay while the sun shines. They typically do really well during benign years, and then get smoked in years where there are CATs (this is even more so the case for CA quake business and HI homeowners’ business; they have longer benign periods). Can they get back to years like 2006 and 2007? Sure. And those years had adverse development, so if you add back those hits earnings were really high. My only concern now is that mgmt is getting too aggressive writing new business, they might not be putting up enough reserves, and they are potentially lowering their reinsurance. If that is all true, they could get really hit badly during a CAT year. No CAT and the business and stock will probably do quite well. For a hedge, you could purchase CRD.B. They provide claims outsourcing, so when a hurricane hits and insurers are scrambling to handle all the claims they will hire CRD.B for some help (look at what the stock did in 2008 because of the multiple hurricanes). It also does better in a soft market. Although CRD.B does have some pension issues, Jeff Bowman is pretty solid.

  6. Will do. And now that I know the growth is mainly coming from rate hikes, my concerns are mainly alleviated. At least without digging further into historical loss ratios, reserve development and figuring out what they are doing with reinsurance.

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