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

Buy Federated National (FNHC)!

Federated National (FNHC) provides homeowners insurance in Florida. It is a very small company:

  • Market capitalization of less than $60 million.
  • No analyst coverage.
  • Average volume of less than 14,000 shares traded daily.

It just reported good fourth quarter earnings over a week ago and since then the stock has surged almost 20% from $6.17 to $7.30 yesterday. However, further gains could be in store for this company as revenues should get a huge boost in 2013.

Background

The state owned Citizens is the largest insurer in Florida. Due to concerns about whether Citizens would be able to pay out claims if major hurricanes hit the state, it has been state approved raising rates over the last couple years with the hopes of writing profitable policies and pushing customers to the private sector. This has had a positive impact on Federated:

  • Over 20%+ growth in gross premiums written in 2012 to almost $120 million.
  • State approved rates rises and disciplined underwriting have decreased loss ratio and increased net income to .53/share in 2012.

2013

Based on management’s comments in the earnings call, 2013 should be even a better year:

  • Significant growth in new business in 2013. Last quarter the company was doing $1 million in new business and this quarter it is doing $2 million business and the CEO feels they could reach $2.5 to $3 million in business. Based on normal retention rates of 90% of existing customers, gross premiums will increase anywhere from 50% to 100%.
  • A signed deal which would allow 700 Allstate agents to write business for Federated has not gone into effect yet. This should help grow new business. 
  • Earnings should increase at a higher rate. Even though most of expenses such as reinsurance are variable, some of the smaller costs are fixed which should significantly help the bottom line with the revenue growth.
  • It is possible that earnings could be over $1/share and book value could increase from $8.26 to over $9+ share.

I bought some shares at $6.59, $7.10, and $7.15. I will most likely buy more at the right price.

There is a good seeking alpha article on the stock.

Disclosure: I own FNHC.