AMTRUST FINANCIAL SERVICES AFSI S
August 19, 2013 - 1:00am EST by
Francisco432
2013 2014
Price: 40.30 EPS $3.00 $0.00
Shares Out. (in M): 77 P/E 13.4x 0.0x
Market Cap (in $M): 3,130 P/FCF 0.0x 0.0x
Net Debt (in $M): 400 EBIT 310 0
TEV ($): 3,530 TEV/EBIT 11.5x 0.0x
Borrow Cost: NA

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  • Bankruptcy Risk
  • Aggressive Accounting
  • Insurance
  • Reinsurance
  • Fraud
 

Description

Link to PDF:

https://docs.google.com/file/d/0B86krX6VxmmWSXhzN0lVNHFOeW8/edit?usp=sharing


I believe AFSI is insolvent and incredibly aggressive in their accounting which makes it an attractive short.

Key issues:

  1. Over-marked life settlement investments
  2. Under-reserving for underwriting
  3. M&A accounting games to boost reported profitability
  4. Use of offshore captive reinsurer and related party to get around statutory capital requirements
  5. Numbers that don't add up (literally)

One can see the that their earnings are low quality by looking at the cumulative change in tangible book from YE 2008 to now:

 

In other words, despite reporting $750m of earnings over 4.5 years, their tangible book value has only increased by $230m, $27m of which was the result of issuing a convert (tang book would be ~$100m lower if they recognized DTLs associated with earnings indefinitely). That's a lot of running relative to the distance traveled...

Background:

Amtrust Financial Services is a P&C insurance company operating in four segments: Small Commercial Business (workers comp, commercial package, other P&C for small businesses), Specialty Risk & Extended Warranty (historically warranty, but includes other specialty lines in Europe including Italian medical malpractice and UK legal expense), Specialty Program (workers comp, commercial package, general liability, etc), and Personal Lines Re (quota share with a private related party).

In addition, Amtrust earns "service and fee income" (revenue) from unaffiliated third parties for warranty administration, policy fees, management services for risk retention groups and affiliated third parties for brokerage, asset management, and IT services. This line has grown meaningfully in recent years as a result of Amtrust's frequent acquisitions (ex: Case New Holland Agency - $30m/yr, BTIS agency - $18m/yr, CPP NA (competitor to Lifelock)).

 

AFSI's mix has shifted around a bit in recent years, but generally stayed since 2010 (Italian Med Mal entry & launch of Personal Lines Re with related party NGHC).

 

AFSI booked rather low loss ratios in 2008/9, but they have been creeping up since then (largely as a result of adverse development).

 

AFSI's real advantage seems to be on the expense side, but as I will explain later we believe this is driven more by accounting tricks than the technology advantage that management claims.

 

Below are the resulting combined ratios. Unsurprisingly, most of the volatility comes from the loss ratio.

 


 

Key issues:

  1. 1.       Life Settlement Accounting

http://en.wikipedia.org/wiki/Life_settlement

A life settlement is the sale of an existing life insurance policy to a third party for more than its cash surrender value, but less than its net death benefit.[1] There are a number of reasons that a policy owner may choose to sell his or her life insurance policy. The policy owner may no longer need or want his or her policy, he or she may wish to purchase a different kind of life insurance policy, or premium payments may no longer be affordable.[1] Policy owners often learn about settling their policies from a financial planner or advisor, insurance broker, attorney, friends or family, or estate planning presentations.

Life settlements are a legitimate asset class, but their reliance on assumptions along with the general opacity and illiquidity of the asset provide for a wide latitude of valuations. Unsurprisingly, this latitude tends to attract unsavory characters that have given LS a spotty track record as investments. Examples below:

Mutual Benefits Corp ($1b LS fraud that used internal LE estimates):

http://www.sec.gov/litigation/complaints/comp19274.pdf

Life Partners (systemic underestimation of LE using internal estimates):

https://www.sec.gov/News/PressRelease/Detail/PressRelease/1365171485062#.UhFBMm1k8cs

In determining the value of a policy, there are two primary factors: the life expectancy (LE) of the insured and the discount rate.

Life expectancies:

Investors in life settlements face different adverse selection issues than the carriers who issue the policies -- carriers want the insured to live longer so they receive more premiums and get to pay the death benefit later...LS investors want the opposite. As such, they use different estimates for LEs. Carriers generally use the VBT table (link below). Whereas LS investors use LE providers that specialize in adjusting for the different risks that LS investors face. Two providers have the lion's share of the market: 21st Services and AVS. Fasano is a distant third and EMSI is a further distant fourth.

http://www.soa.org/research/experience-study/ind-life/valuation/2008-vbt-report-tables.aspx

https://www.21stservices.com/

http://www.avsllc.com/

Discount Rates:

As a result of the illiquidity, negative cash flow dynamics (paying premiums), adverse selection issues, risk of litigation, and risk of life extension (double-whammy as more premiums and longer wait for death benefit), the market generally uses a 15-25% discount rate for life settlements. I've confirmed this with private market investors and public company disclosures validate this (IFT - 20.6% MRQ , ALSO - 20-25%, GWG Holdings (public debt) - 13%).  

Additionally, EEA Life Settlement Fund's auditors (E&Y) disagreed with their valuation when they applied a 10% discount rate to the "full credibility scenario" which incorporates a number of additional reserves beyond the move to a life expectancy based on 21st Services, AVS, etc.

"The discount rate of 10% in the “full credibility” value is, in our view, significantly lower than would be used by market participants in an arm’s-length transaction to purchase the assets of the fund"

 

Source: EEA Annual report - http://www.cisx.com/download_news.php?newsID=204669

Amtrust's Life Settlements:

 

Amtrust entered the life settlement space through a JV with ACAC (now NGHC) in mid-2010 with the acquisition of a portfolio of loans that were collateralized by life insurance policies. All of the policyholders defaulted on the loans, enabling Amtrust to foreclose on the policy. At this point, they marked to model the policy and recognized a non-cash, upfront gain.

Inception-to-date, Amtrust has recognized at least 40.7m of net income as gains (72.6m gains on I/S less 27.6m of NCI recognized). I say at least because AFSI's footnote disclosures show 162.5m of net income from life settlements (gross of NCI, net of profit commission). There is no disclosure or explanation in the filings for the difference and IR simply said they aren't related (hard to believe) and didn't want to talk about life settlements any more. Regardless, the company now carries them at $209m gross / ~99.2m net of profit commission and NCI (but also indirectly has another $10m of exposure through their stake in the JV partner). As such, they represent 17% of tangible book value.

Before going into AFSI's assumptions, it's worth highlighting what FAS 157, which governs LS accounting says:

"The fair value measurement objective is to determine an exit price from the perspective of a market participant... unobservable inputs (ie: discount rate) shall reflect the reporting entity's own assumptions that market participants would use in pricing the asset or liability (including assumptions about risk)."

Level 3 inputs

30. Level 3 inputs are unobservable inputs for the asset or liability. Unobservable inputs shall be used to measure fair value to the extent that relevant observable inputs are not available, thereby allowing for situations in which there is little, if any, market activity for the asset or liability at the measurement date. However, the fair value measurement objective remains the same, that is, an exit price from the perspective of a market participant that holds the asset or liability. Therefore, unobservable inputs shall reflect the reporting entity’s own assumptions about the assumptions that market participants would use in pricing the asset or liability (including assumptions about risk). Unobservable inputs shall be developed based on the best information available in the circumstances, which might include the reporting entity’s own data. In developing unobservable inputs, the reporting entity need not undertake all possible efforts to obtain information about market participant assumptions. However, the reporting entity shall not ignore information about market participant assumptions that is reasonably available without undue cost and effort. Therefore, the reporting entity’s own data used to develop unobservable inputs shall be adjusted if information is reasonably available without undue cost and effort that indicates that market participants would use different assumptions.

 

AFSI's 2q13 10Q:

The fair value of life settlement contracts as well as life settlement profit commission is based on information available to the Company at the end of the reporting period. The Company considers the following factors in its fair value estimates: cost at date of purchase, recent purchases and sales of similar investments, financial standing of the issuer, and changes in economic conditions affecting the issuer, maintenance cost, premiums, benefits, standard actuarially developed mortality tables and industry life expectancy reports. The fair value of a life insurance policy is estimated by applying an investment discount rate based on the cost of funding the Company's life settlement contracts as compared to returns on investments in asset classes with comparable credit quality, which the Company has determined to be 7.5%, to the expected cash flow generated by the policies in the Company's life settlement portfolio (death benefits less premium payments), net of policy specific adjustments and reserves. The Company adjusts the standard mortality for each insured for the insured's life expectancy based on reviews of the insured's medical records. The Company establishes policy specific reserves for the following uncertainties: improvements in mortality, the possibility that the high net worth individuals represented in its portfolio may have access to better health care, the volatility inherent in determining the life expectancy of insureds with significant reported health impairments, the possibility that the issuer of the policy or a third party will contest the payment of the death benefit payable to the Company, and the future expenses related to the administration of the portfolio. The application of the investment discount rate to the expected cash flow generated by the portfolio, net of the policy specific reserves, yields the fair value of the portfolio. The effective discount rate reflects the relationship between the fair value and the expected cash flow.

These reserves sound an awfully lot like EEA, ALSO, and IFT...who all use much higher discount rates. Also, note that these reserves were not mentioned until after the OWS report.

1q13 CC - Ron Pipoly, CFO (emphasis added):

 

Additionally, there has been some confusion in the marketplace surrounding our life settlement portfolio. I want to take this opportunity to clarify and explain how we account for and how we value our life settlement portfolio. We utilize a very conservative approach in determining the fair value of the portfolio. There are many factors that go into determining the value of the portfolio not simply at discount rate.       

 

To be clear, our effective discount rate on our life settlement portfolio for 2012 was 17.7%. If  you were to reference our 2012 10-K you would note that we disclosed a discount rate of 7.5% and an internal rate of return of 17.7%. That internal rate of return is our effective discount rate on our life settlement portfolio.

 

To illustrate, the total future positive cash – gross positive flows in our life settlement portfolio are expected to be $795 million. Those cash flows are reduced by adding additional reserves that we apply. Among those reserves is a life expectancy reserve. Life expectancies are updated every year by two of the most widely recognized life expectancy providers and weighted to the more conservative of two life expectancies.

 

Additionally, we provided mortality adjustment reserve by reducing the standard mortality tables based on the assumption that higher net worth individuals will live longer based on access to better healthcare. We also provided additional reserve for future expenses, operational risk and the reserve for highly impaired lives.

 

For 2012, the total of those reserves were $356 million. That gives us future positive net cash flows of $439 million. That $439 million is then discounted by 7.5% resulting in our December 31, 2012 carrying value of $193 million and an effective discount rate of 17.7%. On both a quarterly and an annual basis, our evaluations are reviewed by a nationally-recognized life actuarial firm. If we would have simply used the discount rate of 7.5% applied to the expected positive future cash flows of $795 million, the carrying value of our portfolio would've been $383 million as opposed to the $193 million, which we actually carried in December 31, 2012.

 

To date, we have had four mortality events and have collected benefit on all four of those policies. The total benefit collected was $24.5 million. Those four policies were purchased for $1.3 million, and we paid a total of $400,000 of premium. We carried those policies at a value of $5.2 million. Those four policies generated a cash gain of $22.8 million.

 

We acquired these assets when the market for these assets was very distressed and that philosophy is consistent with being very contrary and buying assets cheaply that produce very high returns over the long term with very little capital at risk.

 

To summarize, what is referred to as our internal rate of return in our 10-K of 17.7% is our effective discount rate on our life settlement portfolio.

 

 

Here is how I interpret his comments:

  • Start with VBT ("standard") LE -- $795m in expected future cash flows
  • Life expectancy reserve -- moving from VBT to AVS/21st/etc -- reserve for more premiums and discounting the death benefit for more time.
  • Mortality reserve - this would also be factored in by the transition to AVS-like LEs.
  • Discount the $439m cash flows resulting from AVS-like LEs at 7.5%.
  • Presto-Chango, AFSI generates earnings!

If my interpretation of their "reserves" being the difference between VBT and specialty LE providers' estimates of LE, then their assumptions are vastly off market and clearly contradict the accounting rules for these assets.

AFSI Assumptions

Life Expectancies (LEs):

        I.            10K/Q:

  1. "Standard life expectancy as adjusted for insured’s specific circumstances"
  2. "The Company (Amtrust) provides certain actuarial and finance functions related to the LSC entities."
  3. These disclosures are rather vague, so I asked IR who they use for LE providers...to which she said they use internal actuaries. Two other investors I've spoken to received the same answer BEFORE Off Wall Street published a report highlighting some of these concerns.
  4. NGHC's CFO (their JV partner) said that "standard" refers to VBT.

      II.            1q13 CC (After OWS report):

  1. "Life expectancies are updated every year by two of the most widely recognized life expectancy providers..."
  2. Unlike other LS market participants, AFSI does not disclose who they use for the LE estimates or how they blend/adjust them.

In addition, AFSI's LE estimates have been steadily falling more than the passage of time (196 months at 12/31/11 to 155 months at 12/31/11 to 139 months at 12/31/12) despite

  • LE generally falling 0.6x the passage of time (actuarial reasons)
  • minimal change in the portfolio during 2012 (237 -> 255 policies)
  • flat LEs across the space (IFT polciy count went from 190 to 214 inclusive of 31 acquired policies, but the average LE was flat y/y)
  • 21st Services extending LEs by 19% on average with premium financed policies increasing more on average:
    • https://www.21stservices.com/video/full-presentation/full-presentation.html

 

AFSI discount rates:

Despite attempting to twist the definition of discount rate to be the same as expected IRR (7.5% is not the "investment discount rate" rather than simply the discount rate and "Internal Rate of Return" is now "Effective Discount Rate"), the fact is they are discounting their investments at 7.5%.

Compare AFSI's assumptions to IFT (10K excerpts):

Valuation of Insurance Policies

..We currently use a probabilistic method of valuing life insurance policies, which we believe to be the preferred valuation method in the industry. The most significant assumptions which we estimate are the life expectancy of the insured and the discount rate.

In determining the life expectancy estimate, we analyze medical reviews from independent secondary market life expectancy providers (each a “LE provider”). An LE provider reviews the medical records and identifies all medical conditions it feels are relevant to the life expectancy of the insured. Debits and credits are then assigned by each LE provider to the individual’s health based on these medical conditions. The debit or credit that an LE provider assigns to a medical condition is derived from the experience of mortality attributed to this condition in the portfolio of lives that it monitors. The health of the insured is summarized by the LE provider into a life assessment of the individual’s life expectancy expressed both in terms of months and in mortality factor.

The resulting mortality factor represents an indication as to the degree to which the given life can be considered more or less impaired than a standard life having similar characteristics (e.g. gender, age, smoking, etc.). For example, a standard insured (the average life for the given mortality table) would carry a mortality rating of 100%. A similar but impaired life bearing a mortality rating of 200% would be considered to have twice the chance of dying earlier than the standard life. Historically, the Company has procured the majority of its life expectancy reports from two life expectancy report providers and only used AVS life expectancy reports for valuation purposes. Beginning in the quarter ended September 30, 2012, the Company began utilizing life expectancy reports from 21st Services for valuation purposes and began averaging or “blending,” the results of the two life expectancy reports to establish a composite mortality factor. However, when “blending” the AVS and 21st Services life expectancy reports, if the difference in the probability of mortality between the reports is greater than 150%, the Company will reduce the higher mortality factor until the difference is 150%.

Comment: Skewed to the more conservative estimate.

... However, beginning in the quarter ended September 30, 2012, the Company transitioned to a table developed by the U.S. Society of Actuaries known as the 2008 Valuation Basic Table, or the 2008 VBT. However, because the 2008 VBT table does not account for anticipated improvements in mortality in the insured population, the table was modified in conjunction with outside consultants to reflect these expected mortality improvements. The Company believes that the change in mortality table does not materially impact the valuation of its life insurance policies and that its adoption of a modified 2008 VBT table is consistent with modified tables used by market participants and third party medical underwriters.

Comment: making adjustments to the 2008 VBT table to reflect anticipated improvements in mortality is equivalent to "adding reserves".

...As is the case with most market participants at December 31, 2012, the Company used a blend of life expectancies that are provided by two third-party LE providers.

...The Company believes that investors in esoteric assets, such as life insurance policies, typically target yields averaging between 12%—17% for investments of more than a 5 year duration, and had historically used a 15%—17% range of discount rates to value its life insurance policies.

...Although the Company believes that its entry into the Non-Prosecution Agreement had a positive effect on the market generally and for premium financed life insurance policies specifically, the Company believes that, when given the choice to invest in a policy that was associated with the Company’s premium finance business and a similar policy without such an association, all else being equal, an investor would have generally opted to invest in the policy that was not associated with the Company’s premium finance business.

As of December 31, 2012, the Company owned 214 policies with an aggregate investment in life settlements of $113.4 million. Of these 214 policies, 171 were previously premium financed and are valued using discount rates that range from 16.80% to 33.80%. The remaining 43 policies are valued using discount rates that range from 14.80% to 21.30%.

Comment: AFSI's policies were almost entirely premium financed which means that the policyholder likely paid little to nothing on the policy...a "lender" advanced the premiums and foreclosed after the two year contestability period.

IFT's weighted average discount rate (mix of premium financed and non-premium financed): 24.01%.

 

Phoenix exposure:

Last but not least, AFSI has substantial exposure to Phoenix as a counterparty. This came to light when Tiger Capital sued PHL for increasing the Cost of Insurance on their policies. In the suit, Tiger disclosed 138 policies with Phoenix (out of 241 at the time / 261 now).

Phoenix policies trade at substantial discounts because of PNX's poor financial health and litigious approach to dealing with life settlement investors. For example, PNX's statutory surplus declined from $922.5m at 12/31/12 to $789.2m at 6/30/13 -- to support $13B of policy liabilities -- and PNX's AM Best rating has been downgraded below where most agents will take business.

https://www.phoenixwm.phl.com/public/about/financialstrength/ratings/index.jsp

I'll add more on the discrepancies here in the comment section.

In summary, the life settlement issues are:

                    I.            Questionable LE estimates

                  II.            Far off-market discount rates that violate the accounting rules

                III.            Substantial counterparty risk


 

  1. 2.       Under-reserving

AFSI has grown by leaps and bounds (33.6% CAGR of Net Premiums Written from 2007-2012) despite the soft market for P&C insurance which begs the question -- how were they able to grow so much and report results so much better than peers in a terrible insurance market? The short answer is that they weren't able to do so...

 

  1. a.       IBNR as a % of total reserves has been steadily falling

IBNR = Incurred but not reported. Case Reserves = reserves for claims already filed. Case reserves could also be a source of over/under-reserving, but IBNR is where management tends to have more discretion because IBNR is a more general reserve whereas case reserves are specific to claims.

Possible explanations:

  • Change in mix
    • Not the case. In fact, they've gone into longer-tail policies by entering Italian med mal and ramping up workers' comp.
    • Seasoning of the portfolio (reserves for first policy written is all IBNR before claims begin)
      • Steady/rapid growth keeps the seasoning of the portfolio
      • Inadequate development factor
        • Development factor is a multiplier of various measures (ie: paid losses or losses incurred) used to estimate total losses associated with a given accident year.
        • If a company uses too low of a development factor, they will be inadequately reserved.
        • Ex: $100 premiums taken in at T=0.
        • At T+1, losses incurred (case reserves + claims paid; losses incurred is used differently in this instance than in the income statement sense) = $20 * 3.5 development factor = $70 estimate for ultimate loss.
        • At T+2, losses incurred = $30 * 2.5 development factor = $75 re-estimated ultimate loss --> $5 of adverse development recorded at T=2 for this accident year.

 

Given AFSI's substantial underwriting leverage (NPW / Stat Cap; Loss Reserves & Unearned Prem / Stat Cap), tangible book is highly sensitive to changes in reserves. If AFSI were to boost reserves to where IBNR was 45% of total (holding case reserves constant) -- the 2010 YE level -- tangible book value would fall by more than half.

 

  1. b.      Reserving methodology

 

WorkersComp reserves are calculated using the "incurred development method" which:

 

AFSI 10K:

Quarterly Incurred Development Method (Use of AmTrust Factors)

Quarterly incurred loss development factors are derived from our historical, cumulative incurred losses by accident month. These factors are then applied to the latest actual incurred losses and DCC by month to estimate ultimate losses and DCC, based on the assumption that each accident month will develop to estimated ultimate cost in a similar manner to prior years. There is a substantial amount of judgment involved in this method.

 

Yearly Incurred Development (Use of National Council on Compensation Insurance, Inc. (“NCCI”) Industry Factors by State)

Yearly incurred loss development factors are derived from either NCCI’s annual statistical bulletin or state bureaus. These factors are then applied to the latest actual incurred losses and DCC by year by state to estimate ultimate losses and DCC, based on the assumption that each year will develop to an estimated ultimate cost similar to the industry development by year by state.

 

...rely on historical development factors derived from changes in our incurred losses, which are estimates of paid claims and case reserves over time. As a result, if case reserving practices change over time, the two incurred methods may produce substantial variation in the estimate of ultimate losses. We have not used any “paid” development methods, which rely on actual claims payment patterns and, therefore, are not sensitive to changes in case reserving procedures. As our paid historical experience grows, we will consider using “paid” loss development methods.

 

Of the two methods above, the use of industry loss development factors has consistently produced higher estimates of workers’ compensation losses and DCC expenses.

 

 

In other words, AFSI uses the historical pattern of its own estimates (for case reserves) to estimate losses and acknowledges that using its own methodology is always lower than the industry.

 

The low end of the range is established by assigning a weight of 100% to our ultimate losses obtained by application of our own loss development factors. The high end is established by assigning a weight of 50% each to our ultimate losses as developed through application of Company and industry wide loss development factors.

 

From these disclosures, we can back into what the loss reserve would be if they only used industry factors -- $155m for just workers' comp.

 

 

 

 

  • Specialty Risk & Extended Warranty (mostly warranty, but also Italian Medical Malpractice)

Surprisingly, AFSI does not address Medical Malpractice reserving policies, particularly given the very long tail nature of this line and highly IBNR driven aspect (a pacemaker fouling up years later).

Specialty Risk and Extended Warranty claims are usually paid quickly, development on known claims is negligible, and generally, case reserves are not established. IBNR reserves for warranty claims are generally “pure” IBNR, which refers to amounts for claims that occurred prior to an accounting date but are reported after that date. The reporting lag for warranty IBNR claims is generally small, usually in the range of one to three months. Management determines warranty IBNR by examining the experience of individual coverage plans. Our consulting actuary, at the end of each calendar year, reviews our IBNR by looking at our overall coverage plan experience, with assumptions of claim reporting lag and average monthly claim payouts. Our net IBNR as of December 31, 2012 and 2011 for our Specialty Risk and Extended Warranty segment was $26.6 million and $52.9 million, respectively.

The primary actuarial methodology used to project future losses for the unexpired terms of contracts is to project the future number of claims, then multiply them by an average claim cost. The future number of claims is derived by applying to unexpired months a selected ratio of the number of claims to expired months. The selected ratio is determined from a combination of:

  • past experience of the same expired policies,
  • current experience of the earned portion of the in-force policies or contracts, and
  • past and/or current experience of similar type policies or contracts

 

 

  • Property & Casualty

 

We began writing general liability, commercial auto and commercial property (jointly known as CPP) business in 2006. In order to establish IBNR for CPP lines of business, we rely on three methods that utilize industry development patterns by line of business:

Yearly Incurred Development (Use of Industry Factors by Line). For each line, the development factors are taken directly from Insurance Services Office, Inc. (“ISO”) loss development publications for a specific line of business. These factors are then applied to the latest actual incurred losses and DCC by accident year, by line of business to estimate ultimate losses and DCC

Expected Loss Ratio. For each line, an expected loss ratio is taken from our original account level pricing analysis. These loss ratios are then applied to the earned premiums by line by year to estimate ultimate losses and DCC

Bornhuetter-Ferguson Method. For each line, IBNR factors are developed from the applicable industry loss development factors and expected losses are taken from the original account level pricing analysis. IBNR factors are then applied to the expected losses to estimate IBNR and DCC

...Because we determine our reserves based on industry incurred development patterns, our ultimate losses may differ substantially from our estimates produced by the above methods.

Because of the numerous third party administrators we use, we have utilized only limited incurred development methods based on historical loss development patterns, or methods that rely on paid development factors. Paid loss development methods rely on actual claim payment patterns to develop ultimate loss and DCC estimates.

Comment: Implies they use "Expected Loss Ratio" and B-F Method. No disclosure of gross/net/case/IBNR for these lines of business.

  1. c.       Adverse Development

In each of the last three years, AFSI has seen adverse development, particularly for years 2009 and 2010 when the company was booking aggressive initial loss ratios of 54.3%/57.1%. However, because they have grown their underwriting so aggressively in recent years, the adverse development has been swamped by new business that is also subject to aggressive initial loss picks.

The questions are:

  • Can they keep growing in order to keep swamping the prior year development?
    • Capital will be the primary constraint -- i'll address this in the next section.
    • Will improving insurance rates bail them out?
      • They are starting to help.
      • Are they now adequately reserved? IBNR would suggest not.

 

  1. d.      Discrepancies with MHLD disclosures

AFSI discloses the premiums, losses and expenses ceded to MHLD in related party footnotes and MHLD breaks out the AFSI quota share as a separate segment disclosure. AFSI's CEO is the Chairman of MHLD and they share BDO as an auditor...so why do they report such different results for MHLD's share of the AFSI quota share and, more importantly, why does AFSI have a 710 bps lower loss ratio than what they cede to MHLD on a quota share when it covered  84.6% of their underwriting (cumulative since mid-2007)??

Note that the disclosures match up on the NPE line (8m difference - qtrly timing of recognition).

Neither AFSI nor MHLD had an explanation for this, but MHLD confirmed that those disclosures are mirrors of one another in what they cover.

 

  1. Competitors

Two competitors have recently had adverse development that was across similar business lines (WC, Commercial Multi-Peril, and Commercial Auto) and account sizes (small biz) - Meadowbrook (MIG) and Tower Group (TWGP). MIG was subsequently downgraded by AM Best and forced to find a reinsurance partner and TWGP is now under review.

Note that all three were relatively strong performers in 2008-2010 (they were also each growing more rapidly than the industry.

 

Some of AFSI's customers require a rating of "A-" or higher (and agents would re-direct new policies). Given the high degree of leverage and relative illiquidity of some of AFSI's large assets, a severe liquidity crunch is very possible at AFSI (particularly given the significant debt funding at the holdco level subject to rating and net worth covenants).

 


 

  1. 3.       Use of offshore captive and related party to get around capital requirements

Below is an estimation of AFSI's consolidated statutory surplus and the residual stat surplus after allocating capital to specifically disclosed subsidiaries.

 

Below is the resulting consolidated underwriting leverage at AFSI (using YE surplus to be generous with the exception of 2013 which uses 2012 YE).

 

In comparison, MIG (recently downgraded by AM Best) was writing at 1.5x NPW / Stat Surplus.

So why is AFSI able to use so much more leverage? Bermuda!

They cede over 70% of GWP to Amtrust International Insurance (AII) which then cedes 40% of the original GWP to MHLD (another related party). AII then collateralizes the statutory subsidiaries' reinsurance recoverables with a combination of letters of credit (off balance sheet debt of 152.8m at YE 2012) and a collateral trust (MHLD also has a collateral trust for the benefit of AII/US Stat subs). In total, the US subs have 1.76B of reinsurance recoverables that are not subject to a haircut since they're collateralized .

However, AII lacks the liquid assets it requires to fund the entirety of their share of the recoverable, so they use (1) the previously mentioned letters of credit (2) a collateral funding agreement with MHLD for ~168m and (3) repo financing of $292m.

AII 2010 financial statements that show all of AFSI's consolidated repo financing is attributable to this entity:

www.dsnrrg.com/forms/AmTrust%20International%20Financials%20for%20year%20ending%2012-31-10.pdf

AII's incremental source of cash flow is premium payments (via US subs). So if AFSI were forced to slow down underwriting growth (or heaven forbid shrink/stop), AII would not have the liquid assets to fund the repo repayment.

What assets does AII have to sell beyond those tied up? Equity investments in:

  • NGHC (not publically listed, but going through the registration process -- difficult to sell given overlapping controlling shareholders)
  • AEL (UK Statutory Subsidiary) - can't tap that for liquidity because those assets are supporting their own reserves.
  • AIUL (Irish Statutory subsidiary) - can't tap that for liquidity because those assets are supporting their own reserves.
  • ACHL (Luxembourg captive reinsurance subsidiary) - few reserves to support, but substantial tax penalties to draw this down.
  • Life Settlements -- I guess we'd find out how good their marks are if they tried to sell this in a hurry...

Given this lack of liquid assets and callable debt (repo), AII is the weak link in the chain. So what, you say, the regulators don't care...it's been going on forever!

Ben Lawsky, the Superintendent of Financial Services & NYDFS are working on it and getting some scalps (including Metlife). I believe AFSI's structure is exactly the sort of hidden risk they are seeking to expose and correct.

http://www.dfs.ny.gov/about/press2013/pr1306121.htm

http://www.dfs.ny.gov/reportpub/shadow_insurance_report_2013.pdf

Background on DFS Investigation into Shadow Insurance

In July 2012, DFS initiated an investigation into shadow insurance at New York-based insurance companies and their affiliates.
Insurance companies use shadow insurance to shift blocks of insurance policy claims to special entities — often in states outside where the companies are based, or else offshore (e.g., the Cayman Islands) — in order to take advantage of looser reserve and regulatory requirements. Reserves are funds that insurers set aside to pay policyholder claims.

In a typical shadow insurance transaction, an insurance company creates a “captive” insurance subsidiary, which is essentially a shell company owned by the insurer’s parent. The company then “reinsures” a block of existing policy claims through the shell company – and diverts the reserves that it had previously set aside to pay policyholders to other purposes, since the reserve and collateral requirements for the captive shell company are typically lower. Sometimes the parent company even effectively pays a commission to itself from the shell company when the transaction is complete.

This financial alchemy, however, does not actually transfer the risk for those insurance policies off the parent company’s books because, in many instances, the parent company is ultimately still on the hook for paying claims if the shell company’s weaker reserves are exhausted through a “parental guarantee.” That means that when the time finally comes for a policyholder to collect their promised benefits after years of paying premiums — such as when there is a death in their family – there is a smaller reserve buffer available at the insurance company to ensure that the policyholders receive the benefits to which they are legally entitled.

http://www.bloomberg.com/news/2013-05-21/metlife-limits-offshore-reinsurance-after-n-y-review.html

‘Shadowy World’

Lawsky praised MetLife’s announcement in a Twitter message today, citing “progress on making the shadowy world of insurance ‘captives’ more transparent.”

MetLife Chief Executive Officer Steve Kandarian said the offshore reinsurance program began in 2001 and “makes less sense” now.

“The New York Department of Financial Services’ industry inquiry regarding captives was an important factor in our taking a closer look at our offshore reinsurance subsidiary,” Kandarian, 61, said at the investor presentation. “We’re going to take steps to bring these businesses back on shore and to a more highly capitalized, U.S.-based and U.S.-regulated entity.”

 

 


 

  1. 4.       M&A accounting to boost reported profits
    1. Acquire distribution

AFSI acquires renewal rights and/or managing general agents, sometimes even paying them contingent consideration as a % of future premiums written -- these look a lot like commission expenses, but because they are bought instead of built, they do not hit the income statement (any intangibles that get amortized are over long periods even those are added back to "operating earnings").

Even though they're following GAAP (except for the add-backs), it is a misrepresentation of the economics of the business. One way to see through the M&A accounting fog is to look at tangible book growth (as we did at the beginning) which is lacking.

Back of the envelope, I think this "trick" brings AFSI's expense ratio down by 500-600 bps based on ~$1.2b of GWP (~50% of 2012 GWP) from acquired distribution channels at 10-12% commission rates.

For the sake of argument, let's say that if the distribution had been third parties, AFSI would have had a ~30% expense ratio (about in-line with MIG/TWGP) but since they acquired half of their distribution, they don't have to pay those commissions (renewal rights roll and MGAs are done with contingent consideration to keep them incentivized).  That brings the expense ratio on a gross basis down to ~24-25%.

  1. Enhanced by ceding commission

Then AFSI cuts MHLD in on the quota share, but wants reimbursed for the cost of generating those premiums -- at the (fair based on my assumptions) rate of 30% ceding commission for premiums ceded (about what they get). AFSI gets to run this through the income statement and nets it against expenses for the expense ratio.

If $100 of premiums are written and 40% are ceded pro-rata for a 30% commission, AFSI will get $12 of ceding commissions to count against their $25 of gross loss expense, making the net expense ratio $13. Since they retain $60, the net expense ratio becomes 21.67% (13/60).

Voila! Better expense ratio via acquisition & ceding...assuming you don't mind that you probably overpaid for the distribution on the front end which hurt the cumulative change in tangible book.

To keep this "trick" going, they have to continue generating at least the same amount of their distribution as they did before. That's fine if they don't need to grow, but AFSI needs to keep growing  to cover up adverse development from under-reserving and keep cash flowing to AII.

However, they're starting to run out of tangible book and consolidated statutory surplus to spend with tangible book sitting at ~$600m and needle moving deals likely to cost $75m+ and be entirely comprised of intangibles if they are purely distribution.

  1. Spring-loading acquisitions to dress up reported earnings

Given the length of this report, i'm going to leave this for the comments section as a follow-up.

 

  1. Luxembourg acquisitions

 

Given the length of this report, i'm going to leave this for the comments section as a follow-up.

 

  1. 5.       Numbers that don't add up (literally)

AFSI has math problems. That's troubling for an insurance company.

Below is a comparison of press releases and SEC filing disclosures. They never explained any of the changes, and the income statement, shareholders equity, and goodwill/intangibles were never changed.

How does premium receivable go up $47m between the PR and 10K without impacting revenues or unearned premium?? I'll refrain from accusing them of something more nefarious than clever accounting gimmicks and aggressive assumptions, but I'm certainly suspicious...

 

There are a myriad of other disclosures that we have not been able to reconcile for AFSI against its own disclosures as well as related parites NGHC and MHLD. I'll touch on some of them in the comments section.


 

Valuation:

With all these red flags, you might think that AFSI would trade at a discount to the space. Hardly!

For the most part, compas trade between 60-160% of stated book and 90-150% of tangible book. AFSI is off the charts on these metrics. At 5x tangible book (with inflated assets and deflated loss reserves), AFSI is anything but cheap, unless you think I'm dead wrong and/or that the game will go on forever.

 

The table below doesn't match in some instances because it pulls from CapIQ without making any of the relevant adjustments (ie: AFSI 10% stock dividend).

 

 


 

Catalysts:

  1. Running out of tangible book / statutory surplus to support M&A and underwriting growth
  • Given the slow playing, uncertain nature of the other catalysts below, the fact that their NPW / Tang equity has gone from ~150% in mid-2010 to ~336% in 2q13 gives me some comfort that they are nearing the end of their game
  1. Issuing equity
  • Per my first point, I think the best thing they could do to add value is issue gobs of equity at this ridiculous valuation.
  1. Impairment of LSC
  • Management is obviously not going to do this of their own volition.
  1. Adverse development in reserves, particularly if accelerated
  • Mechanics of reserve development will keep pressure on the company here and make it increasingly difficult to book aggressive initial year loss picks.
  1. Pressure to bring captive insurers onshore
  • Lawsky seems to be looking for targets.
  1. Potential AM Best downgrade as a result of leverage
  2. Covenant trip
  • Wouldn't be the first domino, but it would significantly accelerate the process with potentially severe outcomes (letters of credit and repo at AII with no good alternatives -- parent is tapped out as well).
  1. Somewhat rapid rise in interest rates
  • A slow and steady would probably benefit them

 

Risks:

  1. High insider ownership & incentivized management team
  2. Slow-playing catalysts,
  • many of which are dependent on third parties that tend not to be forward looking.
  • Part of my reason for writing up this name was to try to highlight the issues and get a conversation going -- either to prove me wrong or have more aggressive investors pick up the ball and run with it.
  1. High short interest
  • It's come down a little of late, but it's still not low relative to ADV / float.

                                                                                                              I.       

Appendix:

IFT 10Q:

Investment in life settlements — The Company has elected to account for the life settlement policies it acquires using the fair value method. Due to the inactive market for life settlements, the Company uses a present value technique to estimate the fair value of our investments in life settlements, which is a Level 3 fair value measurement as the significant inputs are unobservable and require significant management judgment or estimation. The Company currently uses a probabilistic method of valuing life insurance policies, which we believe to be the preferred valuation method in the industry. The most significant assumptions are the estimates of life expectancy of the insured and the discount rate.

In determining the life expectancy estimate, we analyze medical reviews from independent secondary market life expectancy providers (each a “LE provider”). An LE provider reviews the medical records and identifies all medical conditions it feels are relevant to the life expectancy of the insured. Debits and credits are then assigned by each LE provider to the individual’s health based on identified medical conditions. The debit or credit that an LE provider assigns to a medical condition is derived from the experience of mortality attributed to this condition in the portfolio of lives that the LE provider monitors. The health of the insured is summarized by the LE provider into a life assessment of the individual’s life expectancy expressed both in terms of months and in mortality factor.

The resulting mortality factor represents an indication as to the degree to which the given life can be considered more or less impaired than a standard life having similar characteristics (e.g. gender, age, smoking, etc.). For example, a standard insured (the average life for the given mortality table) would carry a mortality rating of 100%. A similar but impaired life bearing a mortality rating of 200% would be considered to have twice the chance of dying earlier than the standard life. The probability of mortality for an insured is then calculated by applying the blended life expectancy estimate to a mortality table. The mortality table is created based on the rates of death among groups categorized by gender, age, and smoking status. By measuring how many deaths occur during each year, the table allows for a calculation of the probability of death in a given year for each category of insured people. The probability of mortality for an insured is found by applying the mortality rating from the life expectancy assessment to the probability found in the actuarial table for the insured’s age, sex and smoking status. The Company has historically applied an actuarial table developed by a third party. However, beginning in the quarter ended September 30, 2012, the Company transitioned to a table developed by the U.S. Society of Actuaries known as the 2008 Valuation Basic Table, or the 2008 VBT. However, because the 2008 VBT table does not account for anticipated improvements in mortality in the insured population, the table was modified by outside consultants to reflect these expected mortality improvements. The Company believes that the change in mortality table does not materially impact the valuation of its life insurance policies and that its adoption of a modified 2008 VBT table is consistent with modified tables used by market participants and third party medical underwriters.

The mortality rating is used to create a series of best estimate probabilistic cash flows. This probability represents a mathematical curve known as a mortality curve. This curve is then used to generate a series of expected cash flows over the remaining expected lifespan of the insured and the corresponding policy. A discounted present value calculation is then used to determine the value of the policy. If the insured dies earlier than expected, the return will be higher than if the insured dies when expected or later than expected.

The calculation allows for the possibility that if the insured dies earlier than expected, the premiums needed to keep the policy in force will not have to be paid. Conversely, the calculation also considers the possibility that if the insured lives longer than expected, more premium payments will be necessary. Based on these considerations, each possible outcome is assigned a probability and the range of possible outcomes is then used to create a value for the policy.

Historically, the Company has procured the majority of its life expectancy reports from two life expectancy report providers and only used AVS Underwriting LLC (“AVS”) life expectancy reports for valuation purposes. Beginning in the quarter ended September 30, 2012, the Company began utilizing life expectancy reports from 21st Services, LLC (“21st Services”) for valuation purposes and began averaging or “blending,” the results of the two life expectancy reports to establish a composite mortality factor.

On January 22, 2013, 21st Services announced revisions to its underwriting methodology and on February 4, 2013, announced that it was correcting errors discovered in its previously announced revised methodology. According to the 21st Services, these revisions have generally been understood to lengthen the average reported life expectancy furnished by this life expectancy provider by 19%. At March 31, 2013, the Company had not received any life expectancy reports from 21st Services utilizing its revised methodology and, to account for the impact of the revisions and based off of market responses to the methodology change, the Company lengthened the life expectancies furnished by 21st Services by 13% prior to blending them with the life expectancy reports furnished by AVS.

As of June 30, 2013, the Company received 98 updated life expectancy reports from 21st Services that utilize its revised methodology. These life expectancies reported an average lengthening of life expectancies of 15.8% and, based on this sample, for the six months ended June 30, 2013, the Company increased the life expectancies furnished by 21st Services by 15.8% on the rest of its portfolio of life settlements prior to blending them with the life expectancy reports furnished by AVS. The Company expects to continue to lengthen life expectancies furnished by 21st Services that have not been re-underwritten using their updated methodology. Since the Revolving Credit Facility necessitates that the Company procure updated life expectancies on a periodic basis, the amount of policies that are lengthened by the Company in this manner will decrease over time and the fair value calculations in future periods will, accordingly, reflect the actual impact of the revised 21st Services methodology on a policy by policy basis as updated life expectancy reports are procured. At June 30, 2013, had the Company not applied a 15.8% increase to the 21st Services life expectancy reports, the portfolio would have increased from the reported amount of $265.8 million by $5.3 million.

Prior to the quarter ended June 30, 2013, when blending AVS and 21st Services’ life expectancy reports to derive a composite mortality factor, the Company would cap the higher mortality factor at an amount that was 150% above the lower mortality factor. This was done so as to reduce variances between life expectancies furnished by these two life expectancy providers. For the period ending June 30, 2013, the Company terminated its use of such a cap. The Company believes that the elimination of this cap is consistent with valuation methodologies employed by other market participants in connection with 21st Services’ revised methodology.

 

 

ALSO 10K:

The discount rate used to calculate the present value of the life settlement contracts was determined based on the following at August 31, 2012:

 

The Company utilizes actuarial pricing methodologies and software tools that are built and supported by leading independent actuarial service firms such as Milliman USA and Modeling Actuarial Pricing Systems, Inc. (“MAPS”) for calculating expected returns. The MAPS (formerly Milliman) system is the most widely used platform for generating mortality reports. The Company uses life expectancy data from major non-related third-party life expectancy data providers. MAPS uses the life expectancy data and calculates a multiplier to the VBT data to reflect the current state of health of the insured. MAPS generates a report encompassing three individual valuations, two valuations based on two separate life expectancy reports and one valuation based on the weighted average of the two life expectancy values. The Company utilizes the valuation generated from the larger life expectancy value. The next step in the valuation process is determining the appropriate discount rate for the asset type. The discount rate incorporates current information about market interest rates, the credit exposure to the insurance company that issued the life settlement contracts and the Company’s estimate of the risk premium an investor in the policy would require. The Company believes that investors in alternative investments typically target yields averaging between 13 - 16% for investments of more than a 5 year duration. A 16% rate of return over a five year duration is a reasonable target for investments that are highly illiquid, relatively new and more volatile (i.e. life settlement contracts) than standard investments. In recent months, there have been a number of government investigations of several life settlement companies. These investigations, and subsequent Securities and Exchange Commision Inforcement Actions, in one instance, have caused a temporary dislocation in the life settlement market. Liquidity has tightened even further. The current market is still in a state of flux brought on by economic circumstances in Europe (traditionally the largest investors in the life settlement markets). These factors have caused investors in life settlements to demand a higher yield (averaging between 20 – 25%) because of the perceived risk in life settlements. Additionally, in the past 6 months, the Company, in the normal course of business, sold two fair value policies (each with face amounts below $15 million) to another investor, for a discount rate of between 19% and 22%. Additionally, in discussions with investors for potential debt offerings, and in discussions with other investors for potential sales of policies, the discount rate, for policies with face amounts below $15 million, indicated a rate of between 18% and 22%. For policies with face amounts above $15 million, of which there are fewer purchasers present, investors indicated a rate of between 25% and 28%. In light of all of these factors, the Company believes the perceived risk or uncertainty over these assets has changed and therefore the risk premium an investor would require has changed, therefore, in the third quarter ending May 31, 2012, management made a change in accounting estimate and adjusted its discount rate from 16% to 20%, for policies with face amounts below $15 million, and to 25%, for policies with face amounts above $15 million. Additionally, management has elected to report the more conservative of the values generated by the MAPS system, by utilizing the values linked to the longer life expectancy report. Management believes that a more conservative discount rate is appropriate due to the recent sales of policies and in discussions with other investors in the life settlements market.

 

...

 

The Company utilizes the MAPS system for valuations. MAPS is a generally accepted third party pricing system utilized by funds and investors engaged in the purchase and sale of life settlements.

 

Life expectancy reports are generated by third party medical underwriting firms, such as AVS, 21 st Century, EMSI and Fasano. These firms review medical data for an individual and grade using a series of debits and credits. The resulting values are used to generate a life expectancy value. The MAPS system utilizes this life expectancy data to calibrate underlying mortality curves generated for each individual case.

 

MAPS utilizes the appendixes to the VBT2008 report as a base for mortality projections. This chart established 25 unique values corresponding to 25 statistical values indicative of the next 25 years of a persons life. The value is the statistical probability that the individual will meet an untimely end in that given year. When a life expectancy provider produces a report, it indicates a value at which point a certain individual will achieve a 50% chance, statistically, of dying. This is calculated by randomly making 1000 simulations and calculating an exact point of death for each simulation. The point at which the cumulative deaths equal 500 is the median point or the life expectancy.

 

 
 

In order to calibrate this curve, a multiplier is formulated to cause the median mark to equal the life expectancy value provided by the life expectancy provider. For every case, 1000 simulations are run, each simulation resulting in a unique death month. For example, if a life expectancy equals 50 months, the underlying data would show 500 deaths prior to the 50th month and 500 deaths after the 50th month.

 

The MAPS system takes the results of the modified life expectancy curve and applies it to the premium and death benefit projections stream. For the 500 deaths prior to the 50th month, utilizing our previous example, it would apply the percentage of the simulated runs that died in each 12 month period to the death benefit and premium schedules to form estimated cash flows. The net present value, using a discount rate defined by the user, of the streams of values created by this method form the indicated value of the policy.

 

I do not hold a position of employment, directorship, or consultancy with the issuer.
I and/or others I advise hold a material investment in the issuer's securities.

Catalyst

  1. Running out of tangible book / statutory surplus to support M&A and underwriting growth
  • Given the slow playing, uncertain nature of the other catalysts below, the fact that their NPW / Tang equity has gone from ~150% in mid-2010 to ~336% in 2q13 gives me some comfort that they are nearing the end of their game
  1. Issuing equity
  • Per my first point, I think the best thing they could do to add value is issue gobs of equity at this ridiculous valuation.
  1. Impairment of LSC
  • Management is obviously not going to do this of their own volition.
  1. Adverse development in reserves, particularly if accelerated
  • Mechanics of reserve development will keep pressure on the company here and make it increasingly difficult to book aggressive initial year loss picks.
  1. Pressure to bring captive insurers onshore
  • Lawsky seems to be looking for targets.
  1. Potential AM Best downgrade as a result of leverage
  2. Covenant trip
  • Wouldn't be the first domino, but it would significantly accelerate the process with potentially severe outcomes (letters of credit and repo at AII with no good alternatives -- parent is tapped out as well).
  1. Somewhat rapid rise in interest rates
  • A slow and steady would probably benefit them
    sort by    

    Description

    Link to PDF:

    https://docs.google.com/file/d/0B86krX6VxmmWSXhzN0lVNHFOeW8/edit?usp=sharing


    I believe AFSI is insolvent and incredibly aggressive in their accounting which makes it an attractive short.

    Key issues:

    1. Over-marked life settlement investments
    2. Under-reserving for underwriting
    3. M&A accounting games to boost reported profitability
    4. Use of offshore captive reinsurer and related party to get around statutory capital requirements
    5. Numbers that don't add up (literally)

    One can see the that their earnings are low quality by looking at the cumulative change in tangible book from YE 2008 to now:

     

    In other words, despite reporting $750m of earnings over 4.5 years, their tangible book value has only increased by $230m, $27m of which was the result of issuing a convert (tang book would be ~$100m lower if they recognized DTLs associated with earnings indefinitely). That's a lot of running relative to the distance traveled...

    Background:

    Amtrust Financial Services is a P&C insurance company operating in four segments: Small Commercial Business (workers comp, commercial package, other P&C for small businesses), Specialty Risk & Extended Warranty (historically warranty, but includes other specialty lines in Europe including Italian medical malpractice and UK legal expense), Specialty Program (workers comp, commercial package, general liability, etc), and Personal Lines Re (quota share with a private related party).

    In addition, Amtrust earns "service and fee income" (revenue) from unaffiliated third parties for warranty administration, policy fees, management services for risk retention groups and affiliated third parties for brokerage, asset management, and IT services. This line has grown meaningfully in recent years as a result of Amtrust's frequent acquisitions (ex: Case New Holland Agency - $30m/yr, BTIS agency - $18m/yr, CPP NA (competitor to Lifelock)).

     

    AFSI's mix has shifted around a bit in recent years, but generally stayed since 2010 (Italian Med Mal entry & launch of Personal Lines Re with related party NGHC).

     

    AFSI booked rather low loss ratios in 2008/9, but they have been creeping up since then (largely as a result of adverse development).

     

    AFSI's real advantage seems to be on the expense side, but as I will explain later we believe this is driven more by accounting tricks than the technology advantage that management claims.

     

    Below are the resulting combined ratios. Unsurprisingly, most of the volatility comes from the loss ratio.

     


     

    Key issues:

    1. 1.       Life Settlement Accounting

    http://en.wikipedia.org/wiki/Life_settlement

    A life settlement is the sale of an existing life insurance policy to a third party for more than its cash surrender value, but less than its net death benefit.[1] There are a number of reasons that a policy owner may choose to sell his or her life insurance policy. The policy owner may no longer need or want his or her policy, he or she may wish to purchase a different kind of life insurance policy, or premium payments may no longer be affordable.[1] Policy owners often learn about settling their policies from a financial planner or advisor, insurance broker, attorney, friends or family, or estate planning presentations.

    Life settlements are a legitimate asset class, but their reliance on assumptions along with the general opacity and illiquidity of the asset provide for a wide latitude of valuations. Unsurprisingly, this latitude tends to attract unsavory characters that have given LS a spotty track record as investments. Examples below:

    Mutual Benefits Corp ($1b LS fraud that used internal LE estimates):

    http://www.sec.gov/litigation/complaints/comp19274.pdf

    Life Partners (systemic underestimation of LE using internal estimates):

    https://www.sec.gov/News/PressRelease/Detail/PressRelease/1365171485062#.UhFBMm1k8cs

    In determining the value of a policy, there are two primary factors: the life expectancy (LE) of the insured and the discount rate.

    Life expectancies:

    Investors in life settlements face different adverse selection issues than the carriers who issue the policies -- carriers want the insured to live longer so they receive more premiums and get to pay the death benefit later...LS investors want the opposite. As such, they use different estimates for LEs. Carriers generally use the VBT table (link below). Whereas LS investors use LE providers that specialize in adjusting for the different risks that LS investors face. Two providers have the lion's share of the market: 21st Services and AVS. Fasano is a distant third and EMSI is a further distant fourth.

    http://www.soa.org/research/experience-study/ind-life/valuation/2008-vbt-report-tables.aspx

    https://www.21stservices.com/

    http://www.avsllc.com/

    Discount Rates:

    As a result of the illiquidity, negative cash flow dynamics (paying premiums), adverse selection issues, risk of litigation, and risk of life extension (double-whammy as more premiums and longer wait for death benefit), the market generally uses a 15-25% discount rate for life settlements. I've confirmed this with private market investors and public company disclosures validate this (IFT - 20.6% MRQ , ALSO - 20-25%, GWG Holdings (public debt) - 13%).  

    Additionally, EEA Life Settlement Fund's auditors (E&Y) disagreed with their valuation when they applied a 10% discount rate to the "full credibility scenario" which incorporates a number of additional reserves beyond the move to a life expectancy based on 21st Services, AVS, etc.

    "The discount rate of 10% in the “full credibility” value is, in our view, significantly lower than would be used by market participants in an arm’s-length transaction to purchase the assets of the fund"

     

    Source: EEA Annual report - http://www.cisx.com/download_news.php?newsID=204669

    Amtrust's Life Settlements:

     

    Amtrust entered the life settlement space through a JV with ACAC (now NGHC) in mid-2010 with the acquisition of a portfolio of loans that were collateralized by life insurance policies. All of the policyholders defaulted on the loans, enabling Amtrust to foreclose on the policy. At this point, they marked to model the policy and recognized a non-cash, upfront gain.

    Inception-to-date, Amtrust has recognized at least 40.7m of net income as gains (72.6m gains on I/S less 27.6m of NCI recognized). I say at least because AFSI's footnote disclosures show 162.5m of net income from life settlements (gross of NCI, net of profit commission). There is no disclosure or explanation in the filings for the difference and IR simply said they aren't related (hard to believe) and didn't want to talk about life settlements any more. Regardless, the company now carries them at $209m gross / ~99.2m net of profit commission and NCI (but also indirectly has another $10m of exposure through their stake in the JV partner). As such, they represent 17% of tangible book value.

    Before going into AFSI's assumptions, it's worth highlighting what FAS 157, which governs LS accounting says:

    "The fair value measurement objective is to determine an exit price from the perspective of a market participant... unobservable inputs (ie: discount rate) shall reflect the reporting entity's own assumptions that market participants would use in pricing the asset or liability (including assumptions about risk)."

    Level 3 inputs

    30. Level 3 inputs are unobservable inputs for the asset or liability. Unobservable inputs shall be used to measure fair value to the extent that relevant observable inputs are not available, thereby allowing for situations in which there is little, if any, market activity for the asset or liability at the measurement date. However, the fair value measurement objective remains the same, that is, an exit price from the perspective of a market participant that holds the asset or liability. Therefore, unobservable inputs shall reflect the reporting entity’s own assumptions about the assumptions that market participants would use in pricing the asset or liability (including assumptions about risk). Unobservable inputs shall be developed based on the best information available in the circumstances, which might include the reporting entity’s own data. In developing unobservable inputs, the reporting entity need not undertake all possible efforts to obtain information about market participant assumptions. However, the reporting entity shall not ignore information about market participant assumptions that is reasonably available without undue cost and effort. Therefore, the reporting entity’s own data used to develop unobservable inputs shall be adjusted if information is reasonably available without undue cost and effort that indicates that market participants would use different assumptions.

     

    AFSI's 2q13 10Q:

    The fair value of life settlement contracts as well as life settlement profit commission is based on information available to the Company at the end of the reporting period. The Company considers the following factors in its fair value estimates: cost at date of purchase, recent purchases and sales of similar investments, financial standing of the issuer, and changes in economic conditions affecting the issuer, maintenance cost, premiums, benefits, standard actuarially developed mortality tables and industry life expectancy reports. The fair value of a life insurance policy is estimated by applying an investment discount rate based on the cost of funding the Company's life settlement contracts as compared to returns on investments in asset classes with comparable credit quality, which the Company has determined to be 7.5%, to the expected cash flow generated by the policies in the Company's life settlement portfolio (death benefits less premium payments), net of policy specific adjustments and reserves. The Company adjusts the standard mortality for each insured for the insured's life expectancy based on reviews of the insured's medical records. The Company establishes policy specific reserves for the following uncertainties: improvements in mortality, the possibility that the high net worth individuals represented in its portfolio may have access to better health care, the volatility inherent in determining the life expectancy of insureds with significant reported health impairments, the possibility that the issuer of the policy or a third party will contest the payment of the death benefit payable to the Company, and the future expenses related to the administration of the portfolio. The application of the investment discount rate to the expected cash flow generated by the portfolio, net of the policy specific reserves, yields the fair value of the portfolio. The effective discount rate reflects the relationship between the fair value and the expected cash flow.

    These reserves sound an awfully lot like EEA, ALSO, and IFT...who all use much higher discount rates. Also, note that these reserves were not mentioned until after the OWS report.

    1q13 CC - Ron Pipoly, CFO (emphasis added):

     

    Additionally, there has been some confusion in the marketplace surrounding our life settlement portfolio. I want to take this opportunity to clarify and explain how we account for and how we value our life settlement portfolio. We utilize a very conservative approach in determining the fair value of the portfolio. There are many factors that go into determining the value of the portfolio not simply at discount rate.       

     

    To be clear, our effective discount rate on our life settlement portfolio for 2012 was 17.7%. If  you were to reference our 2012 10-K you would note that we disclosed a discount rate of 7.5% and an internal rate of return of 17.7%. That internal rate of return is our effective discount rate on our life settlement portfolio.

     

    To illustrate, the total future positive cash – gross positive flows in our life settlement portfolio are expected to be $795 million. Those cash flows are reduced by adding additional reserves that we apply. Among those reserves is a life expectancy reserve. Life expectancies are updated every year by two of the most widely recognized life expectancy providers and weighted to the more conservative of two life expectancies.

     

    Additionally, we provided mortality adjustment reserve by reducing the standard mortality tables based on the assumption that higher net worth individuals will live longer based on access to better healthcare. We also provided additional reserve for future expenses, operational risk and the reserve for highly impaired lives.

     

    For 2012, the total of those reserves were $356 million. That gives us future positive net cash flows of $439 million. That $439 million is then discounted by 7.5% resulting in our December 31, 2012 carrying value of $193 million and an effective discount rate of 17.7%. On both a quarterly and an annual basis, our evaluations are reviewed by a nationally-recognized life actuarial firm. If we would have simply used the discount rate of 7.5% applied to the expected positive future cash flows of $795 million, the carrying value of our portfolio would've been $383 million as opposed to the $193 million, which we actually carried in December 31, 2012.

     

    To date, we have had four mortality events and have collected benefit on all four of those policies. The total benefit collected was $24.5 million. Those four policies were purchased for $1.3 million, and we paid a total of $400,000 of premium. We carried those policies at a value of $5.2 million. Those four policies generated a cash gain of $22.8 million.

     

    We acquired these assets when the market for these assets was very distressed and that philosophy is consistent with being very contrary and buying assets cheaply that produce very high returns over the long term with very little capital at risk.

     

    To summarize, what is referred to as our internal rate of return in our 10-K of 17.7% is our effective discount rate on our life settlement portfolio.

     

     

    Here is how I interpret his comments:

    • Start with VBT ("standard") LE -- $795m in expected future cash flows
    • Life expectancy reserve -- moving from VBT to AVS/21st/etc -- reserve for more premiums and discounting the death benefit for more time.
    • Mortality reserve - this would also be factored in by the transition to AVS-like LEs.
    • Discount the $439m cash flows resulting from AVS-like LEs at 7.5%.
    • Presto-Chango, AFSI generates earnings!

    If my interpretation of their "reserves" being the difference between VBT and specialty LE providers' estimates of LE, then their assumptions are vastly off market and clearly contradict the accounting rules for these assets.

    AFSI Assumptions

    Life Expectancies (LEs):

            I.            10K/Q:

    1. "Standard life expectancy as adjusted for insured’s specific circumstances"
    2. "The Company (Amtrust) provides certain actuarial and finance functions related to the LSC entities."
    3. These disclosures are rather vague, so I asked IR who they use for LE providers...to which she said they use internal actuaries. Two other investors I've spoken to received the same answer BEFORE Off Wall Street published a report highlighting some of these concerns.
    4. NGHC's CFO (their JV partner) said that "standard" refers to VBT.

          II.            1q13 CC (After OWS report):

    1. "Life expectancies are updated every year by two of the most widely recognized life expectancy providers..."
    2. Unlike other LS market participants, AFSI does not disclose who they use for the LE estimates or how they blend/adjust them.

    In addition, AFSI's LE estimates have been steadily falling more than the passage of time (196 months at 12/31/11 to 155 months at 12/31/11 to 139 months at 12/31/12) despite

    • LE generally falling 0.6x the passage of time (actuarial reasons)
    • minimal change in the portfolio during 2012 (237 -> 255 policies)
    • flat LEs across the space (IFT polciy count went from 190 to 214 inclusive of 31 acquired policies, but the average LE was flat y/y)
    • 21st Services extending LEs by 19% on average with premium financed policies increasing more on average:
      • https://www.21stservices.com/video/full-presentation/full-presentation.html

     

    AFSI discount rates:

    Despite attempting to twist the definition of discount rate to be the same as expected IRR (7.5% is not the "investment discount rate" rather than simply the discount rate and "Internal Rate of Return" is now "Effective Discount Rate"), the fact is they are discounting their investments at 7.5%.

    Compare AFSI's assumptions to IFT (10K excerpts):

    Valuation of Insurance Policies

    ..We currently use a probabilistic method of valuing life insurance policies, which we believe to be the preferred valuation method in the industry. The most significant assumptions which we estimate are the life expectancy of the insured and the discount rate.

    In determining the life expectancy estimate, we analyze medical reviews from independent secondary market life expectancy providers (each a “LE provider”). An LE provider reviews the medical records and identifies all medical conditions it feels are relevant to the life expectancy of the insured. Debits and credits are then assigned by each LE provider to the individual’s health based on these medical conditions. The debit or credit that an LE provider assigns to a medical condition is derived from the experience of mortality attributed to this condition in the portfolio of lives that it monitors. The health of the insured is summarized by the LE provider into a life assessment of the individual’s life expectancy expressed both in terms of months and in mortality factor.

    The resulting mortality factor represents an indication as to the degree to which the given life can be considered more or less impaired than a standard life having similar characteristics (e.g. gender, age, smoking, etc.). For example, a standard insured (the average life for the given mortality table) would carry a mortality rating of 100%. A similar but impaired life bearing a mortality rating of 200% would be considered to have twice the chance of dying earlier than the standard life. Historically, the Company has procured the majority of its life expectancy reports from two life expectancy report providers and only used AVS life expectancy reports for valuation purposes. Beginning in the quarter ended September 30, 2012, the Company began utilizing life expectancy reports from 21st Services for valuation purposes and began averaging or “blending,” the results of the two life expectancy reports to establish a composite mortality factor. However, when “blending” the AVS and 21st Services life expectancy reports, if the difference in the probability of mortality between the reports is greater than 150%, the Company will reduce the higher mortality factor until the difference is 150%.

    Comment: Skewed to the more conservative estimate.

    ... However, beginning in the quarter ended September 30, 2012, the Company transitioned to a table developed by the U.S. Society of Actuaries known as the 2008 Valuation Basic Table, or the 2008 VBT. However, because the 2008 VBT table does not account for anticipated improvements in mortality in the insured population, the table was modified in conjunction with outside consultants to reflect these expected mortality improvements. The Company believes that the change in mortality table does not materially impact the valuation of its life insurance policies and that its adoption of a modified 2008 VBT table is consistent with modified tables used by market participants and third party medical underwriters.

    Comment: making adjustments to the 2008 VBT table to reflect anticipated improvements in mortality is equivalent to "adding reserves".

    ...As is the case with most market participants at December 31, 2012, the Company used a blend of life expectancies that are provided by two third-party LE providers.

    ...The Company believes that investors in esoteric assets, such as life insurance policies, typically target yields averaging between 12%—17% for investments of more than a 5 year duration, and had historically used a 15%—17% range of discount rates to value its life insurance policies.

    ...Although the Company believes that its entry into the Non-Prosecution Agreement had a positive effect on the market generally and for premium financed life insurance policies specifically, the Company believes that, when given the choice to invest in a policy that was associated with the Company’s premium finance business and a similar policy without such an association, all else being equal, an investor would have generally opted to invest in the policy that was not associated with the Company’s premium finance business.

    As of December 31, 2012, the Company owned 214 policies with an aggregate investment in life settlements of $113.4 million. Of these 214 policies, 171 were previously premium financed and are valued using discount rates that range from 16.80% to 33.80%. The remaining 43 policies are valued using discount rates that range from 14.80% to 21.30%.

    Comment: AFSI's policies were almost entirely premium financed which means that the policyholder likely paid little to nothing on the policy...a "lender" advanced the premiums and foreclosed after the two year contestability period.

    IFT's weighted average discount rate (mix of premium financed and non-premium financed): 24.01%.

     

    Phoenix exposure:

    Last but not least, AFSI has substantial exposure to Phoenix as a counterparty. This came to light when Tiger Capital sued PHL for increasing the Cost of Insurance on their policies. In the suit, Tiger disclosed 138 policies with Phoenix (out of 241 at the time / 261 now).

    Phoenix policies trade at substantial discounts because of PNX's poor financial health and litigious approach to dealing with life settlement investors. For example, PNX's statutory surplus declined from $922.5m at 12/31/12 to $789.2m at 6/30/13 -- to support $13B of policy liabilities -- and PNX's AM Best rating has been downgraded below where most agents will take business.

    https://www.phoenixwm.phl.com/public/about/financialstrength/ratings/index.jsp

    I'll add more on the discrepancies here in the comment section.

    In summary, the life settlement issues are:

                        I.            Questionable LE estimates

                      II.            Far off-market discount rates that violate the accounting rules

                    III.            Substantial counterparty risk


     

    1. 2.       Under-reserving

    AFSI has grown by leaps and bounds (33.6% CAGR of Net Premiums Written from 2007-2012) despite the soft market for P&C insurance which begs the question -- how were they able to grow so much and report results so much better than peers in a terrible insurance market? The short answer is that they weren't able to do so...

     

    1. a.       IBNR as a % of total reserves has been steadily falling

    IBNR = Incurred but not reported. Case Reserves = reserves for claims already filed. Case reserves could also be a source of over/under-reserving, but IBNR is where management tends to have more discretion because IBNR is a more general reserve whereas case reserves are specific to claims.

    Possible explanations:

    • Change in mix
      • Not the case. In fact, they've gone into longer-tail policies by entering Italian med mal and ramping up workers' comp.
      • Seasoning of the portfolio (reserves for first policy written is all IBNR before claims begin)
        • Steady/rapid growth keeps the seasoning of the portfolio
        • Inadequate development factor
          • Development factor is a multiplier of various measures (ie: paid losses or losses incurred) used to estimate total losses associated with a given accident year.
          • If a company uses too low of a development factor, they will be inadequately reserved.
          • Ex: $100 premiums taken in at T=0.
          • At T+1, losses incurred (case reserves + claims paid; losses incurred is used differently in this instance than in the income statement sense) = $20 * 3.5 development factor = $70 estimate for ultimate loss.
          • At T+2, losses incurred = $30 * 2.5 development factor = $75 re-estimated ultimate loss --> $5 of adverse development recorded at T=2 for this accident year.

     

    Given AFSI's substantial underwriting leverage (NPW / Stat Cap; Loss Reserves & Unearned Prem / Stat Cap), tangible book is highly sensitive to changes in reserves. If AFSI were to boost reserves to where IBNR was 45% of total (holding case reserves constant) -- the 2010 YE level -- tangible book value would fall by more than half.

     

    1. b.      Reserving methodology

     

    WorkersComp reserves are calculated using the "incurred development method" which:

     

    AFSI 10K:

    Quarterly Incurred Development Method (Use of AmTrust Factors)

    Quarterly incurred loss development factors are derived from our historical, cumulative incurred losses by accident month. These factors are then applied to the latest actual incurred losses and DCC by month to estimate ultimate losses and DCC, based on the assumption that each accident month will develop to estimated ultimate cost in a similar manner to prior years. There is a substantial amount of judgment involved in this method.

     

    Yearly Incurred Development (Use of National Council on Compensation Insurance, Inc. (“NCCI”) Industry Factors by State)

    Yearly incurred loss development factors are derived from either NCCI’s annual statistical bulletin or state bureaus. These factors are then applied to the latest actual incurred losses and DCC by year by state to estimate ultimate losses and DCC, based on the assumption that each year will develop to an estimated ultimate cost similar to the industry development by year by state.

     

    ...rely on historical development factors derived from changes in our incurred losses, which are estimates of paid claims and case reserves over time. As a result, if case reserving practices change over time, the two incurred methods may produce substantial variation in the estimate of ultimate losses. We have not used any “paid” development methods, which rely on actual claims payment patterns and, therefore, are not sensitive to changes in case reserving procedures. As our paid historical experience grows, we will consider using “paid” loss development methods.

     

    Of the two methods above, the use of industry loss development factors has consistently produced higher estimates of workers’ compensation losses and DCC expenses.

     

     

    In other words, AFSI uses the historical pattern of its own estimates (for case reserves) to estimate losses and acknowledges that using its own methodology is always lower than the industry.

     

    The low end of the range is established by assigning a weight of 100% to our ultimate losses obtained by application of our own loss development factors. The high end is established by assigning a weight of 50% each to our ultimate losses as developed through application of Company and industry wide loss development factors.

     

    From these disclosures, we can back into what the loss reserve would be if they only used industry factors -- $155m for just workers' comp.

     

     

     

     

    • Specialty Risk & Extended Warranty (mostly warranty, but also Italian Medical Malpractice)

    Surprisingly, AFSI does not address Medical Malpractice reserving policies, particularly given the very long tail nature of this line and highly IBNR driven aspect (a pacemaker fouling up years later).

    Specialty Risk and Extended Warranty claims are usually paid quickly, development on known claims is negligible, and generally, case reserves are not established. IBNR reserves for warranty claims are generally “pure” IBNR, which refers to amounts for claims that occurred prior to an accounting date but are reported after that date. The reporting lag for warranty IBNR claims is generally small, usually in the range of one to three months. Management determines warranty IBNR by examining the experience of individual coverage plans. Our consulting actuary, at the end of each calendar year, reviews our IBNR by looking at our overall coverage plan experience, with assumptions of claim reporting lag and average monthly claim payouts. Our net IBNR as of December 31, 2012 and 2011 for our Specialty Risk and Extended Warranty segment was $26.6 million and $52.9 million, respectively.

    The primary actuarial methodology used to project future losses for the unexpired terms of contracts is to project the future number of claims, then multiply them by an average claim cost. The future number of claims is derived by applying to unexpired months a selected ratio of the number of claims to expired months. The selected ratio is determined from a combination of:

    • past experience of the same expired policies,
    • current experience of the earned portion of the in-force policies or contracts, and
    • past and/or current experience of similar type policies or contracts

     

     

    • Property & Casualty

     

    We began writing general liability, commercial auto and commercial property (jointly known as CPP) business in 2006. In order to establish IBNR for CPP lines of business, we rely on three methods that utilize industry development patterns by line of business:

    Yearly Incurred Development (Use of Industry Factors by Line). For each line, the development factors are taken directly from Insurance Services Office, Inc. (“ISO”) loss development publications for a specific line of business. These factors are then applied to the latest actual incurred losses and DCC by accident year, by line of business to estimate ultimate losses and DCC

    Expected Loss Ratio. For each line, an expected loss ratio is taken from our original account level pricing analysis. These loss ratios are then applied to the earned premiums by line by year to estimate ultimate losses and DCC

    Bornhuetter-Ferguson Method. For each line, IBNR factors are developed from the applicable industry loss development factors and expected losses are taken from the original account level pricing analysis. IBNR factors are then applied to the expected losses to estimate IBNR and DCC

    ...Because we determine our reserves based on industry incurred development patterns, our ultimate losses may differ substantially from our estimates produced by the above methods.

    Because of the numerous third party administrators we use, we have utilized only limited incurred development methods based on historical loss development patterns, or methods that rely on paid development factors. Paid loss development methods rely on actual claim payment patterns to develop ultimate loss and DCC estimates.

    Comment: Implies they use "Expected Loss Ratio" and B-F Method. No disclosure of gross/net/case/IBNR for these lines of business.

    1. c.       Adverse Development

    In each of the last three years, AFSI has seen adverse development, particularly for years 2009 and 2010 when the company was booking aggressive initial loss ratios of 54.3%/57.1%. However, because they have grown their underwriting so aggressively in recent years, the adverse development has been swamped by new business that is also subject to aggressive initial loss picks.

    The questions are:

    • Can they keep growing in order to keep swamping the prior year development?
      • Capital will be the primary constraint -- i'll address this in the next section.
      • Will improving insurance rates bail them out?
        • They are starting to help.
        • Are they now adequately reserved? IBNR would suggest not.

     

    1. d.      Discrepancies with MHLD disclosures

    AFSI discloses the premiums, losses and expenses ceded to MHLD in related party footnotes and MHLD breaks out the AFSI quota share as a separate segment disclosure. AFSI's CEO is the Chairman of MHLD and they share BDO as an auditor...so why do they report such different results for MHLD's share of the AFSI quota share and, more importantly, why does AFSI have a 710 bps lower loss ratio than what they cede to MHLD on a quota share when it covered  84.6% of their underwriting (cumulative since mid-2007)??

    Note that the disclosures match up on the NPE line (8m difference - qtrly timing of recognition).

    Neither AFSI nor MHLD had an explanation for this, but MHLD confirmed that those disclosures are mirrors of one another in what they cover.

     

    1. Competitors

    Two competitors have recently had adverse development that was across similar business lines (WC, Commercial Multi-Peril, and Commercial Auto) and account sizes (small biz) - Meadowbrook (MIG) and Tower Group (TWGP). MIG was subsequently downgraded by AM Best and forced to find a reinsurance partner and TWGP is now under review.

    Note that all three were relatively strong performers in 2008-2010 (they were also each growing more rapidly than the industry.

     

    Some of AFSI's customers require a rating of "A-" or higher (and agents would re-direct new policies). Given the high degree of leverage and relative illiquidity of some of AFSI's large assets, a severe liquidity crunch is very possible at AFSI (particularly given the significant debt funding at the holdco level subject to rating and net worth covenants).

     


     

    1. 3.       Use of offshore captive and related party to get around capital requirements

    Below is an estimation of AFSI's consolidated statutory surplus and the residual stat surplus after allocating capital to specifically disclosed subsidiaries.

     

    Below is the resulting consolidated underwriting leverage at AFSI (using YE surplus to be generous with the exception of 2013 which uses 2012 YE).

     

    In comparison, MIG (recently downgraded by AM Best) was writing at 1.5x NPW / Stat Surplus.

    So why is AFSI able to use so much more leverage? Bermuda!

    They cede over 70% of GWP to Amtrust International Insurance (AII) which then cedes 40% of the original GWP to MHLD (another related party). AII then collateralizes the statutory subsidiaries' reinsurance recoverables with a combination of letters of credit (off balance sheet debt of 152.8m at YE 2012) and a collateral trust (MHLD also has a collateral trust for the benefit of AII/US Stat subs). In total, the US subs have 1.76B of reinsurance recoverables that are not subject to a haircut since they're collateralized .

    However, AII lacks the liquid assets it requires to fund the entirety of their share of the recoverable, so they use (1) the previously mentioned letters of credit (2) a collateral funding agreement with MHLD for ~168m and (3) repo financing of $292m.

    AII 2010 financial statements that show all of AFSI's consolidated repo financing is attributable to this entity:

    www.dsnrrg.com/forms/AmTrust%20International%20Financials%20for%20year%20ending%2012-31-10.pdf

    AII's incremental source of cash flow is premium payments (via US subs). So if AFSI were forced to slow down underwriting growth (or heaven forbid shrink/stop), AII would not have the liquid assets to fund the repo repayment.

    What assets does AII have to sell beyond those tied up? Equity investments in:

    • NGHC (not publically listed, but going through the registration process -- difficult to sell given overlapping controlling shareholders)
    • AEL (UK Statutory Subsidiary) - can't tap that for liquidity because those assets are supporting their own reserves.
    • AIUL (Irish Statutory subsidiary) - can't tap that for liquidity because those assets are supporting their own reserves.
    • ACHL (Luxembourg captive reinsurance subsidiary) - few reserves to support, but substantial tax penalties to draw this down.
    • Life Settlements -- I guess we'd find out how good their marks are if they tried to sell this in a hurry...

    Given this lack of liquid assets and callable debt (repo), AII is the weak link in the chain. So what, you say, the regulators don't care...it's been going on forever!

    Ben Lawsky, the Superintendent of Financial Services & NYDFS are working on it and getting some scalps (including Metlife). I believe AFSI's structure is exactly the sort of hidden risk they are seeking to expose and correct.

    http://www.dfs.ny.gov/about/press2013/pr1306121.htm

    http://www.dfs.ny.gov/reportpub/shadow_insurance_report_2013.pdf

    Background on DFS Investigation into Shadow Insurance

    In July 2012, DFS initiated an investigation into shadow insurance at New York-based insurance companies and their affiliates.
    Insurance companies use shadow insurance to shift blocks of insurance policy claims to special entities — often in states outside where the companies are based, or else offshore (e.g., the Cayman Islands) — in order to take advantage of looser reserve and regulatory requirements. Reserves are funds that insurers set aside to pay policyholder claims.

    In a typical shadow insurance transaction, an insurance company creates a “captive” insurance subsidiary, which is essentially a shell company owned by the insurer’s parent. The company then “reinsures” a block of existing policy claims through the shell company – and diverts the reserves that it had previously set aside to pay policyholders to other purposes, since the reserve and collateral requirements for the captive shell company are typically lower. Sometimes the parent company even effectively pays a commission to itself from the shell company when the transaction is complete.

    This financial alchemy, however, does not actually transfer the risk for those insurance policies off the parent company’s books because, in many instances, the parent company is ultimately still on the hook for paying claims if the shell company’s weaker reserves are exhausted through a “parental guarantee.” That means that when the time finally comes for a policyholder to collect their promised benefits after years of paying premiums — such as when there is a death in their family – there is a smaller reserve buffer available at the insurance company to ensure that the policyholders receive the benefits to which they are legally entitled.

    http://www.bloomberg.com/news/2013-05-21/metlife-limits-offshore-reinsurance-after-n-y-review.html

    ‘Shadowy World’

    Lawsky praised MetLife’s announcement in a Twitter message today, citing “progress on making the shadowy world of insurance ‘captives’ more transparent.”

    MetLife Chief Executive Officer Steve Kandarian said the offshore reinsurance program began in 2001 and “makes less sense” now.

    “The New York Department of Financial Services’ industry inquiry regarding captives was an important factor in our taking a closer look at our offshore reinsurance subsidiary,” Kandarian, 61, said at the investor presentation. “We’re going to take steps to bring these businesses back on shore and to a more highly capitalized, U.S.-based and U.S.-regulated entity.”

     

     


     

    1. 4.       M&A accounting to boost reported profits
      1. Acquire distribution

    AFSI acquires renewal rights and/or managing general agents, sometimes even paying them contingent consideration as a % of future premiums written -- these look a lot like commission expenses, but because they are bought instead of built, they do not hit the income statement (any intangibles that get amortized are over long periods even those are added back to "operating earnings").

    Even though they're following GAAP (except for the add-backs), it is a misrepresentation of the economics of the business. One way to see through the M&A accounting fog is to look at tangible book growth (as we did at the beginning) which is lacking.

    Back of the envelope, I think this "trick" brings AFSI's expense ratio down by 500-600 bps based on ~$1.2b of GWP (~50% of 2012 GWP) from acquired distribution channels at 10-12% commission rates.

    For the sake of argument, let's say that if the distribution had been third parties, AFSI would have had a ~30% expense ratio (about in-line with MIG/TWGP) but since they acquired half of their distribution, they don't have to pay those commissions (renewal rights roll and MGAs are done with contingent consideration to keep them incentivized).  That brings the expense ratio on a gross basis down to ~24-25%.

    1. Enhanced by ceding commission

    Then AFSI cuts MHLD in on the quota share, but wants reimbursed for the cost of generating those premiums -- at the (fair based on my assumptions) rate of 30% ceding commission for premiums ceded (about what they get). AFSI gets to run this through the income statement and nets it against expenses for the expense ratio.

    If $100 of premiums are written and 40% are ceded pro-rata for a 30% commission, AFSI will get $12 of ceding commissions to count against their $25 of gross loss expense, making the net expense ratio $13. Since they retain $60, the net expense ratio becomes 21.67% (13/60).

    Voila! Better expense ratio via acquisition & ceding...assuming you don't mind that you probably overpaid for the distribution on the front end which hurt the cumulative change in tangible book.

    To keep this "trick" going, they have to continue generating at least the same amount of their distribution as they did before. That's fine if they don't need to grow, but AFSI needs to keep growing  to cover up adverse development from under-reserving and keep cash flowing to AII.

    However, they're starting to run out of tangible book and consolidated statutory surplus to spend with tangible book sitting at ~$600m and needle moving deals likely to cost $75m+ and be entirely comprised of intangibles if they are purely distribution.

    1. Spring-loading acquisitions to dress up reported earnings

    Given the length of this report, i'm going to leave this for the comments section as a follow-up.

     

    1. Luxembourg acquisitions

     

    Given the length of this report, i'm going to leave this for the comments section as a follow-up.

     

    1. 5.       Numbers that don't add up (literally)

    AFSI has math problems. That's troubling for an insurance company.

    Below is a comparison of press releases and SEC filing disclosures. They never explained any of the changes, and the income statement, shareholders equity, and goodwill/intangibles were never changed.

    How does premium receivable go up $47m between the PR and 10K without impacting revenues or unearned premium?? I'll refrain from accusing them of something more nefarious than clever accounting gimmicks and aggressive assumptions, but I'm certainly suspicious...

     

    There are a myriad of other disclosures that we have not been able to reconcile for AFSI against its own disclosures as well as related parites NGHC and MHLD. I'll touch on some of them in the comments section.


     

    Valuation:

    With all these red flags, you might think that AFSI would trade at a discount to the space. Hardly!

    For the most part, compas trade between 60-160% of stated book and 90-150% of tangible book. AFSI is off the charts on these metrics. At 5x tangible book (with inflated assets and deflated loss reserves), AFSI is anything but cheap, unless you think I'm dead wrong and/or that the game will go on forever.

     

    The table below doesn't match in some instances because it pulls from CapIQ without making any of the relevant adjustments (ie: AFSI 10% stock dividend).

     

     


     

    Catalysts:

    1. Running out of tangible book / statutory surplus to support M&A and underwriting growth
    • Given the slow playing, uncertain nature of the other catalysts below, the fact that their NPW / Tang equity has gone from ~150% in mid-2010 to ~336% in 2q13 gives me some comfort that they are nearing the end of their game
    1. Issuing equity
    • Per my first point, I think the best thing they could do to add value is issue gobs of equity at this ridiculous valuation.
    1. Impairment of LSC
    • Management is obviously not going to do this of their own volition.
    1. Adverse development in reserves, particularly if accelerated
    • Mechanics of reserve development will keep pressure on the company here and make it increasingly difficult to book aggressive initial year loss picks.
    1. Pressure to bring captive insurers onshore
    • Lawsky seems to be looking for targets.
    1. Potential AM Best downgrade as a result of leverage
    2. Covenant trip
    • Wouldn't be the first domino, but it would significantly accelerate the process with potentially severe outcomes (letters of credit and repo at AII with no good alternatives -- parent is tapped out as well).
    1. Somewhat rapid rise in interest rates
    • A slow and steady would probably benefit them

     

    Risks:

    1. High insider ownership & incentivized management team
    2. Slow-playing catalysts,
    • many of which are dependent on third parties that tend not to be forward looking.
    • Part of my reason for writing up this name was to try to highlight the issues and get a conversation going -- either to prove me wrong or have more aggressive investors pick up the ball and run with it.
    1. High short interest
    • It's come down a little of late, but it's still not low relative to ADV / float.

                                                                                                                  I.       

    Appendix:

    IFT 10Q:

    Investment in life settlements — The Company has elected to account for the life settlement policies it acquires using the fair value method. Due to the inactive market for life settlements, the Company uses a present value technique to estimate the fair value of our investments in life settlements, which is a Level 3 fair value measurement as the significant inputs are unobservable and require significant management judgment or estimation. The Company currently uses a probabilistic method of valuing life insurance policies, which we believe to be the preferred valuation method in the industry. The most significant assumptions are the estimates of life expectancy of the insured and the discount rate.

    In determining the life expectancy estimate, we analyze medical reviews from independent secondary market life expectancy providers (each a “LE provider”). An LE provider reviews the medical records and identifies all medical conditions it feels are relevant to the life expectancy of the insured. Debits and credits are then assigned by each LE provider to the individual’s health based on identified medical conditions. The debit or credit that an LE provider assigns to a medical condition is derived from the experience of mortality attributed to this condition in the portfolio of lives that the LE provider monitors. The health of the insured is summarized by the LE provider into a life assessment of the individual’s life expectancy expressed both in terms of months and in mortality factor.

    The resulting mortality factor represents an indication as to the degree to which the given life can be considered more or less impaired than a standard life having similar characteristics (e.g. gender, age, smoking, etc.). For example, a standard insured (the average life for the given mortality table) would carry a mortality rating of 100%. A similar but impaired life bearing a mortality rating of 200% would be considered to have twice the chance of dying earlier than the standard life. The probability of mortality for an insured is then calculated by applying the blended life expectancy estimate to a mortality table. The mortality table is created based on the rates of death among groups categorized by gender, age, and smoking status. By measuring how many deaths occur during each year, the table allows for a calculation of the probability of death in a given year for each category of insured people. The probability of mortality for an insured is found by applying the mortality rating from the life expectancy assessment to the probability found in the actuarial table for the insured’s age, sex and smoking status. The Company has historically applied an actuarial table developed by a third party. However, beginning in the quarter ended September 30, 2012, the Company transitioned to a table developed by the U.S. Society of Actuaries known as the 2008 Valuation Basic Table, or the 2008 VBT. However, because the 2008 VBT table does not account for anticipated improvements in mortality in the insured population, the table was modified by outside consultants to reflect these expected mortality improvements. The Company believes that the change in mortality table does not materially impact the valuation of its life insurance policies and that its adoption of a modified 2008 VBT table is consistent with modified tables used by market participants and third party medical underwriters.

    The mortality rating is used to create a series of best estimate probabilistic cash flows. This probability represents a mathematical curve known as a mortality curve. This curve is then used to generate a series of expected cash flows over the remaining expected lifespan of the insured and the corresponding policy. A discounted present value calculation is then used to determine the value of the policy. If the insured dies earlier than expected, the return will be higher than if the insured dies when expected or later than expected.

    The calculation allows for the possibility that if the insured dies earlier than expected, the premiums needed to keep the policy in force will not have to be paid. Conversely, the calculation also considers the possibility that if the insured lives longer than expected, more premium payments will be necessary. Based on these considerations, each possible outcome is assigned a probability and the range of possible outcomes is then used to create a value for the policy.

    Historically, the Company has procured the majority of its life expectancy reports from two life expectancy report providers and only used AVS Underwriting LLC (“AVS”) life expectancy reports for valuation purposes. Beginning in the quarter ended September 30, 2012, the Company began utilizing life expectancy reports from 21st Services, LLC (“21st Services”) for valuation purposes and began averaging or “blending,” the results of the two life expectancy reports to establish a composite mortality factor.

    On January 22, 2013, 21st Services announced revisions to its underwriting methodology and on February 4, 2013, announced that it was correcting errors discovered in its previously announced revised methodology. According to the 21st Services, these revisions have generally been understood to lengthen the average reported life expectancy furnished by this life expectancy provider by 19%. At March 31, 2013, the Company had not received any life expectancy reports from 21st Services utilizing its revised methodology and, to account for the impact of the revisions and based off of market responses to the methodology change, the Company lengthened the life expectancies furnished by 21st Services by 13% prior to blending them with the life expectancy reports furnished by AVS.

    As of June 30, 2013, the Company received 98 updated life expectancy reports from 21st Services that utilize its revised methodology. These life expectancies reported an average lengthening of life expectancies of 15.8% and, based on this sample, for the six months ended June 30, 2013, the Company increased the life expectancies furnished by 21st Services by 15.8% on the rest of its portfolio of life settlements prior to blending them with the life expectancy reports furnished by AVS. The Company expects to continue to lengthen life expectancies furnished by 21st Services that have not been re-underwritten using their updated methodology. Since the Revolving Credit Facility necessitates that the Company procure updated life expectancies on a periodic basis, the amount of policies that are lengthened by the Company in this manner will decrease over time and the fair value calculations in future periods will, accordingly, reflect the actual impact of the revised 21st Services methodology on a policy by policy basis as updated life expectancy reports are procured. At June 30, 2013, had the Company not applied a 15.8% increase to the 21st Services life expectancy reports, the portfolio would have increased from the reported amount of $265.8 million by $5.3 million.

    Prior to the quarter ended June 30, 2013, when blending AVS and 21st Services’ life expectancy reports to derive a composite mortality factor, the Company would cap the higher mortality factor at an amount that was 150% above the lower mortality factor. This was done so as to reduce variances between life expectancies furnished by these two life expectancy providers. For the period ending June 30, 2013, the Company terminated its use of such a cap. The Company believes that the elimination of this cap is consistent with valuation methodologies employed by other market participants in connection with 21st Services’ revised methodology.

     

     

    ALSO 10K:

    The discount rate used to calculate the present value of the life settlement contracts was determined based on the following at August 31, 2012:

     

    The Company utilizes actuarial pricing methodologies and software tools that are built and supported by leading independent actuarial service firms such as Milliman USA and Modeling Actuarial Pricing Systems, Inc. (“MAPS”) for calculating expected returns. The MAPS (formerly Milliman) system is the most widely used platform for generating mortality reports. The Company uses life expectancy data from major non-related third-party life expectancy data providers. MAPS uses the life expectancy data and calculates a multiplier to the VBT data to reflect the current state of health of the insured. MAPS generates a report encompassing three individual valuations, two valuations based on two separate life expectancy reports and one valuation based on the weighted average of the two life expectancy values. The Company utilizes the valuation generated from the larger life expectancy value. The next step in the valuation process is determining the appropriate discount rate for the asset type. The discount rate incorporates current information about market interest rates, the credit exposure to the insurance company that issued the life settlement contracts and the Company’s estimate of the risk premium an investor in the policy would require. The Company believes that investors in alternative investments typically target yields averaging between 13 - 16% for investments of more than a 5 year duration. A 16% rate of return over a five year duration is a reasonable target for investments that are highly illiquid, relatively new and more volatile (i.e. life settlement contracts) than standard investments. In recent months, there have been a number of government investigations of several life settlement companies. These investigations, and subsequent Securities and Exchange Commision Inforcement Actions, in one instance, have caused a temporary dislocation in the life settlement market. Liquidity has tightened even further. The current market is still in a state of flux brought on by economic circumstances in Europe (traditionally the largest investors in the life settlement markets). These factors have caused investors in life settlements to demand a higher yield (averaging between 20 – 25%) because of the perceived risk in life settlements. Additionally, in the past 6 months, the Company, in the normal course of business, sold two fair value policies (each with face amounts below $15 million) to another investor, for a discount rate of between 19% and 22%. Additionally, in discussions with investors for potential debt offerings, and in discussions with other investors for potential sales of policies, the discount rate, for policies with face amounts below $15 million, indicated a rate of between 18% and 22%. For policies with face amounts above $15 million, of which there are fewer purchasers present, investors indicated a rate of between 25% and 28%. In light of all of these factors, the Company believes the perceived risk or uncertainty over these assets has changed and therefore the risk premium an investor would require has changed, therefore, in the third quarter ending May 31, 2012, management made a change in accounting estimate and adjusted its discount rate from 16% to 20%, for policies with face amounts below $15 million, and to 25%, for policies with face amounts above $15 million. Additionally, management has elected to report the more conservative of the values generated by the MAPS system, by utilizing the values linked to the longer life expectancy report. Management believes that a more conservative discount rate is appropriate due to the recent sales of policies and in discussions with other investors in the life settlements market.

     

    ...

     

    The Company utilizes the MAPS system for valuations. MAPS is a generally accepted third party pricing system utilized by funds and investors engaged in the purchase and sale of life settlements.

     

    Life expectancy reports are generated by third party medical underwriting firms, such as AVS, 21 st Century, EMSI and Fasano. These firms review medical data for an individual and grade using a series of debits and credits. The resulting values are used to generate a life expectancy value. The MAPS system utilizes this life expectancy data to calibrate underlying mortality curves generated for each individual case.

     

    MAPS utilizes the appendixes to the VBT2008 report as a base for mortality projections. This chart established 25 unique values corresponding to 25 statistical values indicative of the next 25 years of a persons life. The value is the statistical probability that the individual will meet an untimely end in that given year. When a life expectancy provider produces a report, it indicates a value at which point a certain individual will achieve a 50% chance, statistically, of dying. This is calculated by randomly making 1000 simulations and calculating an exact point of death for each simulation. The point at which the cumulative deaths equal 500 is the median point or the life expectancy.

     

     
     

    In order to calibrate this curve, a multiplier is formulated to cause the median mark to equal the life expectancy value provided by the life expectancy provider. For every case, 1000 simulations are run, each simulation resulting in a unique death month. For example, if a life expectancy equals 50 months, the underlying data would show 500 deaths prior to the 50th month and 500 deaths after the 50th month.

     

    The MAPS system takes the results of the modified life expectancy curve and applies it to the premium and death benefit projections stream. For the 500 deaths prior to the 50th month, utilizing our previous example, it would apply the percentage of the simulated runs that died in each 12 month period to the death benefit and premium schedules to form estimated cash flows. The net present value, using a discount rate defined by the user, of the streams of values created by this method form the indicated value of the policy.

     

    I do not hold a position of employment, directorship, or consultancy with the issuer.
    I and/or others I advise hold a material investment in the issuer's securities.

    Catalyst

    1. Running out of tangible book / statutory surplus to support M&A and underwriting growth
    • Given the slow playing, uncertain nature of the other catalysts below, the fact that their NPW / Tang equity has gone from ~150% in mid-2010 to ~336% in 2q13 gives me some comfort that they are nearing the end of their game
    1. Issuing equity
    • Per my first point, I think the best thing they could do to add value is issue gobs of equity at this ridiculous valuation.
    1. Impairment of LSC
    • Management is obviously not going to do this of their own volition.
    1. Adverse development in reserves, particularly if accelerated
    • Mechanics of reserve development will keep pressure on the company here and make it increasingly difficult to book aggressive initial year loss picks.
    1. Pressure to bring captive insurers onshore
    • Lawsky seems to be looking for targets.
    1. Potential AM Best downgrade as a result of leverage
    2. Covenant trip
    • Wouldn't be the first domino, but it would significantly accelerate the process with potentially severe outcomes (letters of credit and repo at AII with no good alternatives -- parent is tapped out as well).
    1. Somewhat rapid rise in interest rates
    • A slow and steady would probably benefit them

    Messages


    SubjectFollow-up: under/un-capitalized AII (Bermuda sub)
    Entry08/19/2013 10:21 AM
    MemberFrancisco432
    I wanted to highlight and expand on this point because it is critical to the story.
     
    Re: -$248m of statutory capital (after allocating stat cap to US/UK/Irish regulated subs)
     
    1. As mentioned, this includes ACAC (now called NGHC), and LSC investments which could not be easily tapped/liquidated by AII if the need to pay claims in excess of premiums written (ie: if they slowed down premium growth).

    2. This capital supports more US claims than the US regulated subs (30%/30%/40% split between US/AII/MHLD, but US cedes 100% of assigned risk which is higher loss and makes the effective split more like 25%/35%/40%) -- that could (should?) be a significant concern to regulators.

    3. This assumes that their reserves are adequate, but obviously the analysis points to meaningful under-reserving (IBNR % of reserves falling, etc).

    Just to reiterate - AII is funding part of their collateral trust assets with:
    • Repo funding (doesn't have the liquid/quality assets to do it themselves) - 292m at YE 2012
    • Letters of credit (off balance sheet debt / low quality capital for stat sub) - 153m at YE 2012

    These short term / low quality sources of funding leave AFSI significantly exposed to any impairments to goodwill/intangibles/LSC or material reserve additions because they are relatively close to their covenants already (0.28x v 0.35x per credit agreement definition of net worth which includes gw/intang) and the LC and repo require covenant compliance around leverage and maintenance of their AM Best rating.

    Given regulators' attention on the space and AFSI's outlier leverage (underwriting and financial), I would think AFSI would be a natural place to sniff around. Not to mention the re-leveraging effect of ceding further to related-party MHLD who is also quite levered...

    SubjectInsolvency math
    Entry08/19/2013 11:19 AM
    MemberFrancisco432
    To be clear, I think it *could be* insolvent, but any material decline in tangible book resulting from a combination of these factors should be enough to trigger an AM Best downgrade and/or scrutiny from regulators (insurance or SEC).
     
    I realized I didn't flush this out, so below is my math:
     
    The "severe" scenario assumes IBNR reserves relative to total reserves need to be taken back up to 2009 levels. Considering the meaningful adverse development in 2009/10, I think this actually represents a pretty reasonable estimation of adequacy. 
     
      Severe Moderate Light        
    Tang Bk / share  $         8.38  $         8.38  $         8.38        
    Less IBNR adj   $         5.57  $         3.27  $         1.65 <<50.7%/45.1%/40.3% (2009/10/11)
    Less LSC adj   $         1.48  $         1.11  $         0.74 <<AFSI direct portion, no tax (none rec'd)
    Less NGHC Haircut  $         0.71  $         0.43  $         0.14 <<embeds aggress reserves & LSC  
    Less 100m unrec'd DTL  $         1.43  $         1.43  $         1.43 <<If capital needs to come back to US subs
    PF Tang Book  $       (0.81)  $         2.14  $         4.42 <<Does not contemplate decline in bond portfolio should rates rise
           

    SubjectUnderwriting Leverage (higher than I said)
    Entry08/19/2013 02:54 PM
    MemberFrancisco432
    I mentioned in the write-up that NPW / Tangible Equity is 336%...this was comparing TTM NPW / Avg Tang Sh Equity (1q13 & 2q13). However, this is probably too generous towards AFSI.

    Using annualized 2q13 NPW and the same Tang Eq implies 417%! MIG (recently downgraded) is 170% by the same measure.
     
    If i give them credit for the pref stock issued in 2q13, it goes to 381% from the regulator/creditor standpoint, 381% is probably more relevant (stat capital is the real q though). However, if one is looking at the common and how sensitive it is to changes in underwriting assumptions/reserves, then 417% is probably the right measure.
     
    Either way, AFSI is far above peers and they are driving this car VERY fast and can't afford to swerve or hit a speed bump.

    SubjectAFSI CFO was involved in a prior insurance fraud
    Entry08/21/2013 12:00 AM
    MemberFrancisco432
    Legal filing:
    https://docs.google.com/file/d/0B86krX6VxmmWWU9NeUduU3c4Rms/edit?usp=sharing
     
    Guess who picked up CGIC assets (stranger than fiction):
    http://www.ohinsliq.com/documents/newsroom/2002/28_prodi_02-13-02amtrust.asp
     
    Michael Saxon and Chris Longo were also at CGIC before joining Amtrust.

    SubjectOddities in recent Form 4s
    Entry08/22/2013 01:25 PM
    MemberFrancisco432
    A few things of interest from the Form 4s filed 7/30/13:
     
    The MK 2005 Grantor Retained Annuity Trust (L Karfunkel trustee) reported a 320k share gift from MK to the GRAT and a distribution from the trust of 296,460 shares to MK as of 5/13/13. GRATs require annual distributions (annuity) to the grantor, so that makes sense.
     
    What's interesting about it is that:
    1. This is the first distribution reported from the GRAT (though it could have had other assets it was distributing) 
    2. The 5/13/13 distribution happens to be 103 days after the 1/30/13 distribution. I highlight the 103 days and retroactive filing because the IRS rules around GRATs require annual distributions be made in a 105 day window (so I'm assuming 1/30 was the first day of the window and 5/13/13 would be the second to last).
    3. GRATs cannot accept additional contributions.
    Article noting the 105 day window and inability to accept further gifts:

    http://www.lowenstein.com/files/Publication/fc1103f5-b098-4c19-aebf-11d932251555/Presentation/PublicationAttachment/1f84824f-f0cc-4ac5-8ed5-2598b7807990/GRATS%20Make%20Sure%20to%20Sweat%20the%20Small%20Stuff%20NJLJ%20MG%20EW%207.14.08.pdf


    SubjectRE: RE: Oddities in recent Form 4s
    Entry08/26/2013 08:36 PM
    MemberFrancisco432
    The way GRATs work, they have an incentive to maximize the value of the stock at the end of the GRAT because the value in excess of the annuity payments (grantor retains an annuity). Since the ceo's wife is one of the beneficiaries, we can pull levers to maximize earnings/stock price. However, if they fail to execute the GRAT according to the rules, it's deemed a gift back to inception. A trust and estate attorney friend confirmed the add'l contribution would blow up the GRAT. This would cause the shares to go directly to beneficiaries, but I estimate it would also trigger a 100-200m (very rough) tax bill for Michael Karfunkel personally. Even a billionaire presumably flinches at that. In addition, Zyskind has a large restricted stock grant that vests based on the operating performance over a few years. If memory serves (ill check when im back in front of a computer), it was 250k time vested and 250k performance based with performance measured over 2012/13.

    SubjectRE: RE: RE: Oddities in recent Form 4s
    Entry08/26/2013 08:38 PM
    MemberFrancisco432
    *the value in excess of the annuity payments (which didnt appear to regularly happen as they should have) goes to the beneficiaries.

    Subjectsec corresp & offshore subs (esp Luxembourg)
    Entry08/29/2013 02:31 AM
    MemberFrancisco432
    PCM: I've read all the corresp going back to the ipo. I think the sec brings up valid points and senses something is wrong, but the sec filings alone haven't provided the smoking gun...which I believe is in a combination of the Bermuda and luxembourg subsidiaries. I'm double/triple-checking my work on those, but will post my thoughts when I'm comfortable we have it correct. Have you or others done any work on the Luxembourg entities? As an aside, mgmt got hostile when I asked about them which made me think there must be something juicy there (why Luxembourg if not to do something shady?).

    SubjectActuary and Tiger
    Entry08/29/2013 02:41 AM
    MemberFrancisco432
    there is a corresp attached to one of the s1/a's that says they use Sg risk as a consulting actuary, not THE actuary. Since that's the nature of the relationship, they pulled the name and have used te consulting actuary term since. It's unclear to me if it's sg or someone else. Their chosen development factor methodology and disclosure is suspect though. Re: Tiger. Yes, I've read the court docs. Amazing how slow/disorganized their lawyer seems to be. Hopefully they have to address the interrogatories and name the LE providers they use (if any - their answer has shifted a couple times). It was also interesting how they really didn't want Zyskind being deposed. Might be nothing, but he's been vocal since the acquisition and was listed as one of the few key decision makers on that deal. I also thought it was worth noting that there was friction btwn afsi and Madison (didn't say what about).

    SubjectRE: Actuary
    Entry08/29/2013 10:17 AM
    MemberFrancisco432
    12/28/06 S-1/A:
     
    Our most significant balance sheet liability is our reserves for loss and loss adjustment expense. We record reserves for estimated losses under insurance policies that we write and for loss adjustment expenses related to the investigation and settlement of policy claims. Our reserves for loss and loss adjustment expenses represent the estimated cost of all reported and unreported loss and loss adjustment expenses incurred and unpaid at any given point in time based on known facts and circumstances. Our reserves for loss and loss adjustment expenses incurred and unpaid are not discounted using present value factors. Our loss reserves are reviewed at least annually by our external, actuary, SG Risk LLC. Reserves are based on estimates of the most likely ultimate cost of individual claims. These estimates are inherently uncertain. Judgment is required to determine the relevance of our historical experience and industry information under current facts and circumstances. The interpretation of this historical and industry data can be impacted by external forces, principally frequency and severity of future claims, length of time to achieve ultimate settlement of claims, inflation of medical costs and wages, insurance policy coverage interpretations, jury determinations and legislative changes. Accordingly, our reserves may prove to be inadequate to cover our actual losses. If we change our estimates, these changes would be reflected in our results of operations during the period in which they are made, with increases in our reserves resulting in decreases in our earnings.
     
    Corresp filed 8/31/09 (but letter dated 8/25/08):

    You disclose in several sections of the filing you “utilize the services of an independent consulting actuary to assist in the evaluation of the adequacy of our reserves for loss and loss adjustment expenses”. While you are not required to make reference to the use of independent consulting actuary, when you do, you must also disclose the name of the independent consulting actuary. If you include their name in or incorporate them by reference into a 1933 Securities Act filing, you will also need to include their consent.
     
    Our reference to our independent consulting actuary was not intended to indicate that we rely on the independent consulting actuary to determine the adequacy of our reserves for loss and loss adjustment expenses. Therefore, we will revise future filings to remove the reference to the independent consulting actuary.

    2012 10K:

    Workers’ Compensation Business

    ...We use a consulting actuary to assist in the evaluation of the adequacy of our reserves for loss and loss adjustment expenses.

    ...Our consulting actuary projects ultimate losses in two different ways:

    Quarterly Incurred Development Method (Use of AmTrust Factors).Quarterly incurred loss development factors are derived from our historical, cumulative incurred losses by accident month. These factors are then applied to the latest actual incurred losses and DCC by month to estimate ultimate losses and DCC, based on the assumption that each accident month will develop to estimated ultimate cost in a similar manner to prior years. There is a substantial amount of judgment involved in this method.

    Yearly Incurred Development (Use of National Council on Compensation Insurance, Inc. (“NCCI”) Industry Factors by State). Yearly incurred loss development factors are derived from either NCCI’s annual statistical bulletin or state bureaus. These factors are then applied to the latest actual incurred losses and DCC by year by state to estimate ultimate losses and DCC, based on the assumption that each year will develop to an estimated ultimate cost similar to the industry development by year by state.

    ...Our consulting actuary estimates a range of ultimate losses, along with a selection that gives more weight to the results from our monthly development factors and less weight to the results from industry development factors.

    ...Management makes its final selection of loss and DCC reserves after reviewing the actuary’s results; consideration of other underwriting, claim handling and operational factors; and the use of judgment. To establish our AO reserves, we review our past adjustment expenses in relation to past claims and estimate our future costs based on expected claims activity and duration.

    ...Of the two methods above, the use of industry loss development factors has consistently produced higher estimates of workers’ compensation losses and DCC expenses.

    Specialty Risk and Extended Warranty

    No mention of actuary.

    Property and Casualty Insurance

    ...We utilize the services of an independent consulting actuary (whoops! language slipped back in) to assist in the evaluation of the adequacy of our reserves for loss and loss adjustment expenses.


    SubjectLuxembourg - hiding losses?
    Entry08/30/2013 01:42 PM
    MemberFrancisco432
    Google doc link to my interpretation:
     
    https://docs.google.com/file/d/0B86krX6VxmmWdHdlbW1ZQ2ZXQ0k/edit?usp=sharing
     
     
     

    SubjectRE: RE: Luxembourg - hiding losses?
    Entry08/30/2013 06:53 PM
    MemberFrancisco432
    AII doesn't reinsure the Luxembourg entities. The Lux entities reinsure AII.
     
    Ceding: AII cedes premiums to Lux operating subs.
    Ownership: AII owns AHL. AHL owns Lux operating subs.
     
    Typically, a captive reinsurer (as AII is to US Subs, AEL, and AIUL; as Lux operating subs are to AII) shares a common parent with the cedant. An insurance company doesn't want to own their own captive reinsurer because that would require consolidation thereby defeating the purpose of creating the captive reinsurer.
     
    However, Bermuda statutory accounting rules require that the equity in affiliates NOT be consolidated.
     
    The impacts of this are amazing for AII:
    (1) Boost profits - cede losses that don't come back onto your income statement / bal sht via consolidation (since they somehow recognize income off these money-losing entities).
    (2) Reduce reported leverage - deconsolidating allows them to reduce underwriting leverage (NPW/Surplus) and total leverage (Policy Liab/Surplus and/or assets/equity) by only recognizing the equity of the ownership (rather than the gross assets/liabs)
     
    Since AII's owned subs are illiquid investments (wholly owned / private), they are highly illiquid. But the problem goes further -- these subs hold capital to support their OWN policy liabilities. Therefore, even if the investment was liquid, they would be restricted from drawing on the capital at AEL/AIUL/ACHL! In other words, AFSI is double-pledging the assets / capital buffer of their regulated entities.
     
    I will try to put together a better way to look at the lack of capital in Bermuda over the long weekend. It's really quite scary what an illiquid/insolvent entity AII is. No wonder they keep growing NPW so quickly -- if they didn't, AII would be not have any liquid assets to pay off claims (collateralized trusts fbo US Subs only covered incurred losses, but they have substantial unearned premiums and obligations to AEL/AIUL that are uncollateralized) PLUS they use letters of credit and repo financing to fund the little liquidity they do have!
     
     

    SubjectLuxembourg Disclosures
    Entry09/04/2013 12:11 AM
    MemberFrancisco432
    AFSI doesn't list Luxembourg operating subs as insurance subs. AFSI sends insurance losses to Luxembourg operating subs (but don't worry, they're not insurance subsidiaries).
     
    AFSI owns AII. AII owns AHL. AHL owns "all the issued and outstanding stock" of Luxembourg operating subs. Losses at Luxembourg operating subs don't get consolidated back to AFSI (per google doc posted Friday in comments).
     
    Does anyone else find this odd?
     
    I'll expand on how i think their Luxembourg "accounting" actually works such that AHL subsidiaries can absorb losses sans premiums from AII yet AII can still report a profit on their investment in AHL once I feel comfortable that it's correct. Hint: it's not GAAP.
     

    A few details, 10K excerpts below.
     
    (1) Notice the conspicuous absence of Luxembourg-domiciled insurance companies in the table below. 
     
    Incidentally, some of the Luxembourg operating subs are are bigger in terms of net losses incurred than several US subs...and it can't be an issue of captive vs primary because AII doesn't write anything directly...so why are the Luxembourg operating subsidiaries left off? It can't be because they aren't doing business because otherwise they'd have to pay 30% taxes on 412 equalization reserves, and AFSI isn't dumb enough to pay taxes when they can just send losses there at the snap of their fingers.
     
    Ed: if it's this easy for Amtrust "40% tang ROE in a soft market" Financial, which can't help but make money writing insurance, surely the previous, less capable, less profitable insurers could find a few losses to send there...oh wait, it's supposed to be arms-length?
     
    (2) Amtrust flat out says they're ceding losses to the Luxembourg entities to work down the DTLs. That's fine (kind of...Luxembourg tax authorities aren't going to be happy with transactions concocted solely to reduce the taxes AFSI would have owed them had they done arms-length terms), but just saying you're sending losses there doesn't mean you don't have to consolidate those losses under GAAP!
     
    (3) And why do they say "AHL own all of the issued and outstanding stock of the seven Luxembourg-domiciled captive insurance companies"? Why not call it a "wholly-owned subsidiary"??
     
    Might the term "wholly-owned subsidiaries" prompt even BDO to tell an audit client they need to consolidate those entities, thereby bring the losses incurred, ceded to Luxembourg entities back from the rather well-hidden (but not well enough!!) view of investors, auditors, and/or regulators?
     
     
    From 10K:
     

    Luxembourg

     AHL, a Luxembourg holding company, is owned by AII, our Bermuda insurance company. AHL owns all of the issued and outstanding stock of seven Luxembourg-domiciled captive insurance companies that had accumulated equalization reserves, which are catastrophe reserves in excess of required reserves that are determined by a formula based on the volatility of the business reinsured. Because AII is an insurance company with the ability to cede losses, the captives are well-positioned to utilize their equalization reserves. Luxembourg does not impose any income, corporation or profits tax on AHL provided sufficient losses cause the equalization reserves to be exhausted. However, if the captives cease to write business or are unable to utilize their equalization reserves, they will ultimately recognize income that will be taxed by Luxembourg at a rate of approximately 30%.

    ...
     
    We may be subject to taxes on our Luxembourg affiliates’ equalization reserves.

    In 2009, we acquired a Luxembourg holding company and five Luxembourg-domiciled captive insurance companies. During 2010 - 2012, we made several additional acquisitions of Luxembourg-domiciled captive insurance companies. In connection with these transactions, we acquire the equalization reserves of the captive insurance companies. An “equalization reserve” is a catastrophe reserve in excess of required reserves determined by a formula based on the volatility of the business ceded to the captive insurance company. Provided that we are able to cede losses to the captive insurance companies through intercompany reinsurance arrangements that are sufficient to exhaust the captives’ equalization reserves, Luxembourg would not, under laws currently in effect, impose any income, corporation or profits tax on the captive insurance companies. However, if the captive reinsurance companies were to cease reinsuring business without exhausting the equalization reserves, they would recognize income that would be taxed by Luxembourg at a rate of approximately 30%. As of December 31, 2012, we had approximately $412 million of unutilized equalization reserves.
     
    ...
     
    We transact business primarily through our eleven Insurance Subsidiaries:
     
    Company Coverage Type Offered Covg Mkt Domiciled
    Technology Insurance Co, Inc. (“TIC”) Small comm., spec prog and spec risk & ext warranty USA NH
    Rochdale Insurance Co ("RIC") Small comm., spec prog and spec risk & ext warranty USA NY
    Wesco Insurance Co (“WIC” Small comm., spec prog and spec risk & ext warranty USA DE 
    Associated Industries Insurance Co, Inc. (“AIIC”) Workers’ compensation USA FL
    Milwaukee Casualty Insurance Co. (“MCIC”) Small Commercial Business USA WI
    Security National Insurance Company (“SNIC”) Small Commercial Business USA DE 
    AmTrust Insurance Co of Kansas, Inc. (“AICK”) Small Commercial Business USA KS
    AmTrust Lloyd’s Insurance Co (“ALIC”) Small Commercial Business USA TX
    AmTrust International Underwriters Ltd ("AIU") Specialty Risk and Ext Warranty; specialty prog EU / USA Ireland
    AmTrust Europe, Ltd. ("AEL") Specialty Risk and Extended Warranty EU England
    AmTrust International Insurance Ltd. (“AII”) Reinsurance EU / USA Bermuda

    SubjectRE: RE: Luxembourg Disclosures
    Entry09/04/2013 02:19 PM
    MemberFrancisco432
    David -
     
    Thanks for the comment. It's true that a regulator needs to move for this to be a relevant issue. However, I don't think it needs to be a regulator from Luxembourg. In fact, i think there are a number of "shots on goal" with regulators and i decided to write this up and post the Luxembourg issue separately so that I could get feedback/pushback and so that others that have more connections/appetite for dealing with the sorts listed below could pick up the ball and run with it if the chose to do so.
     
    If brought to their attention, I would think any/all of the following (in order of my guess on likelihood) organizations would take interest in the issues highlighted (of importance to regulators: aggressive LS assumptions, substantial leverage, offshore dressing up the stat subs, and, most importantly, Luxembourg/hidden losses):
     
    (1) Enterprising journalist - Billionaires hiding losses with Luxembourg shell companies would be a sensational story to help "make a name for one's self".
    (2) SEC - there's been significant correspondence; if my Luxembourg analysis is correct
    (3) NYDFS - they're looking to get some scalps on the offshore issue. Insurance contacts i've spoken to suggest they are a sophisticated regulator.
    (4) AM Best - leverage by itself is an issue. If they thought AFSI was hiding losses and overstating income, the BCAR calcs are much worse.
    (5) Sell side analysts - ranked low because of the banking fees i'm sure AFSI pays them all.
    (6) Bermuda Monetary Authority - offshore jurisdictions are already under pressure, so they don't want to give US regulators more reason to question/challenge the use of Bermuda captives
    (7) Luxembourg Insurance / Tax authorities - i'm not terribly optimistic on this one, but they are the ones losing out the most by AFSI doing what they're doing.
    (8) Aon - managers of the Luxembourg captives. If they know how it's being used, do they really want to be facilitating this?
    (9) BDO - yea, right...

    SubjectInsurance Insider article on AFSI
    Entry09/08/2013 02:21 PM
    MemberFrancisco432
    http://www.insuranceinsider.com/-1245245/21

    Peering behind the triple curtains of the Karfunkel family…

    2 September 2013

    The Karfunkel clan avoid the limelight. But they will soon have influential positions in three different - but related - quoted US/Bermudian (re)insurers. The Insurance Insider lifts the curtain on the three companies to see how the potential conflicts of interest are being managed

    If the proposed IPO of National General Holdings Corporation (NGHC) on the Nasdaq goes ahead as planned, the firm will become the third publicly listed (re)insurance company backed by the Karfunkel family.

     

    Click to enlarge

     

    But even as the latest issue is being marketed to potential investors, a related company, Maiden, is facing allegations from a former senior employee accusing the Karfunkels of using their position to enrich themselves at the expense of other shareholders.

    Meanwhile, the largest firm in the "family", AmTrust Financial - which has been widely admired by shareholders for its consistent returns - has recently been hit by allegations of accounting improprieties and now appears to be the subject of a short selling campaign, with 10.3 million shares, or a third of its free float, sold short.

    The Insurance Insider examines the web of inter-related companies highlighted by the Karfunkels' latest trip to the capital markets.

    1. Related party transactions

    Led by brothers Michael and George Karfunkel, along with Michael's son-in-law Barry Zyskind, the family own a 57 percent stake in US specialty insurer AmTrust through various trusts and foundations.

    Click to enlarge The trio also own 28 percent of Bermudian reinsurer Maiden. Though not a controlling stake, the company's by-laws contain several provisions that tighten the family's control over the company in the event of a potential takeover bid.

    Meanwhile, 63 percent of NGHC's shares will remain in the hands of either the Karfunkel family or AmTrust after the proposed IPO, as the flotation is merely a resale of the shares placed with private investors in a private placement in June.

    AmTrust and NGHC also co-own three joint-venture vehicles which contain investments in life settlement contacts.

    The three companies are also connected through a complex web of business transactions.
    When Maiden was originally formed in 2007 its only source of business was through a quota share from AmTrust. At the end of 2012, Maiden still sourced 60 percent of its top line from either AmTrust or NGHC.

    Furthermore, AmTrust receives cedant fees from Maiden relating to the quota shares, as well as technology consulting fees from NGHC and asset management fees from both.

    In 2012, these related party fees added up to $29mn, or 16 percent of AmTrust's net income.
    Michael Karfunkel is the chairman of Maiden and the CEO of NGHC. Zyskind is the CEO of AmTrust, the chairman of Maiden, and a director of NGHC.

    Michael's sons Barry and Robert Karfunkel both have executive positions at NGHC, while Barry chairs the compensation committee.

    Inevitably, the three companies have to be careful in balancing the conflicts of interest inherent in having shared board members and executives at companies undertaking arms' length transactions.

    2. Potential for conflicts of interest

    In November, Maiden's former general counsel and COO Bentzion Turin will appear in a New York court to accuse his former employers of dismissing him for blowing the whistle on corporate governance failures.

    The aggrieved former employee claims that Zyskind, Michael and George Karfunkel failed to negotiate a related-party transaction at arms' length in order to seal preferential terms.

    The accusation relates to $260mn the company raised in January 2009 to maintain its A- AM Best rating after it purchased the reinsurance business of GMAC Insurance from Ally Financial.

    The transaction saw Maiden issue trust preferred securities that carried a 14 percent coupon and an equity sweetener. The Karfunkels subsequently bought more than half of the offering.

    Turin claims the terms were agreed by the Karfunkels and Zyskind - related parties - without any non-conflicted parties present.

    But the company's defenders argue that with capital markets essentially frozen at the time, the deal was fairly priced.

    However, Turin maintains that even if the terms were fair, due process should have been followed to protect the interests of other shareholders.

    "If something is a bad deal or a good deal it doesn't mean that it's the best deal or the worst deal and it doesn't mean that the deal was arrived at in an appropriate fashion," he said in his April 2010 deposition.

    Maiden said the allegations were without merit, and pointed out that the terms of the capital raising were later approved by the board, made of majority independent directors.

    Whatever the outcome of the case, the suit clearly highlights the delicate issues relating to the management of potentially competing conflicts of interests at the companies.

    3. Life Settlements

    Despite appearing to be a relatively straightforward P&C insurance company on the surface, NGHC also has substantial interests in some slightly more volatile investments.

    As detailed above, NGHC has a $132.3mn interest in several life settlement contract (LSC) portfolios, which it owns 50:50 with AmTrust Financial.

    Once called viaticals, an LSC is a life insurance policy that has been sold to a third-party investor. The investor continues to pay the premium and collects the death benefit when the insured person dies.

    AmTrust's ownership interest in its LSC portfolio and its accounting of them has been one of the issues raised by short sellers.

    The concerns were first raised by research firm Off Wall Street (OWS), which highlighted two key points regarding AmTrust's valuation methodology. The carrying values are determined by a model, as there is a limited market for the instruments.

    The value of LSCs are basically determined by two key inputs: the life expectancy (LE) assumption and the discount rate used to adjust for the riskiness of the assets.

    OWS has argued that the discount rate used by AmTrust is inappropriately low and far lower than peers. AmTrust denies this and argues its methodology is misunderstood.

    But OWS also claims AmTrust is unique among similar public companies in using internal estimates for the crucial LE component rather than employing third party actuaries.

    This should be considered at least a red flag as previous frauds in the sector have been perpetrated using internal estimates only, such as Life Partners and Mutual Benefits, according to OWS.

    The OWS report also pointed to the fact AmTrust appears to have been consistently revising down its LE estimates, resulting in instant paper gains, while other companies invested in the instruments appear to be doing the opposite.

    "Every other LSC investor appears to use third party actuaries to determine the critical LE assumption, and has been revising these LEs upwards (generating portfolio losses). AmTrust, the only investor we can identify that doesn't base its LEs on independent, third party estimates, and is also the only investor that appears to be revising its LEs downwards (generating portfolio gains)," OWS concluded.

    This is material as AmTrust has earned $79mn after minority interest in net income from its LSC investment since the beginning of 2011, representing almost 23 percent of total net income over the period.

    NGHC's LSC investment represents around a quarter of tangible equity, while the result of its earnings from unconsolidated entities implies around 50 percent of its 2011 profit was from LSC gains.

    4. Acquisition accounting

    It also appears that NHGC has been quick to adopt another strategy used by AmTrust that has been criticised by the shorts: the use of acquisition accounting.

    In its filing with the Securities and Exchange Commission (SEC), NHGC disclosed that it has made nine acquisitions since Michael Karfunkel took control of the company in 2010 as it targets growth in accident and health business.

    The critique, first raised by OWS, essentially argues that AmTrust's combined ratio is not comparable to peers as the heavy use of renewal rights transactions means the company is able to capitalise acquisition expenses.

    Normally, an insurer that chooses to grow organically typically has to pay either higher commissions, or price the business at a discount to rivals. Either way, the effect is "expensed" and passes immediately through the income statement.

    By contrast, the "expense" of a renewal rights transaction is capitalised through the creation of an intangible asset. These can be amortised over an incredibly long time period, meaning the expense of winning business is deferred to later period, flattering the current period's bottom line.

    It is worth noting that the first entity to raise a concern with AmTrust's use of this accounting was the SEC itself. Back in 2006 the SEC queried AmTrust's assumption that 95 percent of the value of these intangible assets were assigned to "agent relationships", rather than the renewing policy, which were then amortised over 40 years.

    After a lengthy correspondence with the SEC, AmTrust agreed to halve its useful assumption to 20 years.

    However, short sellers argue the accounting choices still flatter AmTrust on key metrics such as reported earnings and combined ratio in comparison to peers.

    As evidence of the lack of real economic profits being generated, shorts point to the company's lacklustre track record of tangible book value growth.

    For instance, AmTrust has reported $740mn in earnings since 2008 to the middle of 2013. Yet its tangible book value has increased by only $230mn over the comparable period.

    "That's a lot of running for the distance travelled," commented one sceptical source.

    OWS further argues that when discounting the impact of the paper gains of the LSC portfolios and unrealised gains in its bond portfolio, tangible book value has grown only $110mn over the period.

    Meanwhile, its market capitalisation has doubled over the same period, while written premiums have more than tripled.

    This has left AmTrust with 45 percent of its balance sheet as goodwill and intangible assets, with its expanding top line being supported by less and less tangible equity. For instance, its second quarter net written premium represented more than 4x its tangible equity on an annualised basis, far higher than other highly leveraged peers such as Meadowbrook and Tower Group, both of which have had recent run-ins with AM Best.

    Though only one of NGHC's acquisitions has been a renewal rights transaction, it has bought several small agencies far above their negligible net tangible asset value. As such, goodwill and intangibles have grown from 20 percent of equity at the end of 2011 to 25 percent as at the end of 2012.

    5. Luxembourg

    It is also worth noting that NGHC's largest transaction was the $125mn it spent on purchasing Capgemini Reinsurance Company, a captive insurer incorporated in Luxembourg.

    NGHC's SEC filing said the deal "allows the company to obtain the benefits of its capital and utilisation of its existing and future loss reserves through a series of reinsurance agreements with one of the company's subsidiary".

    In a note published on 30 August, OWS raised concerns over the several Luxembourg-based captives owned by AmTrust, purchased for a total of $723.8mn.

    Using statutory account filings from AmTrust's Bermudian reinsurance captive AII, OWS argued the company was channelling losses through its Luxembourg entities before they reached AmTrust or Maiden's loss ratio.

    AmTrust did not respond to a request for comment for this article. Perhaps the company might argue its clever use of loss equalisation reserves in Luxembourg allow it to improve its underwriting return.

    But it does raise questions over whether the company's underwriting results are more down to financial engineering, rather than its usual claim of superior technology and niche risk selection.

     


    SubjectLuxembourg - 2011/12 losses absorbed...
    Entry09/27/2013 03:56 PM
    MemberFrancisco432
    AFSI continued sending losses to Luxembourg in 2011/12. Based on the 2010 filing and language in the 10K, reconciliations between various filings, and the directionality of loss expenses, I continue to believe these are not consolidated.
     
    https://docs.google.com/file/d/0B86krX6VxmmWYVVHZUV0MHV6TkU/edit?usp=sharing
     

    Subject2010-12 Luxemb losses (excl from op results)
    Entry09/29/2013 11:11 PM
    MemberFrancisco432
    https://docs.google.com/file/d/0B86krX6VxmmWWHVwTktIUEd0d3c/edit?usp=sharing
     
    Attached are the relevant excerpts that demonstrate that AFSI continues to send losses to Luxembourg. As previously discussed/demonstrated, these losses do not appear to be captured in the consolidation for SEC/US GAAP purposes. Therefore, earnings and book value appear to be overstated (meaningfully).
     
    I have yet to here any argument against my thesis that they are sending losses there and will post a follow-up supporting my view shortly, but wanted to document the continuation of losses being sent to Luxembourg in the interim.

    SubjectReconciliation showing Luxemb losses are excluded
    Entry09/30/2013 03:22 AM
    MemberFrancisco432
    Please use the link below to see a reconcilation and explanation of 2009/10/11 earnings from foreign domiciles demonstrating that AFSI is excluding losses sent to Luxembourg from their consolidated results.
     
    https://docs.google.com/file/d/0B86krX6VxmmWTFVXd1hNNFQtR0E/edit?usp=sharing

    SubjectInsurance Insider Article re: Luxembourg losses
    Entry09/30/2013 03:42 PM
    MemberFrancisco432

    http://www.insuranceinsider.com/?page_id=1245685&utm_source=Insider-Publishing&utm_medium=Email&utm_content=Untitled35&utm_campaign=Welcome+to+the+latest+issue+of+The+Insurance+Insider&utm_cid=19499

    AmTrust spotlight now turns to Luxembourg captives

    30 September 2013

    Is AmTrust Financial's use of Luxembourg captives to absorb insurance losses clever financial engineering or a breach of US GAAP accounting and the principality's financial regulations?

    That was the question raised by the latest in a series of criticisms of the US insurer's accounting published by the short-focused research firm Off Wall Street (OWS).

    AmTrust has spent $724mn accumulating Luxembourg captives since 2009, a significant total for a company with tangible book value of just $713mn as of 31 June.

    These entities play a characteristically unorthodox role at AmTrust. Its strategy involves purchasing legacy captive entities (see table) and then ceding losses to them to exhaust the equalisation reserves reported at these entities.

    (Ed: in other words, AFSI gets premiums from writing policies and splits the losses with Luxembourg (...then ignores the portion in Luxembourg for US GAAP reporting)).

    An equalisation reserve is a kind of "kitchen sink" loss reserve not associated with any particular claim or line of business. (Ed: or "future losses")

    However, while equalisation reserves are allowed for Luxembourg-based captives, they are not permitted under US GAAP (or IFRS), as they can be used to smooth earnings by putting money away in good years and tapping into the fund in bad years.

    Ordinarily, this loophole is used by insurers as a way of managing their taxes. By channelling losses and premiums through a Luxembourg-based entity, the insurer can record an equalisation reserve expense to reduce pre-tax income (and hence taxes payable). (ed: most insurers channel profits here to benefit from the tax shield).

    However, if a company ever wants to liquidate the entity it would have to pay taxes at 30 percent at this point on the equalisation reserve. 

    AmTrust's strategy appears to be designed to exploit this situation. A company that owns one of these entities with a reserve surplus that no longer wants to operate a captive cannot liquidate it without absorbing a tax charge.

    AmTrust thus offers to buy the company and adds it to its portfolio of Luxembourgian captives, owned by its holding company in the country, AmTrust Holdings Luxembourg.

    But then, rather than ceding a combination of premium and losses to the entities to build its own tax shield, and perhaps a time value of money benefit while it invests the money not spent on taxes, the company appears to be ceding losses only.

    Explaining the rationale behind the purchases in its 10-k filing, AmTrust explained the purchases allowed it to "obtain the benefit of the captives' capital and utilisation of their existing and future loss reserves through a series of reinsurance arrangements".

    Or, to put in layman's language, the company uses a reinsurance contract with its other subsidiaries to send losses to Luxembourg that allows it to unwind the reserve without having to pay the taxes.

    So far so good, you might think. But OWS raises two key concerns with AmTrust's use of these entities.

    First, it alleges that Luxembourg law mandates that all related party or intra-company transactions must be done at an "arm's length" margin. 

    Indeed, the allowance of equalisation reserves is intended specifically to make it attractive to keep capital in Luxembourg. Therefore, the rules are designed to prevent companies from breaking open the piggy bank without at least paying the taxman for the benefit.

    "Does a treaty whereby the reinsurer receives only losses and zero premiums satisfy this requirement? Perhaps not," the firm observes in a 22 September note.

    But even if the transactions are valid, OWS raises concerns with how they are reported in AmTrust's GAAP financials.

    Because US GAAP doesn't permit the use of equalisation reserves, AmTrust is not able to report them on its consolidated financial statements.

    Instead, a hypothetical $100mn equalisation reserve on a balance sheet in Luxembourg appears on a GAAP-reporting balance sheet as a $30mn deferred tax liability (DTL), using a 30 percent tax rate. That is the $30mn tax charge you will eventually have to pay if you wind up the company before the loss reserves are used.

    By ceding losses only to the entities, AmTrust is able to "exhaust" the reserve. 

    Using the numbers from the example above, if $10mn of hypothetical insurance claims were ceded to the company and the equalisation reserve fell to $90mn, the DTL on a hypothetical group's accounts would fall by $3mn to $27mn.

    Fans of accounting (and arithmetic) will know that a reduction in a liability results in a gain that must be reported on the income statement. 

    And you might think a reduction in a tax liability would show up as a reduction in tax expense.

    However, curiously, AmTrust reports the benefit of the transaction in its US GAAP accounts as "a decrease to other underwriting expense". 

    But perhaps even more significant than this tax versus operating classification issue is the way AmTrust accounts for the losses. Under Luxembourg GAAP, a company would report a $10mn loss offset by a $10mn equalisation reversal to result in a net loss of zero.

    However, OWS argues that because US GAAP does not permit the use of equalisation reserves, the $10mn of losses must still show on the income statement when they are consolidated into the US accounts.

    But, according to OWS analysis only the net impact of the transaction (Ed: only the DTL reversal, but not the loss that went to generate it) is shown in a reduction in underwriting expenses. The insurance losses shown on the subsidiaries' accounts in its Bermudian internal reinsurer and its Luxembourgian holding company do not show on the accounts filed with the Securities and Exchange Commission.

    According to a footnote in AmTrust's disclosure, the benefit of its financial wizardry is contained in its specialty risk and warranty segment. This segment houses its controversial large Italian medical malpractice business.


    SubjectRE: Reconciliation showing Luxemb losses are excl
    Entry10/01/2013 10:22 AM
    Memberoldyeller

    Francisco,

    Thanks for all your postings. We appreciate the complexity of your analysis without the help of management. I have tried to tie out to your reconciliation schedule (in Point #3) and have a bunch of questions to make sense of everything:

    1. How are you comfortable that the entities that you are using represent an accurate and comprehensive list?
    2. Your reconciliation includes AIIB, AIIM and other entities which weren’t included in your original Luxembourg posting where you tried to show that these losses transferred to Luxembourg vanish in consolidation (as they aren’t on the AM Best reports)?  Do these entities also have losses and do they get picked up in the AM Best reports you were comparing to?
    3. Footnote 22 of the 2011 10k shows Net Income on a GAAP and Statutory basis for each of the domestic and foreign subs, which doesn’t have subs such as AIIB and AIIM. Any idea on how to tie this out to your work and the consolidated numbers?
    4. Footnote 22 of the 2011 10k shows separate lines for AEL of $54.7M and for AIU of $39.5M. So why do you include these in the “AII direct ops only” line for 2011?   Similarly, should the 2009 and 2010 numbers for these entities tie to your schedule (though they appear to be close)?
    5. The Income Statement for the 2010 AII Financials shows Equity in Earnings of $25.3M for ACAC but I don’t see this adjusted for in your analysis? Is this because ACAC is recorded as an equity investment by AFSI in the corporate consolidation? I am not sure if that makes a difference or not since both AII and AFSI consolidated could have investments in ACAC
    6. I assume AII doesn’t pay any taxes which is why you can compare AIUL, AEL, and ACHL from the 2010 financials (which are post-tax) to your pre-tax schedule?
    7. For AIIM, since this was contributed to AII on 12/31/10, why include this prior to then in 2009 and 2010? Also, I can’t seem to find where you get the $17M and $19M from on the AII or Maiden financials?
    8. For AIIB, how come for 2009 and 2010 you show different numbers than the $14.3M and $17.5M that are listed on the bottom of page 35 of the AII financials?
    9. Since the 2010 AII financial statements state that AII records its investments in subsidiaries as equity investments rather than consolidating them, I take it that you believe that AFSI properly adjusts the accounting so that every AII subsidiary outside of Luxemburg is properly consolidated, and that Luxembourg is the only AII subsidiary where it looks like they are not properly consolidating?
    10. Perhaps the company doesn’t list Luxembourg as a subsidiary on page 57 of the 10k because they already list AII which includes Luxembourg? Exhibit 21.1 of the 10k does include the Luxembourg entities.
    11. Any idea on how ACHL manages to record income? It seems like it is based on recording negative expenses but I am not sure why. Could this be the reversal of the equalisation reserves?

    SubjectRE: old yeller q's
    Entry10/02/2013 11:49 AM
    MemberFrancisco432

    Old Yeller - thanks for the questions. Please see my responses below.

    1. How are you comfortable that the entities that you are using represent an accurate and comprehensive list?

    I'm using the organization structure provided in the US Stat Filings (2011 TIC Supplement, pg 123-127). I compared that to the subsidiaries list filed in the 10K for 2010/11 to allocate where entities belonged. Between the two, I do think we've covered things quite well.

    1. Your reconciliation includes AIIB, AIIM and other entities which weren’t included in your original Luxembourg posting where you tried to show that these losses transferred to Luxembourg vanish in consolidation (as they aren’t on the AM Best reports)?  Do these entities also have losses and do they get picked up in the AM Best reports you were comparing to?

    The original posting showed the net loss expense. Since AIIB (brokerage) and AIIM (investment mgmt services) don't do any underwriting, we don't need to check them for loss expense.

    1. Footnote 22 of the 2011 10k shows Net Income on a GAAP and Statutory basis for each of the domestic and foreign subs, which doesn’t have subs such as AIIB and AIIM. Any idea on how to tie this out to your work and the consolidated numbers?

    They only list the underwriting subs.

    22. Statutory Financial Data

    The Company’s insurance subsidiaries file financial statements in accordance with statutory accounting practices (“SAP”) prescribed or permitted by domestic or foreign insurance regulatory authorities. The differences between statutory financial statements and financial statements prepared in accordance with GAAP vary between domestic and foreign jurisdictions.

    1. Footnote 22 of the 2011 10k shows separate lines for AEL of $54.7M and for AIU of $39.5M. So why do you include these in the “AII direct ops only” line for 2011?   Similarly, should the 2009 and 2010 numbers for these entities tie to your schedule (though they appear to be close)?

    For 2009/10, we have more granular detail thanks to the 2010 AII Financials (link previously posted). Therefore, we can separate out the contributions of AII's direct ops from the earnings that result from their ownership of AEL/AIUL. In 2011, we don't have the ability to separate out the subs from direct operations, since we don't have the same filing for that year. For this reason, I'm more confident in my reconciliation for 2009/10.


     

    1. The Income Statement for the 2010 AII Financials shows Equity in Earnings of $25.3M for ACAC but I don’t see this adjusted for in your analysis? Is this because ACAC is recorded as an equity investment by AFSI in the corporate consolidation? I am not sure if that makes a difference or not since both AII and AFSI consolidated could have investments in ACAC

    I exclude the earnings from ACAC because the footnote I'm comparing it to is before equity in earnings of unconsolidated subs.

    23. Geographic Information

     

    Three of the Company’s insurance subsidiaries (AII, AIU and AEL) operate outside the United States. Their assets and liabilities are located principally in the countries where the insurance risks are written or assumed.

    The domestic and foreign components of Income before equity in earnings (loss) of unconsolidated subsidiaries for the years ended December 31, 2011, 2010 and 2009 are as follows:

                 

    (Amounts in Thousands)

     

    2011

     

    2010

     

    2009

    Domestic

     

    $

    24,328

       

    $

    65,882

       

    $

    73,542

     

    Foreign

       

    204,326

         

    105,519

         

    57,962

     
       

    $

    228,654

       

    $

    171,401

       

    $

    131,504

     
    1. I assume AII doesn’t pay any taxes which is why you can compare AIUL, AEL, and ACHL from the 2010 financials (which are post-tax) to your pre-tax schedule?

    Correct. No tax expenses/assets/liabilities are shown in the AII 2010 Financials.

    1. For AIIM, since this was contributed to AII on 12/31/10, why include this prior to then in 2009 and 2010? Also, I can’t seem to find where you get the $17M and $19M from on the AII or Maiden financials?

    Since AII only owned it for a day in 2010 and didn't own it in 2009, the earnings of this foreign sub would be included elsewhere. For 2011, AII owned it all year, so it gets captured in their reported income.

     

     

    MHLD 2010 10K (F-37)

    Asset Management Agreement

    Effective July 1, 2007, the Company entered into an asset management agreement with AII Insurance Management Limited (“AIIM”), an AmTrust subsidiary, pursuant to which AIIM has agreed to provide investment management services to Maiden Insurance. Pursuant to the asset management agreement, AIIM provides investment management services for an annual fee equal to 0.35% of average invested assets plus all costs incurred. Effective April 1, 2008, the investment management services quarterly fee has been reduced to 0.05% if the average value of the account is less than or equal to $1billion and 0.0375% if the average value of the account for the previous calendar quarter is greater than $1 billion. The annual fee was 0.15% for the years ended December 31, 2010, 2009 and 2008, respectively. The Company recorded approximately $2,643, $2,480 and $1,362 of investment management fees for the years ended December 31, 2010, 2009 and 2008, respectively, as a result of this agreement.

    AII 2010 Filing (pg 13)

    ...The Company (AII) pays AIIM quarterly fees equal to 1.25% of the gross written premiums received. For the years ended December 31, 2010 and 2009, the company incurred fees of 10,938,506 and $9,116,731, respectively. In addition, AIIM provides investment management services to the company as well as other related parties. The Company (AII) pays AIIM a fee equal to 1% of the average value of the Company's assets. For the years ended December 31, 2010 and 2009, the Company incurred asset management fees of $5,388,698 and $5,353,573, respectively.

    1. For AIIB, how come for 2009 and 2010 you show different numbers than the $14.3M and $17.5M that are listed on the bottom of page 35 of the AII financials?

    See below.

     

    MHLD 2010 10K (in MHLD 2011 10K it's on page F-39)

     

    Reinsurance Brokerage Agreements

    Effective July 1, 2007, the Company entered into a reinsurance brokerage agreement with AII Reinsurance Broker Ltd., a subsidiary of AmTrust. Pursuant to the brokerage agreement, AII Reinsurance Broker Ltd. provides brokerage services relating to the Reinsurance Agreement for a fee equal to 1.25% of the premium reinsured from AII. The brokerage fee is payable in consideration of AII Reinsurance Broker Ltd.’s brokerage services. AII Reinsurance Broker Ltd. is not the Company’s exclusive broker. AII Reinsurance Broker Ltd. may, if mutually agreed, also produce reinsurance for the Company from other ceding companies, and in such cases the Company will negotiate a mutually acceptable commission rate. The Company recorded approximately $5,564, $4,399 and $4,188 of reinsurance brokerage expense for the years ended December 31, 2010, 2009 and 2008, respectively, and deferred reinsurance brokerage of $3,552, $3,265 and $3,009 as at December 31, 2010, 2009 and 2008, respectively as a result of this agreement.

    1. Since the 2010 AII financial statements state that AII records its investments in subsidiaries as equity investments rather than consolidating them, I take it that you believe that AFSI properly adjusts the accounting so that every AII subsidiary outside of Luxemburg is properly consolidated, and that Luxembourg is the only AII subsidiary where it looks like they are not properly consolidating?

    I have no reason to think there are consolidation issues with subsidiaries other than Luxembourg (accounting assumptions within them is another question though).


     

    1. Perhaps the company doesn’t list Luxembourg as a subsidiary on page 57 of the 10k because they already list AII which includes Luxembourg? Exhibit 21.1 of the 10k does include the Luxembourg entities.

    AII owns AEL and AIUL, so the subsidiary justification doesn't pass muster. AII itself is a captive as well, so that can't be the justification either.

    I did see that they are listed as subsidiaries. My question is why those are the only entities excluded. My guess is that the captives (subs of AHL) are treated as investments (see excerpt below "AHL owns all of the issued and outstanding stock of seven Luxembourg-domiciled insurance companies" rather than operating subs.

    Since the reported equity under Luxembourg GAAP doesn't go down (just the equalization reserve), perhaps AFSI can justify avoiding the impairment of the investment. However, US GAAP doesn't recognize equalization reserves, so US GAAP would be going down.

    I would also note that AFSI uses KPMG as their auditor in Luxembourg (AHL and captives), but they use BDO for the parent (and at least in 2010 they also used them in Bermuda). Perhaps BDO gets some cover because they can point to the KPMG audit (even if prepared under different GAAP standards).

    Since the 5.3m AII recognized on ACHL was below the typical 10% EBT materiality threshold, maybe BDO didn't have to flush it out (though the 62m obviously was material). Additionally, BDO's opinion was qualified in the 2010 filing (albeit filed much later than the 10K).   

    Pg 23 of AFSI's 2012 10K:

    Luxembourg

    AHL, a Luxembourg holding company, is owned by AII, our Bermuda insurance company. AHL owns all of the issued and outstanding stock of seven Luxembourg-domiciled captive insurance companies that had accumulated equalization reserves, which are catastrophe reserves in excess of required reserves that are determined by a formula based on the volatility of the business reinsured. Because AII is an insurance company with the ability to cede losses, the captives are well-positioned to utilize their equalization reserves. Luxembourg does not impose any income, corporation or profits tax on AHL provided sufficient losses cause the equalization reserves to be exhausted. However, if the captives cease to write business or are unable to utilize their equalization reserves, they will ultimately recognize income that will be taxed by Luxembourg at a rate of approximately 30%.


     

    1. Any idea on how ACHL manages to record income? It seems like it is based on recording negative expenses but I am not sure why. Could this be the reversal of the equalisation reserves?

    Per my comments above, my best guess is that they mix and match Luxembourg GAAP with US GAAP and/or treating ACHL's ownership in captives as investments rather than consolidating their operations.

    Since there are equalization reserves built up (and those are recognized under Luxembourg GAAP), losses ceded to Luxembourg aren't expensed. Equalization reserves are merely an accounting charge for future or catastrophe losses...well, AFSI is saying the future is now (though not with arms-length transactions), so what would be expensed under US GAAP already has an (equalization) reserve, so they don't have to expense it (Lux GAAP).

    I believe the income AII reports on ACHL comes from a reversal of DTLs. Recall that when AFSI buys captives, they record cash, intangible assets, and deferred tax liabilities (corresponding to equalization reserves). When AII sends losses to ACHL, the equalization reserve and associated DTL go down. This reduction in liabilities sans cash payment is booked as a negative expense. As you can see in the ACHL footnote, the vast majority of AII's income from ACHL comes from negative expenses rather than profitable revenues (2009 saw reversal of reserves which were associated with the ACHL level reserves -- only entity acquired that had loss reserves).  

     

    AFSI 2011 10K, pg F-27:

    The Company has classified the intangible assets as contractual use rights and they will be amortized based on the actual use of the related loss reserves. As a result of these acquisitions in 2011 and 2010, the Company reduced its acquisition costs and other underwriting expenses by approximately $23,000 in 2011.

    Since there are no acquisition costs associated with Luxembourg policies (all internal), this is not a decline in y/y expenses -- it's negative expense)

     

    AFSI 2012 10K, pg 68:

    Additionally, the use of deferred tax liabilities related to equalization reserves are netted against related amortization expense and recorded as a decrease to other underwriting expense. Otherwise, we include changes in deferred income tax assets and liabilities as a component of income tax expense.

    Why is a reversal of DTLs treated as opex??

     

    AFSI 2011 10K, pg F-27:

    Loss and Loss Adjustment Expenses; Loss Ratio. Loss and loss adjustment expenses increased $143.7 million, or 43.8%, to $471.5 million for the year ended December 31, 2010 from $327.8 million for the year ended December 31, 2009. Our loss ratio for the years ended December 31, 2010 and 2009 was 63.2% and 57.1%, respectively. The increase in the loss ratio in 2010 resulted from higher actuarial estimates based on current year actual losses and was not the result of any increase in the frequency or severity of losses. Additionally, the loss ratio in 2009 benefited from the effect of a one-time $11.8 million benefit to the Specialty Risk and Extended Warranty segment related to the 2009 acquisition of AHL.

     


    SubjectTWGP as harbinger for AFSI
    Entry10/08/2013 06:02 AM
    MemberFrancisco432
    https://docs.google.com/file/d/0B86krX6VxmmWNkNWeTdIS2I0LTQ/edit?usp=sharing
     
    TWGP was substantially under-reserved. AFSI looks as bad or worse and is more levered to boot.
     
    AFSI's IBNR bleed down stands out as a big flag indicating they are meaningfully under-reserved.

    SubjectRE: TWGP as harbinger for AFSI
    Entry10/08/2013 09:58 AM
    MemberFrancisco432
     
    If the link posted previously doesn't work, try this one:
    https://docs.google.com/file/d/0B86krX6VxmmWNkNWeTdIS2I0LTQ/edit?usp=sharing&pli=1
     

    SubjectLooking back on TWGP (per Aleph)
    Entry10/09/2013 06:04 PM
    MemberFrancisco432
    Serial acquirer who grows at inordinate rates and has odd reinsurance agreements -- sounds familiar.
     
    http://alephblog.com/2013/10/09/on-tower-group/
     

    My, but Tower Group [TWGP] was a juggernaut in its time, but I never bought it or sold it.  Let me explain:

    In 2005 my boss at the hedge fund came to me and said, “Why don’t we own Tower Group?  One of my friends owns it and says it is the greatest company in insurance.”

    Me: “They are a new company underwriting in tough lines, with a weird reinsurance agreement from a small Bermuda company.  They are growing too fast, and I doubt they are as profitable as they claim.”

    Boss: “Well, should we short them then?”

    Me: “I don’t think shorting into strength is smart, so no.  We should do nothing here.” (After a little more, boss leaves, probably annoyed at me because I recommended no action.  He was a man of action!  I am a prudent risk-taker, and very selective about when I short.)

    As an analyst of insurance stocks, I was always skeptical of Tower Group for three reasons:

    1. The acquisitive nature of Tower Group.
    2. The rapid growth in premiums, 52% per year over the last 10 years — no insurance company can successfully grow that rapidly in a mature market.
    3. Odd reinsurance agreements that made me wonder.

    But by the time I ceased being a buy side analyst for a hedge fund in 2007, there was nothing to make me short Tower Group, much as I did not like it.  And so, I stopped following the company, because it is much easier to look only for companies to be long.  (TWGP remained on my “consider shorting” list till the end of 2007.)

    I stopped following it.  Had I been following it, I would have noted the unusual strengthening of reserves for losses from prior year business (Page F-32, worth $69 Million) from the 10-K filed on 3/4/2013.  Someone selling on that day or soon after would have received something in the $18s/share vs. $4s/share now.  Large reserve strengthenings are often a harbinger of greater reserve strengthenings to come.

    After their writedown, Tower Group was downgraded by the rating agencies to the degree that few will buy new insurance or reinsurance from them.  Further, they are seeking a buyer, and the buyers are skittish.

    Thus, the company is probably in runoff. Runoff means there are no more new premiums, and the company aims to pay all legitimate claims until it closes its doors, hopefully leaving the equity investors a little.  Unless you are an expert, I would avoid taking any action here.  It is quite possible that reserves were set fraudulently, and that we have been given as much as the market can absorb in losses.  It’s also possible that the third-party actuaries have given a conservative view of reserves, and things get better from here.

    I feature this company tonight to indicate how fraught with uncertainty it is to invest in insurance stocks, particularly those that grow premiums fast — that is usually a negative sign.

    I have no idea where Tower Group goes from here, but they are a poster child for past fast growth and weak reserving.


    SubjectAFSI - GAAP/SAP Discrepancies (Luxembourg)
    Entry10/11/2013 02:38 AM
    MemberFrancisco432
    In case anyone isn't convinced yet...we show that AFSI's GAAP and Stat gross loss reserves are different (shouldn't be) and diverge by approximately the amount they've ceded to Luxembourg ($277m).
     
    We also show how one can see this playing out in the gross/net reserves over the last few years -- net/gross incurred < net/gross paid, therefore net/gross reserves are falling -- a continuation will eventually put net/gross at absurdly low levels (already odd, but the issue will compound from here).
     
    https://docs.google.com/file/d/0B86krX6VxmmWS21FNGt1WFlDVTg/edit?usp=sharing
     

    SubjectRE: A.M. Best / Luxembourg
    Entry10/15/2013 02:11 PM
    MemberFrancisco432
    I pulled the AM Best report and it has no data whatsoever.
     
    This particular entity is a captive they created (also purchased two other captives) in January 2012. It had zero net premium earned and zero net L/LAE expense according to their Luxembourg filing. Also, it only has 22.5m in assets (including 12.8m reinsurance recoverables) and 7.2m of equity.
     
    Getting this entity rated doesn't make a lot of sense to me, but I haven't talked to the company, AM Best, or anyone else about it. If they were going to get an entity rated, I would think it would be AHL (Luxembourg holding company) or at least one of the larger captives (Amtrust Re Alpha in particular). Perhaps it's just the first with more to come. One rationale for getting an entity rated could be that they get reinsurance credit with regulators and/or this entity is going to start drawing on the letters of credit (?).
     
    Curious if others have different thoughts or speak to the company about why the company chose to have that entity rated.

    SubjectAIG adverse dev in Warranty (re: AFSI)
    Entry11/01/2013 12:05 PM
    MemberFrancisco432

    AIG reported a rough quarter and noted adverse development around their warranty business, especially mobile phones...this is a big business for AFSI. Could present an add'l risk that i hadn't been focused on.


    AIG 10Q:

    Consumer Insurance Quarterly and Year-to-Date Ratios

    The accident year combined ratio, as adjusted, increased by 1.4 points and 2.4 points, respectively, for the three- and nine-month periods ended September 30, 2013 compared to the same periods in 2012.

    The accident year loss ratio, as adjusted, increased by 0.8 points and 0.7 points in the three- and nine-month periods ended September 30, 2013, respectively, compared to the same periods in the prior year, primarily due to higher losses associated with a warranty retail program, which increased the loss ratio by 1.0 point and 0.8 points, respectively.

    ___
     
    <Q - Jay Cohen>: Great. And the warranty business?
    <A>: Yeah. On the warranty business, this is working with one or two large retailers, and in particular one. So, this a
    program where the profits and the risks are shared with the retailer. And there is a mechanism to [indiscernible] up
    through rate change, historical profitability. So, while in any given quarter, you can have fluctuations which we’ve had.
    We have confidence so we can recoup those adverse results within a very prompt period. So, it really is a partnership
    with the retailer, and there’s not as much risk transfer as the numbers would suggest.
    <Q - Jay Cohen>: What kind of underlying products are we talking about, is white goods, computers?
    <A>: All of the above, but in particular mobile phones in this quarter.

    SubjectAFSI - Exp Ratio - "Technology" or more gimmicks?
    Entry11/04/2013 03:09 AM
    MemberFrancisco432
    Full memo: https://drive.google.com/file/d/0B86krX6VxmmWLTU4R2NQRXRqVnc/edit?usp=sharing
     

    AFSI's Expense Ratio "Advantage":  Better technology or more accounting chicanery?

    A significant aspect of the bull case for AFSI rests on the their expense ratio advantage which, they claim, is a result of superior technology and systems (see below). In reality, the drivers of AFSI's lower expense ratio are merely a function of aggressive cost capitalization and other accounting gimmicks.

    Summary:

    • Deferred Acq Cost overcapitalization:                   $199-252m
    • Contingent Consideration Reversals:                     $136m
    • Acq'd distribution / classification of intang:        $47m
    • Luxembourg DTL Reversal:                                          $23m+
    • Total:                                                                                    $405-458m+ (2012 Net Income: 178m)

     

    In the case of the DAC overcapitalization, I think there is a real risk that AFSI is in violation of the "matching principle" (match the recognition of the expenses incurred to generate revenue with the recognition of that revenue).

     


    SubjectAFSI responds to shorts (in progress)
    Entry12/16/2013 05:11 PM
    Membermrsox977
    http://ir.amtrustgroup.com/eventdetail.cfm?eventid=138493

    SubjectNGHC Restatement - will AFSI follow suit?
    Entry02/12/2014 02:01 PM
    MemberFrancisco432
    Related party NGHC restated financials for accounting "errors" in recently filed S-1/A filings.
     
    AFSI still accounts for them the way NGHC did before the restatement, and they share an auditor...will AFSI restate for the same issues?
     
    https://www.dropbox.com/s/p9ljy7s9fm4te17/Will%20AFSI%20Have%20to%20Restate%20Earnings.pdf
     

    SubjectRE: NGHC Restatement - will AFSI follow suit?
    Entry02/13/2014 10:38 AM
    Membermrsox977
    The party continues for the AFSI folks. Growth, favorable loss trends, and nothing but blue skies. Any reactions to their detailed call This am?  Seems to be some short covering going on. 

    SubjectAFSI comments re: Lux support bearish view
    Entry02/20/2014 03:39 PM
    MemberFrancisco432
    Schedule Y, Stop-Loss & Financial Reinsurance...AFSI's comments support bearish view.
     
    https://drive.google.com/file/d/0B86krX6VxmmWUVU2UnN6UkVTb0k/edit?usp=sharing

    SubjectRE: AFSI comments re: Lux support bearish view
    Entry02/20/2014 03:50 PM
    MemberFrancisco432
    Correcting minor typo. Updated version:
     
    https://drive.google.com/file/d/0B86krX6VxmmWS2tDR01Sem9NWmc/edit?usp=sharing

    SubjectRE: AFSI 2014 Proxy
    Entry04/14/2014 01:07 AM
    Membermrsox977
    great catch.  almost equal to their comments at the JP Morgan Insurance Conference a few weeks back when asked to explain how the Lux Reinsurer works.  "People say we use this vehicle to hide losses.  Believe me, if there were a way to hide losses, we... What I am saying is, there is no such thing as hiding losses."

    SubjectMany reasons to be short: great piece in Barron's
    Entry06/01/2014 09:54 PM
    Membermrsox977

    May 31, 2014 1:35 a.m. ET

    AmTrust Financial Services has turned heads in the property and casualty insurance business with its dramatic growth, exceptional margins, and acquisitive ways. Revenue doubled in its latest quarter to $1.1 billion, lifting the stock 10% to $42.70. Wall Street has awarded the family-run business a multiple of 4.3 times its tangible book value, in an industry where the average is around 1.4 times. That's just one of several ways AmTrust seems to be defying insurance industry norms.

    From a skyscraper in lower Manhattan, AmTrust (ticker: AFSI) is piling up premium revenue to a height well above its base of tangible capital. The March quarter's premium revenue, if annualized, was more than five-times tangible book value, compared with just 1.4 times at insurance veteran W.R. Berkley (WRB). Policyholders and investors could have more confidence in AmTrust's capital footing if the insurance group's financial statements squared with each other.

    AmTrust insists that it's "adequately reserved," but the acquisitive insurer's accounting contains several puzzling gaps. That hasn't stopped the stock's rise.Photo: Jenna Bascom for Barron's

    But they don't. Multimillion-dollar incongruities appear in AmTrust's various securities and insurance filings, for example, in inconsistent loss reserves that have the effect of flattering earnings and capital. That's worrisome, because poorly controlled reserving can prove to be a snakebite to an insurer if growth slows–triggering a double whammy as underwriting losses demand new capital while rendering earnings less attractive to investors. If AmTrust's accounting is found wanting, its tangible book multiple could drop back to the industry average of 1.4, bringing shares down below $15.

    The company denies there's a problem. "AmTrust is more than adequately reserved," says investor relations head Beth Malone. "Our reserves also are reviewed for sufficiency regularly by our auditors and outside actuaries."

    Aggressive premium writing and acquisitions led to grief for other casualty insurers that, for a time, showed dazzling returns on equity, including Australia's QBE Insurance Group (QBE.Australia), Meadowbrook Insurance Group (MIG), and Tower Group International (TWGP). Shares of Tower toppled 90% in the past year after the insurer confessed it was underreserved and undercapitalized, meaning it lacked wherewithal to meet anticipated claims.

    As it happens, some of AmTrust's latest growth came from acquiring parts of the Tower Group, in league with a private company controlled by the Karfunkels, the clan that controls more than half of AmTrust shares. Their deep pockets and reputation for opportune investing have given AmTrust stock its appeal. The families of Michael, 71, and George Karfunkel, 66, control two other publicly traded insurers that trade with AmTrust, namely Maiden Holdings (MHLD) and National General Holdings (NGHC), that together with AmTrust have an aggregate enterprise value above $6 billion.

    Earnings surely look good. In the 12 months through March, the company reported that its net income totaled some $3.90 a share–making shares of the business appear fairly priced at 11 times earnings. Those earnings, however, come mainly from insuring property and casualty, which is known to have a "long tail." That is, claims can be reported or litigated years after they arise, confounding what seemed like a profitable underwriting record. When that happens, profits can prove to be figments of aggressive premium writing and underreserving for loss.
    Enlarge Image

    Is that the case with AmTrust? Questions about whether the company is underreserved arise because of some puzzling accounting disparities: AmTrust and Maiden Holdings show a $400 million difference in their accounting for the same reinsurance activities; AmTrust's numbers for acquired reserves differ by $50 million in different parts of its financial reports; while the latest 10-K's tabulation of loss reserves leaves AmTrust with negative reserves for some years—an impossible accounting that would mean that policyholders would actually pay AmTrust millions for claims in those periods.

    AmTrust's reserve puzzles have gone largely unremarked by Wall Street analysts, or by insurance industry raters at A.M. Best who have consistently awarded top ratings to the insurer and its affiliates. A.M. Best analyst Brian O'Larte says he has no concerns about AmTrust's reserves.

    THE REINSURANCE RELATIONSHIP between AmTrust and Maiden is substantial, with AmTrust passing along 40% of most premiums and losses to Maiden. Yet AmTrust's year-end balance sheet showed about $1.9 billion in assets receivable from Maiden, while the latter's balance sheet reported corresponding liabilities due AmTrust to be worth less than $1.5 billion. That $400 million variance seems to lie mainly in the companies' different reserve estimates for policyholder losses not yet reported to the insurers. But such a large disagreement invites the question of whether Maiden is understating its liabilities or AmTrust is overstating its assets.

    Maiden Investor Relations V.P. Noah Fields says that timing differences in the companies' balance sheets account for 40% of the variance. Maiden's financial statements appropriately reflect the AmTrust reinsurance relationship, he says.

    AmTrust's Malone says both sets of books are correct, with the difference arising from the fact that Maiden estimates yet-to-be-reported losses independently of AmTrust. Maiden must post collateral for its reinsurance obligations, she notes. That's an interesting point, because collateral reported by Maiden only seems sufficient by Maiden's count (the two insurers' contract requires collateral that's 102% of Maiden's liabilities) but appears insufficient by AmTrust's accounting, as we show in the chart on this page. Maiden's Fields says his firm's collateral is sufficient.

    There's also the nearly $50 million difference between the $808 million that AmTrust reports for the total net reserves it picked up in last year's acquisitions and the $761 million sum of gross reserves for each acquisition. The latter number is closer to what AmTrust's balance sheet and cash-flow statement imply about the reserves it acquired, which raises the question of where the other $50 million came from and whether it should have been charged against earnings and book value.

    Malone attributes the difference to the activities of an AmTrust reinsurance captive in Luxembourg, which doesn't address why the transactions don't otherwise appear in AmTrust's financial statements.

    Insurance investors usually study a company's annual tabulation of loss reserves for each year. But, as noted, AmTrust's 10-K indicates that its reserves remaining after claim payments for all the years up through 2007 are $95 million more than the amount for those years plus 2008 -- which if correct, would indicate that policyholders will pay AmTrust that $95 million on the 2008 incidents.

    Malone says the fault is in our analysis, not the 10-K. But the same analysis was used in an April industry study by AmTrust investment banker FBR Capital Markets.

    Loose accounting would only add to concerns about AmTrust's underwriting rigor, given the evidence that the insurer picks unusually low estimates for its eventual losses. Compared with peers in workers' compensation insurance, where AmTrust gets half its revenue, the company ended up paying out a higher percentage of its original estimate for losses on accidents in the years 2006 through 2012, according to an analysis of the industry's "paid-to-incurred" ratios in FBR's April report.

    AmTrust's workers' comp business is low risk, notes Malone, and it is receiving "solid rate increases in almost every state."

    ON AMTRUST'S MAY 1 conference call discussing March results, Chief Financial Officer Ron Pipoly told investors that the insurer's net written premiums for the year would be less than 1.5 times "total capital"—a modest-sounding ratio that's close to the premium leverage that other companies show on their statutory capital. But Pipoly's measure of AmTrust total capital includes exceptional levels of goodwill, intangibles, and other unspendable assets that regulators in most states don't count toward statutory capital.

    Since AmTrust doesn't report its consolidated statutory capital, we've attempted to adjust its balance sheet to approximate the rigors of statutory capital, by including debt and excluding unspendable items such as goodwill, intangibles, prepaid assets, deferred costs, and netting for tax effects. With that approach, AmTrust's net written premiums for the 12 months through March exceeded its spendable capital by almost four times. Comparable insurers, like W.R. Berkley, averaged premium leverage of 1.3 times by the same measure.

    The cantilevering of AmTrust premiums over its capital base is notable, because that base contains an element that differs from most American property and casualty insurers. AmTrust's local insurance units cede over half of their premiums and losses to the company's wholly owned "captive" reinsurer in Bermuda (which, as noted, then cedes risk to Maiden).

    State insurance filings of AmTrust units show that the Bermuda captive has lost about $400 million under its reinsurance agreements with its AmTrust counterparts in the last five years. The Bermuda unit's regulatory capital fell last year from $499 million to $416 million, a level just over two-times the minimum required for "solvency" under Bermuda's relatively lenient standards. By contrast, Maiden ended the year with more than four times Bermuda's capital requirement.

    AmTrust's Bermuda unit is more than adequately capitalized, says Malone, and its numbers shouldn't be compared with those of any other reinsurer. That's because it reinsures only stable, predictable risks, she says.

    In its 2013 10-K, AmTrust disclosed that three of the company's U.S. subsidiaries have triggered four or more warning flags in the IRIS database operated by the National Association of Insurance Commissioners. IRIS readings indicate abnormal financial ratios at those insurers, which AmTrust attributed to its reinsurance structure.

    AmTrust clearly has its own ways of counting. As Barron's previously reported ("An Insurer's Feat: Turning Losses Into Gains," Feb. 10, 2014), AmTrust and its sister company National General have enhanced their operating margins by making more than $200 million in underwriting losses go unreported to investors. It did that by sending the losses to wholly-owned Luxembourg reinsurance companies. After our story, the AmTrust restated its past financials to remove the operating profit boost. Before National General's recent initial public offering, the Securities and Exchange Commission challenged its accounting for the Luxembourg transactions and National General restated its financials, while admitting in its SEC correspondence that its unusual Luxembourg accounting was "counterintuitive." Businesses designed to lose money, like the Luxembourg reinsurers, had never been "contemplated by the accounting literature," the insurer told the SEC.

    Perhaps AmTrust and its sibling companies are just smarter than everyone else in the business

    Subjectnew article asserts more Karfunkel shenanigans
    Entry08/20/2014 11:48 AM
    Membermrsox977
    In case you did not see this one.
     

    Subjectnew actuaries may not be so kind to the reserves
    Entry09/19/2014 12:22 AM
    Membermrsox977
    By letter dated September 12, 2014 (the “Approval Letter”), the New York Department of Financial Services (the “Department”) approved ACP Re Ltd.’s (“ACP”) acquisition of Tower Group International, Ltd.’s (“Tower”) New York insurers. Because AmTrust is affiliated with ACP through common ownership, the Approval Letter notes the significant recent growth in AmTrust’s gross written premium and the likely further future growth resulting from its participation in transactions related to ACP’s acquisition of Tower, and states as follows:

    “ Moreover, the Trust [the 2005 Michael Karfunkel Grantor Retained Annuity Trust, which owns more than 10% of the issued and outstanding common stock of both ACP and AmTrust], as a controlling shareholder of AmTrust, which has recently experienced a significant growth in its gross written premium and will likely experience further future growth from its participation in the transactions resulting in connection with the Merger [the merger of Tower into a subsidiary of ACP], has indicated to the Department that it will cause AmTrust to take the following actions:

       
    1.
    In accordance with an actuarial plan (the “Plan”) submitted to and approved by the Department, AmTrust will strengthen its actuarial resources to ensure by year-end 2015 that its actuarial scale and capabilities are commensurate with its size. This will entail both hiring more actuaries, and ensuring that those currently on staff are adequately credentialed. Further, in accordance with the Plan, AmTrust will better institutionalize the role of its internal actuaries by creating a Global Chief Actuary position, as well as Global Chief Reserving and Pricing Actuaries, all of whom will be integrated into AmTrust’s executive management team.

       
    2.
    For the year ending December 31, 2015 and thereafter, AmTrust will cause its insurance company subsidiaries to maintain, in the aggregate, a ratio of net written premium to surplus of 3 to 1. Net written premium shall be net of reinsurance, including business retroceded by AmTrust International Insurance, Ltd. (“AII”) to Maiden Insurance Company, Ltd., a Bermuda insurer and an affiliate of the Applicants [ACP and affiliates], AmTrust and National General Holdings Corp. In support of the foregoing, AmTrust shall, subject to regulatory approval, modify its current intercompany reinsurance structure by reducing the quota share cession to AII to 60% effective January 1, 2015 and 50% effective January 1, 2016 and thereafter.

       
    3.
    AmTrust will cause the intercompany receivables included on line 4 of AII’s 2013 statutory balance sheet to be paid down on or before December 31, 2015, with at least 50% of the amount to be paid on or before December 31, 2014. The method(s) by which these receivables are paid off shall be subject to the review and prior approval of the Department.

       
    4.
    In light of AmTrust’s growth and increased geographic footprint, AmTrust will engage an external auditing firm with corresponding global resources and skills beginning with the audit for the annual period ending December 31, 2015. Before the engagement is undertaken, the selection of the auditing firm shall be subject to the review and prior approval of the Department.

       
    5.
    AmTrust shall, beginning with the month ending September 30, 2014, and for a period of not less than three years, provide to the Department any and all financial information as the Department may request.”

    SubjectNew S.A. piece has $0 price target..
    Entry10/31/2014 12:40 PM
    Membermrsox977
    New S.A. piece has a $0 price target.  Plus, Insurance Insider just reported:
     
    AmTrust breaks with $500mn Italian med-mal distributor
     
    31 October 2014 
     
    Nasdaq-listed insurer AmTrust's relationship with Trust Risk Group, the sole distributor for its $500mn Italian medical malpractice business, has broken down under acrimonious circumstances, The Insurance Insider understands. AmTrust has given notice that it intends to sever the agreement and both parties allege that they are owed significant sums by the other. Trust Risk intends to pursue AmTrust in the Milan courts for EUR500mn ($629mn) in earnings the broker expects to lose over the 11 remaining years of the agreement.

    SubjectGoodwill Impairment in Luxembourg - annual test in 4q. Any guesses on magnitude?
    Entry12/10/2014 02:32 PM
    MemberFrancisco432

    Their valuation methodology for testing purposes is "interesting".


    SubjectAlistair Capital letter to AmTrust's audit committee re: accounting policies
    Entry12/19/2014 10:51 AM
    Membermrsox977

    http://static.squarespace.com/static/539cd868e4b03fddcc16ee43/t/5494142ee4b041d6f14ddcc4/1418990638798/Letter_to_AmTrust_Audit_Committee_FINAL.pdf


    SubjectAFSI finds deficiencies, delays quarterly report filing
    Entry11/11/2016 02:21 PM
    Membermrsox977

    the canary we have all been waiting for?  $4.5b in equity cap on "maybe" $2-$2.5b of real book value.


    Subject10K Etc
    Entry04/11/2017 10:20 AM
    Membersingletrack

    Some interesting results from looking at their reserves.  On the 4Q call they said that they took a 65m reserve charge (which was presumably for prior years b/c they said in their press release: “reserve charge of 65m primarily related to strengthening of prior year losses”).  But, in 10K today, they actually took a $258m charge for prior-year development and offset that with a $193m release for the current accident year (which means they believe they reserved too high in the first three quarters of 2016). 

    So, when you net out the prior year losses of $258m from the current calendar year loss ratio of 67.3%, that means they “picked” the current year at 62%.  That’s down from 66% initial pick last year which already developed negatively by 2% to 68%.  So they are picking 6% lower than last year. 

    And the industry (all lines) picked 2% higher.  That 8% difference from the industry would be $375m (pre-tax) or ~30% of tangible equity.  

    I also noticed this new disclosure in the risk section, referring to cross-defauls and acceleration of other debt:

     

    “In addition, we have entered into joint ventures that are encumbered by outstanding indebtedness that contain similar covenants for which our joint venture partners and we provide guarantees and for which we retain joint and several liability. Our inability to comply with these covenants or meet these financial ratios and deadlines could lead to a default or an event of default under the terms of our credit facilities, indentures or secured loan agreements, for which we may need to seek relief from our lenders and noteholders in order to waive the associated default or event of default and avoid a potential acceleration of the related indebtedness or cross-default or cross-acceleration to other debt.”  

     

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