Description

Overview: American Physicians Capital (ACAP) is primarily a writer of medical malpractice insurance and workers comp. ACAP started out as a mutual insurer in 1975, then called MICOA, operating in Michigan. It was formed by physicians who had difficulty in obtaining med mal insurance because many carriers had pulled back after years of escalating costs (i.e., big lawsuits). In 1996, they acquired a Kentucky med mal insurer, KMIC, and also began writing workers comp coverage, primarily to hospitals and physician groups. In 1999, they began expanding their Ohio and Florida businesses. On 12/8/00, an initial public offering of 10.3M shares at $13.50 was performed.

Earnings: For 1999, their revenues were $187M, including $31M in investment income (II), expenses of $177M, tax credit of $23M for NOI of $33M. For nine months of 2000, pro forma revenues are $162M, expenses are $150M, tax liability is $3.4M for NOI of $8.8M, which may be reduced by $1.1M for employee stock compensation. An EPS of around $1 and a price of $15 may seem like ACAP is no bargain. The key question is what will 2001 EPS be? ABN AMRO estimates 2001 EPS of $1.95. Since they underwrote the IPO, we need to see the drivers behind that. ACAP has begun to consolidate some operations from KMIC, as well as to restructure themselves as a stock company focused on the shareholder. They estimate annual savings to eventually reach $2M. However, some of that is offset by increased expenses associated with buying out the management company SCMC, specifically $1M in annual amortization costs, plus payments. Med mal rates have been raised, but premiums for that line are flat, reflecting a competitive market and underwriting discipline by ACAP. ACAP does retain 81% of their business, which is very good. They are exiting some unprofitable lines (health, personal), as well. They should see further improvement to the bottom line of about $0.25.

Investment Income: an essential component of revenue is investment income. With over $600M of investable assets, ACAP can easily generate $30M in II at 5%. Insurance regulations do dictate the types and quality of investments. The preference is towards high quality bonds, which make up 80% of the portfolio, with the remainder in stocks, mortgage loans and real estate. They are currently reallocating the bond portfolio to emphasize corporate issues in order to improve the return. If they can improve return to be more like their peers (5.5-6%), then they can add $3-6M or $0.30-$0.60 to EPS.

Reserves: Another favorable trend is loss development. Prior to 1996, ACAP discounted reserves, which is an accepted practice of reducing reserves to reflect to the present value of future payments (in effect, reducing reserves to reflect the impact of investing and growing these monies). By not discounting, ACAP took a more conservative reserving approach. Their accident year development has been favorable the past several years. Ernst and Young reviewed and certified ACAP's reserving as of 12/31/99. Standard & Poor has assigned ACAP an “A” rating. AM Best currently assigns them their 4th best rating, “A-“, out of a possible 15; AM Best has upgraded ACAP twice since 1996.

Combined Ratio: This is a general measure of the P&C industry, where under 100 is considered good. Last year's combined ratio was 117.2 and through the first nine months of 2000, it is running at 109. In the prospectus, ACAP presented combined ratios for each line of business, and med mal is at 100, work comp at 109 and the lines they are exiting are over 130. Since ACAP is dealing with long-tail lines, operating ratio is a better indicator, because it factors in investment income, whereas combined ratio does not. ACAP's operating ratio for 1999 was 98.1% and through 9/00, it is at 90%. ACAP's margins are improving, which could $0.50 or more to EPS.

Insurance: Over 80% of the med mal business is on a claims-made basis, which has a shorter tail than occurrence. A claims-made policy covers claims filed in a particular year, whereas occurrence covers any incident that occurs in that year, even if a claim isn’t made until years later. Prior to the 70’s and 80’s, most liability policies were on an occurrence basis, which proved detrimental to insurers. Many national carriers fled the smoldering ruins of med mal insurance, leaving the market to little operations that typically only wrote med mal in one state. The 90’s saw a positive step occur in the market, where a number of mutual med mal insurers converted to stock companies. During this time, a number of mergers took place and other lines were entered, as these insurers attempted to diversify and spread the risk. This is now a maturing line, and I would expect it to favor consolidation among med mal writers.

Market: In 1999, med mal written premium was $5B, of which ACAP has a 2.4% share. St. Paul is the top writer with about 6.7%, but they have cut writings by almost 40% since 1995. ACAP is the top writer in Michigan and Kentucky, and is number two in New Mexico. While not a national powerhouse, ACAP dominates in some favorable markets. It should be noted that med mal insurance can also cover hospitals, clinics, EMTs, nurses, technicians, etc, but ACAP specializes in covering more than 13,000 doctors.

Reinsurance: This is a very important to ACAP. Given their small size, a large loss would adversely impact them, and reinsurance helps them control large losses. Reinsurance is sometimes referred to as insurance on insurance. A parallel could be made to lenders who securitize loans, where some of the risk is transferred to another entity. ACAP retains only $500,000 of any one risk, and reinsures the rest.

Book Value: ACAP had RP Financial render an opinion for the IPO. Their valuation consisted of retained earnings of $222M, plus whatever the IPO netted. At $13.50, the book value was $344, or 38% of book. At $15, ACAP is trading at about 44% of book. Although P/B is not as set a figure as with thrifts, ACAP’s current P/B is well under its peers, which are trading around a P/B of 1.0.

Non-Insurance Operations: ACAP also does risk management consulting (i.e., advising on ways to reduce liability and prevent losses) and alternate risk transfer (ART). These are relatively new operations, so it is difficult to evaluate how significant the fees generated from these businesses will be. ART allows a customer to set-up their own insurance company, or “rent” one from ACAP, who manages the company on behalf of the customer.

Cons: Med mal is like dynamite – very useful to the knowledgable and utter disaster in the hands of fools. ACAP seems to have capable management that has been there since inception. Obvious downside is that as they approach retirement, what kind of bench strength do they have to manage ACAP in the near future? Another concern is that the CEO owns 79% of an agency that accounts for 59% of the business. A sudden departure of the CEO could impact ACAP. Finally, whereas ACAP was originally created in a market with little competition, the current market is more competitive, which is always a concern on whether pricing is adequate.

Catalyst

1. Improving margins (+$0.50 to EPS).
2. Increased investment income (+$0.30 to EPS).
3. Exiting unprofitable lines (+$0.25 to EPS).
4. Low book value relative to peers.
5. Increased capital to write new business.
6. Stated desire of management to expand through acquisitions.

While none of the above reasons is extraordinary, the cumulative effect should result in higher EPS, and a PE multiple more inline with its peers.