Description

ACAP is a medical malpractice and workers compensation insurance company that trades for half of tangible book value and should be profitable by the first quarter of next year, at which time I expect it will trade for about book value, as does its competitor PRA.

ACAP is headquartered in Michigan, with operations in 13 states. 62% of revenues come from medical professional liability, 28% from workers compensation, and 10% “other” (mainly the company's Health Lines Business). The company has a strong franchise in the Midwest, so it is focusing on strengthening its position in these areas, and withdrawing from unfavorable states such as Florida.

ACAP de-mutualized in December of 2000 and then one year later had to strengthen reserves. This reflects poorly on management, and they know it. After extensive changes in operations and underwriting during the past year, ACAP is projecting a return to profitability by the end of this year.

The management team is highly focused on underwriting discipline and intelligent capital allocation. Regarding the former, they have re-examined every piece of business they write, lowered the maximum policy limit to $2mm from $10+mm, ceased writing stand-alone policies for hospitals, exited the unprofitable Florida market, ceased writing occurrence policies in most markets, and ceased writing construction policies. They have combined this improved underwriting with significant increases in premiums (30% for med mal and 15% for workers comp). Consequently, this year net earned premiums are up 17%, due almost entirely to rate increases rather than policy count growth.

ACAP has bought back shares aggressively, reducing diluted shares outstanding by 25% since June 2001, from 11.6mm to 8.7mm. With $276.8 mm of tangible book value, ACAP now has $31.84 a share of tangible book value.

Historically, this has been a terrible business. The problems of the industry are due to several factors, including: 1) In the mid 1990's ACAP and many of its competitors expanded beyond their home markets into states that they did not understand well; 2) This simultaneous expansion caused an increase in competition and hurt pricing; 3) Significant increases in claim severity hurt all industry participants; 4) After 9/11, reinsurance rates rose more quickly than primary insurers could raise their rates, hurting margins. These factors combined to cause the entire medical malpractice industry to suffer large underwriting losses that lead to a major industry restructuring.

For example, one of the largest med mal insurers, St. Paul, exited the business, which caused dislocations, pricing improvements, and new regulatory attention. It also added momentum to the tort reform movement that is underway nationally. According to ACAP, there are signs of progress in this area:

--In April, the Pennsylvania senate sent a resolution to the Supreme Court urging the reinstatement of tort reform provisions ruled unconstitutional in 1996. In July, Governor Schweiker signed into law legislation that is designed to save doctors as much as 20% on their malpractice insurance premiums effective immediately, which included a provision eliminating joint and several liability.

--Ohio legislators recently introduced a new bill (SB 281) that would limit non-economic damages to $300,000. The bill also allows juries to hear evidence of collateral source payments and includes a sliding scale for attorneys’ contingent fees.

--Nevada recently passed a bill placing a $350,000 cap on non-economic damages.

An important issue to be aware of is the related party transactions between the company and an insurance agency owned by the CEO. In 2001, 29.9% of the direct premiums written by the agency – equaling $68.9mm - were for ACAP policies. Additionally, the Company purchased the Stratton-Cheeseman Management Co. (SCMC), which was owned by Bill Cheeseman – ACAP’s CEO - in Oct. 1999 for $19.5 million, consisting of $9.5 million in cash and a commitment to pay $10 million in installments over the next 9 years without interest. This transaction took place because SCMC managed ACAP when it was a mutual and had no employees, so in preparation for going public, the company bought the people who had been managing the business via a service relationship.

Another potential risk, which must always be considered with an insurance company, is the potential for increased reserving. Considering the extensive changes that have occurred with their book of business over the past year, I think this is unlikely, and that the current valuation makes the risk worth taking.

In summary, ACAP has the right strategy for fixing the business, is executing superbly on this strategy and is using its strong balance sheet to buy back shares like crazy.

Catalysts
1) Return to profitability.
2) Continued share buybacks.

Catalyst

1) Return to profitability.
2) Continued share buybacks.