Long time members of this forum will remember my disastrous call on Kingsway Financial Services (KFS), a hodgepodge of insurance risk taking and fee generating businesses that ended up being a snake pit of value destruction.  The Kingsway Linked Return of Capital units fared a ton better, and I was happy to redeem myself, and fellow investors in a security that still, to this day, offers decent upside and current interest income with a reasonable level of downside protection depending on what you believe.  But it’s my final installment in the Kingsway Trilogy, if you will, that I hope will fully redeem me for the losses on the original KFS recommendation.  That installment is Atlas Financial Holdings Inc.

Based in Chicago, Atlas is a niche writer of commercial auto insurance focused on taxis, non-emergency paratransit, limo / livery and business auto.

Atlas was formerly a part of Kingsway, the NYSE listed insurance entity referenced above that was the subject of a Stilwell Value Partners activist campaign gone awry.  Kingway's entire Board and Management had been replaced by the time the activist got de-facto control of the Company and rampant asset sales started in order to relieve the business of significant risk and to free up liquidity.  When Kingsway lost its AM Best rating amidst a tumultuous series of downgrades and write downs, Atlas had to phone up its agents and tell them to stop writing new business.  The Company, which formerly had written ~$100m in premium, was now closer to a ~$20m run rate.

Kingsway knew that Atlas was a diamond in the rough, and decided to hold on to most of it.  Kingsway's Investor Presentation from last November illustrates the steps Kingsway took to shed assets and what it is today: 

 

https://www.kingsway-financial.com/c/document_library/get_file?p_l_id=30128&folderId=248327&name=DLFE-2715.pdf

In order to separate the Atlas business from the much maligned Kingsway name, Kingsway spun part of Atlas out in January 2010 into a public shell listed in Canada.  Kingsway received $57m of consideration broken out as: $7.9m in cash, $18m in Preferred shares, and $31.1m of common (restricted) shares.  The "IPO" was done at $2.00 and Atlas Management put up new money to take an ownership stake as well.  Kingsway's ownership amounts to 75% of the Company through a class of restricted shares (restricted as in their votes are limited so as not to trip up control issues).

CAPITAL STRUCTURE

The capital structure is as follows (as of June 5, 2012):
Price: $1.77
Shares out (breakdown):
Restricted (owned by NYSE: KFS):  13.804861m
Non-restricted:  4.628292m
Total:  18.433153m
Market Cap: $32.6
Preferred: $18**
Enterprise Value:$50.5

TANGIBLE BOOK VALUE

As of March 31, 2012:
Total Shareholder’s equity: $56m
Less Preferred liquidation: ($19m)
Common Equity:  $37.448m
Total Common Shares:  18.433153m
BVP common share before any dilution:  $37.448m/18.433153m = $2.0315  (87% of tangible book)

 

Once again - based in Chicago, Atlas is a niche writer of commercial auto insurance focused on taxis, non-emergency paratransit, limo / livery and business auto.  Atlas' agency force produced more than US$100 million of premium prior to KFS de-emphasis of commercial auto lines.  Recapturing this business will support above average growth without compromising underwriting profit.  Atlas is licensed in 47 states in the United States with emphasis on the Midwest, and predominantly Chicago.  They write ZERO, as in nada NYC Yellow Cab insurance.  As a separate entity, Atlas' capital base will allow it for significant growth without the need for incremental capital. 
Its A.M. Best rating upgrade to “B, Stable” from “B-, Under Review” in 2010 is a testament to its progress, and with a greater history of underwriting results as a separate entity, further ratings upgrades could materialize.

In general, Atlas is well positioned to:

 

- Recapture business lost in recent years under former owner.
- Leverage strong insurance company brands in niche markets.
- Build on expansive base of licenses through organic growth and bolt on acquisitions.
- Grow book value using existing resources and expertise.

 

Atlas' core competencies in this segment of the marketplace include:

- Niche underwriting.
- Unique claims handling attributes.
- Business specific service needs.
- Strong risk management support.

 

Looking at the last 18 months of results for Atlas are misleading.  The Company retained all of its employees post spin out in hopes of growing back into its former self, thus its losses were due to it being subscale.

Since the spinout, Atlas has:

- Grown premium in their core business.
- Renewed business at higher rates.
- Monetized a fairly large real estate portfolio (At the time of the spinout Atlas had $15.9 million in real-estate on its balance sheet.  This number is <$200k today).
- Received a B rating from AM Best and distanced themselves from the shadow of the old Kingsway.
- Hired an investor relations firm for the first time in Company history.

 

 

People get nervous when they hear "taxi insurance" and that's what makes Atlas an interesting idea.  If you know what you are doing in this business and you price the risks right, the returns can be lucrative.  It's the specialized knowledge of the markets, the large data set of underwriting results, and the proprietary systems and tools for handling claims that can make this segment interesting.  Historically, the underwriting performance for the commercial auto industry has been more favorable during hard markets compared to the total P&C industry.  During the hard market of 2002-2005, the commercial auto business loss ratio outperformed the total P&C industry by an average of 8.0% per year with an average loss ratio of 68.0% while the total P&C industry averaged 76.0%.

 

A soft economy can actually help Atlas as cabs take less trips yet continue to pay for insurance.  When driving a taxi is your livelihood and you are paying for a medallion, you would be foolish to simply pay your fixed overhead without getting on the road to try and mitigate your costs no matter how little the activity may be  (unless of course gas prices exceeded your fare intake).  Atlas has strong expertise in modeling frequency and severity of claims and knows what to charge in order to price risks right.  Reinsurance (which is less than 3-4% of premium) covers catastrophic losses over $500,000.

 

 

Investors in any insurance company are buying a leveraged portfolio of cash and bonds in hopes that Management can underwrite to 100% or actually even earn an underwriting profit.  In the case of Atlas, investors must pay $32.6m in market cap for ~$130m of cash and securities, or almost 4x leverage.  This is an attractive entry point, especially as the Company grows into scale.

NOL

Atlas has a large deferred tax asset to shield future profits that I will ascribe no value to, however it exceeds $40m and should be useful in shielding profits.

FINANCIAL MODEL

Based on industry checks, public statements made by Management during the conference calls, and an analysis of trends in this segment, our assumption is that Atlas should be able to underwrite to a mid-high 90's combined ratio in a soft market and a low 90s combined ratio in a hard market.  The investment portfolio should be able to throw off 2.1%-2.5%.  The Company currently has only a run rate of $30-$40m in premium and needs to get to $50m to get back to scale.  I think this is achievable.  The good news is that given Atlas' current level of surplus, they won't need to raise new capital until they are writing $100m of premium.  By that time the 'float' will have grown substantially.  The tail on this sort of business is short and the duration of the bond portfolio is matched as such (3.25 years).  Atlas can indentify most claims within a year.

 

Illustration:

 

net written premium 2 yrs from now: $80m

loss ratio: 70%

other underwriting expenses: 25%

combined ratio: 95%

underwriting profit before tax: $4m

investment income (assumes 2.5% on current portfolio & ignores float): $3.25m

total profit before tax: $7.25m

after tax profit: $5m

return on common equity: ($5m / $37m) 13.5%

 

Value per share at:

 

1.1x book: $2.20 (26% upside)

1.2x book: $2.44 (37% upside)

1.3x book: $2.64 (49% upside)

 

Again, this ignores the tax asset and the substantial float that is generated between now and our sample $80m year.  What does this mean?  If Atlas writes $45m this year and $65m next year, the losses on that $110m of premium are not all paid out in the year that the premium is written.  Insurance gurus can ignore the "primer" here, but that is called "float" and that is what generates more investment income.  Atlas' claims are likely not fully paid out until at least 3 yrs, on average. 

 

As markets harden, price to book value multiples harden as well.  Many niche specialty insurers have traded at 1.5x book in better times.  I've only listed 1.1x - 1.3x to be conservative.

 

Some make take issue with the hypothetical mini-model above given the current financials and lack of meaningful results.  Think of Atlas as a start-up of sorts, valued at a start-up price, but with a long history, underwriting franchise and an existing infrastructure that would garner a better multiple if only it were to scale.  You have to take a step back and do your projections based on what you know about the industry and what you think losses will look like, etc. and draw something up like I have above.  Presupposing you believe that Atlas can march on its way back to $100m in premium, you can use a 92-100% combined ratio if you like and see what the ROE is.  If you think the ratio is above 100% then Atlas is fairly valued its current below book value price and you probably should not invest !

MARGIN OF SAFETY

 

Atlas' multiple state licenses, discount to book value, rated entity, brand names and systems provide a floor price for the stock in the 80% and higher of book value range absent an event where Management shows that they cannot write profitable business.  Given Management's skin in the game (CEO owns >400k shares that he paid for himself) and the early innings of a growth plan to recapture profitable business that they were literally turning away, I do not see sloppy underwriting as a short term risk.

 

Atlas offers investors an inexpensive way to participate in a hardening insurance market, in a historically leading sector (commercial p&c) and through a vehicle with multiple catalysts to win.  The biggest risk to Atlas would be the unavailability of profitable business to write in the marketplace that would hamper their plans to grow into scale.

 

note on the preferred shares
** Preferred shares are not entitled to vote and are beneficially owned or controlled by Kingsway. They accrue dividends on a cumulative basis whether or not declared by the Board of Directors at the rate of $0.045 per share per year (4.5%) and may be paid in cash or in additional preferred shares at the option of Atlas. Upon liquidation, dissolution or winding-up of Atlas, holders of preferred shares receive the greater of $1.00 per share plus all declared and unpaid dividends or the amount they would receive in liquidation if the preferred shares had been converted to restricted voting common shares or ordinary voting common shares immediately prior to liquidation. Preferred shares are convertible into ordinary voting common shares at the option of the holder at any date that is after December 31, 2015, the fifth year after issuance at the rate of 0.3808 ordinary voting common shares for each preferred share.

- Potential sell side coverage.

- Potential NASDAQ listing could attract a greater following.

- Greater liquidity if KFS were to sell their shares (I don't see this as 'overhang' risk in the long run).

- New investor relations function just announced.

- The Company recaptures the premium it once had and demonstrates strong results.

- A hardening insurance market and a return to strong p&c combined ratios.

- Rising rates would also help the investment portfolio (short duration portfolio can be reinvested at better rates).