Description

CRM Holdings (CRM) is a leading provider of a full range of products and services for workers’ compensation risk management. Said another way, CRM is a sleepy, boring and misunderstood insurance services, primary insurance and reinsurance Company that trades for 6.4x FY 2007e earnings and 5.7x my estimate of FY 2008 earnings. Despite a double digit return on average equity, the stock trades for 56% of its IPO price and at least 88% of its liquidation value. A combination of low market cap, a fairly concentrated shareholder base, "penalty box" status after coming public and over promising, and a lack of Investor/Public relations skills in properly explaining the story are the cause of its depressed valuation.

As of the time of this writing, the Company has a market value of $120m, long term debt of $44m and cash of $14.5m.

Throughout this write-up, I will pull various descriptions and information from the Company's 10-K, adding color or changing the format where I feel it appropriate to get the message across.

Background:

Headquartered in Bermuda, CRM HOLDINGS, LTD. was spawned out of the insurance brokerage roots of its CEO, Daniel Hickey. It was founded in 1999 to service New York State self-insured groups (I explain what a self-insured group is below). In 2003 CRM expanded to California and created its Reinsurance arm, Twin Bridges. The Company IPO'd in late 2005 at $13.00 per share and bought Majestic, a primary insurer in November of 2006. CRM's three businesses are detailed below.

1. FEE BUSINESS - SELF INSURED GROUPS (SIGs)
First it is necessary to understand what a SIG is. The operating principles behind group self-insurance are relatively simple. Members contribute into a fund, which is conservatively invested and tracked by policy year. The SIG pays each policy year's expenses (administrative costs, claims, etc.) from collected funds and retains any surplus from contributions and investments for those members who contributed to the group that year. Self-insurance groups are created by employer members to prevent injuries and to help pay for their workers' compensation benefits in a timely, efficient, and cost-effective manner. Employers insured through SIGs contribute to a fund that remains within the group’s control. Any money not spent to cover claims or operating costs is retained by the group and could potentially be refunded to the members.

CRM provides self-insured groups (SIGs) with a comprehensive range of services, including assistance in the formation of self-insured groups, underwriting, risk assessment, safety and loss control services, medical bill review and case management, general management and recordkeeping, regulatory compliance and, in New York, claims management services. CRM also acts as a broker by placing excess coverage insurance and any required surety bonds for the groups. CRM’s reinsurance subsidiary, Twin Bridges (which I will describe in a minute), insures a portion of this excess coverage. Revenues in this segment consist purely of fees paid to CRM for the services I have listed above. Industries represented by these groups include: Healthcare, Contractors, Transportation, Wholesale/Retail, Auto Dealers, Banks & Wineries.

At the end of 2006, CRM managed 2,482 group members (mainly in NY and CA), up from 359 group members at the end of the year 2000. Retention rates have been in excess of 95% in NY State (where the majority of the groups reside) and 97% in California.


WHAT DETERMINES THE FEES THAT CRM RECEIVES?
Fees in NY (w the exception of one group) are based on a percentage of the workers' compensation rates set by the NY Workers' Compensation Board that are attributable to the members of the groups that CRM manages. With respect to groups in CA and in TX (and that one group in NY), CRM's fees are based on a percentage of the premiums paid by group members. CRM also receives fees for medical bill review and case management services in addition to commission income from U.S. insurers for placing the excess coverage that the groups are required by law to obtain.

DISTRIBUTION
All of the business in this segment is generated by general agents and brokers. Given Hickey's history in the brokerage business, it comes as no surprise that CRM has relationships with several hundred general agents in NY and CA.

REVENUE AND EBIT FROM THE FEE BUSINESS SEGMENT DETERMINE ITS VALUE
Fee Revenue has grown from $20.8m in 2003 to $40.0m in 2006. On this revenue base, CRM earns anywhere from $4.5 - $5.5m in EBIT before central corporate overhead costs. Using the midpoint of this number, or $5m, and taxing it at 40%, I estimate that this business in the hands of an insurance brokerage or other financial services-type business is worth $30m, or 10x after tax recurring earnings of $3m. This equates to $1.85 per CRM share.

GROWTH
CRM is growing its fee business by creating SIGs for additional industries such as hospitals and manufacturers. As the business is extremely scalable, each new group under management adds significant operating leverage to the business.

2. PRIMARY INSURANCE BUSINESS - MAJESTIC
Through its subsidiary Majestic Insurance (“Majestic”), acquired for book value in November 2006, CRM is also a direct writer of workers’ compensation provides workers’ compensation insurance through independent insurance brokers and agents primarily to medium and large size businesses located in California. Majestic is also licensed as an insurance company in 15 other states, including New York, with active operations in Alaska, Arizona, Nevada, Oregon and Washington. In addition, Majestic has also historically provided workers’ compensation insurance under the U.S. Longshore and Harbor Workers’ Compensation Act, or the “USL&H Act.” Majestic’s experience in underwriting complex risks allows it to target potential accounts with attractive premiums relative to exposure, good employee relations and effective risk management policies. Majestic is rated A- by A.M. Best.

BACKGROUND: THE MAJESTIC ACQUISITION
CRM acquired all of the outstanding shares of Majestic's holding company for a total purchase price of $48.2 million. CRM USA Holdings, issued $36.1 million in junior subordinated debentures to a newly formed Delaware statutory trust subsidiary in connection with the issuance of $35 million of trust preferred securities used to partially finance the acquisition of Majestic. The balance of the purchase price for Majestic was financed through the sale of investments and the use of cash balances on hand of approximately $17 million.

Majestic's record prior to its purchase looks like this:
2006: Revenue of $72.5m, $6.7m in net income
2005: Revenue of $77.0m, $5.2m in net income
2004: Revenue of $75.8m, $4.4m in net income

WHAT MAJESTIC MEANS FOR CRM
The benefits of Majestic are significant for CRM as the hundreds of agents that CRM touches can now offer a first dollar, standard worker's comp product to its customers.


MAJESTIC - VALUATION
Majestic currently underwrites to just under a 100pct combined ratio, but should improve as it scales its premiums across a fixed expense base. Even though premiums in CA have been in decline for the last 3 - 4 years, claims experience has decreased at an even greater pace. Majestic reported $141m in reserves and $157.5m of invested assets at the end of December 2006. 93% of assets are fixed-income securities with 80% of these securities rated AA or better. Majestic should write ~$65m in premium this year and $80+m in premium next year. Publicly traded SEAB and ZNT, both workers comp players w significant CA exposure, trade at 1.4x and 1.8x book value, respectively. Let's give Majestic a discount for size and scale for the time being. If we take Majestic's $45m of book and put a 1.2x multiple on it, we get $54m, or $3.32 per CRMH share.

3. REINSURANCE BUSINESS - TWIN BRIDGES
Twin Bridges is a Bermuda exempted class 3 insurance company, incorporated in 2003. It reinsures a portion of the excess coverage provided to a significant majority of the groups that CRM manages. Since Twin Bridges began writing this excess coverage in December 2003, only eight claims have been reported and there have been no paid losses. It is in my opinion, the most misunderstood and most exciting element of an investment in CRMH.

The groups CRMH manages purchase excess workers’ compensation coverage from U.S. admitted insurers to cover claims that exceed a minimum level established by state law or regulation or by administrative determination.

Typically, managed groups purchase excess coverage for losses and loss adjustment expenses in excess of $500,000 per occurrence. This “excess coverage”’ purchased by the groups provides them with coverage for losses in excess of the $500,000 per occurrence liability typically retained by the groups up to a per occurrence limit. In addition, all of CRM's groups also purchase coverage to insure against the risk that a large number of claims will occur and result in losses that are each less than $500,000 and that the aggregate result of such losses could exhaust their resources. This “frequency coverage”’ is triggered in the event that the aggregate amount of losses and loss adjustment expenses during the coverage period exceeds a range from 90% to approximately 160% of the premiums paid to the groups by their members. If the frequency coverage is triggered, the reinsurer pays the next $2,000,000 of losses and related loss adjustment expenses of the group during the coverage period.

NOW PAY CAREFUL ATTENTION TO THIS: Since, the excess coverage must be provided by a U.S. admitted insurance company, which Twin Bridges is not, CRM typically would underwrite the coverage through a reinsurance contract with a “fronting” company. The “fronting” company underwrites the entire excess and frequency coverage to our groups and then cedes a portion, or layer, of the coverage to Twin Bridges under a reinsurance contract.

Until CRM's acquisition of Majestic in November 2006, Twin Bridges had been solely engaged in reinsurance contracts with NY Marine & General (ticker: NYM, 14x P/E, 1.4x P/B) as the “fronting” company. Following the acquisition of Majestic, Twin Bridges has entered into a reinsurance contract with Majestic. THIS IS WHERE THE TRUE VALUE OF MAJESTIC / TWIN BRIDGES RESIDES.

Twin Bridges reinsures 90% of the coverage which Majestic provides to the groups net of liability ceded to unaffiliated reinsurers (such as Hanover Re) and receives 90% of the premiums paid to Majestic by the groups net of premiums paid to unaffiliated reinsurers. ESSENTIALLY, CRM not only saves the egregious fees charged by former "fronting" Company NY Marine & General they are able to shift most of their insurance business' income into the tax free Bermuda domiciled company.


RISK MANAGEMENT AT TWIN BRIDGES
Twin Bridges’ liabilities under the quota share reinsurance agreement with Majestic, are capped at specific levels. First, for the excess coverage, Twin Bridges reinsures 90% of the losses and loss adjustment expenses in excess of the group’s retention (currently set at $500,000) up to a per occurrence limit of $2,000,000. For the frequency coverage, Twin Bridges reinsures 90% of Majestic’s policy coverage to the group up to $2,000,000. Twin Bridges allows Majestic a ceding commission of 15% on all ceded premiums to cover Majestic’s costs associated with the policies.

REVIEW OF THE REINSURANCE STRUCTURE
The easiest way to think about the way CRM is set up is as follows:

Old model (2003 - 2005):
first $500,000 of claims: responsibility of SIGs
$500,000 to $1,000,000: 50% Twin Bridges / 50% NY Marine
$1,000,000 to the Statutory Limit: Other Reinsurers

2006 Model (Twin Bridges had more capital to take on more risk)
first $500,000 of claims: responsibility of SIGs
$500,000 to $5,000,000: 70% Twin Bridges / 30% NY Marine
$5,000,000 $50,000,000: Other Reinsurers
$50,000,000 to the Statutory Limit: 70% Twin Bridges / 30% NY Marine

2007 and GOING FORWARD (most favorable)
first $500,000 of claims: responsibility of SIGs
$500,000 to $2,000,000: 90% Twin Bridges / 10% Majestic
$2,000,000 $50,000,000: Other Reinsurers
$50,000,000 to the Statutory Limit: Majestic

SO WHAT IS THE REINSURANCE SEGMENT WORTH?
Twin Bridges will write something in the $30m range in premium this year and sport a combined ratio in the 60% or better range. This $12m in profit before taxes is only taxed at 10% because of its Bermuda status. Net income should fall in between $10m - $11m. At a 10x multiple, this is worth $105m or $6.46 per CRMH share.

ADDING UP THE PARTS
Fee Business: $1.85
Primary Insurer: $3.32
Twin Bridges: $6.46

*** TOTAL VALUE: $11.63 per share (58% upside) ***

Mgmt Guidance for 2007 earnings (re-confirmed on 5/2/07): $1.10 - $1.20
As a P/E of my sum of the parts: 9.7x - 10.5x

haircut my sum of the parts by 15% and there is still a lot of upside in the stock.

MARGIN OF SAFETY: ANOTHER WAY TO LOOK AT THE BUSINESS
Assume for a moment that Majestic and Twin Bridges never wrote another policy and that the fee business was sold to a financial or insurance brokerage buyer. We already know that the fee business is worth $1.85 per CRMH share. How do we pull apart the balance sheet to see what the insurance entities are worth? I try and accomplish this task here by taking total assets and liabilities subtracting the elements related to the fee business. It is not difficult as the assets related to the fee business are mainly people.

Data as of Dec 31, 2006
Total Assets: $306.1m
Less:
Goodwill: ($2.6m)
Other: ($4.4m)
Long Term Debt ($44.11m)
Net Assets before Insurance Segments: $255m
Primary Insurance Claims: (Reserves of $142 x by 95% combined ratio - tgt over time) = ($135m)
Reinsurance Claims: (Reserves of $12m x by 60% combined ratio) = ($7m)
Accrued Expenses: ($14.7)
Reinsurance Payable: ($1.53m)
Unearned Premium (becomes an asset) $8.0m
Unearned Mgmt Fees (becomes an asset) $0.613
Total Value of non-fee businesses of CRM: $105.4m
Shares Outstanding: 16.247
Value per share: $6.49

To recap: Fee business of $1.85 + insurance business of $6.49 = $8.34 per share, or 13.4% above current levels.  This means that the market is basically saying that CRM is worth more dead than alive.  I disagree.


RISKS / FACTORS CONTRIBUTING TO THE DEPRESSED VALUATION
I see the risks to an investment in CRM and the factors that have depressed its valuation to date as being very similar. I will attempt to list them in least-most risky / chronological order.

- In CRM's first earnings even as a Public Company, they disappointed investors by guiding below consensus. As a newly public company, they have yet to set investor expectations properly and meet those expectations.

- California Worker's Comp. As touched on earlier, rates in California have been on the decline, yet it is at a point now where things should be stabilizing. If the Company can produce decent fee income and insurance returns during a depressed rate environment, they should be able to do a lot better as the market hardens. Again, even though rates have gone down, claims have gone down as well.

- Dan Hickey share sales (source of recent weakness in the shares). In an unfortunate case of BAD PUBLIC RELATIONS, on May 21st, (and revealed in an 8-K) Dan Hickey entered into a pre-arranged stock trading plan under Rule 10b5-1 for the "purposes of financial planning and asset diversification". Hickey, who currently holds 1,539,691 shares or approximately 9.7% of the Company’s total outstanding common shares, may sell up to 195,000 shares from May 22, 2007 through December 31, 2007, with no more than 65,000 shares sold in any one quarter, except for certain carry-forwards if shares are not sold in prior quarters. If the full amount of shares is sold pursuant to the plan and no transactions take place outside the plan, Hickey will remain the beneficial owner of over 8.5% of the Company’s common shares based on the number of Company common shares currently outstanding. In addition, two members of the Company’s Board of Directors, Daniel G. Hickey, Sr. and David M. Birsner, and the Company’s General Counsel and Secretary, Louis J. Viglotti, also entered into separate 10b5-1 trading plans on May 21, 2007. Under the plans, Mr. Hickey, Sr., Mr. Birsner and Mr. Viglotti will sell up to 99,000, 100,000, and 195,369 shares, respectively, of the Company’s common shares and were entered into for the purposes estate and financial planning and asset diversification.

When asked about the sales, the word from the Company was that Viglotti is undergoing a personal issue and that Hickey needs to be below 10% or he risks being subject to taxation under the “controlled foreign corporation” rules. If you read the 10-K there is some merit to this. Through incentive stock, Hickey would go over 10% so it makes sense for him to sell down. If would have been nice if CRM did a press release reiterating Hickey's commitment and belief in the business as opposed to the 8-K we got which detailed the share sales. All I can say on that note is welcome to small-cap land. But wait...

SHARE SALE PLAN TERMINATED AFTER INVESTORS COMPLAIN
** Jim Scardino, the CFO, made a special trip to NY following the investor backlash from this 8-K to comfort investors that nothing has changed in the business whatsoever. After hearing investors' concerns, Hickey filed an 8-K ending the share sale plan.** This was an important sign in my opinion that management is willing to communicate with shareholders and listen to their concerns.

- The last risk I will mention is liquidity. Only 54,000 shares a day trade on average.

FINAL NOTE ON THE OPPORTUNITY
CRM is now positioned to offer excess AND primary coverage. They will leverage the extensive brokerage network they developed over years of managing SIGs. Majestic’s reach will expand to places like NY and NJ while Twin Bridges will be able to retain excess premium and earn its returns virtually tax free.

Catalyst

<<1>> A few quarters of actually hitting (and / or) exceeding investor expectations. Management is learning how to manage the Street. <<2>> Investor realization that the Company is worth more alive than dead (as my liquidation analysis shows). <<3>> Shareholder Activism. A few shareholders I have spoken to have expressed an interest in taking a more active approach with the Company if the market continues to discount the value of CRMH shares. There is a lot of "noise" that can be made, from requesting CRM to buy back stock, to de-staggering the Board, cutting high Board fees (for a Company of this size) and instituting a dividend. The Bermuda entity is overcapitalized and could repatriate capital, however that capital probably has the highest return in Bermuda as it's used to grow the book of business. Either way, it will draw attention to CRM's depressed valuation. <<4>> General growth and synergies between the fee / primary and reinsurance business which will take effect in the second half of 2007, the first year in which all three pieces are working in tandem.