Donegal Group trades at 88% of book value and 96% of TBV, which is hardly exciting, but represents an interesting situation due to its unusual capital structure. DGICA pays $0.49/sh in annual dividends for a 3.7% yield and continues to grow the business. Donegal is a $381 million market cap, regional property & casualty insurance company based in Pennsylvania. 64% of its business is personal lines, with personal auto representing 41% of its premium, and the remainder is in commercial lines.

History: Donegal Mutual was formed in 1889 to insure local farmers against fire but made a significant change almost a century later. This is from the company’s web site:

“In 1986, Donegal Mutual formed a downstream insurance holding company, Donegal Group Inc. An insurance holding company is a business corporation that owns insurance companies but is not an insurance company itself. In 1986, Donegal Group Inc. completed an initial public offering of common stock, with Donegal Mutual retaining a majority interest. Two separate classes of common stock of Donegal Group Inc. now trade on NASDAQ under the symbols DGICA and DGICB.”

Since 1986, Donegal has significantly changed itself.

Capital Structure:  Donegal has a complicated capital structure. Shareholders own Donegal Group, the insurance holding company (“IHC”) that is downstream from Donegal Mutual, which is owned by policyholders. There are two classes of shares in the IHC, with the “B” shares having 10 times the voting power of the “A” shares. The shares have the same economic interest in the Donegal Group although the “A” shares are entitled to dividends that are at least 10% higher than the “B” shares. Donegal Mutual owns 39% of the “A” shares and 75% of the “B,” giving it 66% voting control and 49% economic interest. There was initially one class of common stock and the split into two classes occurred in 2001. The “A” shares were set up for employee stock plans and to allow for dividend reinvestment plans without diluting voting control. The other wrinkle is that the Mutual owns 51.8% of Donegal Financial Services, the bank subsidiary, and Donegal Group owns 48.2%. Below is a chart from the latest 10-K that help explains the structure:

The unusual structure has its positives and negatives. The most obvious negative is that the Mutual controls the public company. However, there have been three transactions where a mutual insurance holding company controlled by a mutual was sold to another mutual. You can read more about it in a SC 13D/A filing made by a DGICA & DGICB investor:

http://www.sec.gov/Archives/edgar/data/800457/000095012311097021/c24492exv99w7w8.htm

The transaction that caught my attention was Nationwide buying Harleysville Mutual Insurance (stock symbol “HGIC”) and which was completed on May 1, 2012. Harleysville is located in Pennsylvania, like Donegal, and was majority controlled by the mutual. Nationwide paid a little over twice of book value, which seems very rich for a small, regional P&C insurer until you adjust for the shares owned by the mutual. Nationwide paid the public shareholders 2X book but the mutual’s shares were canceled out, meaning Nationwide really only paid around book value for the entire operation. Reread that last sentence again.

The thought of another mutual insurer buying out the public shareholders of Donegal is tantalizing, but not a given. Donegal has actually used its unique structure to be an acquirer. Since 1988, Donegal has acquired 10 insurance companies but how it has done so is unique because of Donegal Mutual.

For insurance company mergers and acquisitions, the two insurers have to have the same type of ownership. Thus, stock insurers can merge or buy stock insurers but cannot buy mutual insurers directly. In order for a stock insurer to buy a mutual, the mutual must first demutualize by selling itself to policyholders, as happened with the formation of EIHI. This is a complicated process. Donegal’s structure allows it to buy stock insurers through Donegal Group or mutual insurers through Donegal Mutual.

From a technical perspective, mutual insurers do not buy one another but rather they merge. Most mutual insurers cannot raise capital except by retaining earnings or issuing surplus notes, which are loans secured by the capital of the insurer. What Donegal Mutual does is invest in other mutual insurers via surplus notes. Some mutual insurers have found themselves undercapitalized or suffering from a low rating from AM Best and Donegal steps in as in investor. Donegal will provide capital via a surplus note to the other mutual insurer but only if it can name a majority of directors to borrower’s board of directors. Think of it as private equity for mutuals. Thus, Donegal effectively gains control of the other mutual. The acquired mutual insurer benefits from Donegal’s “A” rating from AM Best and from other back office support. Donegal Mutual can then demutualize the company and sell it to Donegal Group.

Donegal has a unique advantage in being able to acquire mutual insurers at very attractive prices. This is reflected in intangible assets being only 1.6% of equity as of 9/30/2012. Also, small mutual insurers often manage risk by ceding significant premium to reinsurers in quota share reinsurance agreements. Once Donegal gains control of a small insurer, those quota share agreements can be eliminated, allowing Donegal to “grow” its net premiums simply by ceding less to others.

Using reinsurance agreements, Donegal pools the results of all its insurance subsidiaries and of its controlled mutual insurers. Donegal Group assumes 80% of the business and Donegal Mutual assumes 20%. This sounds complicated but many insurers with multiple insurance subsidiaries pool results because it allows them to better utilize capital across all the insurance subsidiaries without having to actually transfer capital between the companies.

Target Market: Donegal is primarily a personal lines insurer but has been diversifying by increasing its commercial lines business. See table below.

Donegal primarily writes over half its business in the Mid-Atlantic states, as seen by its distribution by top 5 states based on direct written premiums as of 12/31/2011:

Much of the expansion outside of its traditional footprint has been by acquisition.

Earnings: Earnings have been hurt over the past five years by various weather-related events. However, premiums have increased from $310 million in 2007 to $431 million in 2011. 3^rd Qtr YTD 2012 net premiums were $382 million, a 10% increase over the same period in 2011. This has been largely been driven by acquisitions but also some rate increases. The company reported $0.66/sh of net income through 9/30/2012. There are signs that Donegal underwriting results are improving. The combined ratio for the 9 months of 2012 was 99.7%, compared to 106.2% for the 9 months of 2011.

The bulk of the earnings are driven by the investment portfolio, which is now at $803 million. The run-rate for investment income is about $19 million/year, representing a pre-tax yield of 2.4%. This reflects the shorter duration of property claims and the need for conservative investing.

Reserves: On p. 16 of the 2011 10-K, DGICA provides its loss development triangle that shows how the company initially reserved and then how the reserves changed each year. The reserve deficiencies in recent years have been related to above average weather-related claims.

Management & Directors: The president and CEO of Donegal Mutual is Donald Nikolaus, 70, who has held these positions since 1981 and who has been a director since 1972. He has been president and CEO of Donegal Group since its formation in 1986. He started a law firm in 1972, which is an unusual background among insurance executives but may help to explain the capital structure. He is the architect of the current form of Donegal and owns 4.0% of the “A” shares and 3.3% of the “B” shares.

Some additional facts that I find interesting from the 2012 proxy:

1. 7 of the 11 directors are age 69 or older.

2. In 2011, Donegal Mutual entered into its first executive agreements, which include change of control provisions.

3. The stock option plan, which deals with just “A” shares, has about 1.5 million shares left. The company has granted over 4.1 million stock options in 2010 and 2011so that there are over 5.3 million stock options outstanding as of 12/31/2011 with a weighted average strike price of $14.18/sh. Considering that there are 25.6 million shares outstanding in both classes of shares, that is a huge amount of stock options. Looking at the HGIC deal, the CEO made $28 million from stock and stock options.

At the current prices, the stock options will not be exercised because there is not enough of a spread and it would require a lot of money from executives to exercise and hold the stock options. If another mutual paid $25/share for the 13.7 million public shares, it would cost $343 million to buy those shares and another $57 million to buy out the stock options. That $400 million is right around book value. $23/share comes to $362 million for all the public shares and stock options, which would be around a conservative TBV that excludes AOCI.

Seeing 5.3 million in stock options against 13.7 million of public shares is disgusting. It’s even bad when including the 11.9 million shares held by the mutual. It may explain why the ‘A’ shares trade at a discount. Greed is good…indicator of what is going to happen. The only meaningful way for management to cash in is to cash out. As Nails4 said: “It is all about the benjamins yo.”

Institutional Ownership: Since Donegal controls the company, this information is less relevant. The company’s “A’ shares show 32.5% ownership by institutions, with the largest being Dimensional Fund Advisors with 7.1%. Noted insurance investor and activist Gregory M. Shepard owns 18.0% of the ‘A’ shares and 7% of the ‘B’ shares but about 29% of the publicly traded shares in each class. Institutional ownership of the ‘B’ shares is only 9.0%.

A-B Shares: One thing that I have found interesting is the difference in pricing between the “A” and “B” shares over the years. I have uploaded a spreadsheet called “DGICA” and one of the tabs looks at the relationship between the shares July 2003. Over the past three years, the median discount of “A” to “B” shares has been 17%; it is currently around 27%. The “B” shares are too thinly traded to put on an arbitrage trade but it does provide a decent gauge of when to buy. Generally, the “A” shares tend to rebound when the discount approaches 30%.

Risks: Below are some of the key risks associated with DGICA:

• The mutual has control over everything.
• The insurance industry is very competitive and cyclical.
• Since Donegal primarily insures property, it is exposed to losses from storms.

Additional Information: The company’s investor relations section on its web site is good. It includes prior conference calls, as well as presentations:

http://phx.corporate-ir.net/phoenix.zhtml?c=85218&p=irol-IRHome