Description

Donegal is a small cap regional property casualty insurance holding company that has performed extremely well over the past two years and yet sells for just over book value. Donegal sells personal and commercial lines insurance products in six Mid-Atlantic States, eight Southeastern states, and five Midwestern states.
Investors may be nervous to invest in this industry due to Eliot Spitzer as well as watching four hurricanes pound the Southeastern region of the U.S. In Donegal's case I believe these are unfounded concerns. First of all, the investigations of Spitzer centers around market service agreements and the way Brokers and Insurance companies deal with each other. Donegal does not deal with Brokers, just Independent agents. The CEO of Donegal recently stated that way Donegal handles its business is totally legal and there is nothing improper about its relationships. As for the four hurricanes and one tornado, Donegal was still able to earn .43 per share in the 3rd quarter after taking a .15 charge for property losses in the quarter. While Donegal has more regional concentration risk than a national insurer, I am comfortable with their diversification. Management has been fairly conservative in its underwriting approach by selectively choosing the business it writes, which has led to combined ratios that consistently have outperformed the industry average. The company has a strong balance sheet with 235 million in equity and 31 million in debt. It is also important to mention that Donegal does not have any legacy issues.
Listed below are the last eight quarters that Donegal has reported in earnings per share and the corresponding combined ratio for the quarter:
EPS Combined Ratio
.43 95%
.50 91.8%
.47 92.7%
.47 93.8%
.40 96.8%
.56 92.3%
.41 97.2%
.39 97.9%

Donegal is a mutual holding company which offers some advantages:
1) Acquiring other mutual companies is easier since they don't have to go through a demutualization process.
2) Primary reinsurance agreements with the mutual company provide protection in case of catastrophes. Also there are pooling agreements which allow for shared premiums, and ways to handle losses and expenses which produce more stable results from year to year.
The Mutual Company owns 42% of the "A" shares (1/10 vote per share) and 62% of the "B" shares. Of the 13.6 million fully diluted shares outstanding roughly 3 million are “B” shares. The Mutual Company has been a fairly active buyer of the shares. 40,000 shares were acquired by the Mutual Company during the 3rd quarter.
Notes from the October 22 conference call:
The 95% combined ratio would have been 90.4% excluding the storms. Reserves are in good shape with the company continuing to show redundancies.
Premiums grew 9.6% excluding the two new acquisitions that occurred in early '04.
Book value reached $17.79 at quarter end. The board declared a .12 quarterly dividend on the "A" shares and a .105 dividend on the "B" shares.
Their distribution system is growing with 82 agencies added so far this year and the target is to hit 100.
In the Commercial side of the business they have seen 4-8% price increases on renewal business. They believe that the small and mid market area that Donegal operates in has not felt the competition that the larger companies are feeling in their markets. This may be because the larger companies were hit with greater rate increases in the 2001-2004 time period and raising prices in this market is more difficult because of it.
In the personal lines side of the business the hurricanes have put a floor under property rates. With the losses that insurance companies have experienced, rates will continue to trend upward in homeowners insurance.
In private passenger auto they continue to see modest rate increases but not as significant as in the past. Donegal is trying to segment different categories the their customers fit into so they can get their pricing up in certain areas while maybe slowing price increases in the areas that are already high profit tiers.
Hurricanes Ivan and Jean actually hurt them more in Pennsylvania due to the heavy rain, than damage done in Georgia and the southern states.
They feel good about the trend in claims and how their loss ratio is positioned for '05.
Investment income has moved from short term Treasury securities to Municipals which reduced the effective tax rate from 30.5% in the 2nd quarter to 28.4% in the 3rd quarter. The company expects the tax rate to stay in the mid 28% range for 2005.

Risks:

1)Limited liquidity. The "B" shares trade around an average of 3,000 shares per day. The "A" shares trade just over an average of 14,000 shares per day. The "A" shares pay a slightly higher dividend and on average over the past 8 months have traded at 1.5% over the price of the "B" shares. With the "B" shares currently selling at more than 5% under the "A" shares, I would opt for the "B" shares at the present time. The "B" shares traded down on over 23,000 shares yesterday as someone paid the price to dump their shares.
2) Voting controlled by mutual holding company.
3) Your opinion on where we are in the insurance cycle.

Catalyst

Consistent underwriting results and my estimate of a forward p/e multiple of under 8 for 2005, I believe this company will begin to attract more attention.