A Canadian Insurer (Not Named Fairfax)

The short version of the thesis is that EGI is a well-reserved insurer trading at 63% of tangible book value and, unlike many other lines of insurance, it may very well be entering a firming non-standard automobile market in Canada.  Currently profitable and sporting a fortress balance sheet, the company is the second largest non-standard automobile writer in Canada.  It boasts a management team and board that have built and sold another non-standard automobile writer in the past.  Significant regulatory changes and more rationale competition also seem poised to help drive returns.  Modest book value growth assumptions and a return to a more respectable valuation would drive strong returns will significant downside protection.

Since about 72% of 2010 written premiums were derived from the personal lines segment it makes sense to start there.  As mentioned the company is the second largest non-standard writer, behind Westaim Corp. (TSX: WED).  Westaim is the current owner of the former non-standard businesses of Kingsway Financial Services Inc. (TSX: KFS), known now as JEVCO.  Kingsway, which has had its struggles over the last several years, sold the businesses to Westaim, a shell company, in early 2010.  The other two main competitors are Pafco (a subsidiary of Allstate) and Perth (a mutual looking to demutualize).

The remainder of the 2010 premiums came from the company's niche lines of business, which are more akin to the excess and surplus market here in the United States.  While smaller in scope, the company is spending a fair amount of time and resources to grow this business given that it is a strategic priority for them.  In addition to the niche business in 2011 we are starting to see some premiums from the company's international expansion into the United States. 

Non-Standard Cycle

Changing Competitive Landscape

Kingsway has been a troubled and distracted institution over the last several years.  While I don't have intimate knowledge of their operations, I view it as a positive that JEVCO is now in the hands of a stable, financially-driven competitor.  I'm not saying Kingsway's former businesses were chasing premiums, but the probabilities suggest their attention was not on the business at all times.  Now controlled by the Alberta Investment Corporation and Goodwood Inc., an investment manager, JEVCO is in good hands.  In most businesses a better capitalized, more focused competitor would be a negative, but in insurance it can very much be a positive. This should bring some further rationality to the market. 

Possible Canadian Consolidation

It may very well make sense for there to be further consolidation in the market.  I could see EFH being an acquirer (they have excess capital) or being acquired (I'd obviously prefer the later!).  Given that Westaim is the fruits of a financial backer and the changing market I wouldn't be surprised to see them pursue a consolidation strategy.

EFH previously attempted to enter the US market by way of a reinsurance business.  While this clearly was not profitable, the effort was designed in such a manner to avoid jeopardizing the group.  Management rightly saw that they could not control underwriting and claims management and decided to pursue a direct underwriting operation in the US. 

The current management team at EGI is comprised of a number of executives from what used to be an independent non-standard auto underwriter in Canada named Pafco Insurance Company.  Pafco (including Pembridge, Inc.) was sold to Allstate in 1998 at what appears to be a greater than 3x multiple to tangible book value and the management team eventually landed at Echelon in a deal with The Co-operators Group to restructure the company.  Current Vice Chairman Douglas McIntyre, who was Pafco's CEO at the time of its sale and several other members of management (http://www.egi.ca/senior.html)  were instrumental in building and selling Pafco.  Pafco is now the third largest non-standard writer in Canada, having seen its premium volume decline by upwards of 50% over several years.  It would appear that the team at EGI knows how to grow and sell a business and more importantly it seems you would want a lengthy non-compete if you were to buy a business from them!

Insider Buys

2011 YTD - Executives at EGI have collectively purchased 31,462 shares in 2011, net of the shares sold by one executive.  Buyers included Paul Little (board member), Steve Dobronyi (CEO) and Henraj Singh (CFO).  Most of the share purchases took place in June and all share buys were in the range of C$8.00 to C$8.70.

8/18/11 - Ian Delaney, Chairman of Westaim bought approximately C$2 mm worth of stock.  While not an insider buy at EFH, I would submit this large purchase speaks to what Delaney sees for his company in the coming market.  It was also, as noted later, at a significantly higher valuation than where EGI is trading today.

Capital Management

Given that the shares are trading where they are trading and the company's excess capital, I would be pleased to see a share buyback, but I unfortunately don't see that in the cards.  Management is clearly on the look-out for an acquisition, which might be positive in the acceleration of their US strategy but is not, in my opinion, the most optimal use of capital at the moment.  I hope they surprise me.

Niche Issues

In the niche business, the company struggled with its first two seasons offering emergency health travel insurance.  This business was a health policy primarily targeted at Canadians traveling abroad where their national insurance didn't travel.  EGI's former executive Mark Sylvia had helped EGI turn around a similar line of business that was previously sold to Co-operators.  The company believed they could repeat that strong performance with a start-up niche line.  Unfortunately, the company failed mightily in their efforts on back-to-back seasons (very seasonal business) and Mr. Sylvia recently left.  The business line was discontinued, though the company still writes a small amount of group business in this niche.  This is the primary reason behind the poor performance in the niche business, especially in 2008 and 2009.

Current P&C Public Universe (Canada and US) (Capital IQ)

Mean -  1.04x TBV

Median - .88x TBV

Westaim Corp. (TSX: WED) - .92x TBV

I think the above exhibits show that on the basis of current public company valuations, a direct competitor valuation, EGI's previous public company valuations and recent transaction multiples that the company is significantly undervalued from a number of perspectives.  I believe it also lends credence to the book value multiples contemplated in the returns exhibit.

Risks

Underwriting Cycle in Non-Standard Does Not Improve or Worsens

Recent price increases by EGI and followed by JEVCO, the largest writer, would seem to suggest that pricing is not deteriorating.  While unlikely to change quickly, this is certainly a risk always present in the business.  I think the more relevant risk to the thesis is the risk that pricing doesn't continue to improve, in which case the more aggressive base and bull case growth in equity would be in jeopardy. 

Niche Programs Continue to Underperform

After the company fixed the emergency health travel business by discontinuing the line, the company ran into an additional problem area recently.  Last year it wrote a large specialty group commercial auto policy that has hurt this segment recently.  This policy was not renewed and the issues should now be contained, but the risk of adverse development from this policy is a real (though manageable) risk.

US Efforts Fail Spectacularly

Given the management team involved, the cautiousness of the company's entrance and the timing of entrance this seems to be somewhat mitigated.  However, this is perhaps the biggest risk.  Does this company come down from Canada and waste a bunch of capital in the US?  Time will tell, despite the mitigating factors.

Investment Portfolio Issues

EGI has significant investment leverage.  At the end of June the company had approximately C$29.74 per share in investments.  Equities per share were C$5.56 and represent 45% of tangible book value.  As you might expect being a Canadian insurer, a significant percentage of the equities are in energy, financial services and materials.  In fact, at the end of 2010 these industries represented 72% of those equities.

Currency

While this can of course be hedged, those that don't should consider the currency, especially since there is little natural hedge as yet (i.e. no US business to speak of).  As a reference the US$ has declined from 1.16 to .96 at the end of June from the start of 2007.

Liquidity

Being a sub-$100 mm market cap company it is less liquid than many names.  10,000 shares seems to be a rather good day over the last six months, though it has been a bit better than that at other points in time.

• Many insurance companies are cheap (though perhaps not as cheap as EGI)
• Small cap Canadian company
• Little recognition that the industry dynamics are changing in this specific line of business
• Recent poor performance
• Worry over US efforts
• No dividend, no buyback, acquisition focus