Description

FPIC is a medical malpractice insurance company that trades at slightly over book value, at 9x current run-rate earnings, and less than 5x 2005 earnings. Earnings should double in the next 2 years, even if they do not write any new business.

They are headquartered in FL and the vast majority of their premiums are written in FL and MO.


INDUSTRY


As most people know, there is a Med/Mal crisis going on in the US. Med/Mal insurance companies lost a fortune on the policies they wrote in the last 4 years. Dozen of companies have pulled out of the business, including the largest writer in the country St. Paul, and the rest have pulled back in many areas or were put out of business by losses.

The response has been a public outcry and several states introducing tort reform. And the insurers have raised rates anywhere from 100% to 400% in almost every state in the US over the past 3 years.

This sort of cycle seems to happen every 10-15 years in Med/Mal. And every time it does, the players left standing end up making a fortune in the hard part of the cycle.

This is where we are today. Based on a detailed review of FPIC’s reserves, I believe the rates in place today will prove to be highly profitable. And FPIC is the best public pure play.


HISTORY


FPIC is a somewhat controversial company. In the last cycle, in the late 90’s the stock traded at nearly 4x book value and was heavily shorted. It was fairly highly leveraged and growing fast.

I was short FPIC as of a year and half ago, believing they would go bankrupt. During the worst part of the crisis, I thought that their reserves were understated, they were over leveraged, and they would go bankrupt.

Every competitor of FPIC reported massive losses in Med/Mal in 2002 and those that had operations in Florida said that Florida was one of the worst states in the country. But FPIC reported good profitability in 2002 and denied having the kinds of problems their competitors were having.

In the past year, it has become clear that FPIC is NOT under-reserved. FPIC has proven skeptics wrong, and proven that due to their focus on primarily one state and their monopolistic position in Florida, they just have a better business than the rest. And the market has yet to realize it.


TODAY


1) FPIC has raised rates about 100% in Florida in the last 3 years.

2) A few months ago, Florida passed tort reform legislation that will cap jury awards.

3) FPIC has the highest rates in the state, but due to the lack of capacity in Florida, they have a 96% retention rate, and could grow almost as much as they want, limited only by their own capital position.


FINANCIALS


FPIC reported $0.47/share in Q3, but the 10Q shows a 9 cent one-time charge. Thus FPIC made $.56/share in operating net income in Q3, adjusting for charges. Analysts didn’t seem to catch this.

Stock Price: $20.90
Shares Out: 9.8mm
Market Cap: $205mm

Run rate earnings: $2.24/share
Book Value: $18.27/share
Tangible Book: $16.27/share

P/E: 9.3x
P/Book: 1.1x
P/Tang Book: 1.3x

ROE: 13.7%


OUTLOOK


After a detailed review of FPIC’s reserves, I believe their reserves for previous years are adequate and that they are being overly conservative on the business FPIC is booking this year. In essence they are building a cushion into their reserves now that pricing is so good. I believe that run-rate earnings are really more like $2.50-$3.00, based on what I believe their true economic losses will prove to be.

As they continue to earn in the 34% rate increase they took this year and the 8% rate increase they will ask for in March, loss ratios should come down dramatically.

Every dollar of rate increase should fall straight to the bottom line, if actual losses stay the same. While loss trends have been going up an average 7% per year, the 34% price increase they took this year and the 8% they will ask for next year dwarf the loss trends. There is a lot of cushion in their current reserving.

If you look at 2002 paid loss trends, it is clear that pricing was already sufficient last year. Plus 2002 accident year didn’t even reflect the entire price increase they took, since it takes almost two years to fully earn-in a price increase. So the 34% price increase taken this year will only fully be realized by the end of next year. Thus, current business, plus the 8% price increase next year, should prove enormously profitable. The EPS leverage on these price increases is enormous, and should start to become visible over the next four quarters.

My estimate is that losses on the current book will prove at least 5-10 points lower than FPIC is currently booking. Every 1 point improvement in the loss rate translates into $0.13/share in EPS. So 10 points would equate to $1.30 in additional EPS.

FPIC would really be making $3.55/share right now if this proves true.


GROWTH


Not only is FPIC poised to show dramatic EPS growth from an improvement in their loss ratio as price increases continue to be earned in, they also have BUILT-IN growth of about 65%, still to come over the next 2 years or so.

FPIC is currently ceding about 1/3 of their premiums to a reinsurer, due to capital constraints. As their capital position grows, they will cede less. Simply by ceding less premiums, they will grow earned premiums by 65% without writing a single new policy.

Premiums will also grow by the amount of rate increases.

FPIC can grow earned premiums by over 80% in the next 2 years, WITHOUT WRITING A SINGLE NEW POLICY.

FPIC, like every other insurance carrier, is also being negatively impacted by low interest rates. If their average yield goes up by only 1%, this adds $0.42/share to EPS. FPIC is carrying a significant portion of its assets in short-term securities in anticipation of rising yields next year. 100-200 basis point rise in yields in the next year or two seems a good possibility.


PROJECTIONS:


I believe FPIC will show a dramatic improvement in loss ratios next year. Based on current claim payment trends, FPIC should prove over-reserved for 2002 and 2003. They will start to show significant improvement in loss ratios next year, and will grow premiums earned and profits dramatically next year.

2004E EPS: >$3.00
2005E EPS: $4.00 - $5.00

P/E 2004 EPS: 7.0x
P/E 2005 EPS: 4.1x - 5.2x

If interest rates go up 100 bp = +$0.42/share
If interest rates go up 200 bp = +$0.84/share

If current reserves prove 5 points redundant = $0.65
If current reserves prove 10 points redundant = $1.30

Then,
2005E EPS: $5.07 - $7.12
P/E 2005 EPS: 2.9x - 4.1x


DOWNSIDE


Despite the run-up in the stock, I do not believe there is any significant downside at this level. I have analyzed their reserves thoroughly and believe the risk to their reserve position is limited – though there is always risk of adverse development in their reserves.

ACAP, a competitor, recently announced disastrous developments in their reserves. However, ACAP’s problems all relate to their “expansion” states. Their home state of MI is actually performing very well. FPIC’s book is almost exclusively in their home state of FL, which explains much of their superior performance.


Downside is limited:
1) Stock is currently trading near book value.
2) Stock is currently trading at only 9.0x current earnings.
3) FPIC has a 14% ROE, and is poised to generate nearly a 20% ROE.
4) Current conditions in the Med/Mal business couldn’t be any better.
5) Pricing is fantastic, and they have the highest prices in Florida.
6) Recently passed tort reform legislation will reduce volatility in FL jury awards and eliminate most egregious awards.
7) They have little competition.
8) They have a virtual monopoly position in Florida.
9) Interest rates will inevitably go up and boost investment income.


TARGET


I believe this will trade at least like a normal insurance company, at 2x book and around 15x forward earnings (below historical peaks in hard insurance markets). Book value at the end of next year will be about $21.00.

My intermediate target $40.

At $40, FPIC will be at about 2x book, and about 13x the then current earnings of $3.00. Run-rate earnings within the next four quarters should be dramatically higher than $3.00.


CATALYST:


1) The obviously cheap valuation

2) Earnings acceleration, which is just starting.

3) When people finally accept that Med/mal, and FPIC particularly, have turned the corner, they will stop applying a distressed multiple to this business.

4) When people see how quickly earnings are growing, FPIC should achieve a premium insurance multiple.

5) AM Best will eventually raise FPIC’s rating back to where it was before the Med/Mal crisis.

6) FPIC will probably raise equity capital in the near future. This will allow FPIC to reduce ceded premiums immediately, pay off remaining debt, get an AM Best upgrade, and will increase the float of the stock.

7) There is also still a relatively high short interest left in FPIC. This always helps.

Catalyst

1) The obviously cheap valuation

2) Earnings acceleration, which is just starting.

3) When people finally accept that Med/mal, and FPIC particularly, have turned the corner, they will stop applying a distressed multiple to this business.

4) When people see how quickly earnings are growing, FPIC should achieve a premium insurance multiple.

5) AM Best will eventually raise FPIC’s rating back to where it was before the Med/Mal crisis.

6) FPIC will probably raise equity capital in the near future. This will allow FPIC to reduce ceded premiums immediately, pay off remaining debt, get an AM Best upgrade, and will increase the float of the stock.

7) There is also still a relatively high short interest left in FPIC. This always helps.