Description

KFS is an opportunity to buy a specialty P&C company run by an experienced, honest and effective management team at the right time in the industry cycle. The company currently trades at about 1.0x 2004est book value and could easily double in price over the next 18 months as the market becomes comfortable with underwriting results after four years of 50% compound increases in premiums written. The company has a market cap $USD 600mm and trades about $3mm per day. The next 45 days provide an ideal accumulation window as the primary catalyst for price appreciation, further evidence of underwriting profitability, will be revealed at the quarterly conference call. BTW, per share price and market cap are in Canadian $ which is where you'll be buying your shares because of trading liquidity.


OVERVIEW
Kingsway Financial Services (KFS) is a holding company for nine Canadian and US operating companies that focus on specialty property and casualty insurance. KFS also owns a Bermuda-based captive re-insurance firm competes against external re-insurers to insure the risks at the other KFS companies. The holding company was founded in 1989 and has been managed by the same CEO, William Starr, since this date (Mr. Starr founded Kingsway General, an Opco, in 1986). The CFO, Shaun Jackson, has been around since at least 1994 (and probably earlier though I haven’t asked him that specific question yet). This pair has produced the following performance along that entire timeline (all $ figures in this write-up are Canadian$ unless otherwise noted):

Premiums Bk Val Company Industry
Comb Rat. Comb Rat.

1990 $18mm $0.78 93.9 110.0
1991 $18 $1.01 88.7 111.8
1992 $14 $1.03 84.8 111.1
1993 $30 $1.12 94.6 110.4
1994 $56 $1.39 93.9 106.9
1995 $60 $1.91 96.6 104.0
1996 $141 $3.27 95.6 104.5
1997 $211 $5.95 95.8 103.2
1998 $409 $6.96 93.9 107.5
1999 $509 $7.12 102.6 106.6
2000 $643 $8.01 101.0 107.8
2001 $1,065 $11.03 99.1 110.3
2002 $2,125 $12.56 99.8 105.8
2003 $2,600 $12.63 101.4 120.0
2004est $3,000 $14.70 97.0 NA

Notes: 2003 accident year combined ratio was 93.1%
12/31/2003 Bk val/shr was $14.50C without currency losses


BRIEF HISTORY OF KFS
As stated above, KFS grew from its Canadian Opco, Kingsway General. Kingsway General was the platform for creating a holding company that grew from less than $5 million in premiums in 1986 to an estimated $3 billion in 2004. KFS’ first expanded in Canada with the acquisition of York Fire & Casualty and then into the US during the mid to late 90s with the acquisitions of seven niche underwriters. KFS currently writes 80% of its business in the United States. The company typically writes minimum limits policies across a wide variety of lines and geographies and is therefore not subject to large, event-driven losses. KFS likes to retain most of its premiums because it typically writes profitable business. What little risk the Opco’s lay off, KFS retains a majority of in its the captive re-insurance subsidiary. This subsidiary has performed well during the last few years and is the only KFS Opco that currently has a significant capital surplus ($120 million).

The company has always prided itself on three objectives:
- Earning an above industry return on shareholder equity (15% target)
- Generating a consistent underwriting profit (96% combined ratio target)
- Growing the business in specialty lines (15-20% targeted future growth)

KFS exceeded its targets through 1999, but fell short during the next few years for two reasons: (1) the rapid expansion of the US business caused some management control problems and higher than expected loss ratio, and (2) underwriting Canadian auto risks has been an industry-wide disaster over the last four years. Counter to my initial expectations, the largest reserving problems for KFS have stemmed from Canada rather than their hyper-growth in the US (111% combined ratio in Canada in 2003 vs. 98% in the US).

The company strategy over the last seven years has been to grow business in the US while maintaining underwriting superiority in Canada. KFS has been largely successful with the acquisitions of seven US companies that they first cleaned up (circa 1998) and then used as a platform to aggressively expand during the hard market, which began in 2000. Coming into 2004, the company is consolidating its market position, slowing premium growth, and conducting detailed forensic reviews of its reserves using external auditors with the goal of refocusing on its core value of always generating underwriting profitability.


Why Does This Opportunity Exist?
The Opportunity to buy KFS at what I believe to be 50% discount to intrinsic value exists because: (1) the company is not followed by US analysts though 80% of its business is in the US, (2) the Canadian auto industry analysts who cover it are focusing on Canadian industry problems not on US opportunities, (3) KFS has just come through a hyper-growth period with mediocre underwriting results – a reason to be wary.

If you buy the Bull Case (below), this company is already fixed. The stock remains at depressed levels because 2003 results were obscured by prior year losses and by currency translation adjustments from the rampaging USD. These will both clear rapidly in 2004.


BEAR CASE (RISKS)
Rapid growth in the insurance industry is almost always disastrous from a balance sheet perspective. KFS grew at irresponsible rates in new lines of business (US long haul trucking was the primary growth driver) and is just now in the process of finding out that it is impossible to outrun the tail. Prior year reserve increases and a recent A.M. Best downgrade of Canadian operations are just the tip of the iceberg. It is only a matter of time until the house of cards comes crashing down. To make matters worse the company has issued debt to fund regulatory capital needs and now has limited financial flexibility and a more risky balance sheet.

The company has grown beyond the profitable Canadian niche player it once was to a sprawling US patchwork of undisciplined Opcos. Bill Starr might have been good at running a little Canadian company, but KFS has outgrown him and, in addition, he’s delegated most of the day-to-day responsibility to a group of regional operating managers who couldn’t hold his jock strap while he focuses on where to spend his retirement.
Further, for a large portion of their commercial trucking business, Bill and Shaun have ceded underwriting and claims collection to a group of Managing General Agents (MGAs) to fuel their US growth (especially in the commercial trucking line). So what few controls they have over their own Opcos are useless in trying to manage a bunch of mercenary underwriters who just want their commissions and will dump KFS once someone else comes around with a better offer. ***For those who aren’t aware of the nuances of the channel in this industry, an MGA is like a managing broker and centralized back-office for a group of selling brokers. This new channel does indeed have risks that internal distribution and claims collection don’t have.


BULL CASE (OPPORTUNITY)
The three most important things when evaluating an insurance company are: management, management, management. Bill Starr, the current CEO has managed KFS since its inception almost twenty years ago and produced a phenomenal record on top of another twenty-five years of industry success in prior positions. Shaun Jackson, his CFO has been with him for at least the last ten years. The pair has combined to drag a no name Canadian insurance firm to a North American presence that will write $3 billion in premiums this year.

Their strategy has been flawless: (1) Target specialty/niche lines where it is possible to write profitably by avoiding large capital flows and creating some differentiation, (2) grow through small acquisitions to establish regional presences in the US market, (3) when market conditions permitted make an aggressive land grab, (4) consolidate gains and reestablish high levels of underwriting profitability.

The execution of this strategy has been a little lumpy over the last few years, but given the magnitude of the company growth, the under-reserving has been relatively benign.

Throughout all of this KFS has maintained an extremely conservative balance sheet both in terms of credit quality and duration.

So yes, KFS needs to improve from here both in its underwriting and in removing a little leverage from its balance sheet, but that should be fairly easy to do given the current “hard market” and the prospect of healthy premiums for several more years.

Bill Starr and Shaun Jackson have spent the last few years strengthening management at the Opco level and installing Holdco management control systems. While Bill is less active than he once was, he “feels good” about the team he has built to carry Kingsway forward and needs to make just a few more fine tuning adjustments.

And as far as the MGAs go, KFS had to use this channel to grow as rapidly as it did. Unlike other insurers who have been burned by paying for volume rather than profitability through this channel, KFS has put all of its MGAs on a 3 year commission payout plan driven by actual underwriting profitability rather than sales volume. So the MGA channel was a necessary “evil” for KFS market share grab that KFS is managing in the most effective manner possible.
Valuation targets – Bull Case
This company should trade from 1.6x – 2.5x book value. 2005 book value should be about $17C. This implies a valuation range of $27C-$42C on 2005 book value. The stock currently trades at $15C. I would argue that as KFS is recognized in the US and as it reestablishes its reputation for consistently strong underwriting, it will trade closer to the high end of that range. There is also upside to the book value estimate if KFS can deploy its short dated government bonds into higher yielding alternatives in a rising interest rate environment (whenever that might occur).

Note: The company should be able to generate 15% ROE prospectively by underwriting at a 96% combined ratio and earning 3% on their investments because they operate at 3x leverage (actually a little higher now given that have some debt on their balance sheet). 4%x3 + 3%x3 = 21% operating income – 6.5% in taxes = 14.5% ROE. Further, there is a dearth of capital in the specialty P&C space so KFS will not have trouble redeploying its profits.


CONCLUSION
The KFS investment is a bet on management. If they have their business under control, this will be a great investment. If they don’t or they are lying, it will be mediocre to poor. I encourage anyone interested in KFS to do three things: (1) read the annual reports on the website, especially the Chairman’s letters, (2) listen to the last conference call, and (3) call Shaun Jackson the CFO.

Aside from the management bet, this is time to be investing in the P&C insurance space given the lack of capital in the space and the fact that a short maturity, high quality balance sheet can be redeployed to produce good investment results in a rising rate environment.

Finally, KFS’ business lines are relatively short-tailed, so it has already had plenty of experience to estimate true reserve needs. The longest tail business is commercial trucking, which is about 3-4 years. KFS is most of the way through this tail since the beginning of its high growth phase in 2000.

Catalyst

(1) Re-establishing consistently superior underwriting results – 2004 calendar year beginning Q1 results,
(2) US investor awareness of a company that does 80% of its business here – ADR only trades 30,000 shares per day.
(3) Turnaround in Canadian auto insurance market – currently under way.