Description

National General: 100% upside, A+ mgmt, high quality, under-the-radar

Investment Summary: National General (NASDAQ:NGHC) is a specialty personal line insurer and a top 20 underwriter of U.S. personal auto insurance with a $1.8 billion market cap. Over 40% of NGHC’s revenues come from affinity channel and niche markets such as RV, non-standard Auto, and Accident and Health supplemental products, whereas the rest comes from standard Auto and Homeowner insurance. Most recently NGHC announced the acquisition of QBE lender-placed insurance, a controversial line historically, which has stabilized after the Dodd Frank reform and retrenchment by several large players. We think that street is not modeling the accretion from acquisitions and A&H business ramp properly. NGHC has bought several distribution channels in the last year and will retain more premiums on its balance sheet increasing the A&H segment profitability. Our 2017 normalized earnings are 20% higher than the consensus. National General has one of the best management teams in the industry and possesses strong competitive advantages against its specialty insurance peers, because of its superior technology, low cost structure, strategic relationships, excellent underwriting driven by analytics, and efficient capital allocation. The Company is small enough to focus on highly profitable and sticky niche markets generating industry leading returns on equity (ROE) of 15%. An investment in National General has the potential to double in 2.5 years as the Company grows its earnings per share at a +20% CAGR in the next 3 years through acquisitions, expense savings, market share gain and organic growth. There are a lot of moving parts in its expense base because of recent acquisitions, retirement of the legacy systems and lease cost savings, which are not well understood, and we see normalized earnings power that is a lot higher than 2017 and 2018 consensus estimates. Furthermore, revenue synergies from a recent acquisition and  growth in the Accident and Health business have the potential to surprise longer term. We see National General earning $3.00  per share by 2018. With a 13x forward earnings multiple, it will be a ~$39 stock in 2.5 years. NGHC is trading at below 9x our 2016 earnings and it is hard to find any significant downside in the stock at the current valuation for a business which is growing earnings  at double digits with a solid management team. The risk reward is highly appealing at the current price with only 10% downside and 100% upside in 2.5 years. Management is very shareholder friendly, and is aligned with shareholders given their high ownership stake of 55%. Management also does a great job in managing risk by keeping low leverage, buying appropriate reinsurance, and writing less risky and higher profitable lines. The stock is not well covered with only 3 sell side ratings by boutique banks. The CEO of the Company, Michael Karfunkel, is a legend in acquiring distressed assets and capital allocation. He has created a lot of value for his public shareholders in the past, and will continue to do so going forward through acquisitions and efficient capital allocation.  We show two examples of deals that National General did for almost nothing in the appendix.  Unlike other insurance companies that operate disparate technology platforms and do not want to incur the high expense involved with integration, Karfunkel took the time to integrate a low cost company with better technology while it was still private.   This gives the company a significant cost advantage versus its specialty competitors and also makes acquisitions highly synergistic and accretive.      

Valuation:

We find an asymmetric risk reward for a long term investor in National General with only 10% downside and 100% upside.  

In the Base case, we assume that the company can grow its gross written premium and net revenue at a 13% and 18% cumulative average growth rate, respectively, in the next 3 years with $3.6 billion in revenue by the year 2018. We find this growth conservative given how much growth has come from acquisitions in the last 2 years.   Net revenue growth should be higher than gross written premium growth because National General is retaining more premiums than before, and its investment income is growing at a faster rate than gross written premium. Assuming a combined ratio in the low 90s i.e. 8-10% underwriting margin and about 15% ROE, we get to $3.00 per share in earnings power for the company by 2018. Using a 13x forward earnings multiple, we see 100% upside in the stock in the next 2.5 years. A 13x multiple is justified and even conservative based on the 20% EPS growth, the superior management, a short tail liability and the sticky nature of the business. At a 15% ROE, 13x PE multiple translates into a 1.95x BV multiple, whereas its sister company AmTrust (NASDAQ:AFSI) currently trades at 2.38x book, even though it is growing at a slower rate, and has a longer tail business (i.e. longer term liabilities), which can be hard to measure. Similarly, Progressive (NYSE:PGR) which is also growing at a slower rate and serves more commoditized market trades at a premium to National General. Currently, National General is trading at 8.9x our next year earnings estimate, which is even lower than Allstate (NYSE:ALL) and Travelers (NYSE:TRV) at 12.2x and 10.2x earnings, respectively. We think expenses will be elevated in 2016 because of the acquisitions integration and 2017 is a normalized year to look at. NGHC is trading at only 6.8x our 2017 earnings.   In addition, National General is less correlated to macro exposure such as interest rates and yield curve vs. other stocks in Financials such as JPMorgan (NYSE:JPM), Met Life (NYSE:MET), State Street (NYSE:STT), LPL (NASDAQ:LPLA), Ameritrade (NYSE:AMTD) or E*TRADE (NASDAQ:ETFC).  

In our Bear case, we assume that National General is unable to grow its revenue much with $3 billion in revenue by the year 2018 at a 1.5% CAGR excluding current acquisitions. We find this extremely conservative, because it assumes no more acquisitions and growth in its A&H business, whereas pricing alone should provide 1 to 2% growth. In that case, the Company will have a big capital surplus, and the worst case could be mitigated through buybacks. With combined ratios in the mid to high 90s or only 4 to 5% underwriting margin and about 11% ROE, we get to $1.70 in EPS. Using a conservative 10x forward multiple, we see only a 10% downside in the stock.

Insurance 101:

An insurance company makes money through underwriting and investment income. Underwriting income is the profit that an insurer makes by collecting premiums and paying out losses on all the policies net of expenses to run the business. Since it takes time to pay down the losses on policies, an insurer generally sets up reserves for these losses and expenses, which are invested with leverage to generate investment income. The premiums that an insurer collects are called gross written premiums. To reduce risk, an insurer sometimes reinsures itself by giving away a portion of its premium (Ceding premiums) to a reinsurer, which is called Quota reinsurance. It also buys reinsurance for extra-ordinary losses beyond a threshold which is called Excess of Loss reinsurance. Net of these ceded premiums, the premiums that an insurer retains are called net written premiums, which translate into net earned premium as they are earned over the duration of policy under GAAP accounting. Besides the premium collection, sometimes an insurer also collects fee income from late fees, ceding commissions and other services, which all combined with net earned premium add up to the total revenue.

Loss and Expense ratios are a few metrics used to measure the underwriting efficiency of an insurer, collectively they are called the Combined ratio. A GAAP loss ratio is calculated as losses and loss expenses incurred over net earned premium, whereas, expense ratio is calculated as underwriting expenses incurred net of fee income over net premiums earned. Generally speaking, a 96% combined ratio (i.e. 4% underwriting profit ratio) is considered excellent for an insurance company. An insurance company amplifies its underwriting return through operating leverage. Below, you can see the National General business model:

Company overview:

National General is a specialty personal line insurer and a top 20 writer of U.S. personal auto insurance. Michael Karfunkel acquired GMAC in 2010, restructured it, and since then has made 12 acquisitions to grow the business.  National General recently added a complementary homeowners book, and in recent years began building an Accident & Health business from the ground up. Pro forma for the Tower Personal Lines and Imperial transactions, National General has >$2.2 billion in gross written and managed premiums, $1.05 billion of shareholders’ equity and $1.3 billion of total capital. Below, we have provided a company overview from the latest National General investor presentation (Note the mix below doesn’t include recently announced Assurant Healthcare acquisition which hasn’t closed):

Source: National General

Segments overview

P&C Affinity business (54% Auto/ 46% RV & Packaged): Entered in 1953 in this business, National General Operates the Business throughout the U.S. with key states including MI, CA, FL, TX, and WA. It distributes its polices directly through numerous long-term affinity relationships (top 10 have been in place for over 10 years), and offers a customized insurance product and pricing for following affinity groups on a white label basis. This business is cheap to write and serves a price insensitive and sticky customer base.

• Good Sam – National General is one of the top writers of RV coverage in the U.S. via Good Sam, an RV club with over 1 million members which also operates Camping World. National General’s exclusive contract runs until Jan 21, 2032.

• General Motors & Family First – National General provides coverage for the employees and extended families of General Motors and their subsidiaries through the GM Family First program.

• Rural Letter Carriers – National General provides insurance to the National Rural Letter Carriers’ Association, a 109 year-old labor union representing over 100,000 American rural letter carriers.

Property & Casualty – Agency (North Carolina 36%, Commercial Auto 12%, Motorcycle 1%, Rest of U.S. Auto 51%): Entered in 1939 in this business, National General operates it throughout the U.S. with key states including NC, NY, VA, FL, WA, and CA. It distributes polices through more than 19,000 independent agents and brokers. National General also owns its own MGA, Clearside General, which allows it to distribute its products in a cost effective way. National General offers auto insurance for sub-standard, preferred, and standard risks, as well as commercial vehicle and motorcycle insurance as following

• North Carolina – Through Integon National subsidiary, National General is a top writer of personal auto in North Carolina. The state has a unique “take all comers” market supported by the North Carolina Reinsurance Facility (NCRF), to which it cedes roughly 40% of its gross written premium in the state. Because of this unique state law, National General enjoys a healthy profit in North Carolina with loss ratios 10%+ better than other states. National General’s unique size and customized platform to serve niche customers gives it a competitive advantage over large insurance companies, and as a result it dominates this market.

• Commercial Auto – These policies include coverage for liability and physical damage caused by light-to-medium duty commercial vehicles, focused on artisan vehicles, with an average of two vehicles per policy.

• Motorcycle – National General provides coverage for most types of motorcycles, as well as golf carts and all-terrain vehicles

Accident & Health: Entered in 2012 in this business, National General operates the business in the U.S. and Europe. National General distributes its policies through numerous distribution channels including call center agencies, independent agencies, worksite marketing, and third party general agencies. It provides niche supplemental and non-major medical insurance to individuals and small employer groups. We can see this segment growing similar to how Assurant (NYSE:AIZ) grew its book many years ago. Accident and Health will be competing more with certain product lines of Aflac (NYSE:AFL) rather than United Health (NYSE:UNH) or Aetna (NYSE:AET). Here are some more details about the products its offers and its distribution channels:

• Products: Accident/AD&D, Limited Medical/Hospital Indemnity, Short Term Medical, Cancer/Critical Illness, Stop Loss, Term Life, Dental/Vision.

• Distribution: Call Center Agency (VelaPoint), Independent Agency (AHCP), Worksite Marketing (TABS), Large 3rd Party General Agencies.

• Target Customers: Uninsured, Underinsured, Existing P&C Customers, Small-to-Mid Sized Employers.

Tower Personal Lines (Personal Auto 16%, Home / Umbrella 84%): Tower dates back to late 1800s. Tower operates throughout the U.S. with key states including: CA, CT, MA, ME, NH, NJ, NY, RI, and VT. Through this acquisition National General will be also managing the Reciprocal Exchanges (Adirondack Insurance Exchange and New Jersey Skylands Insurance Association), which wrote $223.0 million of Gross Written premiums in 2013. National General does not take any underwriting risk on Reciprocals and only earns a fee income to manage these policies. It distributes its products through established relationships with large national insurers to offer homeowners coverage, as well as over 1,000 independent agents. Tower provides homeowners, personal auto, package and umbrella coverage.

Imperial (Commercial Auto 3%, Federal Flood 8%, Home 18%, Personal Auto 72%): Imperial was founded in 1990, and acquired by National General in 2014. It operates in select states in the South/Southeast, with key states including FL, TX, and LA. It distributes its policies through over 2,000 independent agents, an in-house independent retail agency and an internal MGA. Imperial underwrites personal auto, homeowners, commercial auto, and Federal Flood policies through four operating subsidiaries:

• Fire & Casualty Insurance Company - Underwrites personal auto in AR, FL, LA, OK and TX; homeowners in LA and TX; a commercial auto program in LA; and is licensed to write Federal Flood policies in 20 states.

• National Automotive Insurance Company - Acquired in December 2013 and provides non-standard personal auto insurance through independent agents across LA, with a heavy policyholder concentration in New Orleans.

• Insurance Agencies - Acquired in 2001, an independent agency group that sells auto, homeowners, and RV insurance products through 32 retail locations in LA and TX.

• Insurance Partners - Acquired in 2009, a Managing General Agency that produces specialty auto programs and non-standard auto business, operating in FL with a concentration in Miami-Dade County.

Source: National General

Affiliated Companies:

AmTrust Financial: AmTrust is a public commercial lines P&C company with a $3.9 billion market cap. The Karfunkel Family owns 59% of AmTrust.  AmTrust provides National General IT systems development and asset management for a fee.

Maiden Holdings (NASDAQ:MHLD): Maiden is a public reinsurance company with a focus on non-cat lines, and a market cap of $0.9 billion. Historically, it has provided quota reinsurance to National General. The Karfunkel Family owns 28% of the Company.

ACP RE: ACP Re is a Bermuda based Reinsurance Company, which is privately owned by the Karfunkel Family. ACP Re acquired the Tower Group legacy business, which had two businesses - commercial insurance and personal property casualty insurance. ACP Re helped National General restructure a transaction with regulators to acquire the Tower’s personal lines business.

Investment thesis details / value drivers:

Acquisitions and capital allocation: Michael Karfunkel, who has a great eye for distressed assets has acquired 12 companies since 2010, and doubled the size of National General in just the last year. The company’s strategy is to acquire small P&C and A&H companies with high expense ratios.  It adds its superior technology platform to meaningfully reduce the expense ratio. These deals have also added scale, new product lines, geographic diversification, and revenue synergies. With the acquisition of the Tower Group P&C renewal rights and with Imperial Group, Karfunkel not only almost doubled the size of the Company, but he also acquired them for almost nothing. Both deals were highly accretive to the book value per share as well as earnings per share. The recently announced QBE and Assurant deals are also highly accretive to NGHC.  Through its superior technology and advantageous platform, National General will continue to acquire inefficient operators at great prices and realize synergies/expense reductions. Karfunkel is one of the best capital allocators we have ever seen, and has created significant wealth for himself and his shareholders in his current and past ventures including AmTrust and American Stock Transfer & Trust Company. P&C Insurance is a highly fragmented market, and it will provide him ample opportunities to buy more of these assets and grow the Company through consolidation with its advantageous platform.

Expense ratio improvement: We believe the expense ratio, which measures expenses relative to revenue will go up to the 30s next year as acquisition expenses will be elevated and then finally settle down at 28.5% in 2017. With revenue growing higher than cost on a scalable platform with ample capacity, we don’t see a reason why expense ratios won’t be even lower than 28.5% as National General continues to deliver on growth.

• Tower Group: Before closing, the Tower Personal Lines business was written at a 20% ceding commission on UPR or 22% ceding commission on new and renewal business, plus a 4% claims handling expense (included in the loss ratio). After closing, the expense ratio will likely be closer to a blend of Tower’s historical run-rate of 40% and legacy P&C segment expense ratio of 28% i.e. around 31%. Over the next 12-18 months, the expense ratio should return to 28% as National General integrates TWGP and retires its systems to cut the cost.

• Focused on value: National General bought its office building in Cleveland for $7.5 million, whereas Keycorp spent $400 million to build a new building down the street.  National General bought and developed its call center for $6 million, and could sell it today for $30 million. The management is clearly value and cost focused and that is why they are able to maintain such a low expense ratio.

• The recent move of 100% of policies to NPS, which is National General’s comprehensive state of the art policy administration system, and the retirement of 3 legacy systems is expected to result in a benefit to the expense ratio beginning in early 2014; a partial offset will be the increased NPS development cost for the transitioned homeowners products in the coming quarters. Historically, the Company has talked about $25 million in expense savings from the retirement of these legacy systems, but that savings could be slightly lower now as National General integrates Tower systems.  

• Recent real estate related cost saving efforts include the relocation of the Winston Salem office and a reduction in office space usage in St. Louis, expected to result in annual cost savings of $4 million and $2 million, respectively, beginning in the third and fourth quarter.

• 50% of the book is agency, where National General is increasingly using a lot of more analytics and thus improving the underwriting and the expenses.

Source: National General

Premium growth: We can see National General growing its premium to $3.4 billion by 2018 at a 13% CAGR for the next 3 years through acquisition and organic growth. By the end of next quarter, National General will have $2.0 billion of total available capital pro-forma of recent capital raise including a $135 million line of credit. At 1.8x operating leverage, National General can write $3.6 billion of premiums and $5.2 billion by 2018 with growth in book value. In essence, National General has enough fire power to support the recent acquisition and grow its business in coming years.   

• Collapse of Quota share: National General collapsed its quota share (i.e. started retaining more premiums instead of giving it away to a reinsurer) of 50% with a third-party, which was completed on August 2014, resulting in higher retained premium and underwriting income. As a result National General’s Property & Casualty legacy net written premium will almost double from 2013.  

• Market share gain in homeowners lines in North East: National General acquired the Home owners line through the Tower acquisition. Homeowner’s writers remain cautious in the North East with 2 recent ‘1 in 100 years’ storms. These lines are highly profitable. With cheap reinsurance and low market share, National General can really scale up its business profitably in North East. Increasing market share by as little as 1% could translate into nearly $400 million of premium growth for National General.

• Cheaper reinsurance: The reinsurance market continues to see an influx of capital resulting in an oversupply and lower rates. National General continues to get cheaper reinsurance by ceding less premiums thus retaining more premiums.

• Growth in Accident & Health business: The Accident and Health line is rapidly gaining scale as the Company brings more business on its own paper and expands its product offerings. We think Accident & Health gross written premiums could reach +$600 million by 2018 with Assurant’s healthcare business acquisition, and with 87.5% combined ratio, it will yield $70 million+ in underwriting income. Premium growth details:

• VelaPoint ($90 million of premiums by 2017): National General acquired VelaPoint in February 2012, which is a general agency call center with ~50 licensed agents and ~220 employees that sells a full range of supplemental medical & individual major medical policies via state/federal exchanges, and > 90 carrier relationships. VelaPoint produced ~$74 million of premiums for third-parties in 2013. VelaPoint began selling National General accident and critical illness products in September 2013, and will be expanding state and product offerings throughout 2014. Once approvals are received, one should expect a significant percentage of VelaPoint sales to be written by National General.

• The Associated Benefits Solutions (TABS) ($40 million of premiums by 2017):  Acquired in September 2012 from the Coca-Cola Bottlers’ Association, TABS administers specialty self-insurance arrangements, offering ERISA qualified self-insured plans to employers in affinity associations or trade groups and selling medical stop loss coverage to employers. TABS wrote approximately $19 million of stop loss premium in 2013.

• EuroAccident ($100 million of premiums by 2017): Acquired in April 2013, EuroAccident is a Swedish group life and health insurance MGA. EuroAccident produced ~$80 million in premiums in 2013 on behalf of third parties. On January 1, 2014, European insurance subsidiary began reinsuring all business placed by EuroAccident; beginning April 1, 2014, all new and renewal policies began being underwritten by National General European subsidiaries on its paper.

• Rest of the $70 million in premium growth should come from following  and new acquisitions/ initiatives

• America’s HealthCare Plan (AHCP): Acquired in February 2012, AHCP is a managing general agent/program manager. AHCP works with > 8,000 independent agents/general agents across the U.S. to provide an array of insurance products, including those from third-party insurers, and will serve as a significant distributor for NHIC products.

• National Health Insurance Company (NHIC): Acquired in November 2012, NHIC is a TX-domiciled life/health insurer established in 1979 licensed in 48 states & DC. NHIC has filed and are receiving approvals for a significant number of our target A&H insurance products for individuals and groups. To date 690 of 950 initial product filings have been approved by various states.

• Healthcare Solutions Team (HST): National General acquired HST, an Illinois based healthcare insurance managing general agency, in January, for $15 million and potential future earn out payments based on HST's overall profitability.

• Assurant acquisition should drive over +$300mm revenue over time: NGHC is acquiring Assurant’s small group self-funded (stop loss insurance) and supplemental product lines (big dental book), and North Star marketing assets. One thing to keep in mind is that NGHC is buying the best pieces of Assurant’s health book, while Assurant is shutting down most of its troubled lines, which haven’t been profitable after the new healthcare regulation i.e. individual major medical, small group fully-insured and short-term medical health insurance lines. The acquisition will add scale to the A&H business, double the size of the business and should be accretive to 2016 earnings. The final terms of the contract haven’t been disclosed yet, but our guess would be that NGHC will get favorable terms given Assurant was trying to shut down its healthcare business and sell side was predicting no buyers for it and a high run-off cost.  In addition, Assurant might be just happy with finding a buyer as it won’t need to lay-off more employees. In total, these businesses should provide National General with access to up to approximately $280mm of potential additional A&H revenues in 2015, which is mostly complimentary and has the potential for decent growth with strong Northstar distribution of 45,000 agents. NGHC thinks that this business should do a similar combined ratio in the long term as its current A&H business i.e. 85-90%. Assuming $320mm of incremental revenue in 2016 from Assurant’s business and 13% margin post integration, it will be +11% additive to 2016 pre-tax earnings assuming lower acquisition growth in the P&C business as some of that capital is used for A&H expansion. 2/3 of the new revenues are coming from the stop loss business (which should provide scale to recent TABS acquisition), and 2/3 of the stop loss business revenue is coming from premiums vs. fees. Supplemental is a 100% premium business.   The underwriting leverage in A&H business is higher than P&C business at 2-3x vs. 1.7x thus the deployment of capital in A&H should be more accretive to ROIC than a P&C acquisition.

• QBE lender-placed insurance acquisition: QBE acquisition should add about $450mm in NPW and $40mm in additional servicing income. This business should run at a low 90s combined. Including the investment income on premiums and reserves invested, the acquisition should be highly accretive. NGHC is paying $90mm in cash payment and will receive various assets, including technology systems, client servicing accounts, intellectual property, and certain vendor relationships. Additionally, through a reinsurance agreement, NGHC will assume all related liabilities and receive $92M in loss reserves, $247M in unearned premium reserves, and $342M in invested assets. It also has four office locations, the Seattle Specialty business, 1,300 employees, and a management team. Lender-placed insurance used to be a controversial line of business, but now the market has stabilized after Dodd–Frank reform. Some of the large players have also pulled back from the market. There could be some revenue synergies with NGHC's homeowner's book. One-third of lender-placed book is auto where there are no regulatory issues. We are using 13x multiple on the business now vs. 14x that we have used historically because of the new acquisition.

National General competitive advantage:

• Superior Capital Allocator: The Company has proven leadership with an experienced management team that has a history of creating shareholder value in previous ventures

• Low cost provider:  

• Technology: Often big companies get stuck with multiple technology and infrastructure systems as they grow. For example, even Progressive, an industry leader in technology has 10+ core old legacy systems.  Multiple systems are not only expensive, but also inefficient. National General started with a clean slate after the GMAC acquisition in 2010, and has been able to simplify all the Policy Administration systems into 1 system, which is highly scalable with low incremental cost and high margins. National General doesn’t use Duck Creek and Guidewire, because they are very expensive, time consuming, and require large payments for enhancements and proprietary offerings. National General has consolidated 1 million policies onto one platform. Its policy administration system NPS is highly scalable and can do 1 million quotes per month. The reason why National General was able to do this vs. any other company is because integration of these systems came with a lot of hassle and most CEOs don’t want to take the risk. Consolidation of these systems could result in a big hiccup and it generally takes 2-3 years, whereas an average CEO tenure is only 3-4 years. Karfunkel didn’t hesitate taking a long term view since he owns a majority stake in the Company and major heavy lifting was done while the Company was private. Below is a quick overview of NGHC technology.

• Cost focus operations: Management is really cost focused and has set-up offices in low cost places. National General bought a building in Cleveland during distressed sale for $7.5 million, whereas Keycorp spent $400 million to build a new building down the street in the same location. National General also hired a cheap and hardworking labor force in Cleveland.  National General’s call center was bought / developed for $6 million, and today it can be sold for over $30 million. These small things add up to a much lower expense base than competitors. The company maintains a flat organizational structure where high level executives review sizable companywide expenses on a weekly basis to ensure that costs are properly controlled.

• High fee income: Since National General has a big portion of non-standard customers, it derives high fee income, which also lowers its expense ratio.

• Superior underwriting platform and organization capability: National General’s focus on specialty markets and niche distribution channels allows it to have superior loss ratios than its peers. For example, National General has one of the biggest share positions in North Carolina, where the State cedes insurance companies for a big portion of its losses. This allows National General to keep the most profitable polices and cede the worst to the State. National General also has one of the highest market shares in the RV business, which is one of the most profitable non-standard auto lines. These RVs are parked for most of the year and demand higher premiums as they are seen as non-standard auto. Further, its affinity relationships allow it to serve a price insensitive sticky customer with better loss and expense ratios.  National General also has sophisticated analytics, which drives better risk selection and improved margins.

• Strategic relations: Since Karfunkel controls AmTrust, Maiden and ACP Re, it allows National General to save a lot of cost by using their platforms. For example, ACP Re provides IT development and asset management almost at cost, and Maiden has provided cheap reinsurance in the past to scale National General’s business. ACP Re helped National General in acquiring Tower’s personal line business by dealing with serious regulatory hurdles. In essence, these relationships have provided National General significant strategic competitive advantages in acquisition capabilities, technology, asset management, and several other operational areas.

Risks:

• Loss of high fee income: National General has a higher mix of fee income than a usual insurer because of the higher non-standard auto mix, which could get affected by adverse regulation. These fees have been common in the industry for a long time, and we see a low probability of them going away as they are mainly designed to offset higher non-standard expenses.

• Loss of an Affinity channel: National General depends on a relatively small number of affinity partner relationships for a big portion of net premium revenue, and the loss of one of these significant affinity partner relationships could have a materially adverse effect on the business. The top 10 contracts have been in place for 10 years, and National General’s exclusive contract with Good Sam runs until Jan 21, 2032, therefore, we don’t see a material change in affinity partnerships in the near future.

• Regulatory changes in North Carolina: National General is one of the leading auto underwriters in North Carolina, which has unique laws for ceding losses to the State. If those laws changes, National General can lose its market share, and its loss ratios can increase substantially. The rates in North Carolina remain relatively cheap compared to the other states. Additionally, the Rate Bureau, which was created in 1977 and roots going back to 1930s, recently decided to stick with its policy for a 2nd time. As a result, we don’t see any material change in the policy for next few years.

• Rating risk: If Nat Gen gets downgraded by A.M. Best, it could reduce the amount of business that the company would be able to write. Since National General carries low leverage and has disciplined risk management, we see a low probability of a rating downgrade.

• Luxembourg: National General could be subjected to taxes on its Luxembourg affiliates’ equalization reserves resulting in a higher tax rate for the Company.

• Pricing: The Property and Casualty insurance industry is cyclical in nature, which could affect National General overall financial performance if the pricing cycle starts softening. In general, the industry has been very rational about pricing, so we haven’t seen any negative pricing movements yet. Additionally, National General serves a niche market with its unique distribution, which makes it less price sensitive than the industry.

• Catastrophic losses: Cat losses or the frequency of smaller insured losses may exceed the industry’s expectations as well as the limits of National General reinsurance, which could adversely affect National General’s financial condition. National General is reinsured for a 1 in 150 year event, so likeliness for that is low.

• Duration risk: Average duration of National General portfolio is 4.8 years vs. duration of its reserves that is less than 1.5 years. In a rapidly rising interest rate environment, National General can take a mark to market hit to its investment portfolio which would hurt its book value and operating leverage in the near term. In general, National General has a very conservative investment portfolio.

• Reinsurance Recoverables: National General has a big reinsurance recoverables book from the NCRF and the MCCA, which is very safe, but if National General is unable to recover those Reinsurance Recoverables, it could result in a serious mark down of its book value.  

• Regulatory pressure in historically troubled lender-placed insurance line

Appendix:

Luxembourg Reinsurance Companies:

National General has bought Three Luxembourg Reinsurance Companies (LRC) since 2012. Purchasing an LRC is not unique to National General.  LRC’s are sold at a discount in order to limit seller’s taxes, and include equalization reserves which are best described as equivalent to redundant reserves. Equalization reserves are released through intercompany reinsurance agreements approved by Luxembourg authorities. The release of redundant reserves allows for the recognition of the discounted value of the business purchased. There is no impact on the loss ratio from intercompany reinsurance agreements. National General established a Deferred Tax Liability (DTL) equal to approximately 30% of the unutilized statutory equalization reserves carried at LRCs. The DTL is adjusted each reporting period based primarily on amounts ceded to the LRC under intercompany reinsurance agreements. As the income or loss of the LRC is primarily from intercompany activity, the impact on the overall pre-tax income for the consolidated group is generally zero. The reduction of the DTL for the utilization of equalization reserves creates a deferred tax benefit reflected in the income tax provision line on the income statement, which correspondingly reduces our effective tax rate. These investments are only 9% of the total investments.

Life settlement contract:

(LSC) is a contract between the owner of a life insurance policy and a third party who obtains the ownership and beneficiary rights of the underlying life insurance policy.

National General has a 50% ownership interest in four LSC Entities (Tiger, AMT Alpha, AMTCH and AMTCH II) that hold certain life settlement contracts. The LSC entities currently hold 282 policies with a face value of $1.8 billion as of September 30, 2014. The average age of the insured is 81.1 years, average life expectancy is about 10 years and effective discount rate is 13.9%.

National General could sell life settlements any day for $100 million gain, but believe it is worth more. Nat Gen’s 50% stake in LSC entities could be worth more than $400 million, but on the books it is carried at $130 million.

AmTrust short thesis and National General: Historically, AmTrust, one of the National General’s Sister Companies has been attacked by short sellers for it reserves, loss and expense ratio accounting, and the investments in the Life Settlements. We don’t think it is much of a concern for the National General Shareholders because of the following reasons:

• National General P&C business has a short tail of 6 months to a year vs. AmTrust which has a very long tail, therefore, setting up reserves is simpler and easier at National General than AmTrust and there is a less room for errors.

• Michael Karfunkel runs National General himself and dedicates most of his time to the Company. In National General, he has one of the highest ownership among all his ventures.

• GAAP loss ratios are usually lower than the statutory loss ratios. The Loss ratio consists of pure loss and loss adjustment claims expenses (LAE). LAE is further divided into Allocated LAE (ALAE i.e. LAE directly attributed to a known loss (usually legal expenses)) and Unallocated LAE (ULAE i.e. LAE not identified with any specific item (overhead)).  The main reason why statutory loss ratios are higher than GAAP is because GAAP loss ratios have ULAE and only some portion of ALAE vs. the statuary ratios has all of the ALAE. The rest of the ALAE for GAAP ratios goes into the operating expenses, thus GAAP loss ratio technically should be lower, but expense ratios should be higher than statutory ratios. Now statutory expense ratios are still higher than GAAP for another reason i.e. you can't counter deduct the fees from the numerator in the statutory expense ratios vs. in GAAP you can (fee income reduces the expenses in GAAP expense ratio). Owning Luxembourg Reserves doesn’t change the Companies loss ratios at all, because those changes only flow through taxes when the Deferred Liability is reduced. Please see the paragraph on Luxembourg Reserves to understand the reserves accounting.

• Life settlement contracts are slightly complex, but highly lucrative investments. If we owned 100% of National General, we would buy these contracts any given day for the similar price National General bought them at. National General can sell life settlements any day for $100 million gain, but it believes that it is worth more. Nat Gen’s 50% stake in LSC entities could be worth more than $400 million, but on the books it is only carried at $130 million. We think National General book value is under-valued on the balance sheet.

Acquisition history

Tower Personal Lines acquisition– National General acquired Tower Personal Lines business in 2014, which provides access to >$650 million GWP & managed premium, adds homeowners and umbrella product lines and ability to bundle products to agents/customers, enhanced geographic footprint, and access to >1,000 independent agents. In order to meet a regulatory hurdle, this is how National General structured the transaction through ACP Re.

• National General got into an agreement to acquire renewal rights and certain assets of the personal lines insurance of Tower Group and entered into a Personal Lines Quota Share Reinsurance Agreement with Tower, under which it will reinsure 100% of all the losses for Tower new and renewal personal lines business written after September 15, 2014.

• National General also became an Attorney-in-Facts that manages the Reciprocal Exchanges for a cost of $7.5 million in cash given to ACP Re.

• National General issued a 7-year $125 million note to ACP Re bearing interest at 7%, which is higher than its 3.5% average investment yield.

• ACP Re gave a full backstop (Retrocession) of up to $125 million for the stop loss reinsurance of the Tower book, for which National General will pay $28 million less a 5.5% ($1.5 million) fee, payable 5 years after closing ACP Re Receives from National General.

• ACP Re also received a Ceding commission of 2% on the business written on the Tower paper, and an earnout fee of 3% of GWP payable for a three year period following closing, capped at $30 million total.

• In essence, National General only paid $28.5 million-$1.5 million+$30 million=$57 million for the deal and receiving $125 million*7*7% = $61.25 million for the note.  Effectively, National General paid nothing for a highly profitable book of $650 million including Reciprocal.

Imperial acquisition – National General acquired Imperial in 2014 and added two underwriting companies with $150 million in GWP, an independent agency that produces $45 million in GWP, and an MGA; business, which includes personal auto, homeowners, Federal Flood, and commercial auto with a geographic concentration in FL, TX, and LA. Imperial has an attractive fee business and could cross leverage Tower’s platform to grow its flood business. Mark Carter who runs Imperial is a good manager, but the Company was caught in a poor investment from its old owners. Southport bought Imperial in 2013, and put part of its portfolio in illiquid assets which went south. As a result, the Management team turned the Company to the regulators and National General bought it from them. Here are the details of the acquisition:

• Southport put about 1/3 of the book into illiquid and hard to value assets. Under the structure of the deal, the illiquid securities were dividended back to Southport.

• The overall asset portfolio was $90 million; of which $30 million was dividended back.

• National General paid out $20 million to the Conservator and put $30 million in equity to restore Imperial equity to $50 million. Thus for $60 million of assets that National General received in Imperial, it only paid out $20 million and invested $30 million in the business.

• The Company makes $7 million in total pretax income with $3.5 million from fee income, $1mm in investment income, and $2.5 million in underwriting income.

• Imperial was running the book in high 90s combined, which could come down over time as National General integrates it into its system and bring down the expenses.

Strong catastrophe protection:

National General’s property catastrophe program provides $550 million of coverage in excess of a $50 million per event retention, with one reinstatement, which provides coverage for greater than a 1-in-150 year event. The casualty catastrophe program provides $45 million of coverage in excess of $5 million retention. The property catastrophe program for the Reciprocal Exchanges provides $190 million of coverage in excess of a $10 million per event retention, with one reinstatement

Source: National General

Management and Board:

Michael Karfunkel: Chairman, Chief Executive Officer

• 40+ years’ experience in the financial services industry

• Holds significant interests in insurance, banking and real estate companies

• Co-Founder and former Co-Owner/President of American Stock Transfer & Trust Company, Chairman of AmTrust Financial Services (AFSI)

Michael Weiner: Chief Financial Officer

• 19+ years of experience in the financial services and insurance industry

• Joined National General in March 2010

• Previous experience: Cerberus, Citigroup, KPMG LLP and Bankers Trust Co.

Michael Murphy: Executive Vice President – Accident and Health

• 31+ years of experience in the health insurance industry

• Joined National General in December 2012

• Previous experience: Coventry Healthcare, United Health Group and CIGNA

Peter Rendall: Chief Operating Officer and Treasurer

• 12+ years of experience in the insurance industry

• Joined National General (via GMAC Insurance) in August 2002

• Previous experience: various roles at GMAC/National General, Integrated Services, Inc. (software)

Source: National General

Ownership

Currently 55% of National General’s shares are owned by the Karfunkel family and AmTrust Financial with 45% publicly floating.  The Karfunkel Family owns about 43% and AmTrust owns about 12% of the shares. The Karfunkel Family and his Foundations also own a majority stake in AmTrust of about 56%. Other top shareholders in National General includes Kingstown, MSD Capital, Kensico Capital and BHR Capital, which are all long term sophisticated insurance investors and do not worry about a quarter.  

Catalyst

earnings upside from higher accretion than street is modeling; future accretive M&A