Description

NAHC is a microcap P&C insurer trading around 77% of tangible book value and about 6.7X estimated 2006 earnings. The stock has been left like road-kill on the Jersey Turnpike, but management recently announced a stock buyback and I believe the market is underestimating its earnings potential going forward.

Business: National Atlantic Holding Company is a holding company whose primary business is Proformance Insurance Company (“Proformance”). It also has three ancilliary businesses: Riverview Professional Services (“RPS”), National Atlantic Insurance Agency (“NAIA”) and Mayfair Reinsurance Company (“Mayfair”). NAHC has $11 million of cash and no debt.  Proformance writes insurance solely in New Jersey. 77.1% of its business is personal auto, 10.2% homeowners and 12.7% commercial (“Main Street” type businesses).

Proformance was formed by a bunch of insurance agents in New Jersey to write personal auto. The New Jersey auto insurance market is the 2^nd most difficult market in the US; Massachusetts takes low honors. Proformance struggled during the 90’s but hit a jackpot of sorts in 2001 when Ohio Casulty agreed to a replacement carrier transaction (RCT) with Proformance. Ohio Casualty (OCAS) agreed to pay NAHC to take their New Jersey personal auto business off its hands. NAHC netted $38.4 million from the deal over five years, as well as $13.5 million in equity investment from OCAS. Similar deals were struck with Sentry Insurance and Metropolitan P&C in 2003. These transactions really helped stabilize the company.

The remaining businesses are not significant from an earnings point but they are important. Mayfair was formed to retain more risk when reinsurance became unaffordable. NAIA handles “orphaned” insureds from an RCT, that is, policyholders not placed with any independent agencies with which Proformance has contracted. RPS provides case management review for medical injuries and AT&T is a big client. NAIA and RPS are the main contributors of dividends to the holding company.

Replacement Carrier Transactions (RCT): While they have grown organically, the biggest growth has come from RCT’s. Let me explain the dynamics. Once a company starts writing personal auto in NJ, regulatory requirements, such as “take all comers” clauses, make it difficult to withdraw. However, regulators will approve a replacement carrier transaction whereby one insurer can transfer renewal rights to another insurer.

The OCAS transaction was unique because OCAS was desperate to get out of the personal auto market in New Jersey. The book of business was significant because NAHC’s earned premiums shot up from $25 million to $143 million between 2001 and 2003. It is also why NAHC needed the equity investment, to support that additional writing and to keep their underwriting leverage below 2.5 to 1.

One initial concern that I had on the RCT was adverse selection.  I spoke with the CFO, Frank Prudente, about the RCT process. NAHC sees most of the claims history on the policies as the agents from the transferring insurer will typically enter into contracts with NAHC. They retain about 70% to 75% of the transfers in the first year, and about 58% to 64% over time. NAHC typically caps any rate increase to about 15% per year on transferred policies for three years. However, the book is re-underwritten in the second year, so they know which pricing tiers to place the policies. This helps to retain good insureds and weed out the bad ones.

The Sentry and Met P&C RCT’s involved a combined payment of $10.9 million, plus a $10.0 million equity investment from Met P&C. NAHC has not provided much detail on these transactions but they noted in their 10-K that they added $32.1 million in direct written premium for 2004.

The current RCT’s are with The Hartford for 8,500 policies and Hanover for 16,000 policies. To get a ballpark figure of how much premium this represents, I will look at the OCAS RCT. While earned premium increased $117 million between 2001 and 2003, I will assume $100 million was from OCAS. This RCT involved 67,000 policies initially and assuming 64% retention rate, that is 42,880 policies. Divide $100 million by 42,880 and the average policy is for $2,332. To be conservative, I will assume $2,000 average policy premium. Multiply 24,500 policies by $2,000 average policy premium, then multiply by 58% retention rate and you get $28.4 million of premium. That represents a 16% increase to 2005 earned premium. That is strictly from personal auto policies and does not include any additional coverages that they cross sell.

Strategy: The competitive market for personal auto insurance has led them to write more homeowners and small commercial. They have created a personal package policy that they call High Proformance Policy that combines auto, homeowners, boat and umbrella. This helps them compete against monolines like GEICO, Even though they are paying for the RCT’s with The Hartford and Hanover, they can leverage the deal by expanding beyond personal auto insurance. They have an overview slide show that you can access at that may help explain what they are doing:

http://www.sec.gov/Archives/edgar/data/946492/000095012306007434/y22018exv99w1.htm

The commercial business is primarily general liability and commercial auto. They do not cover property or workers comp.

Regulation: The NJ legislature enacted the Automobile Insurance Competition & Choice Act (AICC) in 2003 that introduced reforms to make the auto insurance market more competitive.  AICC had two significant impacts to NAHC. First, the economics on the RCT’s flip-flopped and NAHC now has to pay for the RCT, although the fees are relatively small. The second impact was new competition from GEICO, Mercury Insurance and Progressive entering the NJ market. NAHC has responded by introducing a personal package policy that combines personal auto, homeowners, umbrella and boat insurance into one policy. They are also focusing on small “Main Street” businesses.

Commissions: The overall commission expense is 13%. This consists of 15% on new personal auto policies and 12% on renewal. Homeowners pay 18% for new and 15% for renewal. The RCT business handled by NAIA is paid between 7-8%. These rates are slightly high but not surprising from a company formed by agents and who have agents as shareholders.

Ratings: AM Best recently upped their rating from “B” to “B+”. In speaking with the CFO, Frank Prudente, he mentioned that their last BCAR from AM Best actually put them in “A-“ territory but that Best has been reluctant to make major ratings changes after last year’s hurricane season. This has been frustrating for management because they had a “B” rating all through the 90’s when they were losing money. They are now profitable, and received a capital infusion from last year’s IPO.

Capital Structure: NAHC has 11.2 million shares outstanding, plus 0.4 million of in-the-money options. There is no debt. From the proxy, Hovde Capital owns 16.2%, the chairman and CEO owns 15.0%, American Century owns 6.6%, Boston Partners owns 6.5% and The Commerce Group owns 5.6%. Since then, Hovde has bought an additional 80,650 shares. The CEO and one director have sold some shares but retained most of the shares that they had acquired through option exercises. Also, 15% of the stock is owned by 105 Partner Agents, who had to buy a minimum of $50,000 of NAHC stock. The stock debuted on April 21, 2005 at $12.00/sh.

Reserves: In 2005, they had $10 million of adverse reserve development. This was primarily driven by a court case, DiProspero v. Penn et al, where the New Jersey Supreme Court struck down legislation that had limited plaintiffs ability to sue for non-economic damages, i.e. pain and suffering. This took place in 3^rd quarter of 2005 and so far, it seems like they did the right thing in increasing reserves for this. In fact, MCY recently had to up its reserves for New Jersey personal injury protection claims:

http://www.marketwatch.com/News/Story/Story.aspx?guid=%7B85132CE3%2D1B78%2D4C61%2D97B5%2D9EEE78039280%7D&source=blq%2Fyhoo&dist=yhoo&siteid=yhoo

In prior years, any reserve releases have been small, which leads to questions about adequate reserving. I believe part of the issue has been the change in RCT economics. Previously, they could afford to run higher combined ratios because they made up for it in fees. Now that they have to pay for RCT’s, they have to show an underwriting profit. I also believe having public shareholders, including the Partner Agents as shareholders, now makes them more focused on turning a profit.

Investments: Their portfolio is fairly straightforward for a P&C insurer: Lots of bonds, with a tendency towards government agency debt (Fannie, Freddie, Farmer, FHLB). The bonds all have ratings of “A” and higher. Stocks comprise a little over 4% of the investment portfolio, with 2/3 in indices. There are no alternative investments.  The good news is that investment income is up dramatically from its low two years ago and is making a solid contribution to the bottom line. That comes at a price to the mark-to-market on the balance sheet and in the 1^st Quarter 2006, NAHC shifted 14.6% of the fixed maturity investments from “for sale” to “held to maturity.”

Valuation: TBV is $12.18 as of 3/31/06 and I think it could trade to a 10% premium. The bigger question is what it can earn, as that will drive the upside the most. If they break even on the insurance business, they can earn $15 million in investment income or about $0.84/sh after tax. Last quarter, they earned $0.35/sh, which implies $1.40/sh potential earnings. With increased writings from the Hartford and Hanover RCT’s, they might push $1.60/sh (16% increase to 2006 EPS). 8X-9X those earnings would be decent. I see this as a $13-$14 stock in a year, with limited downside (outside a hurricane ripping through NJ).

Risks:

• illiquid è USE LIMIT ORDERS AND DON”T BID OVER $10.00
• Personal auto insurance is a political hot-button in New Jersey
• Proformance has negative unassigned surplus that prevents it from paying dividends to the holding company and they are dependent upon the other businesses for cash flow
• AM Best ratings
• Storm/hurricane risk to New Jersey
• They retain most of the risk, save for about $80 million of cat cover
• AT&T does not renew its contract with RPS that expires on 10/15/06
• Their auditor identified materially weaknesses in internal control, which they hope to have addressed with two system upgrades
• The Hartford and Hanover RCT’s do not pan out

References:

2005 10-K: http://www.sec.gov/Archives/edgar/data/946492/000095012306003915/y19199e10vk.htm

1Q06 10-Q: http://www.sec.gov/Archives/edgar/data/946492/000095012306006422/y21349e10vq.htm

Proxy: http://www.sec.gov/Archives/edgar/data/946492/000095012306004696/y19380def14a.htm

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