Description

RTWI is workers compensation insurer that is selling at a little over 50% of book value and 1.5X 2002 EPS from operations (this is a case were the pro forma results are *worse* than actual results due to a tax refund). RTWI is in the second year of its turn-around and is doing well. AM Best even upgraded its lead company this week from "B-" to "B" because capital surplus increased from $18 million to $25 million due to cash generated from operations.

Some may remember this company from late 2001, when ACAP made a serious bid for RTWI at split adjusted price of $6.20 a share. ACAP shareholders ultimately nixed the deal, which left RTWI dangling in the wind. Founder and former CEO David Prosser, who will be 78 this year, increased his stake, reseated himself as chairman of the board and brought back two former executives to help right the ship. Before founding RTWI. Mr. Prosser ran an employment agency that specialized in nurses. He also noticed how insurers rarely involved medical people in workers compensation cases. This led Mr. Prosser in 1983 to help launch a company dedicated to providing “return-to-work” rehabilitation services on workers compensation (W/C) claim cases. Seeing an opportunity to apply this concept further, he started American Compensation Insurance Company (ACIC) to write just work comp insurance in 1992. The idea was to focus on above-average risk industries that would benefit from their focused claims monitoring and rehabilitation services.

The founders of RTWI decided to scale back their roles at RTWI and selected Carl Lehmann as CEO in 1998. Unfortunately, Mr. Lehmann implemented a different strategy, whereby they would cede most of the insurance risk, reduce their claims handling and attempt to capture the spread. This required that RTWI aggressively expand, in order to make up for the additional premium ceded to reinsurers. From 1996 through 2000, ACIC had a combined ratio of 107.9 and an operating ratio of 99.7. Basically, they broke even, which is notable considering the reserve hit and 120+ combined ratios in 1998 and 2000.

In beefing up reserves as of 12/31/2000, though, ACIC had to tap their capital surplus. Thus they became very close to being over-leveraged, meaning that they were writing more premium (net of reinsurance) than they had capital surplus to support it. Accordingly, AM Best dropped their rating from B++ to B+, then to B and finally to B-, which is the last stable rating before insurers are rated as vulnerable. With significant rate increases filed to boost rates, ACIC had to do something to either lower net written premiums or raise capital. Since their stock was plummeting, they could not raise capital from the equity or bond markets. They had already borrowed $8 million (at LIBOR + 240 bp) on a 5 year note to buyout the last founder in March, 2000 when the stock was at a pre-reverse split price of $10. ACIC basically had no choice but to enter into a 50% quota share reinsurance treaty effective 1/1/2001 in order to reduce net written premium. In this arrangement, ACIC was sharing the risk with the reinsurer. In May, 2001, ACIC initiated a series of rate increases with a 29% increase in Minnesota rates. Seven months later, RTWI announced that they were closing their Missouri and Massachusetts offices, and would focus primarily on Minnesota, Michigan and Colorado. Three other members of the Prosser family also stepped up to the plate and bought 5%+ stakes back in the company in 2001.

A significant change in 2002 was to their reinsurance. Previously, they were ceding losses between $25,000 and $300,000 but they changed it to reinsure losses in excess of $360,000. This forced RTWI to more actively manage claims, which in my opinion, is their strength and what differentiates them in the market. They have seen their claim frequency and average claim reserve decrease. At the end of the year, they were able to cancel the quota share with St. Paul, which resulted in a return $28 million of assets back to their investment portfolio. RTWI will be able to earn more on this block of money than the 2.4% in interest that St. Paul was paying them. One negative was that they had to do a reverse 2-for-1 stock split in order to avoid delisting.

The outlook for 2003 is looking better. They have lowered their retention levels to $200,000 because despite loss frequency being down, loss severity is up. They have also shifted their investment portfolio by selling all their corporate securities and buying Treasuries and mortgage-backed securities. They will also pay off the note payable ahead of schedule, which will leave them debt-free by 2004. They are also reducing expenses, as several leases run-off from discontinued operations, from renegotiating existing leases and selective . Lastly, they still have $6.6 million in deferred tax assets that will reduce their tax burden (they realized $7.9 million of deferred tax benefit in 2002).

The difficult part is estimating what 2003 earnings will be. Management has not given any guidance, other than to say that their rate increases are in place and they expect premium levels to be flat for the year. As with most micro-caps these days, analyst coverage is minimal, but SNL Financial does cover RTWI. They are forecasting 2003 EPS of $0.34 with their 1st Quarter estimate at $0.06 and 2nd Quarter estimate at $0.07. So why is RTWI selling at such a low forward P/E of 9? I believe that investors are taking a wait-and-see approach to consistent earnings.

I also believe the key shareholders are interested in realizing greater value in RTWI. Besides the 16.2% owned by Mr. Prosser, four other Prossers own a combined 29.5%, Federated Investors owns 10.5% and Dimensional Fund Advisors owns 8.0%. This is pure conjecture on my part, but RTWI belongs on another company's balance sheet. A well-capitalized company would be able to improve earnings simply by leveraging RTWI and adopting their claims strategy. I think the Prossers would like to convert some of their holdings and it will be difficult for them to sell any significant stake on the open market.

Catalyst

1. Continued turn-around in capital position that lead to another upgrade
2. Reducing lease expenses, paying off debt, increasing investment income
3. Potential buyout