Description

Specialty Underwriters’ Alliance. Inc.

Specialty Underwriter’s Alliance (SUAI) is a compelling risk/reward opportunity: a differentiated business model that should produce 20% ROEs for several years in a “target-rich” environment, with a management team that has a demonstrated track record of profitable underwriting, and has already shown commendable discipline in committing their capital available, partner agents who own stock in the company and whose compensation is linked to the long term underwriting results of the book of business that they provide. All this is available for 1.1x book, most of which is still cash, while comps with inferior designs are at 2.0x book. Did I mention that this bargain price is the singular result of “busted IPO” trading dynamics?

So why is this stock on sale? SUAI completed its initial public offering in November 2004 at $9.50 per share. A combination of unique events rippling out from a delayed and downsized IPO (discussed further below) impacted the company’s ability to write business in Q1. Then the potential emergence of pricing pressure in one line of business from an irrational competitor emerged in Q2. The company told investors that they would not yield on price given the other profitable opportunities that they had, and that as a result it might take an extra quarter to roll out other lines and get to a full premium run rate. Investors appear to have punished rather than rewarded this prudence.

Our diligence suggests that there is plenty of business available to the company at compelling prices, and rather than being opportunity constrained, the company will soon be capital constrained. By the fourth quarter of this year, we believe that the concerns will have lifted, and we believe that the stock has the potential to double or better within the next eighteen months, while continuing to produce ~20% ROEs for many years to come.

We project an EPS run rate of at least $1.40 by year end 2006. We see a $16 stock within a year, with further upside from there. The downside risk is mitigated by book value of $7.70/share. With a 15% downside to 100% upside on a proven management team whose partners are betting on them, we think 6:1 is an outstanding risk/reward ratio.
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Disclosure Statement: This is not a recommendation to buy or sell the stock. We own shares of the company, and we may buy more shares or sell shares at any time without notification.

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Specialty Underwriters’ Alliance, Inc. (“SUAI”) writes specialty program insurance. The company provides insurance to tow truck operators, small contractors, certain types of worker’s comp and other niche customers. Each business line is “high frequency/low severity,” allowing for predictable underwriting results over time.

Traditional Program Business:
Specialty insurance companies get nearly all of their business from “wholesale agents” and “managing general agents”. These are typically privately-owned businesses that source $10- 50mm of annual premiums and earn half a million to three million dollars per year. These firms aggregate policies from retail agents and certain professional organizations and are customarily paid flat commissions by the insurance companies that take the business. They are responsible for sourcing and underwriting business, handling claims, and designing the specialty policies. The issues with this structure are that the agents are incented to maximize volume at the expense of underwriting profit.

SUAI Model:
SUAI’s model differs in a number of key ways:
• They retain underwriting (a core competency)
• They retain the claims management function (again, a core competency, though they have outsourced it to a third party in one case for an initial period)
• A significant portion of the compensation paid to the partner agents will be directly tied to the underwriting profitability of their specific programs.
• Partner agents are required to buy $1MM of stock, which is effectively locked up for 5 years.
• The company also notes that “ we anticipate that all transaction processing will be done through our proprietary technology system in order to ensure data integrity and efficiency”. In other words, they are building a web based front end for most of their policies, which streamlines the processing, but also guarantees that all policies are written to their standards.

SUAI currently gets all of its business from four wholesale agents. In return, SUAI pays the agencies an up-front fee to cover costs plus a contingent commission over 3-4 years. The agencies can only make money if the book performs exceptionally well. This arrangement is unique in the specialty program industry. This means that the owners of wholesale agencies are forfeiting a year of current income by entering into this arrangement with SUAI. In addition, the owners of the wholesale agencies are each investing $1 million in shares of SUAI over the next 18 months at the market price. These owners are making very large personal bets on the future profitability of SUAI’s business. In researching other specialty insurance companies, we have seen years of data for certain niche specialty lines. It is our belief that pockets of inefficiency exist in specialty insurance, and a smart management team can exploit these and earn high risk-adjusted returns over a long period of time. SUAI’s “deal” with its partner agents is a extremely clever self-selecting process to direct some of this outlier ROE business onto its books.

The wholesale underwriters have a long history with their books of business, which means they know how it has performed and how it renews over time. As the policies come up for annual renewal, the wholesale agencies will simply put the business onto SUAI’s paper. If the book of business doesn’t come to SUAI in a timely manner and perform well, then the businessmen who own the agencies will 1) have no income and 2) lose money on their meaningful investment in the common stock of SUAI. We view this as unlikely.

The partners and their books of business are discussed in the company filings. What makes these partners and programs so attractive is usually some combination of factors including:
• Dealing with one of the few general agents for a small book of business (such as tow trucks), where the firm is known to be one of the few aggregators. At small scale, competition is that much less in lines that require specialized industry knowledge.
• Detailed policy design and exclusions / Careful risk selection among a class of insureds (eg: no tow truck business in Texas)
• Niche opportunities within a larger class that has seen huge pricing increases as a result of adverse development in the non-niche component. (eg: not all artisan contractors carry the same risk).
• Individual underwriting of insureds within a program to avoid adverse selection (eg: Florida PEO).
• Limited size of business lines – these are typically lines of business that will produce a very limited volume of premiums ($20 to $50 million per year initially, in most cases) and so are not as competitive. Just as with stock picking, at small scale pockets of inefficiency do exist.

It’s worth noting that the current partner agents were chosen from a search through dozens of potential partners and programs, and given the downsizing of the IPO, represent a further “culling” for the most profitable niche programs. It gives some further level of assurance that the lines chosen should be of above-normal profitability.

The management team
As with EDLG, my prior write-up, the key to the story is the chance to bet on an experienced team that’s done it all before. SUAI’s management team has been doing program business for many years and has a wealth of experience and contacts in the industry. The CEO, Courtney Smith, was formerly CEO of Coregis, where the underwriting record was stellar up to its sale to GE in 1998. He was brought in by Fairfax to try to fix the program business at TIG. The company was beyond repair as a result of business written before Courtney ever got there, and was ultimately shut down and put into runoff. He has demonstrated underwriting discipline, and he has an experienced group with him. Pete Jokiel, the CFO, was CFO of CNA Financial, and Bill Loder the Chief Underwriting Officer has over 30 years of experience and worked with Courtney Smith at TIG. Gary Ferguson, the chief claims officer, worked with Courtney Smith at Coregis and TIG. I don’t think they’d thank me for saying this, but this is a team with some serious gray hair from 30 years in the business. Our diligence says that they’ve done it before, in hard and soft markets, and have done it profitably.

The Delayed IPO
SUAI originally planned to do business with 5 managing agents in 9 programs. The underwriters came back to SUAI and cut the size of the IPO late in the day by 30-40%, leaving the team with about 2/3 of the capital raise that they anticipated. This left them in a situation where they could unilaterally cut partners and programs in a rush to market, or preserve relationships and negotiate with the partners for a smaller start. The management took the long term view and opted to renegotiate with their partner agents. The group was reduced to three, and the programs to five at the launch. Unfortunately, the process of renegotiating effectively took until year end 2004. In addition, SUAI’s rating from AM Best was delayed (we believe as a result of the departure of the analyst), and as a result SUAI missed the January and February renewals, most of which were underwritten by December. This business is not gone for good, but will be available to be underwritten next year. In addition, the company noted that they had decided to take the opportunity to initiate business with another one of the original five partners, and expand some of their existing profitable programs to other states (as had been planned). The point was clearly that there was that timing of premiums, not volumes, was the issue. Nonetheless, when the issue came up on the Q4 call, it led to the first sell off of the stock, from the IPO level of $9.50 down to the $8.00-$8.50 range.

The Q1 call. Q1 volumes were as expected, but the company refused to give guidance for Q2 volumes because a competitor (writing worker’s comp in Florida) was pricing extremely irrationally, and as a result, SUAI was unsure of what volumes it would generate in that line (its largest) since they would not yield on price. The company did make it clear that regardless of what the Q2 number was, that they were very confident of the year end premium run rate of ~$150MM. Nonetheless, the stock sold off to the low $7 range before recovering to $8.50.

The investment case:

The bear case on the company appears to be that since they may not hit the number in the analyst models for Q2 that they will be unable to ever produce the premium volumes to fully employ their capital profitably.

Our view is that, as Warren Buffett points out in his annual report, it is easy to produce volumes in insurance – all you have to do is drop your price and you can write all that you want. In the same way, you can buy all the stock you want if you are willing to hit every ask price. The trick to only commit capital at the price that allows you to show an underwriting profit. SUAI has done exactly what any owner with a long term view should want it to do:
• Walked away from low pricing and maintained price discipline
• Expanded its underwriting in profitable lines.
• Initiated underwriting in other lines that it had already pre-qualified.

In other words, they should be able to hit the volumes they want without compromising profitability, it just probably won’t be there by Q2. When questioned on the call, the CEO clearly stated that he expected to be at $150MM annual premium run rate by the end of the year and further, saw the need for a Trust Preferred security in the near future – Q405 or Q106 – implying $200 million premium annual run rate at 1.5x premium leverage.


Valuation:
You can sketch out a very crude set of numbers for yourself but here is how I look at the risk/reward potential in the name. The underwriting history of the various books of business is known. I think it’s reasonable to assume that management has targeted combined ratios of 85% or so given the highly specialized nature of some of their lines (we have heard very encouraging historical loss experience on some lines, but the truth is that we’ll only know for sure as the lines develop).

Nonetheless, if we assume 88% as a combined ratio on $200MM of premiums (1.5x premium leverage, including 20MM of trust preferred), float life of 1.3 years and an investment return of 3.5% I get EPS of $1.30

Using the combined ratios that I expect the company to hit in my base case, about 85% (some of these lines have VERY low historical loss ratios and the number could be lower), and a 4% investment yield (as a result of rising rates), I get to a number of $1.60.

Those numbers spell a likely stock price of $12-$20 a year out for 50% – 100% upside from current levels. On top of that, the company should be able to continue to employ capital at 15%-20% ROEs within their existing lines of business for a number of years to come.

Specialty insurance comps include MKL (2.0x BV, 12.9x ’06), HCC (1.9, 10.5), PHLY (2.8,11.2), ZNT (2.5,10.9), and PROS (1.2, 7.7). You can choose your own comps as well. Note that with whatever comps you choose, low multiples with specialty companies are a result of 1) unknowable legacy liabilities or 2) another failed FBR IPO but with an inferior story.

Downside: Current Book Value per share is $7.70, with tangible book value of $6.97.
The difference is the insurance licenses that they bought for about $10 million. Assume that they could sell them for half of what they bought them for, and you have a worst case downside of $7.30, for about a 15% downside from current levels (we think this is highly unrealistic).


RISKS
Poor underwriting: These are lines that may be new on SUAI’s paper, but the partner agents have experience going back several years. In addition, the lines are high frequency, low severity typically which makes results more predictable. Further, careful policy design has allowed the company to further carve out a lot of the risks (eg: the two year sunset and mold exclusions in the construction defect policies). SUAI retains control of the underwriting and claims and the management has a track record of profitable underwriting. Finally, you have partner agents who have tied both their commission income and personal capital (via the stock investment) to the success of the firm. Remember that for each line of business written by SUAI, there is a businessman out there who forfeited current income in order to do business to SUAI. It seems unlikely that these guys chose to make personal bets on their marginal lines. This can’t be overemphasized.

Premium Volumes: The company has to put its capital to work in order to make all the happy little modeling above mean something. So far, the rollout has been slower than the more optimistic models projected. Talking with the company and its partner agents, we don’t think that putting $150MM - $200MM to work will be an issue given that there is at least one other partner agent that they originally planned to work with who is available to them, as well as additional programs and geographies with their existing partners.

Soft market: The bane of all property/casualty companies, the beginnings of price competition. Softening is real, but there are a few things to be clear about – first off, the market is softer, not soft. Secondly, certain lines are affected worse than others, and some are still seeing price increases. Thirdly, the nice thing about being a small insurer is that you can be quite nimble about where you choose to deploy your capital. Finally, as noted above, small highly specialized lines tend to be somewhat less competitive.

Investment returns. The company has kept investment durations relatively short and investments fairly conservative so far – currently they are in A rated (or better) bonds earning about 3.4%. There are no guarantees about the future, but I would expect them to be well placed to earn a higher rate as those investments mature.

Execution Risk. The company has an experienced management and has hired out pretty much all of the team that they need. Courtney Smith, Pete Jokiel and Bill Loder have done this before. We have visited headquarters in Chicago, and sat down with management. Nonetheless, this is a startup. Most of the systems and people are in place and running already but this is still a growing company.

B+ A.M. Best rating. A lot of SUAI’s business doesn’t even need an AMB rating. A year or two of execution and careful capital management will bring an upgrade, but we don’t see it as a significant limiting factor for the lines of business that they are in.

Catalyst

Pretty straightforward – the company has to show premium volumes and an appropriate combined ratio over the next few quarters. Q2 and to a greater extent Q3 numbers should provide a lot of comfort to those investors who are willing to buy at the current price.