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In my last article on Fremont (OTC:FMMH), I wrote that "The proof of the pudding in terms of management's serious about shareholder interests will be if we see significant progress on the expense ratio front next quarter and beyond and a move to expand to other states." This latest quarter, Fremont has had another remarkable improvement in its expense ratio.

The company reported earnings Monday, and their underwriting results were outstanding at a combined ratio of 87.1. The combined ratio and the expense ratio both improved substantially from previous quarters, leading to a significant increase in diluted EPS.

This past quarter, compared to the same quarter twelve months ago, the company reported $0.72 EPS vs. $0.31 EPS, an increase of 132.3%. For the last 9 months, diluted EPS increased by 41.6%. The loss ratio was extremely impressive, reflecting Fremont's focus on underwriting profits, excellent agency relations, and Vice President Frank Massucci's formidable pricing skills. The company is small, so it is basically cherry-picking the best risks it can find from committed independent agents. At a P/B ratio of .75 with growing underwriting profits, I believe the company is overlooked by the investment community.

Moreover, structurally, the expense ratio has become much more competitive. Twelve months ago the expense ratio was 37.3, the last quarter before this one it was 34.1, and in the latest quarter just reported it hit 32.7. Essentially, it has improved by 4.6 points in the last twelve months and by 1.4 points since last quarter. Using independent agents for their entire business, I believe the company can hit 28 in a year if management continues to watch expenses with the same intensity. A drop in expenses to 28 would further boost net income, given a normalized loss ratio and investment income. A reduction in the expense ratio to 28 could be achieved by a renogotiation of the company's reinsurance contracts, to increase retentions from the current level of $150,000 per risk.

Why should investors look at Fremont? It has a balance sheet which would put a Puritan to sleep, and it actually sticks to writing auto, homeowners, commericial, farm, and marine lines, rather than esoteric derivatives and/or financial insurance. In addition, they have shown that they are serious about reducing the expense ratio and increasing underwriting profits, allowing the company to grow intelligently. Thanks to CFO Kevin Kaastra, the company consistently over reserves, unlike most insurance firms, lending credibility to its earnings and to its balance sheet. You would be surprised at how common under-reserving is in the insurance business. It is an insidious practice. Fremont's reserving table, unlike that of many of its competitors, is a model of conservativeness.

In contrast, fiascos such as American International Group (NYSE:AIG) share some defining charecteristics. They got too big for their britches, over-leveraged their balance sheets, and did not adequately understand the risks they were taking in complex derivative instruments and financial insurance.

Investors need a well-run, conversatively financed company which can grow. I believe it will be hard for them to find that near Wall Street, or even Hartford. They may find it in Fremont. What is the downside? Like every other financial firm, I believe Fremont may have had some turbulence in its investment portfolio when the 10-Q comes out. Unlike most financial firms, however, they last reported a AA bond portfolio with a relatively short duration. In addition, the company has incurred zero debt. The equity to assets ratio is .436, which is extremely conservative. Compare that to the Hartford Insurance Group (NYSE:HIG), and you may sleep better at night in Michigan.

In terms of strategy and corporate governance, I think it is a double-edged sword. On one hand, the company has B++ A.M. Best rating, due to, most prominently, their status as a solely Michigan insurer. How has Fremont managed to grow so much, given that they do not have an A- rating? Their strategy is to be extremely close to their independent agents, who know Michigan (and the company) extremely well. For instance, Michael Dekuiper's White Agency is their largest producer. He sits on the company's board and is the father-in-law of CFO Kevin Kaastra. Two other independent agents for Fremont sit on its board as well. I believe they are Donald C. Wilson, and Harold L. Wiberg, but I could be wrong. That's what I have gathered from the filings.

These gentlemen are amazing agents, judging by Fremont's loss ratios. It looks to me, judging from the numbers, that they are feeding the company their choicest, most conservative risks. They are clearly extremely important to the company and are instrumental in the company's growth. The only question is whether there might be a potential conflict of interest in their oversight of management, given the substantial commissions they are paid as independent agents. In other words, in essence, three agents providing oversight of management as board members received $526,000 in total regular and profit sharing commissions in 2007 from Fremont. Clearly, these agents are critical and valuable to Fremont.

The issue is that, often, these relationships can create the appearance of conflicts. And that can make problems down the road for a public company. One of the challenges, at any company, is having a board which can have open discussions with management. That requires an absence of potential conflicts, and it requires total, absolute independence. In addition, another director, Jack A. Siebers, is a partner in a law firm that the Company "has retained" and "continues to do so" for $74,000 in 2007.

Moving on to strategic isues, an important point to remember is that "most" potential agents for the company do not already sit on its board nor are related through marriage to executives. They will not have, naturally, the same familiarity or comfort level with the firm, even though Fremont was founded in 1876. Without an A- rating, life is a bit harder for Fremont than need be when it comes to winning new business. It means that VP of Marketing Kurt Dettmer has to work twice as hard as Fremont's higher-rated competitors to get the same business (although at double-digit premium growth, he makes it look easy!).

What is a potential solution? Fremont could get an A- A.M. Best rating by expanding regionally to neighboring states. No one is advocating that the company "diworsify" by going to the Gulf Coast, or to an area that would prove problematic due to pricing, weather pattterns, or the regulatory environment. Certainly, there couldn't be a harder hit state than Michigan economically. Expanding to other states could get the company an A- rating, and it would actually increase the company's reach in Michigan itself, since many agents who do not know the company find it hard to consider firms with only B++ ratings. It would also reduce catastrophe risk, regulatory risk, and economic risk.

I would imagine that management would have to do a lot of soul-searching about contemplating such an expansion. Perhaps it would challenge their identity as a Michigan-only carrier. But there comes a cross-road in every company's evolution where such an expansion could bring myriad benefits. I think the Fremont team will be surprised at how much easier it is to operate in more bountiful soil. If the company can grow premiums significantly in Michigan, which essentially is in a business depression, I can only imagine the strides an aggressive Vice-President of Marketing, such as Kurt Dettmer, could make in states which have been a little less hard-hit than Michigan, or in Michigan itself if the company sported an A- rating.

If the company wanted to further leverage CIO and EVP Dave Mangin's skills in IT, they could even expand to other states by writing over the Internet, which would be icing on the cake. As Warren Buffett opined to GEICO executives in Snow Ball, "He who wins the Internet, wins the war" (page 777). I believe that IT has allowed the company to achieve remarkable operating leverage, whereby increases in premiums are not met with commensurately increasing expenses. Writing insurance over the internet in other states would structurally change the expense ratio structure to one that could hit the low 20s. Since it would be in other states, it would not alienate the Michigan agents on the company's board, and it would make the company a formidable potential competitor to larger firms such as Progressive and GEICO, whose bread and butter are razor-thin expense ratios.

Fremont has taken a great step in the right direction. It is a credit to COO Kent Shantz and CIO Dave Magin that their promotions have been accompanied by blowout numbers on the underwriting side of the business and significant improvements in Fremont's expense ratio. If they can keep up the pace, Fremont will become a top-flight insurance investment.

Disclosures: Harry Long owns FMMH shares directly, through partnerships, and through trusts. To the best of his knowledge, certain of his family members own FMMH shares through partnerships and trusts. Such ownership may change at any time.

Source: Fremont Michigan Insuracorp: Taking Great Steps in the Right Direction