Fremont Michigan Insuracorp: The Possible Benefits of Lowering Reinsurance Levels

Jan.25.09 | About: Fremont Michigan (FMMH)

It might be extremely profitable for Fremont Michigan Insuracorp (OTC:FMMH) to moderately reduce its level of reinsurance in certain of its lines. While this might make underwriting results more volatile on a quarterly basis, it would very likely reduce the combined ratio of the company on a longer term basis and significantly increase underwriting profits. This approach would make sense, since it would increase the company's longer term intrinsic value, rather than the current approach, which I believe might reflect a shorter term focus that views public shareholders as unable to tolerate more volatile quarterly numbers. However, long term Fremont investors deserve the lowest combined ratio possible, rather than a higher combined ratio number which is smoother and less volatile quarter to quarter due to a relatively higher, suboptimal level of reinsurance.

From Berkshire's 1995 Chairman's Letter:

We will get hit from time to time with large losses. Charlie
and I, however, are quite willing to accept relatively volatile
results in exchange for better long-term earnings than we would otherwise have had. In other words, we prefer a lumpy 15% to a smooth 12%. Since most managers opt for smoothness, we are left with a competitive advantage that we try to maximize. We do, though, monitor our aggregate exposure in order to keep our "worst case" at a level that leaves us comfortable.

From Berkshire's 1994 Chairman's Letter:

Too often, insurers (as well as other businesses) follow sub-
optimum strategies in order to "smooth" their reported earnings. By accepting the prospect of volatility, we expect to earn higher long-term returns than we would by pursuing predictability.

It might be optimal to reduce reinsurance more in auto lines, which are a bit less weather sensitive than homeowners' policies. I find workers compensation lines absolutely terrifying, due to their terrible loss histories at many other insurers. Simply put, it is almost impossible to mathematically model jury decisions or fraud, and therefore it might be intelligent to either eliminate the workers' comp line, or to do overkill on the reinsurance for that line. I would, of course, recommend the former.

My concern is not really about the company's history of workers compensation (Fremont started its workers' comp line in 1997), as it is about the industry's terrible overall history of workers' compensation claims. I'm just not sure the risk/reward is there.

I think the main reason why Fremont offers it is to please their agents, who want to be able to offer a full package to clients--vehicles, buildings, workers comp, etc. If it is a value judgment between pleasing agents, or protecting shareholders, I think the company has a fiduciary obligation to protect shareholders.

COO Kent Shantz was hired in 2007, and he oversees commercial lines, which include workers' compensation. So far, I haven't seen anything notable about it one way or the other, but that's the nature of workers' comp. It's kind of like earthquakes--the ground is pretty stable until one strikes. However, unlike hurricanes, wokers' compensation lawsuits are social, and not natural phenomenon, and hence, do not lend themselves well to actuarial science. I think writing those risks is akin to playing with fire. Very, very few companies do it well. In the past, it has hurt the very best insurers. This is why I advocate ending that line of business. Auto insurance has a much better risk/reward ratio, and the company does it well. Kent's considerable energies, creativity, and intelligence could be best used focusing on auto insurance, farm and homeowners' lines, or larger strategic company issues as COO, such potential regional expansion.

Returning to the main point about reinsurance:

The company's history of net premiums written divided by ending statutory surplus is:

1.30 in 2007 1.20 in 2006 1.52 in 2005 1.80 in 2004 1.21 in 2003
Source: [Page 30, close to the bottom of the page]

Definitions (simplified and abridged for the intelligent lay reader):

  1. The net loss and loss adjustment expense (LAE) ratio is the net loss and LAE in relation to [divided by] net premiums earned.
  2. The expense ratio is the policy acquisition and other underwriting expenses in relation to [divided by] net premiums earned.
  3. Added together, these two percentages are equal to the combined ratio. A combined ratio below 100 signifies an underwriting profit. A combined ratio over 100 signifies an underwriting loss.
Direct Premiums Written (DPW) is the total level of premiums written, including premiums ceded to reinsurers.

Net Premiums Written (NPW) is the the total level of premiums that Fremont retains. Direct Premiums Written - Premiums ceded to reinsurance companies = Net Premiums Written.

Net Premiums Earned (NPE) is the adjustment of net premiums written for the increase or decrease of the company's liability for unearned premiums.


I used the latest quarterly press release for the numbers:

Key Assumptions:

Everything extraneous will be simplified.

The reinsurers, over the long term, are pricing business rationally and earning underwriting profits. This would rule out the possibility that reinsurance is a net savings to Fremont in a form of reinsurance arbitrage.
Net Premiums Earned differs from Net Premiums Written due to the timing of premium payments. However, over periods of a year and longer, the two numbers should converge, though not exactly. In order to simplify and to avoid making assumptions about timing differences in premium payments, I will use NPW as a proxy for NPE in order to illustrate points about tendencies within Fremont's expense structure, which I believe, may yield positive results for decreases in premiums ceded to reinsurers (and for NPW growth absent reinsurance changes).

Therefore, the kind reader might better focus on the relationships between the variables to judge the correctness or incorrectness of my main point, not NPW vs. NPE calculations, though I do recognize that using NPE is called for in all combined ratio, expense ratio, and loss ratio calculations.


We will use the extreme case of no reinsurance to illustrate the high probability that moderately less reinsurance may be desirable.


First, let us assume (momentarily) that the combined ratio on premiums ceded is equal to the combined ratio on the premiums not ceded.

The base case underwriting profit (if we use the current NPW as a proxy for NPE, in order to remain consistent) would be=$3,418,467, or 100-90.8=9.2, or .092 x Net Premiums Written of $37,157,252.

With the above assumption, underwriting profits would be $4,152,210 if no reinsurance were used whatsoever.

The calculation: $4,152,210 = .092 x Direct Premiums Written of $45,132,718, if no premiums were ceded to reinsurers. Note that the old DPW ($45,132,718) is the new NPW if no premiums are ceded to reinsurers.

Second, let us assume that the relationship observed over the latest 9 month period between premium growth and underwriting & acquisition expense holds. In other words, in the above example we held the expense ratio constant. The expense ratio would change with the level of Net Premiums Written. But how and why?

When NPW written increased from $ 33,051,028 to $37,157,252 [+12.4%], expenses grew from $11,661,017 to $12,018,546 [+3.1%].

Intuitively, if we understand that not ceding premiums to reinsurers increases the NPW, then an increase in NPW from $37,157,252 to $45,132,718 , or by 21.5% should increase expenses by 1/4 as much, or by 5.38%, from $12,018,546 to $12,665,144

Of course, this would be true if the NPW represented additional organic growth in policies, but since it reflects a lower level of reinsurance, Fremont might not necessarily take on any additional underwriting expense whatsoever, further lowering the expense ratio. However, we will proceed as if the increase in NPW were reflective of the acquisition of new policies, rather than an elimination of reinsurance, in order to illustrate a point about operating leverage.
For instance, even without a change in reinsurance policy, growth in NPW would bring down the expense ratio by itself, if the above relationship continues between NPW growth and expenses. The previous article on Fremont illustrates the premiums written per employee increasing, which is a prime driver of the company's dropping expense ratio.

$12,665,144 / $45,132,718= 28.1 on the expense ratio. So then we take 28.1 + 56.5 (the latest 9 months loss ratio)= 84.6.

100 - 84.6 = 15.4

.154 X $45,132,718= $6,950,438.58 underwriting profits in the latest 9 months, doubling underwriting profits.


However, could this be feasibly done? If we assume that statutory surplus is equal to its level of $33,777,000 on Dec. 31, 2008, and if we assume an annualized rate of Net Premiums Written are equal to the rate of Direct Premiums written at an annualized rate for 12 months, or at $60,176, 957, we get a NPW to statutory surplus ratio of 1.78.

While ceding less premiums to reinsurers would be very profitable in certain lines, it could be suicidal in a line such as workers' compensation
, which, a case could be made, should probably be eliminated anyway on the basis of the number of insurance companies that have been destroyed by workers' comp claims, fraud, unpredictable court verdicts, etc.

I have not done this example with the purpose of advocating that no premiums are ceded to reinsurers, but merely with the aim of showing that it might be very profitable for Fremont to cede moderately fewer premiums to reinsurers, given the operating leverage inherent within the company's expense structure.

In other words, realistically, we could hit a more optimal NPW to statutory surplus ratio of well below 1.78 (but above the current ratio), while simultaneously increasing the underwriting profits by a significant amount, were the company to employ a more optimum level of reinsurance coverage.

My recommendation: a moderate increase in Fremont's retentions, subject to actuarial studies, etc. would make quarterly results more volatile, but over the longer-term, would result in lower combined ratios and higher underwriting profits, everything else being equal, if done selectively.

In essence, ceding less premiums to reinsurers, everything else being equal, would be a way for the company to grow its NPW with its current book of business. This growth, everything else being equal, might have positive effects on the expense ratio due to the company's cost structure. If the company continues to grow NPW profitably, as it has, the double effect of NPW growth due to new policyholders and NPW growth due to a renegotiation of the reinsurance contracts could have a sizable effect on underwriting profits.

As the old saying goes in insurance, "If the risk is good enough to write, it's good enough to keep!".


However, we are not including the effect of investment income, since we have only been occupied with underwriting profits. There is an opportunity cost to ceding premiums to reinsurers that is not reflected in any changes in the expense ratio. Essentially, if the premiums are on the reinsurers' balance sheets, they are not available to the company to invest and/or earn interest on its balance sheet.

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.