Fremont Michigan: A Case Study in Board Structure and Risk Control Oversight

| About: Fremont Michigan (FMMH)

This past year, many of us have asked ourselves how corporations could practice such lax risk control. Often, in order to understand a board's effectiveness at risk control, it is wise to examine a board's makeup and the structure of incentives between board members. While corporate strategy is often complex, board members' incentives are often quite obvious after a thorough analysis of footnotes in company filings, such as 10-Ks and Proxy Statements.

Indeed, while many boards meet stock exchange and legal standards of independence, that does not mean that they are free from management influence.

Fremont Michigan Insuracorp is an interesting case study in the structure of board incentives.

  1. There are familial relationships between board members and company officers. Michael Dekuiper, a board member, is the father-in-law of CFO Kevin Kaastra. I do not believe that familial relationships are conducive to board independence.

  1. Three board members (including Michael Dekuiper) are independent agents of the company, receiving hundreds of thousand of dollars, in aggregate, from the company in commissions. I am confident these payments are proper. However, in my opinion, these payments may create incentives that make it hard for directors to be truly independent. If I were an agent on Fremont's board, I would not want to do anything that would upset executives, since I would be afraid that would jeopardize my business and commissions from the company. Therefore, no independent agent of the company should be sitting on its board. I feel that their presence entrenches management.

For example:

Three nonemployee directors of the Company are also owners of independent insurance agencies. These individuals are currently appointed as agents with and write insurance for the Company. The terms and conditions of the agency agreements between these agencies and the Company are similar in all material respects to agency agreements with other agents of the Company. The Company pays all agencies commissions on business produced. All agencies are also able to earn profit sharing commissions based on the profit margins of the business produced. Total regular and profit sharing commissions earned by these agencies approximated $545,000, $526,000 and $484,000 in 2008, 2007 and 2006, respectively. The commission rates, including profit sharing commission opportunity, are the same as other agents of the Company. The agencies are independent agents and also write with regional and national insurers that may be competitors of the Company.

(Quoted from Fremont's latest 10-K, page 80)

  1. In order to assure shareholders and agents that business is being placed with agents on the basis of merit, not familial relationships, or membership on the company's board, the company should publicly disclose the loss ratio of business generated by board members who serve as independent agents in relation to the average loss ratio for the company, broken out by each of the company's business lines, not only each year, but on average for the past 5 years.

  2. One board member, Jack A. Siebers, is employed as a principal of Siebers Mohney PLC, a law firm that receives legal fees from the company. I would argue that such legal fees might incentivize him not to jeopardize business for his firm. Similarly to the three agents on the board, I believe his presence entrenches management. Whether or not board members pass stock exchange definitions of independence, the most important thing is that they are independent of any conflicts of interest or incentives which would run counter to their representing shareholders' interests.

For example:

A nonemployee director of the Company is a partner in a law firm. The Company has retained this law firm for certain legal matters in the past and plans to continue to do so in the future. Legal fees paid by the Company to the law firm were approximately $69,000 in 2008, $74,000 in 2007 and $35,000 in 2006.

(Quoted from Fremont's latest 10-K, page 80)

  1. The board is staggered. This prevents shareholders from being able to elect a majority of board members in any individual year. A non-staggered board is shareholders' best check on management. As we have seen in America, we need stronger board oversight, not weaker oversight of management, to prevent breaches in corporate governance and irresponsible risk-taking. Being able to replace the entire board at one annual meeting is an excellent check on management.

  1. The company needs to be far more diligent in its public filings. For instance, in its 2008 proxy statement, it stated the wrong deadline for the nomination of directors. The deadline in the proxy, disturbingly, contradicted the date stated in its Articles of Incorporation.

  2. Fremont's personal lines have gone from a 2006 underwriting gain of $4,129,003 to a 2008 loss of $806,725. Simultaneously, net premiums earned in personal lines have grown tremendously. This growth has continued in the latest quarter reported at a high rate. Why is management growing a line with profitability that has declined for years and has now gone negative? If management and directors really understand that this is a grave problem, why haven't they stopped and indeed contracted the growth in premiums in this line until the issue of losses has been shown to be successfully remedied for at least two years?

  3. Management must be open to suggestions on how to improve the situation and publicly articulate a plan to ALL shareholders. This plan must include a provision not to grow personal lines until the underwriting situation is fully remedied, with a strong combined ratio in the line of below 95, for at least 2 years. I believe that management's failure to do so already violates the tenets of conservative underwriting. In addition, I believe that the board's failure to insist on such a plan is clear evidence that the board is not overseeing risk properly.

As we have seen in America, at financial institutions, board oversight of risk control is a key function of good corporate governance, and indeed, corporate survival. Board members with incentives which are potentially not aligned with shareholders must resign.


Disclosure: 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.