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Dominic over at the Pretoria Investment blog recently sent me a link to his analysis of Homeowners Choice, Inc (NASDAQ: HCII), a property and casualty insurer focused on the Florida market. Given my interest in the insurers Investors Title Company and Stewart Information Services Corporation, he thought I might be interested in the opportunity he sees in HCII.

Dominic believes there is a value opportunity in part due to the fact that HCII has $80 million in cash and $42 million in securities, which combined outweigh the company’s total liabilities of $115 million. Thus, investing at these prices, you get $7 million in cash and securities extra after paying off all of the liabilities, the company’s properties (which interestingly includes a Marina) $10 million in receivables, and the profitable operations are all thrown in for free. Obviously this is a simplification, as the regulators don’t allow insurance companies to close up shop and distribute excess cash in this manner, but I’ll take a closer look anytime profitable companies are trading below theoretical liquidation value.

The first thing I noticed about HCII is that it is a relatively new creation. It was formed in June 2007 in order to assume the insurance policies of Citizens Property Insurance Corporation, which was a state-supported insurer. My understanding is that Florida wanted to reduce its exposure to the insurance industry, and HCII was formed in order to facilitate this as a private sector insurer.

Though on an asset basis and historical earnings basis the company does indeed appear to present a slight value opportunity (see Dominic’s write-up for details, though I am generally not a fan of relative valuations and would be more conservative in my assessment of the potential upside), I do have several concerns.

First, as noted, the company is relatively new. Given the short track record, I won’t invest. I need a longer track record in order to assess a company’s true operational capabilities. I’ll discuss these capabilities more in detail in a few paragraphs.

Second, it is difficult to assess the company’s future revenues. The company’s revenues to date are largely the result of assuming the policies from Citizens and renewing those policies. It is great to start a business and be handed a significant client base, but when these policies come due, policyholders can opt for coverage with a competing insurer. Though this is the case with all insurers, HCII is in the unique situation where not a single one of its customers has willingly chosen HCII. What percentage of these will ultimately stay with HCII is anyone’s guess.

For these first two reasons, assessing HCII’s earnings power is impossible (or rather, it is possible to model something, but I would have very little confidence in the result).

Third, the company has significant geographic exposure. For title insurers like Investors Title Company and Stewart Information Services Corporation, this does not bother me, as the nature of their insured liabilities does not lead to geographic clusters of losses (one wouldn’t expect title defects to be highly correlated to geography). HCII on the other hand insures homeowners and tenants against losses which can stem from catastrophic events such as hurricanes. Though the company utilizes reinsurance policies in order to offset some of this risk, it does retain some exposure. Simply put, if I were to invest in this type of insurer, I would want it to be geographically diversified.

Fourth, when analyzing an insurance company like HCII, it is important to consider the “combined ratio” which is the aggregate of the company’s loss ratio (losses / net premiums earned) and expense ratio (operating expenses / net premiums earned). This gives an indication of how efficiently the company operates and underwrites in relation to its core business, which is insurance. The lower the ratio, the more efficiently the company operates.

However, it is important to note that a combined ratio above 100%, though indicating unprofitable underwriting operations, can be acceptable in some scenarios, such as the situation where the insurance company’s float (the premiums it is paid by its customers in exchange for taking on various risks, which the company can invest as it sees fit until those risks are realized in the form of losses and payments to the insured) is successfully invested such that returns from the company’s investment arm counteract the losses from the company’s underwriting operations. In this scenario, the losses from underwriting can be viewed as low cost funding for the investment operations.

I should note that if you are interested in the insurance market, it would be worth your time to read the shareholder letters of Prem Watsa of Fairfax Financial (TSE: FFH). If you have any other good resources, please leave them in the comments below (or email me).

The following chart shows HCII’s combined ratio by quarter since inception, along with its revenue sources (click to enlarge image):

Homeowners Choice, Inc - Combined Ratio and Revenue Sources, 3Q 2007 - 2Q 2011

Homeowners Choice, Inc - Combined Ratio and Revenue Sources, 3Q 2007 - 2Q 2011

Here we see that the company initially had a very low but volatile combined ratio. This is to be expected in the early years of operations, as the company’s policy losses begin to build to normal levels. We see these levels appear to normalize around 3Q 2009 to levels more commonly found among mature insurers. To date, the company has experienced underwriting losses in only two quarters: its first quarter of operations and in 1Q 2011. I am not worried about the first quarter, given various start-up costs. The second instance is a bit more troublesome, but unless it became a trend, I would be inclined to not worry about this either. I would like to see the company’s investment income comprise a greater portion of total revenues, as this would provide some cushion in the future where the combined ratio rises above 100%. As long as the company can keep its combined ratio below 100% and built its float, over time this should be achieved.

Given the company’s short history, I cannot say with confidence whether the company will be able to maintain a combined ration consistently below 100%. I would prefer to invest in a P&C insurer that has been through several business cycles and seen both strong and soft pricing, which would give me more to go on when forecasting its future earnings. Given the company’s short track record and geographic concentration, I will take a pass.

What do you think of Homeowners Choice, Inc?

Disclosure: No position.

Source: Homeowners Choice: Relatively New P&C Insurer Appears Cheap