Charlie Munger, the Vice-Chairman of Berkshire Hathaway (NYSE:BRK.A), has often pointed out that it is most instructive to not only study success, but also failure. Ironically, a balance sheet is often a direct reflection of the executives' values and the social mores of their environment. The soul of a company can often be found, not only in its financial statements, but in its location. From what soil does it grow?
Berkshire Hathaway is profoundly Midwestern in its ethos and its financial structure. In short, keep the debt level reasonable, write business at prudent rates, and make shrewd investments. AIG (NYSE:AIG) is very New York I-bank-esque: overleveraged, greedy, and vacuous. One firm owned Coke (NYSE:KO) stock, the other subprime mortgages. Of course, the shareholders of Berkshire sleep well at night, while the shareholders of AIG paid a high price for their lack of discernment.
Keeping such thoughts in mind, what would the Anti-AIG look like? It would be Midwestern, have zero debt, write lines that are easy to understand, price at economically attractive rates, have a plain vanilla investment portfolio, and have great management. Fremont Michigan Insuracorp (OTC:FMMH) fits the bill with its auto, homeowner, farm, marine, and commercial lines.
As we have previously written here and here, I have been in extensive talks with management to lower the firm's expense ratio, drive growth, and lower business risk through a variety of proposals, and since our last writing, it looks like they are starting to bear fruit. The expense ratio has dropped by 1.3 to 34.1 compared to the same quarter last year. Diluted EPS rose 1.6% last quarter and 15.1% for the latest six months. The book value per share grew by 10.4% in the last 12 months.
Insurance companies would do well to boost ROE (everything else being equal) through lower expense ratios, not balance sheet debt which artificially shrinks the equity. With a plain vanilla portfolio and a focus on underwriting profits, the expense ratio will drive ROE for a given loss ratio. And I believe the company is starting to come to that realization. Its success in driving a lower expense ratio will be the catalyst that will boost ROE, and hence the book value and the stock price. Selling at 81.5% of book value (as of this writing) with redundancies in the reserving table, zero debt, a plain vanilla investment portfolio, and growing underwriting profits and book value, the stock is dirt cheap and should not be if the company continues its solid performance.
Some specific reforms which could further lower the expense ratio and boost growth for the company would be:
I. New blood with expanded leadership roles. Kent Shantz has been promoted to COO of the company and is widely respected by his fellow vice presidents. After meeting with him and other executives, I was impressed by his keen understanding of competitive dynamics in the industry and the strategic issues Fremont is facing. Shantz has been instrumental in the establishment of a strong commercial business which has allowed the company to offer brokers and policy holders a one-stop solution when it comes to covering disparate risks. In an area which can prove explosively dangerous in today's litigious environment, he has expertly led the commercial business through treacherous waters without succumbing to the hazards which have blind-sided scores of other insurance firms and harshly penalized misjudgments.
David Mangin has been promoted to Executive Vice President and CIO of the company. More than anyone, his leadership in creating the Fremont Complete platform has been instrumental in driving growth by giving the company a fast, reliable system which allows brokers to write business, get quotes, and monitor their book with the company electronically. His accomplishments will become even more important to the company going forward as IT is recognized as the main driver of efficiency and low costs. Fremont needs such a leader as the business logic of writing business direct over the internet in other states becomes undeniable. Like Kent, David is extremely impressive. He is one of those people who is so insightful, that when he says something you find yourself thinking "Why didn't I think of that?!"
With Kevin Kaastra, the CFO who has spearheaded the company's rock-solid reserving practices (no mean feat in an industry accustomed to reserving deficiencies rather than redundancies), they should make a very strong team.
II. Diversification to other states to reduce catastrophe/overall business risk (which together with the expense ratio reduction would get them an A- AM Best rating and dramatically help their growth prospects).
III. An increase in risk retentions from the current $150,000 per risk, which would be recognition that such a level or reinsurance might be more about earnings smoothing than risk transfer. Increasing the retentions significantly would further lower expenses and also reduce the opportunity costs of not having more capital on the balance sheet (as opposed to the reinsurers' balance sheets), increasing potential investment income.
IV. Leveraging the Fremont Complete platform by writing insurance directly over the Internet in other states, further reducing the average expense ratio to 20 or below on a medium to long term basis (and not infuriating the current agent force in Michigan).
The proof of the pudding in terms of management's seriousness 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.
Disclosures: Harry Long owns FMMH.OB shares directly, through partnerships, and through trusts. To the best of his knowledge, certain of his family members own FMMH.OB shares through partnerships and trusts. Such ownership may change at any time.