Progress at Fremont Michigan Insuracorp: The Anti-AIG

Charlie Munger, the Vice-Chairman of Berkshire Hathaway (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 (AIG) is very New York I-bank-esque: overleveraged, greedy, and vacuous. One firm owned Coke (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 (FMMH.OB) 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.

Comments

[FMIC Agent:]

As a Fremont Insurance Company agent, I've watched Fremont go through dramatic changes over the years and I know the new leadership team intimately. They are poised to make good things happen for the future. Kent Shantz (COO), Dave Mangin (CIO), Kevin Kaastra (Controller), Kurt Dettmer (VP of Marketing) and Skip Masucci (VP of Underwriting) have risen to their respective positions over the past 7 years and together make a strong team.

Where to go from here? Fremont needs to focus on their core business - that which makes them successful and prevents them from becoming "New York I-bank-esque: overleveraged, greedy, and vacuous." At its best, Fremont has a strong financial position, strong leadership and a good agency force that will allow them to move forward with above average profitability and ROE. Unfortunately, it is often the pressure of investors that push companies to become AIG's instead of remaining within the scope of their known abilities. Another such noteworthy company would be Philadelphia Insurance - with a 3 year combined ratio average of 75%! Most every year since the mid 60's they've posted combined ratios under 90! They were recently purchased by Tokyo Marine and things are likely to change. I've heard that Tokyo Marine sees Philadelphia as not being aggressive enough. This will likely erode the strong tradition of profit. I expect that we will see this well run company become average at best as we look forward to the next 20 years.

As for Fremont diversifying to other states to obtain a "A-" rating from A.M. Best is backwards thinking at this time. Fremont Insurance Company is not ready or capable of diversifying to other states yet. A.M. Best should upgrade Fremont for knowing its own limits and where it can be successful and remain financially strong. Consultants and advice are great - but at the end of the day when you run a successful business, you must be certain that such advice does not steer you from the intended course you've worked so hard to achieve. Many companies have initially struggled when entering other states - timing is crucial. A company needs extra capital and is best timed to enter at the tail of a hard market when you can price your product below the competition, but still earn a profit. All the while gaining market share in the new state with the hopes of achieving economies of scale.

As furher evidence, look back as recent as 5 or 6 years ago, and you will know that Fremont has come a tremendously long way in product availability, underwriting profitability and in building a sound financial position. They have a bountiful harvest to pick in their own backyard right now - growing for at least the next 5 years in Michigan before they will even be close to thinking about stepping beyond Michigan. While geographic diversification reduces risk (in theory), it will also have a negative impact on profits for a period of time. When Fremont is mature enough and truly ready, they will know it. And then, and only then can they be assured of entering other states successfully. Many companies have failed for not having a sound strategy and good timing when entering new states. I doubt Fremont will always be a Michigan Exclusive Company - but I think they will and should stay Michigan Exclusive for at least the next 10 years. At that point, they may then be prepared for such an expansion.

As for leveraging the Fremont Complete automation platform, the platform is not yet ready for that. When it is ready, there are better ways to do it without the short sighted strategy of selling direct over the internet. First, Fremont Complete is not world class yet - take it from an agent who has worked with many platforms from a variety of insurance companies. That is not to say that Fremont hasn't done wonderful things - indeed they have done amazing things with limited resources. Given their size, they should accomplished only a fraction of what they've done. They've introduced more automation than most of their peers in a short time. Stability is much improved over the past 2 years, along with speed. On the other hand, while the platform is functional it is not built to the appropriate level of intuitiveness. In other words, it takes practice to get used to it and to learn its quirks. It also needs better streamlining for their agents to do things more quickly and efficiently. Fremont's automation needs to be better designed around exactly what an agent does each day.

Achieving a proper level of intuitiveness and ease of use will require intervention from an outsider who specializes in matching programming requirements with a the desired ease of use - so it will be natural and efficient to navigate. Presently the platform contains quirks that you must practice in order to master the use of the system. In addition, agents must commit more time when using the Fremont Complete platform as compared to other insurance companies when issuing new policies - particularly when bridging a proposal from a comparative rater such as Capital or ACS. Ease of doing business is always a big driver of business from agents to insurance companies. Right now Fremont has a lot to be proud of with their automation accomplishments, but after getting the rest of the foundation in place, will need to go back and improve the level of intuitiveness from a 3 to a 9 on a scale of 1 to 10.

Once these changes are worked out, there are other ways to leverage the system in lieu of selling direct. I'll save those thoughts for a time when Fremont is more prepared to act on them.

As for the recommendation of selling direct outside of Michigan, this idea does not hold water with their current agency force, who also make up a good percentage of the stock holders. It was suggested to sell direct in states where Fremont is not represented by agents, with the thought that it might not infuriate the current agent force. If this were to occur or if I even caught wind that it was in the plans, I would rapidly move my clients away from Fremont Insurance Company. Agents know that if a company is not committed to 100% to our distribution channel, then as agents we will not be in a good position to serve our clients. This is an understanding that only comes with time and experience in the insurance industry.

Independent agents offer many cost savings not readily visible in the financial statements. It is easy to think that it might be more cost effective to sell direct, until you recognize exactly what it is that agents do for an insurance company. Look at the advertising costs per customer of direct response companies - it is astounding. Those companies also have higher claim adjusting costs. Independent agents save insurance companies tremendous expense in both of these areas.

Consider Cincinnati Insurance Company for a moment - they have an annual advertising budget of around $15,000! Why, because they know their advertising does not bring in customers - but that loyal agents do. Name recognition and image to satisfy a company's objectives is all a company has to do when represented by independent agents.

Claim adjusting is another significant contribution made by agents. Agents often have authority to settle numerous small claims for insurance companies. There is no additional compensation paid to the agents for this services and it assists in building client retention. Agents are the first line for all claim reporting - again, saving work load for the insurance company claims staff.

Agents also help reduce costs by boosting customer retention. Having an agent advise a client to stay with an insurance company - helping to explain the full value of what they receive is far more effective than a direct response company who has no such advocate speaking to the customer. Independent agents are experts at knowing their clients and working with an insurance company to retain customers longer than a direct response company will. Our professionalism, expertise and ability to build a trusting relationship with our clients will outperform direct response companies - wait and see. We rarely lose a good customer to a direct response and if we do, they often come back in 6-12 months - and then they stay for good. Our experience is that savvy buyers value the advice, local service and trustworthy relationship that they can only get with an agent. Selling direct would not be a good use of resources or talent that Fremont Insurance Company possess. They have the leadership and long relationships with agents to succeed well in their chosen marketplace, and their profits have demonstrated just how successful it can be. Fremont's management team has worked hard to position the company as a premier carrier among independent agetnts. With the investment they have made in working with independent agents, they have the ability to grow briskly and profitably. It simply takes another mentality and skill set to deal with the unique challenges of selling direct. And as a stock holder, I would not want to weather the investment cycle for such a strategy - knowing that it would not be a good fit for this quality organization.

As for increasing retentions, it may be more about smoothing out the losses, but I have every confidence that Fremont will know when the time is right to make changes to their retention program. They've done it successfully in the past and that speaks loudly for their current management's excellent judgment.

Sticking with the theme of Fremont being the Anti-AIG, Fremont's midwestern conservative values will serve them well, including the value of not risking more than they can afford to lose. Fremont has been through hard financial times in the past and could quickly return to that state if they don't exercise vigilance in sticking to what they know. That being said, I know that Fremont has a bright future because I know their values. They will continue to be the Anti-AIG and we will continue to recommend them to our clients with pride and confidence. FMIC Agent

2008 Sep 18 11:06 PM

[Harry Long:]

Dear FMIC Agent,

First, thank you so much for your hard work on behalf of the company. I appreciate, as I know my fellow shareholders do.

Second, I appreciate your candor. It is always wonderful to have a no holds barred, full contact discussion of the issues. I think you have a very interesting point of view.

If you have any other thoughts on the company, or points I should consider, please feel free to post them here, or contact me personally. I am especially grateful that you posted your thoughts on the ease of use of the Fremont Complete system.


--Harry Long
email: info@contrarianindustr...

2008 Sep 18 11:49 PM