Please Note: Blog posts are not selected, edited or screened by Seeking Alpha editors.

Is A Reciprocal Insurer Right For You?

|Includes: Erie Indemnity Company (ERIE), KKR, ZURVY

Summary

Reciprocal inter-insurance exchanges exist on the premise of offering lower costs for a homogenous groups of insured members.

Possible conflicts of interests between the insured and trustee, or Attorneys-in-Fact, of an exchange may arise.

Reciprocals are likely to feature lower capitalization cushions than traditional insurers.

If you own or rent property, drive a car or have cherished valuables, you are no doubt familiar with the intricacies - and often maddening complexities - of property and casualty (P&C) insurance. Most policyholders nevertheless regard the purchase of insurance as a necessary and prudent expense; however, many buyers do not appreciate how the structure of an insurer can be an important consideration in their purchasing decision and ultimate financial well-being.

Conventional insurance companies are typically organized around two common business structures: stock companies, which are owned by shareholders, and mutual companies that are owned by the policyholders. A third variant, the so-called reciprocal inter-insurance exchanges, or 'reciprocals' for short, retain attributes of both.

A reciprocal is an unincorporated risk-pooling alternative to stock or mutual insurance companies where the members, known as 'subscribers', agree an exchange of contracts of insurance amongst themselves thereby attaining a preferred level of risk pooling and diversification in order to indemnify the other members. The subscribers are part of an association in which the amalgamated risks are exchanged in order to cross-insure each other. A reciprocal is often likened to a partnership where each member is individually and severally liable, but as is the case in for example a law firm, not jointly liable.

Organizational Structure of Reciprocals

A reciprocal, like a mutual insurer, is policyholder owned but, as is convention, typically administered by an independently owned managing agent called an 'attorney-in-fact' ("AIF").*

The AIF is a necessary aide-de-camp to a reciprocal and administer - in return for fees and commissions - its day-to-day operations, which includes, amongst others, the signing of individual contracts, settling claims, establishing deposits, and investing funds. The subscribers, through a power of attorney or subscribers' agreement, commonly contained in the same document, confer the authority, responsibilities and prerogatives to act on behalf of the subscribers. The AIF, whilst expected to maintain all and any underwriting standards, performs the role of unbiased mediator to simplify and expedite transactions and may be an individual, partnership, or corporation.

The organizational structure also includes a committee, known as a 'subscribers advisory committee', or SAC, which represents all subscribers, supervises the AIF and the reciprocal's finances and operations, and acts in their stead except as limited by the power of attorney. Many reciprocals are organized without any organic act other than the power of attorney, which is used to set forth rights and obligations of the members as well as the duties, and powers of attorney.

Origin, Objectives and Definition of Reciprocals

The reciprocal insurance exchange can track its genesis to 1881, when six dry-good merchants in New York agreed to indemnify each other owing to a feeling of discontent with insurance companies of the time being unable to offer equitable rates for their exacting and unique insurance needs. These merchants, despite their buildings being of superior construction and maintained in good repair, were charged insurance premiums that did not mirror the amount of potential losses of other similar commercial buildings. Insurance companies of the time applied a broad brush in their classification of risk as sophisticated rate-setting techniques were only in their infancy. Being moreover well-capitalized to absorb certain losses, the incentive to 'self-insure' was born out of a desire - and ability - to lower costs.

Reciprocals thus operate on the supposition that similarities and qualities within a specific grouping class establishes a framework to achieve cost saving for insuring specific risks that might otherwise not be properly rated by, for example, mutual insurance companies. Their inherent homogeneity allow for an avoidance of being plodded together with a general underwritten community with uneven requirements and risk profiles, increasing the overall risk profile, premiums and the profitability of traditional underwriters. Distinct groups of individuals or businesses generally have associated incentives to lower their exposure and increase their safety, thus producing a superior loss ratio. Although a reciprocal can effectively lower the total cost of your insurance over time, the structure can also create unique conflicts of interest between policyholders and the AIF. Fundamentally, like any successful insurance company, premiums charged must be adequate to cover all claims and expenses.

A reciprocal is therefore a homogeneous association of individuals, partnerships, or corporations with well-aligned interested and insurance requirements, vested under the terms of a common written agreement signed by each of the subscribers. The agreement provides that each subscriber, being a co-insured member, is protected by the other members; the purpose of which is to make each member whole at a cost wherein no additional modifications within the association can reduce the total cost to the individual members over the period of their membership.

What you need to know

Like stock and mutual insurance companies, successful reciprocals pledge to be around for the long run, to process and pay claims, and to provide affordable and consistent insurance coverage to their affinity groups. However, not all reciprocal insurers can hold their promises. When looking to sign up for a policy with a reciprocal insurer, you might want to ensure they meet some basic criteria:

1. Who owns the AIF and is risk and reward aligned appropriately with members?

Reciprocals are often marketed as 'policyholder owned', but their commercial mindset and culture will most likely reflect the owners of the AIF. For instance, if the AIF is owned by a stock insurance company, it will most likely have underwriting capabilities and return hurdles in line with the insurance industry. Private equity backed AIFs are likely to have the most aggressive return expectations for their investors with the shortest investment horizons, creating uncertainty related to possible material changes in control when a PE firm eventually unwind their investment. Publicly traded AIFs are typically obliged to provide transparent disclosures and have return expectations commensurate with investors of insurance brokers and service companies.

A separately owned management company creates a unique conflict of interest as profitable fees are generated at the expense of exchange members. A study by Emilio Venezian of Rutgers University, examining the arrangement and practical implications of AIF management firms, confirmed this jeopardy. He concluded that serious problems might arise in the management of reciprocals if the AIF holds direct sway over their own remuneration rates, as the incentive to increase their own private welfare may become a priority above, and at the expense of the subscribers.

This has resulted in several lawsuits brought by reciprocal members against AIFs claiming a lapse of their fiduciary duties by mismanagement and or excessive fees being paid to the AIF.† This conflict is even more apparent when the AIF or its shareholders generate interest income through debt provided to the reciprocal and or when reciprocal assets are used to invest in affiliates of the AIF or its shareholders. Prospective subscribers are to ensure that the AIF has clearly disclosed and quantified all related party transactions when considering the credibility of an AIF.

 

PURE

USAA§

Farmers**

ERIE

AIF Shareholders

Private Equity

Not for Profit Association

Zurich (OTCQX:ZURVY)

Public Company

2015 AIF Fees to Shareholders

$103M

N/A

$2,652M

$1,487M

2015 Net Income to Members

$10M

$1,114M

$98M

$466M

AIF Profit Margin

Not Disclosed

N/A

50%

16%

Source: 2015 Company filings.

2. Does the reciprocal make a profit?

The most important requirement for any insurance entity is that premiums charged are adequate to cover claims and expenses. For reciprocals, this includes AIF fees, reinsurance and interest. A prudently managed reciprocal will generate a profit that can either be retained or returned to policyholders depending on capital needs.

Net income and return on members' capital is the ultimate indication of how efficiently member's capital is managed by the AIF as poor underwriting or investment performance will erode member capital over time.

A high expense ratio may indicate the charging of excessive fees by the AIF or a failure in operating the exchange efficiently. Premium growth should never be at the expense of sensible underwriting as high growth combined with poor underwriting is unsustainable. If investment yield is low or negative, the AIF is likely taking excessive investment risk or interest payments are placing a burden on investment returns.

 

PURE

USAA

Farmers

ERIE

Net income to members

$10M

$1,114M

$98M

$466M

Return (loss) on avg members capital

37%

5%

3%

7%

Return on sales

2%

7%

1%

8%

5 Year (2010-15) capital generation

$34.9M

$12,894M

$252M

$2,101M

Underwriting profit margin

7%

5%

(2%)

(2%)

Investment yield

(3%)

3%

2%

4%

Expense ratio

37%

13%

34%

27%

Direct premium growth

39%

7%

2%

4%

Source: 2015 Company filings.

3. How well is the reciprocal exchange capitalized?

As owners of the reciprocal exchange, members should always consider its standalone financial strength. Subscribers should be aware of financials that consolidate non-member owned entities; reports to members that are marketing focused; and omit key financial information such as the reciprocal's net income.

Low levels of capital leaves policyholders exposed to claims not being paid and a high percentage of debt signals additional financial risks.

Reinsurance is typically required to protect a portfolio of insurance risks but an over-reliance on reinsurance is expensive for members and may indicate an AIF that is overstretched.

 

PURE

USAA

Farmers

ERIE

Total capital

$99M

$24,368M

$5,468M

$7,142M

- of which debt

69%

-

42%

-

- interest on debt

10%

N/A

6%

N/A

Coverage multiple (EBIT / interest)

(0.4x)

N/A

0.8x

N/A

Members' capital

$30M

$24,368M

$3,186M

$7,142

Use of reinsurance

68%

3%

22%

6%

Source: 2015 Company filings.

Summary

A cursory look at the main players in the reciprocal market illustrate a disconnect between legacy brands such as ERIE (NASDAQ:ERIE), Farmers or USAA, and new players such as PURE. While the first group boasts a solid customer base and a sturdy balance sheet (exceeding $5B equity), PURE reveals itself as a riskier choice.

Notes:

*Some reciprocals such as USAA are not managed by an independent AIF. Instead, power of attorney is granted by members to a designated executive. This structure is more consistent with traditional mutual companies.

†See also: triblive.com/news/adminpage/3438026-74/e...

‡Privilege Underwriters Reciprocal Exchange, PURE, has had re-capitalized equity funding investments from funds managed by Stone Point Capital and KKR (NYSE:KKR).

§United Services Automobile Association (Combined P&C filings).

**Farmers excludes Farmers Reinsurance Company owned by Zurich (the AIF).

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.