I have been asked several times to discuss 21st Century Holding Company (Nasdaq: TCHC) and why it trades at a such a big discount to its STATED book value.
Currently, that discount stands north of 50%.
Let me start by saying that TCHC is not the same company that can be seen in flashy television commercials marketing car insurance – that would be 21st Century Insurance the auto insurer which was formerly owned by AIG and sold to Farmers Insurance, a unit of Zurich Financial Services.
AIG sold the business for $1.9 billion or 1.00x Tangible equity and 0.85x its stated equity. TCHC is the Florida insurance holding company which has a current market capitalisation of approximately $27 million.
It has been said before: “insurance is a promise.” You and I pay insurance premiums in the expectation that, should some unwanted event occur, our insurer will be there to cover the costs. Well, what if they can’t? I often like to tell people that in the financial sector, earnings are what management says they are, until proven otherwise.
The question for holders of TCHC stock is twofold: 1) does the company have enough reserves to pay current and future claimants and, if so, 2) how much, if any, equity will the company have left for shareholders? Based on the market cap of the company’s publicly traded shares, the answer is: 1) yes and 2) half of what is presented in the company’s latest Form 10Q.
In 2009, the company was the target of a hostile offer by Homeowners Choice Inc. (Nasdaq: HCII). HCII offered $1.00 per share cash and 0.5 shares of its stock (which was trading at $8.60 at the time), for a total value of $5.30 to TCHC shareholders – equal to approximately 56.5% of the stated book value of $75.1 million. The Board of Directors for TCHC unanimously rejected the offer stating that it was “inadequate and not in the best interests of the shareholders.” HCII then dropped its offer issuing a detailed press release. However, HCII did leave the door open to revisit TCHC saying that they may consider another hostile acquisition “at a later date.” It should be noted that the STATED book value has plunged to $61.9 million – did the management at HCII know more about TCHC’s business than its own executives?
To add insult to injury to TCHC’s shareholders, management then announced its intent to buy Homewise Insurance company March of 2010. Expected to close by June of the same year, the companies announced that the deal was “terminated by mutual decision of the parties” a little over one month later.
TCHC trades at $3.42 today, while HCII is trading at $8.35 per share. Did shareholder miss their chance at the Golden Goose?
Pluses and (Mostly) Minuses
TCHC is holding company which controls insurance companies which underwrite personal and commercial lines property and casualty (P&C) insurance. As I noted in my earlier article regarding Biglari’s (NYSE: BH) hostile attempt to take control of Fremont Michigan Insuracorp (Nasdaq: FMMH.OB), the P&C market is currently in a “soft market.” Nonetheless, there are plenty of insurers still generating a profit – TCHC is not one of them.
In 2009, TCHC’s net premiums written totaled $48.2 million. This is down 10.0% from 2008 and down 45.8% from 2007. On a gross written basis (before reinsurance), the premiums split was 66.8% Homeowners and 31.5% commercial liability. It is important to note that of the $84.7 million of the company’s homeowners’ policies, $24.0 million (28%) was assumed from Citizens Property Insurance Corporation (Citizens). Citizens is the “insurer of last resort” in the State of Florida. (Minus)
Only “300 [independent agents] actively sell and service” the company’s products. While most independent agents will seek the best overall insurer for their clients, it is undeniable that they are motivated – to some extent – by the commissions they are paid from the carrier. It appears that TCHC has been paying up to attract more business. (Minus)
TCHC utilizes significant reinsurance (the insurer’s insurer) and it pays dearly to do so. The company retains the first $5 million of losses for each “event” (think hurricane with significant losses). The $5 million per event exposure is equal to approximately 8% of the company’s capital base. Management stated on its conference call that it was able to reduce its reinsurance cost from $52 million to $43 million on its second quarter conference call (which should drop to the bottom line). A real issue has to do with losses from Hurricane Wilma in 2005. The company has used 99.2% of the $194.8 million of coverage available for Wilma. If losses continue to climb, TCHC’s liability could grow exponentially. (Minus)
Fee income from insurance products is another revenue contributor. TCHC generates fees from several subsidiaries. Fee income is high quality revenue because there is no associated underwriting risk. For example, the company charges a non-refundable application fee of $25 for new policies. In 2009 total fee based revenue was $3.3 million. (Plus)
The last piece of revenues comes from managing the company’s float. This has proven problematic. TCHC had a large net realised loss in their investment portfolio of $10.6 million in 2008. Following the loss, the company hired an outside manager to take over the investing activities. (Plus)
Management can “massage” the numbers by setting reserves for losses above or below the “true” losses. Looking at TCHC financials, it’s clear that they either have a poor underwriting team or they were managing the numbers. For the past 3 years they have had to add to prior year’s reserves – this is known as “adverse development.” In 2009, adverse development was $1.7 million. This follows adverse development of $4.5 million and $9.2 million in 2008 and 2007, respectively. What are the odds this will happen again? For starters, the company’s net loss and LAE reserves are on the books for $58.7 million, 4% below the midpoint of the range provided by the company’s outside actuaries at year end 2009. Pre-tax earnings should have been $2.5 million lower. (Minus)
I always find it interesting when companies don’t report the most widely used ratios – such as a loss ratio or expense ratio. Usually that is a sign that the company is underperforming. After dropping the company’s financials into my trusty Excel spreadsheet, I saw why. The nearby table shows some selected financial data that highlight certain trends in the company’s performance. (Click Table to enlarge)
The company’s Cost of Goods Sold begins with its Loss and LAE expenses. To measure underwriting performance, we look at the Loss & LAE ratio (Loss & LAE/Premium Written). This has risen from 58.3% in 2005 to 83.3% for the 9 months ended September. This means that the company’s payment of claims from writing $1 in premium has gone from $0.58 to $0.83! Commission expense (compensation for the independent agents to peddle the company’s insurance products), calculated by dividing Net Premiums Written by Acquisition Expense has steadily increased from 17.6% in 2005 to 28.7% in 2009. Stated differently, for each $1 of premium the company was able to write, it paid $0.29 to the agents. (Minus)
The CEO was appointed in June of 2008. He has a 13 year career with the company – he was previously the COO. Before he joined the company, he was the managing partner for an independent chain of agencies acquired by the company. It is unclear if he has true underwriting experience. The CFO worked in the “Enterprise Risk Services” practice for several accounting firms before joining TCHC. While this suggests that he has risk management expertise, it is not underwriting experience. (Minus)
Finally, capital adequacy is also an issue. In 2009, the company’s primary insurance subsidiary fell to 245% from 739%. This required a $10 million surplus injection to Federated National Insurance Company from the parent to maintain the subsidiary’s “A”. (Minus)
Not for the Faint of Heart
This is a turn-around story at best. The company needs to demonstrate that it has the horsepower to underwrite a profitable book of business. Florida has been a tough state for insurance carries to earn a profit. This is why several major insurers decided to pack up their bags. Why should anyone believe that this seemingly inexperienced underwriting team can turn around the business. Reserves are another question, will they be adversely impacted yet again? Will their west coast neighbours come back “at a later date” but before capital and surplus reaches a level that the regulators come in and take action? Until these clouds are cleared, TCHC will trade below book. Even then, it is not guaranteed that it will trade at book.As an investor, you must ask yourself if the potential for a 25%-30% (possibly more) gain is worth losing all your money. At this point, I would view TCHC more as an option, not a stock.
*A more detailed analyis is being edited and will be available upon request.
Since Georgetown Jack is still the new guy around here, you can follow him on here Twitter