Affirmative Insurance: Potential Turnaround

Full disclosure - I know nothing about insurance companies.  I'd like to though, so I try to keep an eye on some cheap ones and learn from Berkshire Hathaway's annual letters.  Affirmative Insurance (AFFM) came up in the same screen, if not right next to Allied Healthcare, which I wrote about previously.  While Affirmative Insurance would no longer show up on the screen, I was just looking for companies near 52 week lows with positive earnings that were below book value.  I initially passed on the stock and I'm still passing, but it will be interesting to see what happens.  While the quantitative situation has continued to deteriorate, there are increasing signs that the qualitative situation is turning around as new management is given a chance to turnaround the company.

Basically Affirmative Insurance sells non standard auto insurance, which is for people with poor driving records or a high performance car, or something that generally insurance companies don't want to insure.  From a general business philosophy standpoint, this sounds like a business that one could earn attractive returns since they can likely charge a premium for the product.  Markel, a company touted as a mini-Berkshire, makes a good chunk of money on non traditional insurance such as malpractice insurance for doctors with drug addiction problems.  Theoretically, this should be a pretty good business.  Affirmative Insurance uses agents and retail locations to distribute its policies, which isn't the most profitable way to write car insurance (i.e. GEICO and Progressive), but it does not mean that the business cannot be profitable.  To be clear though, the business is not profitable right now.

As indicated in the financial results, Affirmative Insurance has not been adequately charging for the risk it has been taking on, which is why the company trades below book value and at a multiyear lows.  Additionally, previous management did a horrible job in just about every aspect from pricing to reserve estimates.  Basically, the company was poorly run.  This is why insurance companies are tricky.  They can post phenomenal or even just decent results for years and then when the truth finally catches up, shareholders are left with a crap business and each person in the senior management has 5 vacation homes each they bought with their bonuses based on past results that were purely fictional.  Insurance companies are very dependent on how they are run, if not entirely.  

Results have been pretty atrocious as the company has really increased reserves in the past years to make up for poor pricing.  The company has $200m in debt compared to a book value of $93m, which includes $163m of goodwill.  The company has $60m in cash, although netting that out would be foolish with the liabilities of the company and the nature of the insurance business.  This is a very messy balance sheet.  The risk is definitely high with investing in this company.  The stock price seems to clearly reflect the risk, although that doesn't make the stock any more attractive due to the additional downside.

The company has entered into reinsurance agreements for 2011, so they should be able to continue to write policies without putting further stress on their decreasing amount of capital.  The interesting thing about this company's business is that car insurance is priced and sold on short term contracts.  If the company is making the right moves to become profitable, it will be able to do so pretty quickly as they can quickly move beyond their poorly written insurance contracts.  Management plays a key role in this, and the recent changes are the reason why I would continue to pay attention to this company.

The company has been on the slide for a while now and appointed a new CEO in Octorber, 2010.  While they should have admitted they had a problem long ago, it is good to see that the company is aggressively moving forward to restore the company.  In regards to the recently released results the new CEO said:

The 2010 results are unacceptable, extremely disappointing and the result of poor execution in key aspects of our business. The majority of the 2010 negative results are related to the performance of our subsidiary insurance companies. Several specific factors contributed to the 2010 losses, including most significantly: reserve estimates that resulted in inadequate pricing of our insurance products; unacceptable loss ratios in our independent agent distribution channel; a lack of strong underwriting controls, particularly with respect to proof of discounts for our insurance products; and weak performance of our claims unit, resulting in part from significant changes to the claims processing procedures and methodology. 

While I pay little to no (a lot closer to no) attention to management's typical mealy mouthed quotes in press releases, clearly this guy is not sugarcoating the situation and is confronting the situation head on.  His bio is:

Mr. Kusumi's background includes his most recent experience as President and CEO of GMAC Insurance's Personal Lines business. In addition, he served as an Executive Vice President in the Great American Insurance organization, as well as spending over ten years of experience at Progressive Corporation in a variety of senior managerial positions.

I will do more digging, but Great American Insurance focused on speciality P&C, and Progressive is a company that is phenomenally managed and is very similar to GEICO.  I do not know anything about GMAC Insurance's Person Lines business.  At the end of March, a new Chief Claims Officer was appointed who was previously a senior claims manager at Progressive.  It will be interesting to see if these moves will right the ship.  Progressive is well run, although two people aren't going to be able to single handily fix up the company.  All companies have ingrained cultures and it will take time and effort to change them, although as I stated above car insurance companies are well situated to turn around their operations quickly.

The board is interesting as well, as several investors have stakes in the company and seats on the board.  There are 3 different firms with 51%, 6%, and 5%.  The most interesting is the firm that owns 51%.  David Schamis and Avshalom Kalichstein, both directors of AFFM, are managing directors at JC Flowers, a PE firm that has dabbled in distressed companies.  JC Flowers through "New Affirmative"owns 51% of the company.  JC Flowers has been involved since 2005 and 2006 though at substantially higher prices in the stock.  Their investment is now worth under $20m, down from what I think is well over $150m when they first started buying.  It's a lot easier to lose 85% of an investment than make back the 650% to get back to break even though.  While I doubt they are going to just forget about it, my guess would be that they don't want to throw good money after bad money or that they would use their high ownership to orchestrate a debt financing or recapitalization that is super advantageous to them.  I wouldn't blame them.  I have no idea what these guys are thinking, although I wouldn't be shocked if they did something now that new management is in place.

I realize that I haven't really discussed the financials much and have really just provided a narrative.  Quite frankly, the financials are a lot uglier than the potential upside from a turn around.  Taking a static view of the 10-K, the company is not one I want to go near.  I'm not a pro at insurance balance sheets, which is one reason I'm staying away, but it doesn't take an expert to see that it needs fixing up.  That all being said though, because of the industry it operates in, the new management that has experience at well run companies, and the financially invested directors, good things might happen.  In order for good things to happen though, bad things can't happen.  At this point in time though, it looks like bad things are happening that might get in the way of good things ever happening.

Disclosure: None