Tuesday, December 25, 2007

Big Reserve hit at Canadian insurer . But were the warning signs there years earlier?

Its been a not so merry Christmas for shareholders of Toronto based non-standard auto and specialty insurer Kingsway Financial (KFS-TO,KFS-NYSE)

On Monday , 17th December, Kingsway’s founder & CEO, Bill Starr announced his sudden resignation. Starr said it was a difficult decision to retire but that the “time was right” to make the transition to a new leadership (Starr remains as Chairman while former CFO Sean Jackson takes up the role of CEO).

Then on Tuesday 18th December , Kingsway Financial(KFS) dropped a bombshell when it announced it needed to further increase its claims reserves in its long haul trucking & artisan contractors liability books of business at its Lincoln General subsidiary by between $95mil to $125mil. This is on top of $83 milion of unfavourable reserve development already reported by Lincoln in the nine months to September 30 2007.

Thats around $180-200 million in reserve development, a substantial hit for an insurer with shareholders equity of around $1 billion. The market was unimpressed, marking down its share price down by 22% to $11.82, a far cry from the $20 share price Kingsway enjoyed at the beginning of January. This amounts to Kingsway’s market cap being cut by around $400 million in value in just 12 months.

In the light of Tuesday’s announcement, Bill Starr’s departure as CEO was probably more than a coincidence. One could speculate the timing was quite deliberate, an acknowledgement of his responsibility for the ongoing failures at Lincoln General.

Certainly the management of Kingsway have lost credibility. Just over one month ago in November 2007, Bill Starr was reassuring investors on the third quarter conference call that Lincoln General had put the worst behind it and there was every reason to be optimistic about their results going forward.

Here are two excerpts from the conference call

BILL STAR: “Most of our people, particularly at Lincoln, feel that they've done a great job in reserving, bringing more claims in-house, reserving them much higher this year than they have in the past, so that should reduce the amount of development in the future years.”(Bill Starr 3Q 2007 conference call)

JOHN REUCASSEL:” I guess just the broader question, then, would be, what I'm trying to get at is -- maybe for Bill -- is it's been a struggle here with Lincoln this year. Can you give us some sense of when you expect this to turn around? I know you don't want to talk about next quarter, but it would just be interesting to get some insight into you as how long this should take or what the timeline is here? “
BILL STAR: “John, with all the corrections we have done in the past 12 months, there's every reason to believe that going forward we should have much better results from the Company. That is our expectation.” ( 3Q 2007 conference call)
Bill Starr then discussed measures being taken by Kingsway Financial to fix the problems at Lincoln General including making changes to management, discontinuing certain lines, removing agents where they had poor experience and using computer systems to monitor the majority of the underwriting activities of their MGA’s and wholesale brokers.

So what has gone wrong at Lincoln General & were the warning signs there years earlier?

Lincoln General was acquired by Kingsway Financial in 1998 as part of their push to grow their insurance business in North America. Lincoln has been specialist in providing insurance to the transportation industry since 1977.

The first point worth noting is that 33% of Kingsway’s US business is providing trucking insurance. This is one line where Lincoln has been forced to substantially raise its reserves. This has always been a very tough area to operate profitably in as an insurer. Tony Markel of Markel Corporation (MKL), a leading insurance industry veteran, has indicated that two insurance lines his company ,Markel Corporation, will always avoid because the profitability levels are unacceptable are long haul trucking insurance and workers compensation.

As well as operating in difficult waters of the insurance business, a number of aspects of Lincoln’s business were presented at the investor day conference in November 2007 and perhaps provide a series of clues to investors about what went wrong.

In one chart , Lincoln’s direct premium’s written is shown as having grown at a furious pace from $44 million in 2000, to $171 million in 2001,$690 mil in 2002 and $994 mil in 2003. It is the case that the insurance industry was enjoying a hard market existed in 2002 and insurance pricing had definitely improved , however, Lincoln grew premiums by over 300% between 2001 and 2002 , this suggest that Lincoln was not simply enjoying better pricing, but was pushing aggressively for business.

In most industries, if a company achieves rapid sales growth is often associated with a healthy growing company. However in insurance, extremely rapid premium growth is more often than not associated with insurers that are prepared to forgo pricing discipline for the sake of premium growth. It is probable that Lincoln was able to rapidly grow its premiums because it was prepared to underprice its competitors, it was taking on the business that other insurers had viewed as unprofitable. Its recent announcement to significantly raise claims reserves certainly point to this conclusion.

It is stated in the 2002 Annual Report that Kingsway’s US operations including Lincoln had used thousands of independent agent agents and around 20 MGA’s to write business for their US subsidiaries.

“We market and distribute our automobile insurance products through a network of over 3,500 independent agents and approximately 20 MGAs in the United States , in 2002 approximately 58%
of our gross written premiums in the United States were sourced through MGAs and approximately 42% were sourced through independent agents “(Kingsway Financial - Annual Report 2002)

In the same 2002 Annual report, Kingsway states that it sets clear guidelines over what business its agents and MGAs have authority to bind on its behalf. However, whether its agents & MGAs were following these guidelines in practice is another question.

In the 3Q 2007 conference call, Bill Starr stated the following “… In the case of Lincoln, we have made management changes. We've also made several changes in respect to the programs and discontinued several lines, particularly the business that was written directly through agents. So now all of the business at Lincoln is written through MGAs or wholesalers, which we have found have a better experience on an overall basis.”

These comments suggest that independent agents appointed by Lincoln General were either writing business which did not meet Lincoln’s required guidelines or alternatively Lincoln had not set out the right guidelines in the first place ie. Lincoln had not correctly estimated the eventual loss experience it would have on specific business lines.

Bill Starr in the 3Q 2007 conference call also indicated that there were control deficiencies in Lincoln’s management of its independent agents and MGAs. Bill Starr’s comments were as follows

“…..We have also introduced a new computer system to Lincoln to more effectively handle the commercial business going forward. And one of the other important steps that we've taken is that we will have all of our MGAs or a majority of them using our system directly so that we know that all the business being written is property rated. That's a control we did not have in place before. The only control we'd have is going out and physically looking at the files.” (excerpt -3Q 2007 conference call)

This comment does suggest that Lincoln’s management may not have been fully aware at all times that business its independent agents and MGAs were writing was in fact business that met Lincoln’s underwriting requirements. Kingsway has said it had over 3,500 independent agents and 20 MGAs writing business for its US subsidiaries on its behalf in 2002. Keeping a careful watch and making regular house calls on all these entities on a regular basis would have been difficult. In the 2005 investor day presentation, John Clark of Lincoln General indicates that they performed 84 underwriting audits on their program partners in 2002 and this increased to 176 audits in 2005. Its unclear if this included both the audit of independent agents and MGAs nad whether or not they were auditing all of their third party representatives . Certainly what is clear is that Lincoln general was concerned enough about its underwriting to raise its level of scrutiny over its underwriting partners

Outsourcing Claims

Keeping a handle on claims is vital if an insurer is to accurately price its business. Most insurers don’t delegate the claims handling function because by keeping it inhouse management has more control over its pricing and reserves.

In 2002, Lincoln had 65% of its claims handled externally , in 2003 it was 40% and reduced in 2007 to 14%. So in 2002 and 2003 during a period Lincoln was rapidly increasing its premiums, it was using a substantial number of external assessors to value its claims and so it was really relying on third parties to provide the information required to set its reserve levels. Furthermore, the 2005 investor presentation indicates for the Kingsway group the level of pending claims in 2003 varied between 13,141 and 13860 compared to a lower level below 12,500 in the nine months ending September 2005. The fall in claims pending at the same time in-house claims processing at Kingsway was increasing would indicate that as claims were brought inhouse they were being closed faster. The higher level of pending claims in 2003 would have made it harder for Kingsway to accurately price these claims and set its reserves at that time.

In conclusion

In my opinion, Lincoln General’s reserving problems arose from a number of factors including its focus on providing long haul trucking insurance where it is hard to write profitable business , its decision to aggressively pursue premium growth over the 2001-2005 period while at the same time permitting third party agents and MGAs to write business on Lincoln’s behalf when it lacked critical controls needed to supervise their activities and its over-reliance on third party claims organizations to accurately price its claims which meant management of Lincoln effectively relied on third parties when pricing and setting reserves.

Given recent events, Kingsway Financial’s management have a big job to do now in rebuilding their trust with their shareholders. Investors will be hoping that further reserve increases at Lincoln will not be required and that the troubles at Lincoln have now been dealt with once and for all.

Disclosure: I owns shares in Markel Corporation (MKL) but have no interest in any other securities discussed.


John Gilleland, CPCU said...
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John Gilleland, CPCU said...

Please let me know what you meant by "lacked critical controls needed to supervise their activities". I worked at a subsidiary of Kingsway and would like to develop a checklist or some other tool that may serve to evaluate other insurer's "controls". Some of my work can be seen at www.profitableunderwriting.com.