October 18, 2010

Board of Directors (“Board”)
Fremont Michigan InsuraCorp, Inc.
933 East Main Street
Fremont, Michigan 49412

To the Board of Directors:

Loeb Arbitrage Management LP and Loeb Offshore Management LP, together doing business as Loeb Capital Management, and affiliated entities (collectively, “Loeb”) have management discretion over 160,600 shares of Fremont Michigan InsuraCorp, Inc. common stock (OTC: FMMH) (“Fremont”), or approximately 9% of the company. The recently-revised offer from Biglari Holdings Inc. (New York: BH) (“Biglari”) compels the Board to engage in a sincere process to maximize shareholder value; more to the point, Loeb thinks it is incumbent upon the Board, in keeping with its fiduciary duties to shareholders, to sell the company to the highest bidder.

Fremont, an illiquid stock, has scarcely traded at or above its tangible book value per share during its capital market history. Fremont is substantially dependant on one state for its profits. With an A- rating from A.M. Best Company (“A.M. Best”) and a premiums-to-surplus ratio of roughly 1.4x, prospects for growth, and therefore multiple expansion, are limited. The management of Fremont has put forth a strategic plan to achieve USD 100 million of direct premiums by 2013. It is not clear that the company can reach this level of premium production without an equity financing or loss of its current A.M. Best rating. Assuming everything goes according to management’s plan (a potentially unreasonable leap of faith) and assuming a 95% combined ratio, Loeb estimates that this premium level could produce operating earnings per share of $3.00. The offer from Biglari represents a P/E multiple of nearly 10x prospective 2013 earnings. Considering the earnings multiples of comparable regional insurers, Loeb thinks it unlikely that the company on its own merits would trade at a valuation of 10x P/E in the marketplace.

As a significant shareholder of Fremont, Loeb is not in favor of further tactics that put off potential buyers of the company. It is time to put aside mechanisms and campaigns such as a poison pill with a low trigger, a staggered Board and a concerted effort to secure legislation limiting shareholder rights. Again, the Board owes shareholders a fiduciary duty to maximize the value of the company, particularly in light of the current circumstances. A path has been provided for the Board to maximize value for the owners of an illiquid equity in the near term. Please note that this letter should not create the understanding that Loeb would accept an offer of $29.00 per share; rather, Loeb is simply of the opinion that Biglari’s offer is credible and that the valuation is high enough to be a springboard for a value maximization process. Loeb reserves its rights as a shareholder to take such actions to secure value maximization. Further, we hereby request a meeting with the CEO and Chairman of the Board of Fremont as soon as is practicable but in any event no later than October 29, 2010. Please contact Alexander H. McMillan, General Counsel at (212) 483-7069 to arrange such a meeting. Additionally, we request that Fremont raise the ownership threshold which triggers its poison pill, thereby allowing Loeb to increase its holdings (notwithstanding the necessary approvals from the Michigan Office of Financial and Insurance Services). Finally, please note that Loeb reserves the right to buy or sell stock.

Thank you for your immediate attention to our request.

Sincerely,

/s/ Gideon J. King
Gideon King
President, Chief Investment Officer

/s/ Blaine Marder
Blaine Marder
Vice

Biglari Holdings Inc. (NYSE:BH – News) today announced a proposal to acquire 100% of the issued and outstanding shares of common stock of Fremont Michigan InsuraCorp, Inc. (OTC Bulletin Board:FMMH.OB.ob – News) that it does not already own for a purchase price of $29 per share in cash. The purchase price represents a 41% premium over the closing price of Fremont’s common stock on October 11, 2010. Biglari Holdings is presenting its proposal to the Fremont Board, expecting its Board to exercise its fiduciary duties and therefore meet with Biglari Holdings to reach a mutually satisfactory transaction.

Press Release (Biglari Holdings)

To preface, I don’t own any Biglari Holdings stock anymore. Biglari’s struggle for Fremont has been well documented on my blog. Initially, Biglari offered $24.50 per share in a combination of cash and stock. At the time, many derided the offer and said it undervalued Fremont because he was only willing to pay close to 90% of book value for the company. Eventually, the management team used their political pull in Michigan to introduce legislation which would impede his ability to pursue a hostile offer against the company.

The new offer is $29 per share or about 1.1x book value, which might be fair given Fremont’s current troubles. Fremont’s underwriting has deteriorated recently and posted a combined ratio of 108 in the last quarter, which means its operations are generating losses. Combined ratios are calculated by taking underwriting expenses + loss adjustment expenses and dividing them by the amount of earned premiums. A combined ratio of less than 100 means underwriting operations are profitable. More broadly, the insurance market as a whole is feeling the pressures of the low yield environment. Most P/C underwriters have had the bulk of their profits come from their investment portfolios, not their underwriting. The problem with this is that insurance investment arms typically take a levered bond fund approach and safe bonds aren’t yielding a whole lot right now. This puts insurers who are bad at underwriting in a precarious position. They face losses on both ends and so far the soft market (weak insurance pricing cycle) is showing no signs of persisting.

So in a way, it’s possible that a capital allocator such as Biglari could be helpful. If he could adjust the company’s current allocation split between cash and bonds, Fremont might be able to generate investment gains that would offset their underwriting losses. Right now Fremont’s investment portfolio is just under $70M with about 83% of it in bonds. Biglari reportedly already has an insurance executive on staff who would be brought in to turn around underwriting operations which have so far run into losses as they’ve grown their personal lines business.

It’s easy to see why he wants Fremont. Being able to add an insurer would help diversify BH’s business from being so dependent on fast food and would also add a business line which brings recurring earnings to the table. Plus, the float from the insurance business (which is smaller because of the short-tail nature of their claims), could be used as dry powder when pursuing activist investments or takeovers. Similarly, Mark Schwarz of Newcastle Partners has taken this approach by gaining control of Hallmark Financial (NASDAQ:HALL) and using it to then gain control of Pizza Inn (NASDAQ:PZZI).

While I don’t have a stake in this situation, it’s still fun to watch given the tactics being employed by both sides.

When I started out in investing, insurance companies seemed really difficult for me to analyze. I found out that insurance companies aren’t necessarily harder to analyze than any other company, but that there is a good deal of jargon to get used to.

I don’t know how good I am at teaching this kind of thing, so please use the comments section or e-mail me suggestions or issues you have with the post. Once I have finished this series, I’ll put all the parts into one big PDF, that way new investors can quickly grab the whole thing to study. My other goal is to eventually post guides for other industries; think banks, restaurants, retailers, and more.

The Income Statement

For the first part, we are going to look at the income statement. Now, I prefer to look at actual cases, so we will be analyzing Fremont Michigan Insuracorp (OTC:FMMH) for the rest of the series. I think it is useful to learn from companies like Fremont, because they are smaller and tend to have fewer moving parts. You can access the company’s latest 10K by clicking here.

One of the most confusing aspects of P&C insurance companies is how they make money. It is not as simple as just looking straight at the revenues line on an income statement. Instead, P&C insurance companies generate revenues in three ways: underwriting, investment/dividend income, realized gains.

Take a moment to look at the income statement line by line. One of the things that will stand out is how revenues are related to net income. You can see that each year, revenues grow, but net income actually decreased in 2008. This sometimes happens with insurance companies, they get a little loose with their underwriting standards and write too many policies without anticipating what they will do to the bottom line. As an investor though, you can sometimes use these periods to find an undervalued insurer. Say they had been writing policies for some kind of unprofitable line and decide to quit – that is an avenue for earnings to change.

Underwriting

When you think of the insurance, underwriting is probably what comes to mind. Underwriting is the act by which insurance companies take on risk. In exchange for that risk, they are paid premiums, usually on a fixed basis. The job of an insurance company is to take on the right kinds of risk, priced appropriately, so that they wont have to pay out too often or at rates that exceed their premiums.

This is why insurance is such a difficult business. In the past, Warren Buffett has noted that most insurance companies often relax their standards during a soft market (a time when insurance premium prices decline) and take on large volumes of risk that are priced too low. This narrows the margin of safety an insurance company has. If accidents happen at a higher rate than expected, an insurance company can easily go belly up. We’ve seen a lot of that in the past.

Premiums

Whenever you enter into a policy, say for auto insurance, you are paying a premium every month. That monthly premium allows you to get coverage by the insurance company. Now, to get to net premiums we have to go through a few steps.

In general, when Fremont writes an insurance policy, it goes under gross premiums written. But, as you can see, that does not appear on the company’s income statement. What happens is, most insurance companies will actually buy some reinsurance for a premium. Basically, this reduces the amount of total risk they are taking on because the reinsurance company will cover some of it — this practice is called ceding premiums.

Gross Premiums Written – Ceded Premiums = Net Premiums Written

Still, that does not get us to net premiums earned. To get there:

Net Premiums Written / 12*10 = Net Premiums Earned

A reader pointed out to me that the example I gave is a generalization, here is his approach which is better:

I think a more accurate equation, which inherently must involve the balance sheet, is:

Net premiums earned = net premiums written – increase in the unearned premium reserve (UEPR)

When an insurer writes a policy, it immediately posts a liability (the UEPR) against the cash received of 100% of the premium. Releases from the UEPR become earned revenue.

Simple example: insurer writes a 12 month policy on December 1, 2010 for $1200 and collects all cash upfront and purchases no reinsurance on this policy. The balance sheet would show $1200 in cash and an unearned premium reserve of $1200. Assuming premium is earned pro rata over the life of the policy, at 12/31/10, the UEPR would reduce to $1100 and earned premium (the top line revenue item) on this policy would be $100, the amount of the release.

The 2010 income statement on this one policy would be calculated as follows:

Net premiums earned = net premiums written of $1200 minus $1100 (the increase in the UEPR from 0 to $1100 at year end) = $100

What you are doing is assuming that the insurance company will have 10 months of the same result over 12 months. Insurance companies earn premiums pro rata over the life of the policy. Different policies have different lengths, auto insurance is generally shorter at 6 months while commercial lines may be 1 year in length.

Fremont appears to be growing by writing more policies. They recently announced a plan to expand beyond their local Michigan market, which might help propel growth prospects and diversify their risks out of just Michigan. For an insurer, this is a pretty good sign.

Loss and Loss Adjustment Expense

Accidents happen. If you write an insurance policy, you have to be ready for losses. These come under the Loss and Loss Adjustment Expense:

An insurance company will incur losses in two ways, paying claims and establishing a reserve. When you receive a check from the insurance company? That’s paying a claim. The loss reserve? That is a liability on an insurance company’s balance sheet. Basically, Fremont sets a pool of reserves for losses they think they will encounter. Premiums are often split between loss reserves and investments. When a claim is submitted, that amount is then paid out from the loss reserve.

Paid Claims + Reserve Charge = Expenses

Insurance comes in two forms, long tail and short tail. Short tail insurance has to be paid out more frequently, so the investment prospects are usually shorter. If you look at any great investor who has taken control of an insurance company, they tend to gravitate towards longer tail policies.

Besides paying out claims, an insurance company incurs underwriting expenses.

Commissions + Other Underwriting = Total Underwriting Expenses

Most insurance companies have to deal with agents and brokers who actually go out and acquire customers. They are paid commission fees for their work, typically a percentage of premiums. Other underwriting expenses are typically your administrative costs, technology, taxes, and office rent.

The Combined Ratio

Every industry has some go-to metric for figuring out how to compare one business to the other. For fast food it might be same store sales, for retail sales per square feet, but for insurance — I think it is the combined ratio. The combined ratio is this:

Expense Ratio + Loss Ratio = Combined Ratio.

Loss Ratio:

Losses and LAE incurred / Premiums

Expense Ratio:

Underwriting Expenses / Premiums

When looking at combined ratios, a 100% CR means the insurer is breaking even on their insurance operation. Below 100% means an underwriting profit and above 100% means an underwriting loss.

I can’t stress this enough – when you are examining an insurance company you really want one that is a profitable underwriter. This is not a business where you want to get yourself involved in a turnaround. You want a turnaround? They usually end badly. Fairfax endured 7 lean years as a result of picking up some very difficult to turnaround distressed insurance operations.

Overall, you can see that Fremont’s underwriting operation is profitable. Their combined ratios are coming down below 100% and are not abnormally low which would indicate that they are under-earning.

Investment Income

Most insurance companies will have a lag time between when they collect premiums and have to pay out claims. In between, insurance companies will usually invest at least a portion of those collected premiums. The idea is to beat the time value of money effect; a dollar today is worth more than a dollar tomorrow. Investment income is made up of the dividend and interest income that an insurance company receives from its investments.

Remember that discussion about short-tail and long-tail insurance? Well that affects how long insurance companies are able to hold on to their reserves and deploy them into investments. Short-tail insurance is paid out more frequently so their investments usually have less time to compound. The opposite is true for long-tail insurance. This is one of the reasons Berkshire Hathaway is involved in reinsurance is the face that they are able to write policies on events that may never happen or wont happen for a long time. This long-tail insurance allows them to deploy premiums into investments and compound for a longer period.

Unfortunately, the insurance market takes this into account and prices insurance policies accordingly. Many forms of long-tail insurance have higher combined ratios than short-tail risk insurance.

Within investments are two other components:

1. Realized Gains (Losses):

As I said, most insurance companies operate some kind of investment portfolio. When the company actually makes a sale on one of their investments, they will record a realized gain (or loss) depending on the price they originally paid and the price they sold for.

You’ll see that Fremont took some losses in 2008, most likely tied to the financial crisis. A number of insurance companies got into purchasing fixed income securities for yield without looking at their true nature. Some were involved in the dreaded toxic assets — I have not looked at what Fremont was selling back in 2008, but you could probably find out by accessing state insurance filings via the NAIC.

2. Unrealized Gains (Losses):

This is when the company’s investment portfolio appreciates or declines, without any sales actually occurring. Due to the mark to market laws, an insurance company might report changes in unrealized gains every quarter depending on the stock market’s performance. Keep in mind that changes in unrealized gains do not register in the income statement, rather, they are found in the balance sheet as a driver of shareholders equity via retained earnings.

Since many insurance companies use fixed income instruments to obtain dividend income, their portfolios are sensitive to changes to interest rates. If they are buying securities that are yielding close to current rates, and we see rates rise, the value of those securities will fall — forcing the insurance company to record unrealized losses.

Some insurers that are not profitable on their underwriting can still crank out a profit via investments. Fairfax Financial is well known for having this ability, it really requires a strong investment team at the helm. Unfortunately, the nature of investments is changing for some insurance companies. A recent article reported that many will cease to manage their investment portfolios in house. I like when insurers foster an in house investment operation because their incentives are often more aligned with the insurer. When you farm out your assets to Wall Street, you might get into products that require only a management fee (meaning performance does not matter) and the insurer will be taken for a stroll by Wall Street sales guys who only care about their commissions — not the well being of the insurer. I’d rather that insurance companies try to create a really good, value oriented investment operation in house. Guys like Tom Gayner and the folks at Hamblin-Watsa exemplify this best.

Conclusion

Hopefully, this has helped you understand some of the terminology and items that you will find on an insurance company’s income statement. Once you see how the income statement works, you can look at it from a variable perspective. One of Fremont’s criticisms is that their expenses could be lowered, this is a good point. If the company could reduce 2009 underwriting expenses by 5.9% net income would rise by almost 25%.

Let me know if I have been unclear in this walk through the income statement. My next post will focus on the balance sheet.