STABLEBOY SELECTIONS

U P D A T E

As I wrote previously, several of CRM’s self-insured groups are under-reserved. Furthermore workers’ compensation rates have fallen to a point where self-insurance makes little sense compared to products offered by traditional carriers—CRM has a very tenuous business model.

The moral seems to be that statistical bargains are cheap for a reason: they are usually accompanied with poor qualitative factors.

T H E S I S

Employers are required to buy insurance coverage for medical care costs and lost wages of injured employees. As the costs of these benefits increase, workers’ comp insurance premiums increase as well. And if premiums exceed a certain percentage of payroll, regulators enforce rate decreases. This regulation can only go so far, as insurers will leave a state where business is unprofitable. Employers seem to have no choice but to pay ever increasing premium rates.

One successful solution is self insurance. Under this arrangement, an employer insures himself by setting aside cash to cover future expected losses. However, since the employer does not aim to make a profit (as does an insurance company) the cash he sets aside should, theoretically, be less than an insurance premium covering an equivalent risk. If we consider also that around 30% of insurance premiums go toward covering insurance company overhead (in addition to the risk incurred), the appeal of self-insurance is manifest. And not only does the employer retain the profit that would otherwise go to the insurer; he also gets to invest the funds till claims come due. This combination of factors amounts to savings of at least one-third. (I am basing this on industry expense ratios and present T-bill returns.)

Self insurance is certainly a cheap alternative. However, three requisites keep some employers from using this method: (1) lack of infrastructure, (2) inability to quantify future claims and (3) inadequate funds to cover future claims. The first two obstacles are easily overcome: employers need only hire managers to handle claims and risk consultants to determine the correct loss reserves. The third obstacle is state mandated—companies need to be financially strong enough to maintain substantial loss reserves. This is why most self-insured employers are large corporations.

CRM Holdings helps employers overcome all three obstacles. It was founded in 1999 in response to strong demand for self insurance in New York. Separately, small employers could not meet state requirements for loss reserves. CRM grouped these employers with others in the same industry, with the same risk exposures, thereby allowing them to satisfy requirements. CRM also helped the groups with underwriting, medical bill review, case management and regulatory compliance. For its services, CRM received a fee based on a percentage of the groups’ self premium. This management fee operation was its only business from 1999 to 2003.

In addition to paying self premiums, groups are required to purchase excess workers’ comp insurance. This protects a group from losses exceeding a certain point. For instance, a self-insured group sets aside $1 million in self premium. The policy stipulates that the group is only liable for losses up to $2 million. If a catastrophe occurs in which many workers are incapacitated and losses total $6 million, the excess insurance provider would sustain a $4 million loss. CRM had its employer groups select the New York Marine and General Insurance Company, a third party, for excess insurance coverage. Because CRM was not yet a licensed insurance company it could not provide this service, even though it understood the risks better than anyone.

In December 2003, CRM set up Twin Bridges to reinsure the excess coverage provided by NYMAGIC. If NYMAGIC sustained a loss on its excess insurance product of $4 million, Twin Bridges would be liable for up to $1.5 million—its per occurrence limit. A single terrorist attack or natural disaster, no matter how devastating, would count as one occurrence. This limit would probably spare the company in a worst case scenario. Only eight claims have been reported to Twin Bridges and there have been no paid losses. Its reinsurance treaty with NYMAGIC ensures that losses will only occur in years of unusual frequency or severity. Reinsurance—about 33% of revenue, 73% of income before taxes—is far more profitable than CRM’s management fee operation—54% of revenue, 31% of income before taxes. (The two latter figures total 104% because a corporate segment produces negative income.) In 2003 Twin Bridges reinsured only a small percentage of NYMAGIC’s excess coverage. It did not have enough capital to reinsure more.

Then in 2005, CRM went public. Proceeds of the IPO increased Twin Bridges’ capital, allowing it to reinsure a greater percentage of NYMAGIC’s excess book. It soon reinsured 50% of the excess coverage; in 2006 it reinsured 70%. This growth, while tremendous, was strictly the result of contract language with NYMAGIC. There was no guarantee beyond the one-year life of each contract that NYMAGIC would continue to grant Twin Bridges reinsurance business. To eliminate this uncertainty, CRM purchased Majestic Insurance Company and began offering its own excess insurance product. Twin Bridges’ profitable reinsurance business now has a guaranteed customer—Majestic.

CRM’s self insurance operation is less exposed to the major risk of traditional workers’ comp carriers, viz., poor underwriting. Selling insurance is like short selling stocks—the seller gets money upfront but isn’t sure how much he will have to repay. If his assumptions are wrong, he may have to repay much more than he received initially. This has ruined many insurance companies and short sellers. But if CRM sets premiums too low, such that loss reserves cannot cover claims, the self insured group absorbs a large part of the loss. Nor is CRM legally accountable for under-reserving—since it earns management fees as a percentage of self premium, it has incentive to suggest higher self premiums to the group (thus over-reserving).

If CRM faces any substantial problems in the future, it will come instead from primary workers’ comp insurance (itself a low risk operation). This is Majestic’s traditional insurance product—separate from self insurance. Compared to the average workers’ comp underwriter, Majestic is outstanding. Its combined ratios (losses and overhead expenses as a percentage of earned premiums) have been far lower. Results are posted here: http://majesticinsurance.com/about/about_financial.html. Even in 2001, a disaster year for the workers’ comp industry, Majestic sustained light enough losses that investment income fully made up for the underwriting deficit. Over the long term, there is reason to believe Majestic will at least break even on its policies.

CRM now offers a complete self-insurance solution. It forms and manages self-insured groups, provides them with excess workers’ comp insurance and provides reinsurance for this excess coverage. Earnings depend on total self premiums. This in turn depends on general workers’ comp rates, the number of self-insured groups under CRM’s management and the number of employers in each group. In New York no additional groups are being formed, though members continue to join existing groups; rates have been steady. In California, groups are being added along with new members; rates have been decreasing. CRM’s new operation in Texas is not yet substantial. Overall membership grew by 25% in the last quarter, but rate decreases resulted in no top line growth. When rates reverse, the effect on the bottom line will be obvious.

Valuation

According to its Form 10-K, filed March 9, 2007, CRM has 16,273,368 shares outstanding. The stock recently closed at $6.25, indicating a market price of about $100 million.

CRM has three different streams of revenue: (1) management fees, (2) Twin Bridges reinsurance and (3) Majestic. In Note 24 of the consolidated financial statements, these are shown separately along with the costs associated with them. The management fee operation generated $4,857,000 of income before taxes, Twin Bridges generated $12,582,000 and Majestic generated $1,208,000. The first two figures do not need adjustment, but the Majestic figure only reflects that which was generated since CRM’s acquisition—a large understatement. According to a prospectus filed with the SEC, Majestic earned $7,032,000 of before-tax income in 2005. Though using this figure neglects growth of the past year, I will use it anyway for the sake of being conservative. Tax rates differ for each segment and are not shown individually, with the exception of Majestic. It earned $5,173,000 after tax. The other two segments had total before-tax income of $17,439,000, which must be reduced by expenses of the corporate segment. This leaves $14,624,000; after applying a 10% tax rate (as indicated by the consolidated figures) net income comes to $13,161,600. Adding back the Majestic income produces a total of $18,334,600 after tax. In 2005 CRM granted about 90,000 options to executives; in 2006 it granted 160,000. These have no value until the stock price is higher than it was on the grant date, and it’s difficult to estimate the amount that will end up as compensation expense. Using the company’s fair-value based figure of $363,000 yields true income of $17,971,600.

Actually income from Twin Bridges should be increased; in 2006 it reinsured 70% of NYMAGIC’s book (13 of 14 groups); in 2007 it will reinsure 70% of NYMAGIC’s book (7 of 14 groups) along with 90% of Majestic’s book (6 of 14 groups). However, there is a likelihood that this will be offset by decreasing premium rates in California, which will drive down management fees and excess insurance premiums. I believe $17,971,600 to be a good estimate of normalized earnings expectable for the next few years. Discounted at 7% (a rate I consider the long-term risk-free rate) CRM’s earning power value is $256 million. This calculation does not factor in any growth.

At the present price of about 40% of intrinsic value for 2007, CRM’s earnings need not grow for shareholders to be well rewarded. There is a very high probability, however, that CRM will grow earnings, and it appears that no price is being paid for this. In the stock market, neglect doesn’t last forever.