Kingsway Financial Services Inc.
Q4 2007 Earnings Call Transcript

Published: 2 Jan 2008

[Operator:]

Welcome to theKingsway Financial Services Inc. conference call. (Operator Instructions) Iwill now turn theconference over to Shaun Jackson, President and CEO. Please go ahead.

[Shaun Jackson:]

Thank you. Welcome and Happy New Year to allof you. I would like to thank you for joining metoday. Although I have spoken to you inthe past as theChief Financial Officer, this call is my first opportunity to doso as President andCEO of Kingsway. Before we begin, I would like to read theusual warning regarding forward-looking statements. Theremarks that I will make during theconference call contain forward-looking statements that aresubject to risks and uncertainties, and for information identifying theimportant factors that could cause our actual results to differ materially fromthose anticipated in theforward-looking statements, you should read Kingsway’s Canadian and U.S.Securities filings included inour 2006 annual report under theheading risk factors inthe managementdiscussion and analysis section. Thecompany disclaims any intention or obligation to update or revise anyforward-looking statements, whether as aresult of new information, future events or otherwise. Before I open up thecall for questions, I would like to make abrief statement which I hope will anticipate many of your questions. I amsure that you will appreciate that inmy statement and inanswering your questions I will not beable to comment on expected results for thefourth quarter of 2007, as we arenow in theblackout period subsequent to quarter end and prior to theannouncement of thefourth quarter and annual results on February 15th. Firstly, I would like to thank Bill Star for thesupport that he hasgiven me over theyears, and more importantly, theguidance he hasprovided. As many of you know, Bill founded acompany over 20 years ago; his entrepreneurial spirit hasbeen the major driverof the growth inKingsway. I have had thehonor to have worked with him over thelast 12.5 years and have learned agreat deal from him. I wish him thevery best in hiswell-deserved retirement. I amexcited about thefuture of the company,and honored to have been chosen to succeed him as thecompany’s president and CEO. What I would like to dotoday is to provide some insight into theannouncement that Kingsway made on December 18, and also share with you why I amvery positive about theoutlook for the yearwe have just entered. On December 18th Kingsway announced that itwould report a reserveincrease at itsLincoln General subsidiary inthe fourth quarterestimated between $95 million and $125 million. Thepress release of that date provided anexplanation of some of thefactors giving rise to this increase, themost important of which was achange inthe methodology used inestimating Lincoln’s future claimliabilities. This estimated reserve increase, itwas stated there, would initself have a negativeimpact of approximately $1.41 to $1.87 pershare of net income and therefore inbooked value pershare. Since that announcement, trading inthe company’s shares hasreflected a far largerthan expected impact, and several questions have been raised inthe press andelsewhere regarding theannouncement and Kingsway’s expectations regarding upcoming periods. Thefirst thing to note is that this reduction inour earnings and book value pershare will be partially offset by earnings from our other subsidiariesand also our investment income inthe fourth quarter of2007. As a result, we areconfident that thebook value per share atDecember 31, 2007 will beover $17 and our shareholders’ equity will beapproximately $1 billion. Theestimated sanctity surplus inour insurance operating subsidiaries is expected to beapproximately $1.2 billion compared to annualized net premiums written ofapproximately $1.8 billion, which is aleverage ratio of 1.5

[Operator:]

Thank you. (Operator Instructions) Your first question comesfrom Doug Mewhirter- Ferris Baker Watts.

[Doug Mewhirter:]

Good afternoon. Shaun, doyou intend to have someone backfill your previous position of CFO? I justnoticed on the pressrelease that you were still listed as theCFO.

[Shaun Jackson:]

That is something, Doug, that I hope to make anannouncement regarding relatively soon, but I dointend to have areplacement CFO.

[Doug Mewhirter:]

With Lincoln General, I know that last quarter therisk-based capital ratios were close to the200% level and I know that you had to capitalize, inject some capital into thatsubsidiary. After this reserve charge, does that put itagain in aposition where itwould need an additionalcapital injection? Where would thesource of that capital be?

[Shaun Jackson:]

We expect that Lincolnwill require a furthercapital injection. Infact, we have made acapital injection over thelast couple of weeks. We expect that those capital injections will come fromsources within thegroup, Doug. We have alot of companies that areover-capitalized and sowe intend to fund that through internal sources.

[Doug Mewhirter:]

And that would beprimarily from thecash on hand in Barbadosor Bermuda? Not necessarily drawing on aline of credit?

[Shaun Jackson:]

That is correct. We have over-capitalized companiesthroughout the group,and so of course, partof our structure is to beable to draw capital from, as you pointed out, thetwo captives relatively quickly, easily, and they areboth over-capitalized inour view so that wouldbe theprimary source of thecapital we would need to support Lincoln. Infact, some of thelosses from this recent increase, alarge portion of those losses will actually berecognized in theBarbadoscaptive, and that is already contemplated inthe announcement wemade in terms ofquantifying theimpact.

[Operator:]

Your next question comes from Stephen Boland – CIBC WorldMarkets.

[Stephen Boland:]

When you said thecase reserves were developing differently, obviously there were more casereserves required. Is this afrequency problem or severity problem?

[Shaun Jackson:]

Steve, I think theissue was theindependent actuaries and management felt that theindustry development factors, because of theinconsistency in thedata, it hasproven with experience that thecompany’s own case reserves didn’t develop inthe same way that theindustry reserves were anticipated they would. Soit is really one of, Ithink as we come to realize that with thebenefit of hindsight, theindustry factors were not appropriate but again, we didn’t know that atthe time. We now knowwith the benefit ofhindsight.

[Stephen Boland:]

I just want to beclear too that this is allrelated to those accident years ’01 to ’03 and those arethe programs that yousubsequently terminated?

[Shaun Jackson:]

Themost recent increase, some of theincreases, a lot ofincreases were related to themore current accident years. But as we put – and I think perhaps again, with thebenefit of hindsight, we were perhaps optimistic insome of the originalreserves that were set for ’05, ’06 and ’07. ’05, ’06 and ’07 on our continuingprograms, as we look atit today and put thereserves back into theappropriate years, those years for our continuing businesses doshow, are producing anunderwriting profit.

[Operator:]

Your next question comes from Amit Kumar – Fox Pitt Kelton.

[Amit Kumar:]

Thanks and good afternoon. Shaun, I think inthe prepared remarksyou made a commentabout the stock price.Have you perhaps thought of breaking up thecompany and maybe putting some sections inrun off to somehow deal with thecredibility issues here?

[Shaun Jackson:]

Well, as I said on thecall also, Amit, allsubsidiaries areperforming very well. As we look atLincoln’s continuing business we feel that itis producing a profit soI am not clear why wewould put any of thepieces of the companyinto run off, if they remain profitable going forward.

[Amit Kumar:]

Maybe we can discuss that offline. Just moving on to theA.M. Best press release, I think atthe end ittalks about several steps which perhaps they want you to take inorder to deal with thesituation, and then itgoes on to say thatfailure to do sowould result infurther negative pressure which could result ina downgrading of theratings. Have you been intouch with A.M. Best recently and have you gone over allof your plans with them?

[Shaun Jackson:]

We have had discussions with A.M. Best, but as I said on thecall, much of our business is not sensitive to theA.M. Best rating and we expect to have afacility in place thatwill allow us to write any business that is ratings sensitive and retain themost profitable business.

[Amit Kumar:]

I was trying to find theemployment agreements and I did not have much luck; I think inthe Kit states there areno employment agreements. But arethere specific hurdles which need to becleared?

[Shaun Jackson:]

I amnot sure I understand thequestion.

[Amit Kumar:]

Targets which thetop management needs to achieve? Or is itpretty open ended?

[Shaun Jackson:]

I amnot sure of thequestion. Are youasking about our incentive compensation?

[Amit Kumar:]

Yes, that is what I amasking about.

[Shaun Jackson:]

We have anincentive compensation program.

[Amit Kumar:]

And with therecent management change,I would expect thedetails to be inthe proxy?

[Shaun Jackson:]

Well, there is disclosure inthe proxy of ourcompensation program.

[Amit Kumar:]

That’s allfor now, I will requeue. Thanks somuch.

[Operator:]

Your next question comes from John Reucassel– BMOCapital Markets.

[John Reucassel– BMO Capital Markets:]

Just to beclear, the latestreserve adjustments relate to theyears ’05 through ’07? Is that what you said inresponse to a previousquestion?

[Shaun Jackson:]

Yes they do. Itrelates to ’04, ’05 and ’06, but primarily ’05 and ’06. But again, as I saidearlier, when we allocate that to theappropriate years and we look atour continuing business, we still feel that Lincolnbusiness going forward should produce anunderwriting profit.

[John Reucassel– BMO Capital Markets:]

And when we getyour Q4 numbers, I know inyour Q3 numbers you gave some indication of RBCratios and excess capital ratios atsome of the subs. Willwe get that as well inthe Q4 numbers?

[Shaun Jackson:]

We arenot expecting to reduce our disclosure, John, soI would expect that would bethe case.

[John Reucassel– BMO Capital Markets:]

With this going on, arethe acquisitionsmoving to thebackburner for thetime being, or are youstill active in thatarea?

[Shaun Jackson:]

I think our primary focus, certainly for theearlier part of 2008 is going to belooking at ouroperations and trying to improve theprofitability as opposed to looking externally.

[John Reucassel– BMO Capital Markets:]

Shaun, itwas interesting; you mentioned something and I don’t know if I misinterpreted,but you talked about inyour budgeting that you arelooking at softmarkets for ’08. I believe Bill hinted inthe last call thatthey were looking for arecovery in rates in’08. Is that just amore conservative view you guys aretaking or is that just aslightly different interpretation of what is going on inthe market?

[Shaun Jackson:]

I think theKingsway model hasbeen to react to market conditions. My comments were related to instructionsthat we gave to our companies when they did thebudget. We told them to interpret softer conditions for ’08 and lower interestrates. We believe that would set out arealistic and conservative budget for 2008 that we presented to theboard.

[Operator:]

Your next question comes from Keri Pape – National Post.

[Keri Pape:]

Can you explain to meif there is arelationship between Bill Star’s departure and theperformance at Lincoln?

[Shaun Jackson:]

Well, I think theannouncement was fairly clear that Bill retired.

[Keri Pape:]

So thetiming was just coincidental?

[Shaun Jackson:]

I think Bill with theboard felt it was anappropriate time for him to retire. Bill is remaining as Chairmanof the company.

[Operator:]

Your next question comes from Daniel Shapiro – DundeeSecurities Corp.

[Daniel Shapiro –Dundee Securities Corp:]

Reserves relating to IBNR, you reference you areat least atthe midpoint, if not inmost cases, above themidpoint of the rangethat the independentactuary has set out. Ijust had a questionthat is specific to Lincoln, given themost recent increase inreserves, what is theworst-case scenario of that range and have you basically taken theupper end of that range to beconservative and try and prevent any further surprises down theroad?

[Shaun Jackson:]

As I said inthe comments, Daniel, thereason we put a rangearound this estimate was to allow us to review that as we go through thecourse of the next fewweeks. So certainlyour objective is to put this issue behind us.

[Daniel Shapiro –Dundee Securities Corp:]

Sorry, I may bemissing something, but thespecific number you used, was itbased upon the upperend of the range?

[Shaun Jackson:]

Itwas between themidpoint and the upperend of the range, andthat is why we put arange around thenumber.

[Daniel Shapiro –Dundee Securities Corp:]

If you could just comment on themagnitude of some of therecent rate decreasesover the past 12months that Southern United hasbeen taken in theTexas non-standard automarketplace? You’ve reference obviously soft markets, but if you could providesome order of magnitude of what Southern United hasbeen seeing?

[Shaun Jackson:]

Southern United is one of our very small subsidiaries. Theycertainly incompetitive market conditions, I wouldn’t consider its results to bematerial to theoverall group, Daniel. Certainly what we areseeing in markets iscompetitive pricing, but that hasled to, in somemarkets, our volumes declining because of thecompetitive nature of themarket.

[Daniel Shapiro –Dundee Securities Corp:]

My final question, just as afollow-up to one of theprevious questions that was asked with respect to reviewing potential sales ofcertain subsidiaries or thecompany as a whole,and your comment was most of thesubsidiaries areperforming really well and there would beno reason to shut them down or sell them off. But inthe event that themarket doesn’t respond to what you have been saying on thecall today in avery positive way and you continue to trade ata discount to book ina range of 20%, onewould assume you have no choice but to look atputting a process inplace. And just to follow up on that, another question someoneraised before was have you put acquisitions on thebackburner given your current currency? Somy question is, what type of timeframe areyou willing to live with to bring themarket back onside before you would undertake aprocess such as that?

[Shaun Jackson:]

First, let mecomment about two things

[Operator:]

Your next question comes from Tom McKinnon – Scotia Capital.

[Tom McKinnon:]

Can you give us thetail length of theliability, especially of thetrucking business? And then you talked about this artisan contract liabilitybusiness as well. If you could give thetail length on that business?

[Shaun Jackson:]

Thetrucking business is typically, some elements of itdepends on the aspectof theclaim, Tom, if it is aphysical damage that is usually afairly short tail aspect of it. Some of theliability type claims can last longer. You have to remember that inthe States thetrucking business that we write through Lincolnis only a $1 millionprimary liability limit, soit is not thesame level of liability exposure that we have had through our Canadianbusinesses. I would sayon average that tail on that business is inthe two-and-a-half tothree year range if we aretalking about theliability aspect of it, some parts of itcould go a little bitlonger. Theartisan contractor business, which I said inmy comments is only arelatively small part of our business, itis an annual programof about $70 million of annual premiums. Thereserves on that program areonly about 5% of our total consolidated reserves. That program, aspects of itare somewhatlonger. Thecosts on that program areprimarily the defensecosts of defending our insurers. Just as aframe of reference on that program, we look atthe total casereserves on that program and we look atthe IBNR reserves, we arecarrying over $3 of IBNR for every $1 of case reserves, and we consider as Ithink we have said several times, that alot of the destiny ofthat program and theprofitability of that program, to some extent, we feel we can exert anelement of more control over itby virtue of the factthat we tend to work much harder to control our loss adjustment expenses onthat program going forward.

[Tom McKinnon:]

You did alittle bit of buy back awhile ago; are youquiet now? Can you getback in and dosome buy back? Report to the15th and then comment on, I mean, you would certainly want to buyback stock below book.

[Shaun Jackson:]

I think you will seethat in thelast week of December, thebuyback, we haven’t filed our insider trading for thecompany. The companywas actively buying back stock. Severalinsiders, directors were buying stock. I think drawing support for thecompany. We have acorporate policy that we areblacked out as individuals and blacked out as acorporation from theend of the quarter until two business days after weannounced our results, soeffectively as of today we areblacked out until mid-February.

[Operator:]

(Operator Instructions) Your next question comes from AmitKumar – Fox Pitt Kelton.

[Amit Kumar:]

Interms of the reserveincrease, I think you mentioned ’04, ’05 and ’06 and I amwondering, is there aballpark proportion as to how much of thereserve increase came from where?

[Shaun Jackson:]

As I said, Amit, themajority of thereserve increase is from the’05 and ’06 years. Even after theincreases, theinformation, thereserving indicates that those years for our continuing business atLincoln will still remainprofitable from anunderwriting perspective.

[Amit Kumar:]

Then interms of, I think you talked about theinternal versus external claims handling. I think you mentioned a14% number. I went back and looked atyour investor presentation, and that is thesame number that was as of 3Q07. Should we expect that number to declinesubstantially going forward?

[Shaun Jackson:]

Well, itis now a relativelysmall number anyway, Amit. I mean, itmay decline slightly because there area few smaller programsthat we are bringingin-house. It isstaying within that 15%. Alarge portion of that is announced on our automobile program manager where we arevery comfortable with theclaims handling on that program. I mean, itis down to arelatively small number anyway, Amit. I don’t know that itis going to decline to zero.

[Amit Kumar:]

Obviously with this huge reserve increase, would you saythat it is fair toassume that going forward thechances of anadditional reserve increase arefairly minimal?

[Shaun Jackson:]

As I said inthe call, ourintention with this increase was to put thepast behind us.

[Amit Kumar:]

Soyou are saying that inthe next severalquarters we should not seea reserve hit, andhence that would restore theconfidence, right?

[Shaun Jackson:]

As I said, we intend to put itbehind us. We expect that by using more focus on thecompany’s own development factors that should lead to more stable reservinggoing forward.

[Operator:]

Mr. Jackson, there areno further questions atthis time. Please continue.

[Shaun Jackson:]

Thank you very much for joining metoday. As I said, I look forward to speaking with you again following ourfourth quarter and year end earnings release which is scheduled formid-February. Thanks again.