AmTrust Financial Services Inc AFSI S
January 13, 2010 - 11:49am EST by
lvampa1070
2010 2011
Price: 12.15 EPS $2.08 $2.00
Shares Out. (in M): 60 P/E 5.8x 6.1x
Market Cap (in $M): 730 P/FCF 5.8x 6.1x
Net Debt (in $M): 73 EBIT 185 180
TEV ($): 760 TEV/EBIT 4.1x 4.2x
Borrow Cost: NA

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Description

The common stock of AmTrust Financial Services (AFSI) is dearly priced, and appears to have asymmetric return outcomes that provide a short-sale opportunity. While the common of Maiden Holdings (MHLD) is another candidate for short-sale based on significant potential downside, expectations for the stock are lower, so the upside and downside are more in balance.

BACKGROUND

AmTrust was organized in 1998 when the controlling shareholders purchased the damage insurance (warranty) business of Wang Laboratories (computers). Since then, the company has acquired over nine additional insurance operations, boosting net premium earned from $17m in 2002 to $560m in 2009e.

The top shareholders of AmTrust who control 66% of the common are related to the Karfunkel family.  Two brothers, Michael Karfunkel (66) and George (60) each own 15% of AmTrust's common.  Gulf USA owns 13% of Amtrust and is jointly owned (50/50) by the brothers.  The Chesed and Hod foundations own another 12% and are controlled by the brothers. Finally, the CEO Barry Zyskind (37) is son-in-law of Michael Karfunkel, and Zyskind owns 10% of the common.

These three agents founded a reinsurance company named Maiden Holdings with $50m of equity and currently own 30%.  Zyskind is non-executive chairman of Maiden. 

AmTrust and Maiden have an unusually close relationship.In addition to having significant cross ownership and the same President, AmTrust and Maiden have an important reinsurance agreement.  The agreement stipulates for Maiden to reinsure 40% of AmTrust's premium, and for AmTrust to provide Maiden with various services (manage its investments) for a fee. There is considerable self-dealing involved.

1. AMTRUST IS DEARLY PRICED WITH LITTLE MARGIN FOR ERROR

AFSI trades at a high valuation for an insurance business.The price is 1.7x tangible book and 1.4x book, or 6x 2009e EPS and 6-8x the EPS based on the average five and eight (inception) year ROEs of 24% and 18% applied to today's equity capital and share count.  The median P/B ratio for insurance companies in the Russell 3000 is 0.9x compared with a historical average of 1.3x since 1970, within a range of 0.6x to 2.3x.  A subset of insurance companies comprising 22 peers of AmTrust trades at 0.9x book. 

Sell side analysts are bullish.Every one of the three analysts with ratings publicized on Bloomberg rates AFSI "buy."  Coverage was recently discontinued by Signal Hill, which also rated the stock "Buy." 

2. AMTRUST'S HIGH RETURNS ON EQUITY AND GROWTH ARE NOT SUSTAINABLE

The stock's high P/B ratio is based on an unsustainably high return on equity and growth rate.  AmTrust's returns on equity have been 20%+ during the past four years, over 1.5x the industry return.  Signal Hill wrote on January 22, 2008, "In 20% ROAE's We AmTrust; Initiate With a Buy."  More recently, FBR wrote on November 4, 2009, "Among the P/C insurers we cover, none has an ROE that comes even close to AmTrust's. What we find remarkable is that the company's 3Q09 operating ROE of 25% was achieved in an industry where single-digit ROE is the norm." 

The table below illustrates historical returns for AmTrust, Maiden, and the industry.

Return on equity 2002 2003 2004 2005 2006 2007 2008 2009e
AFSI 4% 2% 13% 16% 21% 25% 21% 22%
MHLD           4% 4% 10%
U.S. P&C insurance industry 3% 10% 11% 11% 14% 13% 9% 8%
AFSI/industry 1.4x 0.2x 1.2x 1.4x 1.5x 1.9x 2.4x 2.8x

Maiden's capital is working for AmTrust, but that is unlikely to persist.  Without a supporting reason, high ROEs will fall.  And over long periods, the only way to get high earnings growth is with a high ROE.  AmTrust's high ROE and high growth are due largely to a reason that is not sustainable.  AmTrust is benefitting from a favorable reinsurance agreement with Maiden, which is a related party.  The arrangement exploits Maiden's shareholders for the benefit of AmTrust's management and shareholders, in the near term.  Broadly, this is evident in the disparity between the ROE for AmTrust and Maiden (see the chart above). AmTrust has grown far in excess of the industry by underwriting premium that Maiden reinsures.    

Premium growth 2003 2004 2005 2006 2007 2008 2009e
AFSI 254% 116% 36% 84% 60% 32% 5%
MHLD           194% 36%
U.S. P&C insurance industry 9% 5% 0% 4% 0% -2% -2%

3. AMTRUST'S HIGH ROEs ARE DRIVEN BY A FAVORABLE AGREEMENT WITH A RELATED PARTY

Analyzing the drivers of AmTrust's unusually high ROE illustrates the importance of the Maiden agreement.  Specifically, consider the significant contribution to AmTrust's earnings from Maiden, and AmTrust's returns on equity with and without the Maiden agreement. The Maiden arrangement contributed over half of AmTrust's pre-tax earnings in 2008 and in the first nine months of 2009.  Because the agreement became effective July 1, 2007, the arrangement probably contributed about half of pre-tax income in the second half of 2007.  The contribution to return on equity is magnified by the fact that the fees from Maiden incur no capital charge. 

Account 2006 2007 2008 9M09
Pre-tax income (reported, $-mm)* $66 $121 $101 $94
Fees from Maiden (reported, $-mm) $0 $68 $127 $96
Expenses from Maiden (estimated, $-mm) $0 -$40 -$60 -$45
Pre-tax income from Maiden (est. $-mm) $0 $28 $67 $51
Pre-tax income => Maiden/total 0% 23% 67% 51%
Pre-tax ROE with Maiden 20% 32% 25% 20%
Pre-tax ROE without Maiden 20% 25% 8% 9%
*Pre-tax income ex Maiden declined in 2008 b/c of realized investment losses $15 $5 -$65 -$29

The "fees from Maiden" are many.  First, AmTrust collects from Maiden a ceding commission of 31% or more of premium for acquiring and underwriting the business.  In 2008, the commission was $116mfor cessions of $377m in premium to Maiden.  Second, AmTrust collects a brokerage fee equal to 1.25% of reinsured premiums.  I'm not sure why AmTrust collects this in addition to the ceding commission, but in 2008, the brokerage commission was $5.5m.  Third, AmTrust collects an investment management services fee of 0.2% per annum from Maiden.  In 2008, the asset management fee was $1.4m.  Fourth, AmTrusts performs various marketing and back office services for Maiden and collects costs plus 8%.  In 2008, this amounted to $1.2m. Finally, AmTrust requires collateral for reinsurance from Maiden. So the $173m reinsurance receivable is secured by a loan of $168m from Maiden on which AmTrust pays L+90bps. AmTrust can invest the proceeds at greater than L+90bps, earning a spread of 200bps+, or $3.4m. 

The expense for performing all these services must be estimated, unlike the fees which are disclosed in SEC filings.  I estimate the variable expenses are limited to acquisition costs that amount to 14-16% of premiums written, or $60m in 2008.  The remaining services (underwriting, asset management, marketing, and other back office services) draw upon AmTrust's existing infrastructure.  One may consider these costs fixed, and allocate none to the Maiden agreement, or one might be aggressive, and allocate another 10% of premiums.  AmTrust's total operating expense ratio excluding Maiden is 30%. 

4. AMTRUST IS ENGAGED IN CONSIDERABLE SELF-DEALING

The data above is presented in an attempt to quantify the benefit to AmTrust of a favorable agreement with a related party. The following are some additional factors pointing to self-dealing which contribute to the likelihood of unsustainable returns to shareholders.

a) AmTrust is a roll-up of insurance businesses and includes eleven subsidiaries.Gross premiums written have increased from $28m in 2002 to $1,160m in 2009e. Most recently, AmTrust acquired GMAC's U.S. consumer P&C insurance business in October. According to one senior executive at another insurance company, GMAC was a "shxt business" which AmTrust approached him about providing reinsurance for though he has no interest. "They paid $50m for this piece of shxt because they take fees out and let the public company bear the risk." The CEO's annual bonus is equal to 2% of pre-tax profits (capped at 2.5x his $625,000 salary). 

b) The owners had a prior run-in with the SEC.  Michael Karfunkel and George Karfunkel, both of New York, were issued injunctions by the SEC New York Regional Office in 1971 for violations of the registration and/or anti-fraud provisions of federal securities laws in what a judge described as a "multi-party stock manipulation venture" by a U.S. Court of Appeals judge.  I have not confirmed these Karfunkels are the same owners of AmTrust.

c) Aggressive investor relations effort.  AmTrust has employed three investor relations professionals during the 12 months that I have been in a dialogue with the company's management.  The most recent professional has called a buyside analyst several times to inquire what would be necessary to entice the firm to become a shareholder. 

d) Minority ownership and loan to a customer.  AmTrust booked $87m of gross premiums written in 2008 (8% of total) for a business called Warrantech, a company in which AmTrust holds a 27% equity interest and to which AmTrust has loaned $20 million. AmTrust's $3.9m investment in February, 2007, has been written down to $1.7. AmTrust insures a majority of Warrantech's business. In a separate deal, AmTrust purchased Wesco Insurance Company from Household Insurance Group. AmTrust/Wesco insures Household. And an "affiliate" of Household, HSBC Insurance Company of Delaware, reinsures AmTrust/Wesco. In other words, Household takes risks and pays AmTrust/Wesco to assume the risks.  AmTrust/Wesco now has the risk, but it pays HSBC (an affiliate of Household) to assume the risks. 

e) A lawsuit. AmTrust and various directors and officers are defendants to a complaint that alleges that AmTrust's agreement with Maiden unduly benefits the Karfunkels and Zyskind at the expense of AmTrust.

f) Few independent directors or industry experts on the board.The Board of Directors includes the three family members, three attorneys, and one professional investor.  There is little insurance expertise on the board. 

g) Nepotism.Of course, there is the obvious nepotism with Zyskind as CEO. There is more subtle nepotism too.  AmTrust has a wholly owned subsidiary called Leap Tide Capital Management (a.k.a. "Hedge Funds" per the Proxy) that manages $27m of the company's $1.4b of investments. The analyst for the Hedge Funds is none other than Barry Karfunkel, who is the son of Michael Karfunkel and brother-in-law of CEO Barry Zyskind. Barry gets a salary of $280,000. AmTrust is an important client of Leap Tide Capital Management since virtually all of its assets under management are from AmTrust. Michael and Barry Karfunkel had about $2.2m in the fund, but they withdrew all their funds from the Hedge Funds as of December 31, 2008.

h) Self-dealing.AmTrust's corporate office is 59 Maiden Lane in downtown Manhattan. The 14,807 square feet is leased from 59 Maiden Lane Associates, LLC, an entity wholly owned by Michael and George Karfunkel.  The annual rent of $622,000, or $42 per square foot, is reasonable (negotiated Jan 1, 2008) although probably 15% above market for Class A space today.

5. RISKS

My primary objection to my own work is that no catalyst is present so the time horizon of the short-sale is indefinite.

Underlying businesses look okay.  AmTrust operates three underlying insurance businesses: (1) very small company workers' compensation insurance, (2) extended warranty coverage, and (3) middle-market P&C insurance.  The business model targets high frequency and low severity markets that have more stable loss ratios.  Management tells a story that the company has a technology advantage which enables it to process a higher volume of business opportunities. This is possible, but it appears inconsistent with the company's much lower spending in technology and lower expense ratio than peers.

The reserves do not appear inadequate.  AmTrust typically purchased renewal rights and not liabilities.  I hired a reserve specialist to evaluate the reserves and the conclusion is that the reserves are slightly redundant. 

Catalyst

1) The complaint filed in the Supreme Court of New York against AmTrust and its directors and officers causes a renegotiation of the deal with Maiden.

2) The SEC follows up on its comment letter dated August 6, 2008 with more serious concerns about AmTrust's self-dealing.

3) Maiden's shareholders force an agreement that is more equitable and AmTrust's ROEs decline.

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    Description

    The common stock of AmTrust Financial Services (AFSI) is dearly priced, and appears to have asymmetric return outcomes that provide a short-sale opportunity. While the common of Maiden Holdings (MHLD) is another candidate for short-sale based on significant potential downside, expectations for the stock are lower, so the upside and downside are more in balance.

    BACKGROUND

    AmTrust was organized in 1998 when the controlling shareholders purchased the damage insurance (warranty) business of Wang Laboratories (computers). Since then, the company has acquired over nine additional insurance operations, boosting net premium earned from $17m in 2002 to $560m in 2009e.

    The top shareholders of AmTrust who control 66% of the common are related to the Karfunkel family.  Two brothers, Michael Karfunkel (66) and George (60) each own 15% of AmTrust's common.  Gulf USA owns 13% of Amtrust and is jointly owned (50/50) by the brothers.  The Chesed and Hod foundations own another 12% and are controlled by the brothers. Finally, the CEO Barry Zyskind (37) is son-in-law of Michael Karfunkel, and Zyskind owns 10% of the common.

    These three agents founded a reinsurance company named Maiden Holdings with $50m of equity and currently own 30%.  Zyskind is non-executive chairman of Maiden. 

    AmTrust and Maiden have an unusually close relationship.In addition to having significant cross ownership and the same President, AmTrust and Maiden have an important reinsurance agreement.  The agreement stipulates for Maiden to reinsure 40% of AmTrust's premium, and for AmTrust to provide Maiden with various services (manage its investments) for a fee. There is considerable self-dealing involved.

    1. AMTRUST IS DEARLY PRICED WITH LITTLE MARGIN FOR ERROR

    AFSI trades at a high valuation for an insurance business.The price is 1.7x tangible book and 1.4x book, or 6x 2009e EPS and 6-8x the EPS based on the average five and eight (inception) year ROEs of 24% and 18% applied to today's equity capital and share count.  The median P/B ratio for insurance companies in the Russell 3000 is 0.9x compared with a historical average of 1.3x since 1970, within a range of 0.6x to 2.3x.  A subset of insurance companies comprising 22 peers of AmTrust trades at 0.9x book. 

    Sell side analysts are bullish.Every one of the three analysts with ratings publicized on Bloomberg rates AFSI "buy."  Coverage was recently discontinued by Signal Hill, which also rated the stock "Buy." 

    2. AMTRUST'S HIGH RETURNS ON EQUITY AND GROWTH ARE NOT SUSTAINABLE

    The stock's high P/B ratio is based on an unsustainably high return on equity and growth rate.  AmTrust's returns on equity have been 20%+ during the past four years, over 1.5x the industry return.  Signal Hill wrote on January 22, 2008, "In 20% ROAE's We AmTrust; Initiate With a Buy."  More recently, FBR wrote on November 4, 2009, "Among the P/C insurers we cover, none has an ROE that comes even close to AmTrust's. What we find remarkable is that the company's 3Q09 operating ROE of 25% was achieved in an industry where single-digit ROE is the norm." 

    The table below illustrates historical returns for AmTrust, Maiden, and the industry.

    Return on equity 2002 2003 2004 2005 2006 2007 2008 2009e
    AFSI 4% 2% 13% 16% 21% 25% 21% 22%
    MHLD           4% 4% 10%
    U.S. P&C insurance industry 3% 10% 11% 11% 14% 13% 9% 8%
    AFSI/industry 1.4x 0.2x 1.2x 1.4x 1.5x 1.9x 2.4x 2.8x

    Maiden's capital is working for AmTrust, but that is unlikely to persist.  Without a supporting reason, high ROEs will fall.  And over long periods, the only way to get high earnings growth is with a high ROE.  AmTrust's high ROE and high growth are due largely to a reason that is not sustainable.  AmTrust is benefitting from a favorable reinsurance agreement with Maiden, which is a related party.  The arrangement exploits Maiden's shareholders for the benefit of AmTrust's management and shareholders, in the near term.  Broadly, this is evident in the disparity between the ROE for AmTrust and Maiden (see the chart above). AmTrust has grown far in excess of the industry by underwriting premium that Maiden reinsures.    

    Premium growth 2003 2004 2005 2006 2007 2008 2009e
    AFSI 254% 116% 36% 84% 60% 32% 5%
    MHLD           194% 36%
    U.S. P&C insurance industry 9% 5% 0% 4% 0% -2% -2%

    3. AMTRUST'S HIGH ROEs ARE DRIVEN BY A FAVORABLE AGREEMENT WITH A RELATED PARTY

    Analyzing the drivers of AmTrust's unusually high ROE illustrates the importance of the Maiden agreement.  Specifically, consider the significant contribution to AmTrust's earnings from Maiden, and AmTrust's returns on equity with and without the Maiden agreement. The Maiden arrangement contributed over half of AmTrust's pre-tax earnings in 2008 and in the first nine months of 2009.  Because the agreement became effective July 1, 2007, the arrangement probably contributed about half of pre-tax income in the second half of 2007.  The contribution to return on equity is magnified by the fact that the fees from Maiden incur no capital charge. 

    Account 2006 2007 2008 9M09
    Pre-tax income (reported, $-mm)* $66 $121 $101 $94
    Fees from Maiden (reported, $-mm) $0 $68 $127 $96
    Expenses from Maiden (estimated, $-mm) $0 -$40 -$60 -$45
    Pre-tax income from Maiden (est. $-mm) $0 $28 $67 $51
    Pre-tax income => Maiden/total 0% 23% 67% 51%
    Pre-tax ROE with Maiden 20% 32% 25% 20%
    Pre-tax ROE without Maiden 20% 25% 8% 9%
    *Pre-tax income ex Maiden declined in 2008 b/c of realized investment losses $15 $5 -$65 -$29

    The "fees from Maiden" are many.  First, AmTrust collects from Maiden a ceding commission of 31% or more of premium for acquiring and underwriting the business.  In 2008, the commission was $116mfor cessions of $377m in premium to Maiden.  Second, AmTrust collects a brokerage fee equal to 1.25% of reinsured premiums.  I'm not sure why AmTrust collects this in addition to the ceding commission, but in 2008, the brokerage commission was $5.5m.  Third, AmTrust collects an investment management services fee of 0.2% per annum from Maiden.  In 2008, the asset management fee was $1.4m.  Fourth, AmTrusts performs various marketing and back office services for Maiden and collects costs plus 8%.  In 2008, this amounted to $1.2m. Finally, AmTrust requires collateral for reinsurance from Maiden. So the $173m reinsurance receivable is secured by a loan of $168m from Maiden on which AmTrust pays L+90bps. AmTrust can invest the proceeds at greater than L+90bps, earning a spread of 200bps+, or $3.4m. 

    The expense for performing all these services must be estimated, unlike the fees which are disclosed in SEC filings.  I estimate the variable expenses are limited to acquisition costs that amount to 14-16% of premiums written, or $60m in 2008.  The remaining services (underwriting, asset management, marketing, and other back office services) draw upon AmTrust's existing infrastructure.  One may consider these costs fixed, and allocate none to the Maiden agreement, or one might be aggressive, and allocate another 10% of premiums.  AmTrust's total operating expense ratio excluding Maiden is 30%. 

    4. AMTRUST IS ENGAGED IN CONSIDERABLE SELF-DEALING

    The data above is presented in an attempt to quantify the benefit to AmTrust of a favorable agreement with a related party. The following are some additional factors pointing to self-dealing which contribute to the likelihood of unsustainable returns to shareholders.

    a) AmTrust is a roll-up of insurance businesses and includes eleven subsidiaries.Gross premiums written have increased from $28m in 2002 to $1,160m in 2009e. Most recently, AmTrust acquired GMAC's U.S. consumer P&C insurance business in October. According to one senior executive at another insurance company, GMAC was a "shxt business" which AmTrust approached him about providing reinsurance for though he has no interest. "They paid $50m for this piece of shxt because they take fees out and let the public company bear the risk." The CEO's annual bonus is equal to 2% of pre-tax profits (capped at 2.5x his $625,000 salary). 

    b) The owners had a prior run-in with the SEC.  Michael Karfunkel and George Karfunkel, both of New York, were issued injunctions by the SEC New York Regional Office in 1971 for violations of the registration and/or anti-fraud provisions of federal securities laws in what a judge described as a "multi-party stock manipulation venture" by a U.S. Court of Appeals judge.  I have not confirmed these Karfunkels are the same owners of AmTrust.

    c) Aggressive investor relations effort.  AmTrust has employed three investor relations professionals during the 12 months that I have been in a dialogue with the company's management.  The most recent professional has called a buyside analyst several times to inquire what would be necessary to entice the firm to become a shareholder. 

    d) Minority ownership and loan to a customer.  AmTrust booked $87m of gross premiums written in 2008 (8% of total) for a business called Warrantech, a company in which AmTrust holds a 27% equity interest and to which AmTrust has loaned $20 million. AmTrust's $3.9m investment in February, 2007, has been written down to $1.7. AmTrust insures a majority of Warrantech's business. In a separate deal, AmTrust purchased Wesco Insurance Company from Household Insurance Group. AmTrust/Wesco insures Household. And an "affiliate" of Household, HSBC Insurance Company of Delaware, reinsures AmTrust/Wesco. In other words, Household takes risks and pays AmTrust/Wesco to assume the risks.  AmTrust/Wesco now has the risk, but it pays HSBC (an affiliate of Household) to assume the risks. 

    e) A lawsuit. AmTrust and various directors and officers are defendants to a complaint that alleges that AmTrust's agreement with Maiden unduly benefits the Karfunkels and Zyskind at the expense of AmTrust.

    f) Few independent directors or industry experts on the board.The Board of Directors includes the three family members, three attorneys, and one professional investor.  There is little insurance expertise on the board. 

    g) Nepotism.Of course, there is the obvious nepotism with Zyskind as CEO. There is more subtle nepotism too.  AmTrust has a wholly owned subsidiary called Leap Tide Capital Management (a.k.a. "Hedge Funds" per the Proxy) that manages $27m of the company's $1.4b of investments. The analyst for the Hedge Funds is none other than Barry Karfunkel, who is the son of Michael Karfunkel and brother-in-law of CEO Barry Zyskind. Barry gets a salary of $280,000. AmTrust is an important client of Leap Tide Capital Management since virtually all of its assets under management are from AmTrust. Michael and Barry Karfunkel had about $2.2m in the fund, but they withdrew all their funds from the Hedge Funds as of December 31, 2008.

    h) Self-dealing.AmTrust's corporate office is 59 Maiden Lane in downtown Manhattan. The 14,807 square feet is leased from 59 Maiden Lane Associates, LLC, an entity wholly owned by Michael and George Karfunkel.  The annual rent of $622,000, or $42 per square foot, is reasonable (negotiated Jan 1, 2008) although probably 15% above market for Class A space today.

    5. RISKS

    My primary objection to my own work is that no catalyst is present so the time horizon of the short-sale is indefinite.

    Underlying businesses look okay.  AmTrust operates three underlying insurance businesses: (1) very small company workers' compensation insurance, (2) extended warranty coverage, and (3) middle-market P&C insurance.  The business model targets high frequency and low severity markets that have more stable loss ratios.  Management tells a story that the company has a technology advantage which enables it to process a higher volume of business opportunities. This is possible, but it appears inconsistent with the company's much lower spending in technology and lower expense ratio than peers.

    The reserves do not appear inadequate.  AmTrust typically purchased renewal rights and not liabilities.  I hired a reserve specialist to evaluate the reserves and the conclusion is that the reserves are slightly redundant. 

    Catalyst

    1) The complaint filed in the Supreme Court of New York against AmTrust and its directors and officers causes a renegotiation of the deal with Maiden.

    2) The SEC follows up on its comment letter dated August 6, 2008 with more serious concerns about AmTrust's self-dealing.

    3) Maiden's shareholders force an agreement that is more equitable and AmTrust's ROEs decline.

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