06282017Headline:

Atlas Financial Holdings Inc (AFH): Atlas Financial Holdings’ CEO Discusses Q3 2013 Results

Question-and-Answer Session

Operator

(Operator Instructions) Our first question is coming from Paul Newsome from Sandler O’Neill. Please proceed with your question.

Paul Newsome – Sandler O’Neill

Maybe we could just start off with a little bit more on the competitive environment. I’m particularly curious if there’s been a fall out from the problems that Tower has had in New York.

Scott Wollney

Sure, I appreciate the question. I mean, I’d like to stay away from talking about specific competitors but what I can confirm is that over the last 12 months we’ve seen a number of large of generalists primarily companies who are distributing through MGAs pulling out of the market. While we know that they have terminated those programs we’ve not yet seen the significant amount of non-renewals that are expected as a result of those termination. And that is typical because many MGA programs will have a 12 or even 18-month termination provision.

In terms of other more recent competitive activities, we have definitely seen some of the companies that we’ve talked about being larger, national competitors either make strategic changes and/or face other distractions that are creating what I would best describe I think as tailwinds for us. So we definitely feel very good about the competitive environment again not just because of the issue, Paul that you raised but a number of other issues as well. But we’re definitely anticipating acceleration in terms of opportunities to write business based on what we’re seeing particularly in the last quarter or so.

Paul Newsome – Sandler O’Neill

And then more of a numbers question. If I recall correctly, as you increase your earnings over the course of the year eventually you’ll kick to a level that you start paying taxes. Is that still the case, and are we getting to the point where we would expect some tax payments in fourth quarter?

Paul Romano

Yes, our current philosophy and it’s been in place for the last couple of — for the last few years has been to offset our tax expense on our statement of operation with an offset to our valuation allowance. We’re going to continue that process. We will be evaluating as we have quarter-to-quarter. We will be evaluating our allowance as we move forward. But right now, we’ve not made any decision whether or not to actually take those allowance, those NOL allowances down on the balance sheet.

Scott Wollney

So from an income perspective, as long as we’re carrying that large allowance we shouldn’t be booking tax on the income statement itself. We will pay cash tax above the annual maximum amount we can use every year as defined by 382 which is around $ 2.6 million but until we write down the allowance and essential write up book value, we’ll be able to continue to treat the net income the way that Paul is describing. But in any a case we’ll have that $ 2.6 million of tax free income going forward either on a cash basis or on a cash and income basis in the case where the DTAs are written up.

Paul Newsome – Sandler O’Neill

From a reporting perspective are you going to — I mean, does that essentially mean you will not have reported taxes in the fourth quarter? My understanding was that there was a threshold by which you would start incurring at least on a reported basis.

Paul Romano

Well, to the extent that we have the allowance still up on the balance sheet against the NOLs we will continue to take the profits that we’ve been doing offsetting tax expense with an offsetting decrease in the allowance. We do have $ 1.23 still up on the balance sheet in terms of the allowance against those NOLs. So to the extent that we have that allowance up on the books we will continue this process of writing down the allowance to the extent that we have tax expense.

Paul Newsome – Sandler O’Neill

Okay. You just repeat what you said before and didn’t answer my question. I will just take it offline because before you told me that when you get one point — I think it was $ 13 million of earnings you start incurring taxes under a particular tax rule at least on a reported basis although that does affect your DTA. I understand the DTA wouldn’t change but apparently this is a change in how you’re reporting — its fine from a cash flow I understand that but if this is a change in how you report it that’s fine also. I just want to know if it is or not so that in the fourth quarter which I fully expect you to reach a level of earnings and not putting in effective tax amount in there because of previous guidance?

Paul Romano

Yeah, let’s well –

Paul Newsome – Sandler O’Neill

I’ll take it offline if that’s fine but it is important because you have got in this fourth quarter earnings if you for reason that is purely accounting if that isn’t made clear?

Scott Wollney

Yeah, we can talk to the details offline, Paul; the balance really is the allowance against the DTA is versus the impact on the actual reported earnings every quarter. And so what happens with the allowance impacts what will happen in terms of the taxable earning but we can let’s walk through in detail offline because we can certainly make it clear.

Operator

Thank you. Our next question today is coming from Matthew Berry from Lane Five Capital. Please proceed with your question.

Matthew Berry – Lane Five Capital

I actually have three questions if I can be that greedy. The first is what is the timing in the quarter of the excess program and how much of that was earned in? I know you, the gross written premium is $ 12.6 million but how much of that is actually earned in the quarter?

Paul Romano

So the $ 12.6 million was actually renewed on July 1. So we would actually earn in one fourth of that $ 12.8 million in the quarter.

Matthew Berry – Lane Five Capital

Then the second question is you spoke — I noticed quarter-over-quarter tick up in the acquisition ratio and you spoke about mix and state effects and that some of this may be related to the excess program see such a big change of mix in the quarter but could you just to help sound a little bit what’s going on underneath? Could you talk about the mix and state affects in the quarter and how that impacted the acquisition ratio?

Paul Romano

Sure. It really comes down to the state premium. So state premium taxes range from about 0.5% of written premiums to as much as 2% and where New York is actually one of the highest levels of premium tax even higher than 2%. And so because in the third quarter we have a significant amount of premium written in New York that higher state premium tax has a bigger impact on the acquisition cost than it would in any other quarter. It’s important to note too that the premium tax is based on the written premium, not the earned premium, and so when you see a business makeshift from a written premium perspective that’s where the acquisition costs are really going to be impacted. So that really is the only thing that cause the acquisition cost to be higher, the actual commission rates that we pay the agents including on the excess taxi program are all very similar.

Matthew Berry – Lane Five Capital

Okay, that’s good to know. And then my last question is just around the yields on the investment portfolio. I understand that you wish to be still evaluating on the underwriting scale and so I don’t want to press this too hard, but the yields on the portfolio certainly on an annualized look low relative to market yields and relative to some other P&C companies that I can name. So I was wondering if you could talk about the impact of fees as a sort of percentage reduction that yield and anything else that I need to be thinking about.

Paul Romano

Yeah, really fees weren’t really the driver there. It’s really a function of the fact that we have elected not to take risk in the portfolio. And so 99% of what we have are all fixed income relatively short which obviously in the current interest rates environment does not generate a significant annual yield, but the thought process is as we continue to grow and continue to lever up our surplus which we did illustrate the trend in that written premiums statutory surplus in the deck what we want to make sure is that we are retaining that surplus to deploy into the business. Knowing that we are going into a hardening environment and wanting to really maximize the return on the underwriting on those dollars, we wouldn’t want to invest at this point in equities or other investments that could potentially in the short run cause us to lose surplus or even in the longer run because that would then prevent us from writing more business at exactly the right time to write.

So we are being intentionally conservative in terms of the portfolio joining other P&C companies that may have a flatter growth rate, companies in a more mature point in their lifecycle may elect to put more of that surplus at risk in exchange for a higher yield or a higher return on their portfolio, but we feel like that would be a bad trade off essentially because we think the best investment for our capital is our own business going into this hard market cycle.

Matthew Berry – Lane Five Capital

Okay that makes sense. And then, what is the impact of fees, a very — as a percentage impact on the yield, are you able to calculate that?

Scott Wollney

The management of — the investment manager charges a very low amount, I can let you know offline. Our contract within is confidential but it’s a very small number of this. So it really isn’t a situation where fees went up and that caused the yield to come down. It really was what Paul pointed out in his part of the presentation, which was we just didn’t have any capital gains in the third quarter. Our capital gains were $ 33,000, compared with more like $ 700,000 in the prior period. And so it was really just the absence of capital gains because in some of the prior periods we had liquidated assets to generate the cash to buy Gateway or having bought Gateway, we reallocated some assets across the statutory pool, which created some gains. And so taking capital gains isn’t a normal strategic part of our business plan, it’s something we might do from time to time opportunistically if there’s a specific reason. But it isn’t a sort of a thing that we look for opportunities to take gains every quarter. In fact typically, what we intend to do is hold everything we own to maturity, provided that the basis for the original investment in a particular security holds sound.

Operator

Thank you. Our next question today is coming from Brian Hollenden from Sidoti. Please proceed with your question.

Brian Hollenden – Sidoti

When you look out over the next 12 months based on what you see in the market, how low can your combined ratio go?

Scott Wollney

Well, I guess if you want to look at absolute opportunity or potential — and this is not intended to be guidance. When we saw the markets transition from soft to hard last time around, looking at American country and American services results, the loss ratio went from about 70% fully developed down to the low 50s. We’re currently pricing towards 60%, having again come down from the sort of 70%, 71% range in the most recent soft market. So while that swing from 70% down to 52%, which is 18 percentage points on the combined ratio, is a big swing and the last hard market was a very hard market. That probably gives you the sense for how much potential there is in terms of the U.S. necessity of our niche to the overall hardened property casualty market.

But again, I want to be clear, we right now are pricing towards 60%. As the market or presuming the market continues to harden, we will be opportunistic and improve our pricing targets even further. But I hope that gives you a sense for potential. But again, I want to be clear, I’m certainly not suggesting that that’s where we are going to go because to a great extent that will be a function of the market, in terms of how much it hardened and how long it remains hard. But our focus is definitely to take advantage to the market cycle and what we — we can be informed by prior market cycles, but each one is obviously different. But right now, we’re carrying about a 64% loss ratio, we’re pricing towards 60%. And as we go forward, we’ll continue to take advantage of the market opportunity to generate an increased margin. So that’s on the loss ratio side.

On the expense ratio side, we are obviously approaching that 10% to 12% target range that we mentioned about a point and half of the third quarter OUE ratio related to integration costs for Gateway. As we mentioned before at the end of this year we don’t expect those to continue as we fully integrate the operations in terms of consolidating expenses. We are going to continue to maintain a Saint Louis operation but we feel like we’ve created a platform that will be efficient going forward. For the couple of points left on the expense ratio in terms of opportunity from scale but really it’s going to be the loss ratio that drives increased improvement of the combined ratio going into the hard market cycle.

Brian Hollenden – Sidoti

Thanks. Appreciate the color. One final question, when you expect to pay back the $ 8 million in notes payable?

Scott Wollney

So those all relate to the buyback of the temporarily preferred shares from Kingsway. And so the agreement there is that as the outstanding warrants that exist, which expire on December 31 of this year. Our exercised the money from those exercises will be used to pay down the note, if fully exercised the cash that will come in as a result of the warrant exercises, will allow us to fully pay down the note by the end of this year. Those warrants are stricken in Canadian Dollars and we’ve hedged that FX exposure and so we feel very comfortable that we will be able to pay down the note by the end of the year based on the warrant exercises.

Operator

Thank you. (Operator Instructions) Our next question today is coming from Gregory Macosko from Montrose Advisors. Please proceed with your question.

Gregory Macosko – Montrose Advisors

Two questions. Just going back to the goal with regard to the combined ratio, does the — your discussion of the $ 50 million to $ 60 million net premium earned kind of is a goal I guess, Does that affect — will that have any effect on the combined ratio, your combined ratio goal?

Scott Wollney

It will in the sense that when we first created Atlas and began acquiring the companies we own, we consolidated into an infrastructure and wanted to retain the expertise and really the people that had 15, 20 years of experience in this specialty niche which is a lot of what allows us to create the value we talk about to our customers. And so having done that, we had a bigger in terms of headcount infrastructure than you would need in a steady state to write less than $ 50 million or $ 60 million of earned premium. And so that was a conscious decision. We were very clear and I think communicative about that early on with investors and other stakeholders. But now we are approaching that minimum efficient scale.

So as Paul mentioned, at this point year-to-date we’ve generated $ 50 million in earned premium and so we’re just getting into that minimum efficient scale range of $ 50 million to $ 60 million that we’ve communicated consistently. So as we get up into that range what will happen is we will see our other underwriting expense ratio come down. So it’s at about 14 now, 14.5 or so. We will see that come down by a couple of points just because of the elimination of the Gateway integration cost but then we’ll also see it come down by another couple of points because of our reaching that efficient scale.

Now we are at this point beginning to hire moderately primarily on the business development and the underwriting side of the house kind of the tip of the sword because we are seeing application volumes pick up, opportunities to write business pick up as the market continues to improve and the impact of all the things that we’ve done over the last two years really take hold. So there’s going to be a little bit of a balance where scale will lever down operating expense. We will invest modestly to continue to make sure that we’re well-positioned to take advantage of the market but that should balance out probably at the top end of that 10% to 12% we talked about.

So the short answer to your question is scale will impact the combined ratio by levering down the other underwriting expense ratio by, let’s say, 1% to 2% from scale alone. Really where we’re going to see continued increases in margin beyond that is going to be the impact of pricing action and the improving the market environment where we can drive the loss ratio down.

Gregory Macosko – Montrose Advisors

And then the second question, you mentioned agents, and your agents are pleased, you’re happy with that. And you said you had more agents applying. How are you going to manage that and what’s kind of the goal there?

Scott Wollney

So our goal has always been to have two to five what we call cornerstone agent in every major metropolitan area where we write. We believe we have that. At this point, we’ve got about 280 agents across the country. These are all small relative to Marsh McLennan for example, these are all independently owned and operated agencies that focus on public automobile insurance particularly taxi and paratransit. That’s who we’re interested in working with. So we are not interested in further diversifying the type of agents we work with.

We want to make sure we have efficient distribution. That’s the primary goal. We don’t want to over-saturate any given market where we’re taking opportunities away from a given committed agent, but we will look at agents who approach us. We’re typically appointing about 1 out of 10 that go through the process, and we won’t appoint an agent without doing background checks, reviewing their business plans, physically visiting their offices wherever they’re located and really making sure that they’re going to be additive to our channel as a long term partner as opposed to just somebody who lost their market and is looking for a place to park their business.

And that’s really what’s driving I think a lot of these inbound inquires we’re getting from agents is the fact that the market is hardening, a lot of generalists are pulling out, many agents are losing their markets for the type of business they write and they’re scrambling a new home. So some of those agents may become good long term partners. In more cases, our existing agents will have an opportunity to compete for that business.

Gregory Macosko – Montrose Advisors

So that means you have shall we say 10 or so cornerstone markets? You said two to five for every cornerstone you get 280. So is that kind of what we’re talking about? And do you –

Scott Wollney

No, we have 280 agents altogether. We like to two to five cornerstone agents in major metropolitan areas.

Gregory Macosko – Montrose Advisors

So how many areas then you have?

Scott Wollney

Yes. So we are in 40 states plus Washington D.C. And so we have as I say anywhere from two to five. So in a city like Chicago, we have more than we would have in a place like Springfield, Illinois, for example, where the market size dictates how many cornerstone agents are really efficient distribution obviously you need less in less densely populated areas.

So in terms of agency count having our state count is really where we would expect it to be. It may increase a little bit but really it’s a focus of making sure and getting a proportionate amount of business from each and every one of those agents because we aren’t their only insurance market and we don’t expect them to be exclusive distributors of our product either. And so we are underwriting part of each agent’s book of business and our goal is to through the value proposition and the commitment to the industry any other things that we do to continue to get an increasing proportion of the business they have. And by supporting them we will give them an opportunity in this transitional market to increase their overall book of business as well because many of their competitors at the agency level are losing their markets. And these are the guys to a great extent that we are not signing up. And so that should give them the ability not only to maintain the business they have and rotate more of it to us but also to increase their overall volume of business.

Operator

Thank you. Our next question today is coming from Fang Li from Baleen Capital. Please proceed with your question.

Fang Li – Baleen Capital

Thanks for doing a wonderful job executing so far and for taking my question.

Scott Wollney

Okay.

Fang Li – Baleen Capital

My question is actually a little bit accounting related, it’s on the conversion of written to earned premiums. And so I guess in the quarter you guys wrote $ 30 million of net premiums, earned $ 18 million, and if you add up kind of year-to-date on kind of written to eared premiums there is similar trend you’ve written a lot more than you’ve earned and I just wanted to ask for a little bit more color around that?

Scott Wollney

Certainly. So our policies are unratably over the term of the policy and typically we have 12 month policies. So for example, if we raised $ 12,000 policy in January, we will have writings of $ 12,000 and then earnings of one month worth of that premium in January, one month in February, and so on. So if we didn’t write any more business, we would actually earn off that extra amount every month until it was a fully earned throughout the balance of the year.

So what happens on the balance sheet is, as we write this business it goes into an account called unearned premium reserve. And as we earn off those premiums dollars within that premium reserve, the premium reserve will begin to shrink. However, as we continue to write more and more business, if there is more business written than earned our premium reserve will continue to increase. So for example, our unearned premium reserve balance at the end of Q3 was $ 44.8 million. When we compare that premium reserve to the reserve that we had at the end of Q3 2012 of $ 28.3 million, we actually have grown the unearned premium reserve by 58%. So this is kind of like money in the bank. As we continue to grow the business, the unearned premium reserves should continue to grow and we will be earning no opportunity for those premiums over the course of the next 12 months.

Fang Li – Baleen Capital

So the fact that your Q3 ’13 unearned premium reserves grew at faster rate than your written premiums sorry, your earned premiums implies that maybe it’s just a timing thing where there may be it’s kind of a little bit more just like towards the end of the quarter?

Scott Wollney

Yeah. So we’re going to have some seasonality in our book. When you look at Q1 versus Q2 and Q3 versus Q4, there will be some increases in our unearned premium reserves in Q1 and in Q3 as a result of we write more business in those quarters. But as we continue to grow the seasonality, we become less and less evident in those two quarters.

So for example, like in Q3 of 2012, if we compared Q3 2012 unearned premium balance to Q3 of 2011, we had actually grown that unearned premium reserve by 62.4% from the prior year quarter, as compared to 58.1% for this year. So it is decreasing a little bit but you will see some seasonality particularly in Q1 and Q3.

Fang Li – Baleen Capital

So if the unearned premium balance is kind of like money in the bank that you haven’t — you’ve written, you just haven’t earned it yet, on that as you exited the quarter say like, the last monthly quarter when there was less of a timing issue. What was the run rate level of earned premiums that you would have earned as you’re exiting the quarter?

Scott Wollney

Can you restate the question a little bit?

Fang Li – Baleen Capital

Well, I guess — as — I guess based on — I guess the question is based on the amount of premiums you’ve written to-date especially in Q3, which is a lot higher than what you’ve earned, as you exited the quarter which let’s say in September as opposed to be it, I think July, August, and September, you’re earning a greater proportion of that unearned premium bank?

Scott Wollney

Right.

Fang Li – Baleen Capital

And I was just wondering, so as you exit the quarter what was the kind of run rate level of earned premiums that you’re exiting the quarter with? It was higher than $ 18 million I would guess?

Scott Wollney

Yes. As we continue to move forward and as we continue to grow the book, the earned premiums will continue to grow. As you’ve seen, quarter-over-quarter we’ve increased our earnings by $ 1.50 million or almost $ 2 million every quarter this year. As we continue to grow the top line in the written premium, you’ll continue to see the earned premium increase, but may be not as rapidly as you’ll see the changes in written premium quarter-to-quarter. It’s more of a gradual because you’re dividing that that written premium in any month by 12 and actually gradually earning that in overtime.

Paul Romano

Right. And the actual earnings calculation is done daily in terms of the way that we calculate the earn. So we’re actually taking the written premium and earning at daily over 365 days in the policy period and so it is smoothed out. But over the course of 12 months the full premium will be earned ratably.

Fang Li – Baleen Capital

And then on an incremental basis like, if you show we have premiums, we have earned premiums that haven’t kind of slowed through on an accounting basis yet. We also I guess — the implication on an operating profit basis gives — would it be correct to say that the level of operating expenses that you ran in the quarter was related also to the premiums written not the premiums earned, so that as that slows through the only expenses that will be related to that would be the loss ratio on the acquisition cost but not fee income?

Scott Wollney

There is no bidding for the smoothing under GAAP as well for OUE, as well as the acquisition costs, particularly the commissions. So when we earn in the premium dollars, we’re also earning in the percentage of commission associated with that earned premium. So we’re actually deferring some of the commission expense to the extent that we have unearned premium reserves.

Similar, there are certain expenses within the structure of the other underwriting expenses that we have the ability to defer as well, based on the unearned premium reserves that we have at any point in time. So there is a little bit of a matching but most of the expense are big preponderance of our expenses, are actually based on may be more of a cash basis. However there are expenses that we do continue to earn in as — or expense out as we earn in the premium dollars that we wrote.

Paul Romano

All right. I think it is important to note along the lines of the question saying is, writing new business is more expensive than supporting renewal business. And so in our current growth mode where we’re recapturing a lot of business written in the past, the cost of writing that business is higher in terms of the time it takes for the people in the organization. And so as our renewal book gets bigger and bigger and our renewal retention is about 85%, which is where we’re targeting.

Going forward the cost related to supporting that renewal component of the book will be marginally less than the cost to write that business in the first place. And so that coupled with us, simply getting to that minimum efficient scale that we talked about where we’re just now getting into that range it’s good to have a real compound benefit in terms of what really caused the organization to support the premium dollars that were generated.

Operator

Thank you. (Operator Instructions) Our next question is coming from Dan Farrell from Sterne Agee. Please proceed with your question.

Dan Farrell – Sterne Agee

Just a quick question. You had mentioned that you thought there was an ability to start picking up some more business potentially, some rules, some other careers, through MGAs. And I was wondering if you could just talk about the potential size of that market opportunity and may be if you could relate it to how big a percentage that is of the overall like commercial auto marketplace?

Scott Wollney

Sure, happy to and to be clear that when we talk about picking up business from MGAs it would be by competing with them as opposed to supporting them. Obviously we’re only writing through independent agents but our independent agents are generally competing with other agents who may source their business through these MGAs. So there have been number of generalists who are in the market, they got in, in the soft market through managing general agents. We estimate that the generalists who are either in the process of exiting or have confirmed that they’re exiting to their agency base represent around 300 to potentially as much as 400 million of the total $ 1.5 billion addressable market in our niche. And so it is a big percentage of the total addressable market.

In terms of timing, we would expect that the exit of those programs will occur over the next 12 to 24 months, and to put some color around that, if a carrier terminates a managing general agent and that contract has an 18 month termination provision, which is pretty typical, what that means is that the managing general agent can continue to offer renewals for that full 18 months close to termination and only after that will they be forced to non-renew those individual policies as the policies come up for renewal. So what that means is the rotation of business out can actually take as much as two or three years.

Now if those programs kind of wither away the support tends to disappear as well and so what we generally expect to see is an acceleration of rotation away from those businesses. But in the first year many policyholders will often go ahead and renew even though they may be aware that the program is going away because often times those MGA distributed programs were also the cheapest ones in the marketplace. And coming out of the last soft market, customers as I mentioned are just kind of psychologically getting used to the idea that rates are going up. And so I wouldn’t expect a sudden influx as a result of what we’re talking about but we do think it will be meaningful and we do expect it over the next year to two.

Dan Farrell – Sterne Agee

That’s a powerful detail. Thank you very much.

Operator

Thank you. We’ve reached the end of our question-and-answer session. I’d like to turn the floor back over to management for any further or closing comments.

Scott Wollney

Great. Thanks Kevin and thanks everyone for joining us. We’re available to answer any additional follow-up questions you might have and look forward to speaking with you again after year-end.

Operator

Thank you. That does conclude today’s teleconference. You may disconnect your lines at this time and have a wonderful day. We thank you for your participation today.

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