Blue Hen Investment Club Financials Sector - MHLD Residual Income Model Assumptions

Blue Hen Investment Club Financial Sector: Maiden Holdings Limited Residual Income Model

Explanation of Assumptions for Residual Income Model for Maiden Holdings Ltd (MHLD):

Revenue: Based on the regression model with an adjusted R-squared of

approximately .975 and the assumptions related to the possible growth rates of the following

variables – the total net premiums per quarter for AMTrust Financial, the overall change in price

of the S&P 500 Property and Insurance Index, the overall change in price of the S&P Life

Insurance Index, the consumer confidence index, US domestic auto sales, overall US auto sales,

European auto sales, German auto sales, the total revenue of Aon and Marsh McLennan, and the

fluctuations in the Pound and Euro resulted in a predicted 13% increase in total net premiums

over the next few years. It was assumed that Maiden would be able to increase revenue growth

for 2016; however, it would not be able to maintain this growth in 2017 due to the initiation of

the UK’s succession from the EU, falling global auto sales in both the US and Europe,

decreasing revenues for Aon, AMTrust, and Marsh. I predict we would some recovery in 2018,

but this would be impacted again by the UK’s ultimate succession from the EU around 2019.

For the bear case, I expect revenues to decline overall. For the base case, I expect the revenue to

fluctuate around 11-13% but not exceed this value. For the bull case, I forecast the company

manages to achieve its ultimate goal of 15% revenue growth even with the negative impacts of

currency fluctuations and numerous other factors.

EBIT Margin: Maiden stated in its 10K that they recently experienced more expenses

than originally anticipated due to volatile markets. Historically, the company’s EBIT has

experienced extreme volatility; therefore, an accurate prediction of EBIT is rather difficult since

the historical data appears rather inconsistent over time. For most of the cases, it is assumed that

the EBIT Margin will be correlated with revenue growth given the company’s operating

expenses will most likely remain constant. There is the possibility of an exogenous shock if


another unprecedented terrorist attack on a massive scale occurs in the US provided the recent

implementation of the Terrorism Risk Insurance Program Reauthorization Act of 2015. This act

requires all insurance companies to cover commercial organizations for possible terrorist attacks.

This increases the overall risk of the insurance sector as well as operating expenses if a terrorist

attack were to occur. I know what I am about to say is rather grim, but I predict that given the

increasing frequency of terrorist attacks across Europe and the recent influx of Syrian refugees in

the United States that within the next year to three years the US will experience another terrorist

attack commensurate to or worse than September 11th. If this were to occur in a metropolitan

area – the most susceptible and likely target – these insurance companies would have to cover

the claims causing a devastating impact on the entire sector both property and health wise.

Borrowings Outstanding: The company has very little debt and has even managed to

eliminate its long-term debt. I expect the outstanding borrowings to remain constant given they

have remained constant for the past three years. The bull case does consider the possibility that

they reduce their debt even more. I do not foresee the company issuing more debt given that the

company has only issued debt four times in its thirty-two year life.

Weighted Average Effective Interest Rate: One of the company’s main goals over the past

few years has been to reduce the cost of generating capital. Currently, the cost of debt is 1%. I

expect this to remain constant over the next few years. The bear case assumes that with the

tremendous volatility in the global markets the company experiences another degrading of its

crediting rating increasing its cost of debt. This does not seem likely given how little borrowings

outstanding the company has currently and in the predicted future.

Income Tax Rate: The company did mention that a change in the corporate tax rate of

Bermuda could negatively impact them, but this change would not affect them until 2035. We


have plenty of time to bail if this does happen. The cost of taxes in the UK are expected to rise

by about five percent; this will probably have a negligible impact on the overall income tax for

the company given the UK is not a significantly large segment of its operations.

Dividend Payout Ratio: The historical data exhibits extreme fluctuations meaning finding

a trend in the data is rather difficult. The bear case assumes the dividend payout ratio will

decrease over time to 25% due to the impacts on revenue and other previously mentioned factors.

The other cases assume growing dividend payout ratios in accordance with greater revenue

generation with minor decreases due to the Brexit impacts and the uncertainty of the market.

Weighted Average Cost of Capital: I expect this to generally remain constant; however,

this an interest rate hike on the horizon, the bear case assumes that the WACC will increase. The

other two cases predict constant WACC. The bull case predicts a possible decrease in WACC in

the later years due to management continuing its plans to reduce the cost of generating capital to

yield higher returns on equity, but this is mostly unlikely to occur with the current global

environment of central banks.

Discounted Terminal Value Added: The Residual Income Model calls for the discounted

terminal value to be added to determine the fair value of equity. If the company can generate

growth organically, then this value will not equal zero. However, most insurance companies

enter maturity and continue to sell the same product without much innovation. For example,

many insurance companies have been in business centuries; however, the techniques used have

not changed over time. Yes, the Actuarial models have managed to make an imprecise art into a

more precise science, but the overall innovation has not caused substantial changes to the overall

industry. Insurance is insurance: it is not going to change instantaneously and will always be

there. For this reason, the residual income model simplifies to eliminating the discounted


terminal value for a company can in essence continue to sell product past maturity and still

manage to generate revenue. Since this condition truly does apply to insurance, the bear, base,

and bull residual income models that evaluate the discounted terminal value to be zero are most

accurate.

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Blue Hen Investment Club Financials Sector - MHLD Residual Income Model Assumptions