CFRA BESPOKE DETAILED REVIEW SAMPLE€¦ · Based on the following disclosure, Luxembourg’s captives held $412 million in unutilized equalization reserves at the end of 2012. In

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CFRA BESPOKE DETAILED REVIEW

AmTrust Financial Services, Inc. (AFSI)

Provided for Client

REVIEW CONTENTS:

Key Takeaways Summary Earnings Persistence Asset Quality & Reserving

Funding & Interest Rate Risk Off-Balance Sheet Risk Corporate Governance

ANALYST:

Talgat Irisbekov, CFA, FRM +1.646.517.2463 [email protected]

May 24, 2013

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May 24, 2013 CFRA BESPOKE DETAILED REVIEW: AmTrust Financial Services, Inc. CFRA CONTACT: Talgat Irisbekov | +1.646.517.2463 | [email protected]

© 2013 CFRA. All rights reserved. This document may not be reproduced or redisseminated in whole or in part without prior written permission from CFRA.

Key Takeaway We raise significant concerns over the quality of AFSI’s net expense ratio, which may be benefiting from (1) gains related to changes in deferred tax liabilities on equalization reserves, (2) front loading of profits through the reinsurance agreement with a related party, and (3) potentially discretionary policies related to amortization of contractual use rights. We also raise several reserving concerns including (a) reserve deficiencies for 2009 and 2010 accident years, (b) reserve build within the Specialty Risk and Extended Warranty segment possibly not reflected in the Loss and LAE expense, and (c) potential discretion over changes in unpaid premium reserves. On the accounting for life settlement contracts, we raise concerns over vaguely disclosed profit commission arrangements, which may be detrimental to the company’s interests.

Summary EARNINGS QUALITY p.3 We raise concerns that AFSI’s underwriting expenses include gains from changes in deferred tax liabilities related to equalization reserves held by the Luxembourg captives. The extent of the benefit is not clear but with unutilized equalization reserves of $412 million and related DTLs of $124 million (and growing) they may be material.

AFSI’s net expense ratio also benefits from front loading of profits through the reinsurance agreement with Maiden Holdings, a related party. We calculate that the net expense ratio would be 1-2% lower adjusted for the ceding agreement. However, we also note that it is not unusual for the ceding commission on pro rata reinsurance agreements to include a profit component.

In 2011, the company adjusted its useful life assumption on contractual use rights to “specific use” from “2-3 years,” while also recording lower underwriting expense. We raise concern that “specific use” may indicate greater management discretion over the amortization of these costs.

INSURANCE RESERVES P.8

Significant reserve deficiencies for 2009 and 2010 accident years raise concerns, particularly if they are a sign of broader reserve adequacy issues. We were not able to reconcile substantial reserve increases within the Specialty Risk and Extended Warranty segment, raising concerns that reserve build was not reflected in the Loss and LAE expense. We also raise a red flag that AFSI may have significant discretion over its unpaid premium reserves, with significant swings in net earned/written ratio raising earnings management concerns. Finally, we view the usage of incurred loss models as potentially less credible (especially when own factors are involved) because the company’s estimates of future losses are based on its past estimated losses rather than actual paid losses.

ACCOUNTING FOR LIFE SETTLEMENT CONTRACTS P.15

We raise concerns that AFSI may have been paying or accruing significant profit commissions on Life Settlement Contracts (LSCs) while providing very limited visibility into the profit sharing arrangement. In addition, we raise concerns that while gains on LSCs can be highly volatile and may not materialize for years, significant profit commissions (either cash or accrued) raise fundamental concerns about the benefit of such arrangement to AFSI.

SOURCE DOCUMENTS 10-Q Filing 10-K Filing Conference call transcript 5-years of financial Data

RELATED IRAP Insurance

CFRA SCORE Earnings Score: N/A Cash Flow Score: N/A

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Earnings Quality TAX BENEFITS CONTRIBUTED TO LOWER UNDERWRITING EXPENSE We raise concerns that AFSI recognizes changes in deferred tax liabilities related to Luxembourg captives as an offset to underwriting expense. Between 2009 and 2012, AFSI acquired a number of captive reinsurance companies domiciled in Luxembourg. Although the company does not provide much detail into these transactions, it appears that they were primarily acquired for tax benefit purposes. Premiums paid by AFSI to its captives are tax deductible, resulting in tax benefits as long as the captives continue to operate and can fully utilize their equalization reserves. Equalization reserves are essentially catastrophe reserves held in excess of required reserves. Note that equalization reserves cannot be counted as required reserves under either US GAAP or IFRS accounting rules. Because captives are fully consolidated by AFSI these reinsurance agreements do not result in the reduction of the overall underwriting risk for the company. We note, however, that it is not unusual for captives to be used primarily for tax and capital management purposes rather than for reduction of the actual underwriting risks. The company’s accounting for deferred tax liabilities may potentially result in lower than actual underwriting expenses. According to the new disclosure in 2012 (the underlined sentence was absent in prior year filings), AFSI applies changes in deferred tax liabilities related to the captives’ equalization reserves against net amortization expense, which results in lower underwriting expense and, subsequently, lower net expense ratio, which is a key metric of underwriting profitability:

We record changes in deferred income tax assets and liabilities that are associated with components of other comprehensive income, primarily unrealized investment gains and losses and foreign currency translation gains and losses, directly to other comprehensive income. Additionally, the use of deferred tax liabilities related to equalization reserves are netted against related amortization expense and recorded as a decrease to other underwriting expense. Otherwise, we include changes in deferred income tax assets and liabilities as a component of income tax expense. (AFSI 10-K)

Table 1 below shows growth in deferred tax liability related to equalization reserves. The growth in DTLs is likely due to purchases of new subsidiaries and increased underwriting activity between the company and its captives. Changes in DTL that would result in lower underwriting expense would likely be related to the usage of the equalization reserves, which would potentially result in reclassification of a temporary difference (reason for DTL in the first place) into a permanent difference and a corresponding benefit to AFSI’s earnings.

Table 1: DTLs related to equalization reserves

Source: SEC filings; CFRA

$000's 2009 2010 2011 2012Deferred tax liability related to equalization reserves(included in DTL for Losses and LAE reserves) 14,243 17,090 88,576 123,699 Unutilized equalization reserves n/d n/d 332,000 412,000 Acquired equalization reserves: 126,000 53,000 n/d n/d

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As a related concern, although changes in these DTLs are netted against underwriting expense, the DTLs themselves are recorded as being linked to the Losses and LAE reserves (which are not related to underwriting expense). As shown in the Table 2 below, DTL’s related to Losses and LAE reserves grew from net DTA position to net DTL in the amounts of $56.9 million in 2011 and $90.2 million in 2012 and included the DTLs related to equalization reserves highlighted in the prior table.

Although the extent to which AFSI’s underwriting expenses benefit from tax-related changes is not clear, we raise concern that it could be potentially significant depending on the utilization of the equalization reserves held by the captives. Based on the following disclosure, Luxembourg’s captives held $412 million in unutilized equalization reserves at the end of 2012.

In 2009, we acquired a Luxembourg holding company and five Luxembourg-domiciled captive insurance companies. During 2010 - 2012, we made several additional acquisitions of Luxembourg-domiciled captive insurance companies. In connection with these transactions, we acquire the equalization reserves of the captive insurance companies. An “equalization reserve” is a catastrophe reserve in excess of required reserves determined by a formula based on the volatility of the business ceded to the captive insurance company. Provided that we are able to cede losses to the captive insurance companies through intercompany reinsurance arrangements that are sufficient to exhaust the captives’ equalization reserves, Luxembourg would not, under laws currently in effect, impose any income, corporation or profits tax on the captive insurance companies. However, if the captive reinsurance companies were to cease reinsuring business without exhausting the equalization reserves, they would recognize income that would be taxed by Luxembourg at a rate of approximately 30%. As of December 31, 2012, we had approximately $412 million of unutilized equalization reserves.

Table 2: Net DTLs related to equalization reserves are part of DTLs related to Losses and LAE reserves but changes are reflected in the underwriting expense


$000's 2009 2010 2011 2012Deferred tax liabilities Deferred acquisition costs (79,950) (110,384) (147,819) (186,133) Losses and LAE reserves - - (56,869) (90,174) Intangible assets - - (27,640) (43,556) Unrealized gain on investments - - - (34,586) Other (6,502) (4,610) (6,299) (22,797) Depreciation (2,798) (5,501) (12,379) (21,021) Equity results which cannot be liquidated tax free - (4,179) (8,796) (2,038) Accrual market discount (751) (1,674) (2,062) (1,968) Cash surrender value on insurance (1,770) (1,877) (1,882) (1,939) Total deferred tax liabilities (91,771) (128,225) (263,746) (404,212)

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REINSURANCE RELATIONSHIP WITH MAIDEN HOLDINGS BENEFITS NET EXPENSE RATIO AFSI’s reinsurance relationship with Maiden Holdings (a related party) raises concerns due to what appears to be highly volatile loss ratio on the ceded premiums. The relationship is material for AFSI as in 2012 and 2011 the company ceded approximately 31% of its total written premiums to Maiden. The top part of Table 3 below depicts AFSI’s disclosure of the effects of the relationship with Maiden Holdings on its results of operations. Note significant volatility in the implied incurred loss and loss adjustment ratio, which in recent quarters reached as high as 90% and as low as 42.7%. It is not clear what accounts for this volatility considering that AFSI’s and MHLD’s individual reported loss ratios have been much more stable over this period. The bottom part of Table 3 depicts MHLD’s disclosure of its AmTrust Quota Share Reinsurance segment. The segment may exclude certain other reinsurance relationships with AFSI that were entered into outside of the main Quota Share Reinsurance segment (which primarily includes the quota share agreement and European medical malpractice policies).

Overall, AFSI’s combined ratio benefits from the Maiden Holdings relationship by front loading profits through the commission fee revenue. AFSI calculates its combined ratio on a net basis subtracting ceding commission revenue from commission and other policy acquisition expenses. The company does so because commission and other policy acquisition expenses were incurred to underwrite all written policies (including policies that were ceded to Maiden). Not adjusting expenses for ceded premiums would result in an inflated expense ratio. However, because the ceding commission earned by AFSI is approximately 30% of the written premiums, and the total expense ratio (based on gross written premiums) is approximately 25%, adjusting the ratio leads to lower expense ratio, and consequently to lower net combined ratio as well. As shown in Table 4 below, reported net expense ratio for AFSI was 1-2% lower in most quarters compared to the adjusted net expense ratio calculated on a gross basis (using total acquisition costs in the numerator and net earned premiums + earned premiums ceded to Maiden in the denominator).

Table x: Inability to reconcile AmTrust’s and MHLD’s reporting of mutual relationship

Source: AFSI, MHLD - SEC filings; CFRA

$000's '11Q1 '11Q2 '11Q3 '11Q4 '12Q1 '12Q2 '12Q3 '12Q4 '13Q1Reported by AmTrust (all relationships with MHLD):Written premium - ceded 126,722 213,919 173,218 189,316 190,901 196,380 189,655 269,555 305,786Earned premium - ceded 113,936 136,692 160,210 148,784 166,318 170,002 179,114 214,889 227,690Incurred loss and loss adjustment - ceded 82,107 98,957 94,371 126,387 122,810 152,970 158,646 91,784 152,965Ceding commission 39,725 44,160 48,339 50,092 54,411 50,858 51,955 65,887 89,499Earned ceding commission 35,809 34,364 41,782 41,998 46,274 44,550 49,860 56,298 63,958Implied incurred loss and loss adjustment ratio - ceded 72.1% 72.4% 58.9% 84.9% 73.8% 90.0% 88.6% 42.7% 67.2%Ceding commission (% of ceded written premium) 31.3% 20.6% 27.9% 26.5% 28.5% 25.9% 27.4% 24.4% 29.3%Reported by MHLD (AmTrust Quota Share segment):Net premiums written 126,714 216,449 173,502 152,618 226,000 195,629 186,258 232,459 344,800Net premiums earned 114,474 136,299 159,668 147,756 167,900 167,816 177,293 214,772 220,300Net loss and loss adjustment expenses (73,539) (94,740) (110,727) (101,257) (112,800) (116,755) (120,942) (144,136) (145,600)Commission and other acquisition expenses (37,237) (38,116) (44,845) (40,324) (47,200) (44,590) (50,525) (58,231) (65,100)Net loss ratio 64.2% 69.5% 69.3% 68.5% 67.2% 69.6% 68.2% 67.1% 66.1%Commission and other acquisition expense ratio 29.4% 17.6% 25.8% 26.4% 20.9% 22.8% 27.1% 25.1% 18.9%

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Considering that MHLD is a related party there is possibility that ceding commission may not had been agreed upon on an arm’s length basis. However, it is not uncommon for the ceding commissions on pro rata reinsurance agreements to include a profit component to compensate the ceding party for not just the incurred expenses but also for the portion of the lost profit on ceded premiums. DEFFERED ACQUISITION POLICIES APPEAR CONSERVATIVE, WHILE ACQUISITION ACCOUNTING COULD HAVE RESULTED IN POTENTIALLY UNSUSTAINABLE EARNINGS BOOSTS AFSI’s amortization of deferred acquisition costs (DAC) appears conservative as shown in Table 5 below. The company’s implied amortization period (calculated as the average of beginning and ending deferred acquisition costs divided by amortization expense during the year) has declined from the peak of approximately 2 years in 2010 to 1.73 years in 2012. The amortization period indicates how many years it would take to fully amortize the company’s deferred acquisition costs. DAC have also been declining as % of total assets since 2010.

Table 4: Relationship with Maiden benefits net expense ratio


Table 5: DAC amortization policies appear conservative


$000's '11Q1 '11Q2 '11Q3 '11Q4 '12Q1 '12Q2 '12Q3 '12Q4 '13Q1ReportedNet earned premiums 200,338 248,282 288,848 299,393 314,024 333,994 387,447 383,387 407,994Acquisition costs and other underwriting expenses 81,234 89,580 113,270 114,320 124,025 129,713 143,736 146,239 156,820 less earned ceding commission (35,684) (35,414) (40,732) (42,123) (46,274) (44,550) (49,860) (56,298) (63,958)Acquisition costs and other less ceding commission 45,550 54,166 72,538 72,197 77,751 85,163 93,876 89,941 92,862Reported net expense ratio 22.7% 21.8% 25.1% 24.1% 24.8% 25.5% 24.2% 23.5% 22.8%Adjusted for MaidenNet earned premiums 200,338 248,282 288,848 299,393 314,024 333,994 387,447 383,387 407,994Net earned premiums + ceded to Maiden 314,274 384,974 449,058 448,177 480,342 503,996 566,561 598,276 635,684Acquisition costs and other underwriting expenses 81,234 89,580 113,270 114,320 124,025 129,713 143,736 146,239 156,820Adjusted net expense ratio 25.8% 23.3% 25.2% 25.5% 25.8% 25.7% 25.4% 24.4% 24.7%

$000's 2008 2009 2010 2011 2012Deferred acquisition costs (DAC) 103,965 180,179 224,671 280,991 349,126 - % of total assets 3.3% 5.3% 5.4% 4.9% 4.7%Amortization of DAC 70,260 73,531 102,085 161,392 181,737Implied amortization period (years) 1.24 1.93 1.98 1.57 1.73

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AFSI closed a significant number of acquisitions in recent years, which resulted in substantial growth in intangible assets. As shown in Table 6 on the right, the finite-life intangible assets have significantly longer amortization periods compared to deferred acquisition costs. If some of the costs imbedded within intangible assets would be counted as acquisition expenses in the normal course of business, then capitalizing these costs through acquisitions allows the company to extend effective amortization period significantly and, hence, potentially lower its underwriting expense. Of the intangibles in Table 6, we raise particular concerns about accounting for Contractual Use Rights. In the 2011 discussion of Luxembourg captive acquisitions, AFSI appears to link amortization of contractual use rights to a $23 million decline in acquisition costs and other underwriting expenses:

The Company has classified the intangible assets as contractual use rights and they will be amortized based on the actual use of the related loss reserves. As a result of these acquisitions in 2011 and 2010, the Company reduced its acquisition costs and other underwriting expenses by approximately $23,000 in 2011. (2011 10-K)

As shown in Table 7 below, it also appears that 2011 was the year when the company changed its useful life assumptions on contractual use rights from 2-3 years to “Specific Use”, which could have resulted in greater discretion over amortization of those costs.

Table 6: Intangible assets


Table 7: Change in useful life assumptions for Contractual Use Rights


$000's GrossAccumulatedAmortization Net value Useful Life

Goodwill 229,780 - 229,780 IndefiniteIntangibles with indefinite useful life 31,241 - 31,241 IndefiniteRenewal rights 30,880 7,373 23,507 7-17 yrsNon-competes 7,756 6,629 1,127 3-9 yrsDistribution networks 96,586 20,748 75,838 10-20 yrsSoftware 2,293 2,052 241 20 yrsCustomer relationships 63,595 6,085 57,510 5-18 yrsTrademarks 5,193 3,615 1,578 2-15 yrsLicenses 12,608 1,255 11,353 5-50 yrsContractual use rights 132,991 51,997 80,994 Specific useOther 2,755 957 1,798 4 yrsTotal 615,678 100,711 514,967 10 yrs avg

$000's 2009 2010 2011 2012Contractual use rights - gross balance 7,698 16,309 98,306 132,991 - accumulated depreciation - (7,063) (37,405) (51,997) Contractual use rights - net value 7,698 9,246 60,901 80,994 Useful life assumptions 3 years 2-3 years Specific Use Specitic Use

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Insurance Reserves SIGNS OF UNDER-RESERVING IN RECENT YEARS AFSI has been under-reserving for recent accident years as shown by the cumulative deficiency of reserves for 2009, 2010, and 2011. During 2012, AFSI recorded a loss expense in the amount of $12.9 million related to prior year negative loss development. From the cumulative figures provided in the table we estimated development per accident year and it appears that the $12.9 million in negative development was primarily driven by negative development for policies underwritten in 2009 and 2010, partially offset by positive development for 2011 accident year. Although our calculation may not be precise (due to effect of paid losses which are imbedded in the cumulative reserve figures), it appears to be fairly close as implied cumulative prior year development using our calculation was $13.1 million versus $12.9 million reported by the company. Significant reserve deficiencies for 2009 and 2010 accident years raise concerns, particularly if they are a sign of broader reserve adequacy issues.

Table 9 below shows cumulative paid losses on reserves. It appears from the table that the company has been paying losses faster on its reserves in recent years compared to previous years. However, it is worth noting that the table presents cumulative data both vertically and horizontally. Vertically, cumulative paid losses accumulate for a reserve that was estimated in a particular year. Horizontally, unpaid reserves in a particular year get carried over to the next year obfuscating the year-by-year analysis typically performed for insurance companies. As a result, based on this table alone it is not clear whether the company’s loss and reserving policies changed in recent years, especially considering rapid growth in premiums over this period.

Table 8: Signs of under-reserving in recent years


$000's 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012Loss and LAE reserves (initial estimate) 13,402 33,396 84,919 150,340 251,678 517,365 509,656 530,070 592,660 906,783 1,246,188 Net reserve estimate as of1 year later 13,771 36,812 83,957 150,854 253,767 516,821 504,829 538,016 604,302 919,640 2 years later 13,804 37,954 83,293 150,516 215,465 519,346 490,379 540,723 641,557 3 years later 10,175 35,056 82,906 122,601 221,362 518,877 491,613 559,251 4 years later 11,179 34,844 70,146 120,975 220,505 515,427 497,276 5 years later 10,524 27,992 71,012 121,916 216,830 517,866 6 years later 9,089 28,069 70,078 120,618 216,922 7 years later 9,914 28,211 69,499 120,582 8 years later 9,909 27,932 69,383 9 years later 9,962 27,636 10 years later 9,663 Net cumulative redundancy(deficiency) 3,739 5,760 15,536 29,758 34,756 (501) 12,380 (29,181) (48,897) (12,857) Estimated development per AY (3) (180) (80) (128) (2,347) (3,224) (12,865) (18,727) 24,398

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To analyze changes in the company’s underwriting standards and paid loss history, we can refer to statutory filings provided by AFSI’s US-based subsidiaries (Table 10 below). Please note that net premiums written by the US subs accounted for only 36% of total consolidated net premiums in 2012, hence providing only a partial view of total results. The percentages reflect cumulative paid losses as percent of incurred losses for every accident year but there is no overlap horizontally (each column represents a separate accident year). This table shows much greater stability in terms of paid loss ratios suggesting that the underlying underwriting performance in the US subsidiaries has been relatively stable and if there were significant changes in the reserving dynamics they would be likely occurring in non-US subsidiaries, into which we have very limited visibility.

Table 9: Cumulative paid losses


Table 10: Cumulative paid losses as a % of incurred losses

Source: Statutory filings; CFRA

$ 000's 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012Cumulative paid losses % of reserves1 year later 14.2% 15.2% 17.0% 16.0% 15.1% 22.0% 21.6% 35.6% 38.0% 31.5%2 years later 16.9% 27.7% 29.9% 23.8% 27.7% 30.9% 38.3% 56.2% 62.3%3 years later 20.8% 34.4% 39.7% 32.4% 42.7% 38.5% 51.2% 70.8%4 years later 34.3% 42.1% 46.4% 44.4% 47.7% 42.5% 57.9%5 years later 32.8% 48.6% 59.6% 48.3% 50.6% 45.1%6 years later 44.3% 64.0% 61.1% 48.9% 53.4%7 years later 56.9% 65.5% 62.8% 50.6%8 years later 52.8% 65.8% 64.5%9 years later 53.6% 67.0%10 years late 53.4%

Paid % of initial incurred 2003 2004 2005 2006 2007 2008 2009 2010 2011 20121 year later 34% 34% 39% 31% 32% 34% 38% 39% 35% 33%2 years later 64% 64% 64% 56% 58% 61% 62% 66% 61%3 years later 76% 65% 69% 73% 71% 74% 75% 78%4 years later 84% 74% 80% 77% 85% 85% 84%5 years later 87% 81% 88% 86% 91% 91%6 years later 90% 90% 89% 90% 93%7 years later 85% 92% 90% 93%8 years later 84% 94% 91%9 years later 86% 95%10 years later 86%

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TOTAL RESERVING RATIOS APPEAR RELATIVELY STABLE Overall, reserving ratios demonstrated relatively stable performance in recent years with reserve to total paid losses increasing to 1.8x in 2012 from 1.6x in 2011. The ratio of reserves to net earned premium also remained flat at 0.88x in both 2012 and 2011.

POOR DISCLOSURE OF RESERVE MOVEMENTS IN THE SPECIALTY RISK AND EXTENDED WARRANTY SEGMENT AFSI disclosed that incurred but not reported (IBNR) reserves declined to just 34.5% of total reserve in 2012 compared to 57% five years ago. It appears that this decline was caused less by the decline in total reserves and more by the increase in case reserves. However, as shown further, the disclosure around these reserve movements is opaque and, in one instance, contradictory.

Recent change in the reserving structure within the Specialty Risk and Extended Warranty segment was likely key contributor to the decline of IBNR as % of total reserves. As show in Table 13 on the following page, total net reserves in the segment increased to $334.5 million from $121.8 million in a prior year, while IBNR reserves declined to $26.6 million from $53.0 million. AFSI commented: “The reduction in IBNR as a percentage of overall loss reserves within this segment is a result of redefining IBNR within our European operations, which lead to the classification of a greater percentage of those reserves as case reserves as opposed to IBNR.”

Table 11: Reserving ratios appear relatively stable


Table 12: IBNR reserves declined as % of total reserves


$000's 2008 2009 2010 2011 2012Paid losses: - Current year 144,272 203,210 222,593 390,267 406,238 - Prior year 112,893 109,872 187,012 179,721 285,479 Total paid losses 257,165 313,082 409,605 569,988 691,717

Net reserves 498,502 528,956 593,296 910,656 1,242,407 Reserves to paid losses 1.94 1.69 1.45 1.60 1.80

Net earned premium 439,097 573,882 745,659 1,036,861 1,418,852 Reserve to earned premium 1.14 0.92 0.80 0.88 0.88

$000's 2008 2009 2010 2011 2012Total gross reserves 1,014,059 1,097,944 1,263,537 1,879,175 2,426,400 Of which IBNR reserves 56.5% 50.7% 45.1% 40.3% 34.5%

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It is not clear how and why IBNR reserves were redefined in 2012. It is also not clear how the company accounted for an increase in the segment reserves to $334.5 million from $121.8 million a year ago (see Table 14). Specifically, it appears likely that reserves were added to the Specialty Risk and Extended Warranty segment without a corresponding increase in the Loss and LAE Expense within the segment. We conclude this by calculating implied paid losses for the segment (AFSI does not report paid losses by segment). If incurred losses were the only driver of the reserve build, as they usually are, this would apply that implied paid losses declined sharply to $128.5 million from $228.6 million in a prior year. We view such sudden drop in paid losses as highly unlikely, especially considering that net earned premiums grew 21% in 2012.

Some of the company’s statements regarding the nature of the reserves in the Specialty Risk and Extended Warranty segment appear contradictory. AFSI notes: “Specialty Risk and Extended Warranty claims are usually paid quickly, development on known claims is negligible, and generally, case reserves are not established.” This statement suggests that policies in this segment are relatively short-tailed (develop quickly) and there is little uncertainty around known claims. It does not appear to be consistent with the company’s above mentioned statement that the decline in IBNR reserves in the segment was a result of redefining a greater portion of IBNR reserves as case reserves. ACCOUNTING AROUND UNPAID PREMIUM RESERVE RAISES QUESTIONS We raise a red flag over AFSI’s accounting for the unpaid premium reserve in the Specialty Risk and Extended Warranty segment, which may create opportunities for earnings management. In most cases, unearned premium reserve represents deferred revenue that will be earned ratably over time with relatively little discretion. In certain cases, when there is a significant possibility that losses on unearned premiums will exceed the eventual premiums earned, the company may need to establish premium deficiency reserve after first fully amortizing related deferred acquisition costs. AFSI provides the following discussion around its unpaid premium reserves:

Table 13: Specialty Risk and Extended Warranty reserves


Table 14: Reserve build potentially not reflected in incurred losses for the year


$000's 2008 2009 2010 2011 2012Total net reserves 48,700 34,400 52,900 121,800 334,500 IBNR reserves 27,300 25,400 15,600 52,900 26,600 IBNR % of total 56% 74% 29% 43% 8%

$000's 2008 2009 2010 2011 2012Total net reserves 48,700 34,400 52,900 121,800 334,500 Incurred losses 78,832 98,797 191,149 297,501 341,196 Implied paid losses 113,097 172,649 228,601 128,496 Implied paid/incurred 1.14 0.90 0.77 0.38

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There is generally more uncertainty in the unearned premium reserve than in the IBNR reserve. In the Specialty Risk and Extended Warranty segment, the reserve for unearned premium is, in general, an estimate of our liability for projected future losses emanating from the unearned portion of written contracts. Our liability for return of unearned premium is not significant.

The uncertainty around unearned premium reserve is particularly surprising considering disclosure that premiums tend to be earned over just two years:

As net written premium is earned ratably over the term of a policy, which on average is 24 months, the increase resulted from growth in net written premium in 2011 and 2012

From the disclosures it appears that substantial judgment is involved in how AFSI accounts for the unearned premium reserve account. The discretion may potentially allow the company to build up reserves in favorable quarters and then release (earn) them in less favorable periods. As shown in Table 15 below, changes in unearned premiums can be a significant driver of earned premiums. This concern is further exacerbated by the recent volatility in the net earned/written premium ratio, which rose to 84% in 2010, declined to 73% in 2011 and rose again to 87% in 2012 (see Table 15). It would also be a concern if changes in the unearned premium reserve account reflected losses that would otherwise be reflected in the incurred loss and LAE expense account further down on the income statement as this could potentially understate the reported combined and loss ratios.

UNDERWRITING RATIOS LOWER THAN INDUSTRY AVERAGE FOR THE US SUBS AFSI’s US subs primarily write workers’ compensation policies (54%), followed by other liability (16%) and other commercial (15%). In Table 16 below we show that the company’s loss and combined ratios are significantly below industry averages for workers compensation and other liability business lines, and above industry average on Other Commercial.

Table 15: Unearned premium reserve accounting raises concerns


$000's 2008 2009 2010 2011 2012Unearned premium reserve 211,200 326,200 324,300 492,200 580,600 Net written premium 209,230 245,604 362,100 615,563 624,555 Change in unearned premium (55,294) (55,378) (58,517) (168,798) (82,982) Net earned premium 153,936 190,226 303,583 446,765 541,573

Net earned / written premium 74% 77% 84% 73% 87%

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Chart 1 below shows that the loss and LAE ratio on workers’ compensation is close to being normally distributed for the US P&C companies with AFSI approximately 8% below the average. On the other hand, the combined ratios are more clustered together in the 100-120% range with AFSI significantly outperforming majority of the companies in the industry with a combined ratio of just 92%. This underlines the importance of the net expense ratio for the company, particularly given our above mentioned concerns over its questionable quality.

Table 16: Specialty Risk and Extended Warranty reserves

Source: Statutory filings; CFRA

Chart 1: Industry distributions of workers’ comp loss and combined ratios

Source: Statutory fiilngs; CFRA

(% ) 2008 2009 2010 2011 2012Loss & LAE Ratio 45.00 43.98 60.61 73.53 71.67 P&C Industry 74.17 82.44 86.28 87.67 79.96Combined ratio 68.92 69.93 88.71 96.15 92.51 P&C Industry 100.90 107.96 115.82 116.67 108.39Loss & LAE Ratio 69.38 71.56 68.69 69.90 62.95 P&C Industry 67.30 75.28 79.42 70.59 72.88Combined ratio 84.86 103.07 90.79 87.51 66.41 P&C Industry 95.16 105.62 109.76 100.32 103.97Loss & LAE Ratio 55.71 61.88 63.72 73.51 73.19 P&C Industry 76.99 64.16 61.43 53.90 51.62Combined ratio 54.76 71.15 71.85 84.22 88.55 P&C Industry 106.41 96.81 96.87 86.43 83.50

Workers compensation

Other liability

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USE OF INCURRED RESERVE DEVELOPMENT MODELS MAY ALLOW GREATER DISCRETION In its 10-K, AFSI describes two reserving models used for workers’ compensation policies: Quarterly Incurred Development Model (uses AmTrust factors) and Yearly Incurred Development model (uses NCCI industry factors by state). AFSI also discussed the fact that both models are incurred rather than paid loss models. Usage of incurred loss models can be potentially viewed as less credible (especially when own factors are involved) because the company’s estimates of future losses based on its past estimated losses rather than actual paid losses:

The two methods described above are “incurred” development methods. These methods rely on historical development factors derived from changes in our incurred losses, which are estimates of paid claims and case reserves over time. As a result, if case reserving practices change over time, the two incurred methods may produce substantial variation in the estimate of ultimate losses. We have not used any “paid” development methods, which rely on actual claims payment patterns and, therefore, are not sensitive to changes in case reserving procedures. As our paid historical experience grows, we will consider using “paid” loss development methods.

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Accounting for Life Settlement Contracts DISCRETIONARY PROFIT COMMISSIONS RAISE CONCERN We raise concerns that AFSI may have been paying or accruing significant profit commissions on Life Settlement Contracts (LSCs) while providing very limited visibility into the profit sharing arrangement. In addition, we raise concerns that while gains on LSCs can be highly volatile and may not materialize for years, significant profit commissions (either cash or accrued) raise fundamental concerns about the benefit of such arrangement to AFSI. In the discussion below, AFSI states that the profit commission on life settlement contracts is being accrued (effectively fair valued) only on the contracts purchased prior to December 31, 2010. On the contracts purchased subsequent to December 31, 2010 the company accrues its “best estimate” because “no contractual relationship exists.” We raise concern that lack of contractual relationship may imply significant discretion in profit commission payments exacerbated by the concerns that the company’s partner in the LSC venture is a related party as we discuss further below. However, it is not clear whether the third party administrator of the LSC policies is a related party:

Investments in life settlements are accounted for in accordance with ASC 325-30, Investments in Insurance Contracts, and we have elected to account for our investment in life settlements using the fair value method. We retain a third party service provider to perform certain administration functions to effectively manage these life settlement contracts and a portion of their fee is contingent on the overall profitability of the life settlement contracts. We accrue the related profit commission on life settlements at fair value, in relation to life settlements purchased prior to December 31, 2010. This profit commission is calculated based on the discounted anticipated cash flows and the provisions of the underlying contract. In addition, we accrue a best estimate in relation to profit commission due on certain life settlement contracts acquired subsequent to December 31, 2010 as no contractual relationship currently ex ists.

As shown in Table 17 on the right, investments in life settlement contracts have been highly profitable in recent years earning $56.8 million during 2012 on a $131 million investment (beginning of the year) and $80.5 million in 2011 on just a $22.2 million investment. However, on its income statement AFSI recorded gains on LSC, net of profit commission of just $13.8 and $46.9 million in 2012 and 2011, respectively. It is not clear what accounts for such a material difference. However, as gains

Table x: Life settlement contracts net income and gains


$000's 2010 2011 2012Balance beginning - 22,155 131,387 Net income (loss) 16,853 80,523 56,804 Purchases and issuances 5,302 39,239 15,810 Sales and settlements - (10,530) (10,074) Balance ending 22,155 131,387 193,927

Gain on LSC, net of profit commission 11,855 46,900 13,800

Difference 4,998 33,623 43,004

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on LSC’s are reported “net of profit commission”, it is not unreasonable to assume that the gains on LSC’s shown on the income statement are net income related to LSC’s after payment or accrual of profit commissions. We did not find specific lines in the cash flow statement specifically related to profit commissions. However, these payments (if cash) could be potentially netted against other cash flow lines related to LSCs or the expense could also be accrued as a liability. Our concerns about potentially discretionary profit commissions are exacerbated by the fact that the company’s partner in the venture is ACAC, a related party. ACAC was formed with the Michael Karfunkel 2005 Grantor Retained Annuity Trust. Michael Karfunkel is AFSI’s chairman of the board of directors and the father-in-law of Barry Zyskind, AFSI’s CEO. Michael Karfunkel and his trust own 100% of common shares of ACAC. AFSI holds convertible preferred stock of ACAC, which is convertible into 21.25% of the issued outstanding common shares of ACAC. AFSI and ACAC each own 50% of the entities that invest in LSC’s:

During 2010, we formed Tiger Capital LLC (“Tiger”) with a subsidiary of ACAC for the purposes of acquiring life settlement contracts. In 2011, we formed AMT Capital Alpha, LLC (“AMT Alpha”) with a subsidiary of ACAC and AMT Capital Holdings, S.A. (“AMTCH”) with ACP Re, Ltd., an entity controlled by the Michael Karfunkel Grantor Retained Annuity Trust, for the purposes of acquiring additional life settlement contracts. We have a 50% ownership interest in each of Tiger, AMT Alpha and AMTCH (collectively, the “LSC entities”).

EARNINGS AND CAPITAL SENSITIVITY TO POTENTIAL WRITEDOWN OF LSC’S AFSI’s investments in LSC’s are recorded at fair value as Level 3 assets, with the company relying on potentially subjective assumptions in the valuation process. AFSI discloses its key assumptions in Table 18 below. We note that the average life expectancy declined by 1.3 years even as the average age of the insured increased by approximately 2 years during 2012. Lower life expectancy would make the contracts more valuable and potentially result in higher fair value gains. However, we also note that the change in the life expectancy assumptions could be due to the mix of in the portfolio of the LSC’s as AFSI buys/settles various policies.

Table 18: Valuation assumptions on LSC’s


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Although total value of the LSC investments is $194 million, only 50% is owned by AFSI with the rest held by ACAC. AFSI consolidates these investments and ACAC’s share is reflected in the non-controlling interest account. Considering that only $97 million of the investment is attributed to AFSI, the impact from potential write-down would likely be manageable for the company. In Table 19 below we present a highly conservative scenario of 100% write-down of the LSC investments. Under this scenario and assuming a 21% effective tax rate the impact would have a 43% impact on AFSI’s total 2012 earnings and 6.7% on year-end 2012 stockholders’ equity (excluding minority interest). As a potential question for management, it would be helpful to ask about the best tax rate to use for this analysis considering that it’s a JV and it is unclear whether the company consolidates its tax returns.

Table 19: Earnings sensitivity


$000's 2012Investment in LSC's 193,927 - less 50% of ACAC share 96,964 AFSI's share of LSC investment 96,964

Post-tax impact from 100% writedown at 21% effectivel tax rate 76,601

2012 earnings (after minority interests) 177,987 - impact of writedown on 2012 earnings 43.0%AFSI's stockholders' equity (excluding minority interest) 1,144,121 - impact of writedown on stockholders' equity 6.7%

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CFRA BESPOKE DETAILED REVIEW SAMPLE€¦ · Based on the following disclosure, Luxembourg’s captives held $412 million in unutilized equalization reserves at the end of 2012. In