Toronto-based property and casualty insurer Kingsway Financial Services Inc. is expecting standard auto insurers to increase their underwriting standards, thereby expanding the market for non-standard, or high-risk, insurers such as Kingsway. That, in addition to its recently expanded distribution channel in the U.S., should result in strong growth for the company in the year ahead.

Competition in auto insurance has been fierce. In the wake of high profitability and excess capitalization, standard insurers have boosted volumes by going after riskier clients. Along with cutting premium rates, standard insurers have lowered underwriting standards and taken on customers who wouldn’t normally qualify for their traditional products. That has stifled growth for non-standard insurers.

But historically, when standard insurers saw the impact of lower premiums and underwriting standards on their bottom lines, they have increased premiums and turned away risk-ier auto owners, thereby producing a “hard” market. Kingsway says this is likely to occur again.

In fact, Kingsway has plenty of capacity to take advantage of a hard market. “Annual premiums are only about 1.5 times our statutory capital,” says Shaun Jackson, executive vice president and chief financial officer of Kingsway. “We could go as high as 2.5 times, which would mean another $2 billion in net earned premiums on top of the current $2 billion.” (All figures are in U.S. dollars unless otherwise specified.)

As the market hardens, Kingsway will also have the advantage of a much larger distribution channel in the U.S., a result of its April 2 acquisition of St. Paul, Minn.-based non-standard auto insurer Mendota Insurance Co. Mendota’s insurance agency network is 6,000 strong; before the acquisition, Kingsway had a network of only 2,900 in the U.S.

Kingsway needs a spurt in earnings to reassure investors spooked by the problems at subsidiary Lin-coln General Insurance Co. , a York, Pa.-based truck insurer. Kingsway has added reserves, to the tune of $132 million over the past year, to cover increased estimates of prior years’ claims.

Kingsway president and CEO Bill Star is not happy about the need for these reserves. Lincoln — which was acquired in 1998 — fuelled rapid growth a few years ago by using outside underwriters and claims adjusters. Gross premiums rose to $1 billion in 2003 from $40 million in 2001, but Lincoln didn’t make sure the outside suppliers had the same disciplined standards on which Kingsway prides itself.

“We made a mistake,” Star says.

Last year, when Kingsway began bringing much of the Lincoln claims adjusting and reserving in-house, it discovered the problem and took the appropriate steps. Star believes the issue has been fixed, but analysts don’t like a problem such as this turning up in a company bought so many years previously.

Certainly, Toronto-based RBC Capital Markets Inc. cites Kings-way’s “poor reserving record” in explaining the “underperform” rating it gives the company. RBC has a 12-month target price of C$21 a share for Kingsway. Although that’s more than the C$18 it was trading at in late October, it represents a drop in valuation to 1.05 times book value from the 1.25 times it has been trading at for the past five years.

Jackson disagrees about the likely direction of Kingsway’s multiples. Given the hardening of the market and the additional growth expected in the company’s net premiums in 2008, he says, the price/book multiple will probably rise: “Our price/book multiple has historically trended up to two times book in hard markets.”

As an example of the potential for increased business volumes, Jackson points to New York-based Robert Plan Corp. RPC takes on all the auto insurance business that other insurance companies don’t wish to underwrite. RPC signed an agreement, effective January 2006, that pays Kingsway an annual fee to underwrite all these policies. RPC’s premium revenue is now US$80 million-US$100 million; in the last hard market, in 1999-2001, it had premium revenue of US$400 million-US$450 million, Jackson says.

The U.S. currently accounts for 70% of Kingsway’s business, and that is likely to rise to about 80% because of increased volumes resulting from the hardening of the market as well as the RPC agreement and Mendota’s bigger distribution channel.

In terms of recent financial results, Kingsway had an underwriting operating loss in the six months ended June 30 of $24.5 million, once $61.4 million in reserves for Lincoln are factored in, vs an underwriting profit of $26.1 million in the same period a year earlier. All insurance operations except Lincoln’s were profitable.

@page_break@However, Kingsway has still made a good deal of money overall, thanks to investment income of $65.4 million and net realized gains of $39.9 million. Its net income was $61.4 million in the six-month period, albeit down 11.1% from $69.1 million in the same period a year earlier. Revenue — which is net earned premiums plus investment income and net realized gains — was $997.5 million, vs $951.6 million in 2006.

In terms of debt, Kingsway has $163.3 million in bank indebtedness, $193.3 million in senior unsecured debentures and $87.3 million in subordinated indebtedness as of June 30.

Total assets were $4.5 billion, including an investment portfolio of $3.4 billion. Shareholders’ equity was $988.5 million as of June 30.

Kingsway’s investment portfolio translates into $61 a share — substantially more than the C$18 a share at which the company’s 55.7 million outstanding shares were trading on the Toronto Stock Exchange in late October.

Jackson points out that Kings-way’s investment portfolio is 3.4 times bigger than its shareholders’ equity, offering more upside potential from an increase in investment returns than investors would get from other publicly traded P&C companies. For example, investment portfolios at Northbridge Financial Corp. and ING Canada Inc., both of Toronto, are only 2.5 and 2.7 times as large as their shareholders’ equity, respectively.

The fair market value of the $3.4 billion investment portfolio at June 30 consisted of $1.9 billion in corporate bonds, $396 million in government bonds, $385 million in term deposits and $466 million in common shares.

Here’s a closer look at Kingsway’s main businesses:

> Non-Standard Auto Insurance. The benefits of both the RPC agreement and Mendota’s distribution channel will kick in as the market hardens. Furthermore, there may be other potential acquisitions in the next few years, Star says.

Including Kingsway’s businesses in Canada and the U.S., non-standard auto insurance accounted for about $310 million, or 31%, of its $1 billion in gross premiums in the first six months of 2007.

Kingsway would be particularly interested in acquiring access to more distribution, as it has with Mendota. One source of growth is cross-selling products such as motorcycle policies, which the company already offers, to existing customers.

Jackson points out that the non-standard market in the U.S. is not only much bigger than the one in Canada, it is also much more fragmented, providing opportunities for Kingsway to grow both organically and through acquisition.

Kingsway doesn’t see the same kind of growth in Canada — and not just because it’s a smaller market. Government interference in auto insurance has forced Kingsway to cut back severely in Alberta, which has forced cuts in premium rates, particularly for the riskiest drivers. And with provincial governments providing auto insurance in British Columbia, Manitoba and Saskatchewan, that leaves Ontario and Quebec as Kingsway’s main markets. It already does significant business in Ontario and a good deal in Quebec, a market in which it is also expanding.

There is some possibility that the Alberta market might open up again, but Kingsway isn’t counting on it. Business in that market is down to $20 million in annual premiums in the six months to June 30 from $100 million a year earlier. The company isn’t writing new policies because it can’t charge enough to make a profit, given the ceilings on premium levels. However, it does provide service for the agency that provides insurance for those refused by other companies.

Kingsway has five subsidiaries in this segment: American Service Insurance Co. Inc. and Universal Casualty Insurance Co., both in Illinois; Southern United Fire Insurance Co. in Alabama; Hamilton Risk Management Co. in Florida; and Kingsway General Insurance Co. in Toronto.

> Standard Auto Insurance. This is only available in Canada through Toronto-based York Fire & Casualty Insurance Co. It constitutes a small part of Kingsway’s total business, with gross premiums of $50 million (5%) in the six months ended June 30. This is not a growth area.

> Trucking Insurance. Kingsway does not anticipate any acquisitions in the trucking arena, but expects good growth at Lincoln now that about 90% of the underwriting, claims servicing and setting of reserves was brought in-house. Lincoln — the second-largest underwriter of trucking policies in the U.S. — already has clout. Trucking insurance accounted for $220 million (22%) of Kingsway’s gross premiums in the six months.

> Commercial Auto Insurance. Kingsway also offers insurance for vehicles that carry passengers, primarily taxis, through Elk Grove Village, Ill.-based American Country Insurance Co. in the U.S., which Kingsway bought in 2002, and Kingsway General in Canada.

This is Kingsway’s third-largest business, with about $180 million (18%) of gross premiums, including Canada, in the six months. Star says insuring taxis is a good business.

> Motorcycle Insurance. This is a small business, with about $50 million (5%) in gross premiums in the six months. Kingsway subsidiary Jevco Insurance Co. in Montreal has a dominant market share in Canada at about 35% of gross premiums. Kingsway plans to expand into the U.S. using its significantly expanded distribution network. Jackson notes that Mendota has some experience in this area.

> Logistics Insurance. Insurance products for the logistics industry are offered through Elk Grove Village, Ill.-based Avalon Risk Management Inc., which Kingsway acquired in 2003.

> Wind Property Insurance. This insurance against strong winds, hurricanes or tornadoes is offered through Honolulu-based Zephyr Insurance Co. Inc., which Kingsway bought in 2005. Zephyr’s business is primarily in Hawaii, but it is now expanding into non-coastal Texas. IE