Long Shot: Little Insurance Stock, Big Potential

 | Sep 27, 2012 | 2:00 PM EDT
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Real Money's Long Shot column is dedicated to trading ideas that are highly risky, but which present an opportunity for significant payoff if they work. Such ideas are sometimes characterized as "lottery tickets" and are for only the most risk-tolerant investors, as the potential for 100% loss is high.

With housing continuing to show sprouts of growth, products related to housing also benefit. One in particular is homeowners insurance.

Because homeowner's insurance is such a small expense relative to the overall cost of a home, it's usually a given that a homeowner will get protection. But often, the homeowner has no choice as the mortgage company will demand coverage as a condition of loan approval.

Florida, one of the hardest-hit states in the housing crisis, remains a very attractive market for housing over the long term. There is the great weather  and the absence of a state income tax. Federal National Holding Company (FNHC), formerly known as 21st Century Holding Company, is a micro-cap property and insurance company operating out of Florida. The company boasts a market cap of $45 million and book value of over $60 million for a price-to-book ratio of 0.75. FNHC has struggled for the past couple of years, but the company has done a nice job of turning things around in 2012.

The company operates in several states, but derives more than 90% of its revenues from the Sunshine State.

For the first half of 2012, Federal National earned $2.5 million in net income compared with a net loss of $2.8 million in year-ago period.

According to a company press release, gross premiums written increased 16.7% in the six months ended June 30, 2012. Homeowners' gross premiums written increased 23.1% and as of June 30 its homeowner's policy count increased to 53,000 from 44,000 at the start of the year.

In addition to boosting premiums earned, Federal is dramatically improving its cost structure. For the first six months of 2012, net premiums earned of $14.7 million compared with total expenses of $14.5 million for a combined ratio of less than 100%, indicating an underwriting profit. For the comparable six-month period in 2011, net premiums earned of $11.6 million compared with total expenses (loss expense and operating expense) of more than $15 million, an incredibly inefficient ratio.

As you might suspect, shares in FNHC have surged over the past year from to $5.70 from $2.30. Yet at book value per share it's at nearly $8.00.

With the current insurance environment looking healthy, Federal need only remain disciplined with its underwriting policy and continue controlling costs. With other Florida based peers like Universal Insurance Holdings (UVE) and Homeowners Choice (HCII) trading at P/B ratios of 1 to 2, Federated could easily be worth $8 to $10 a share within the next year. To be sure, both UVE and HCII pay attractive dividends, something currently absent from FNHC. Yet if current operations continue improving, perhaps management considers returning cash back to shareholders via a dividend, which would be another plus for the equity price.

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