Disquieting Developments at Kemper/Lumbermens Mutual

January 27, 2003

Even being in business for over 90 years doesn’t seem to assure financial stability these days. 2002 was not a good year for the Chicago-based Kemper Group, headed by Lumbermens Mutual Casualty Company, a leading writer of workers’ compensation coverage, with an approximately nine percent current national market share.

James S. Kemper founded Lumbermens in 1912 to cover the Midwest’s sawmills and their workers. Now the group has become the latest victim of a series of events that create a “snowball effect.” Once one of the more strongly capitalized mutual insurers—as recently as April 2000 it bailed out California workers’ comp insurer Superior National with a cut through agreement when it was heading for insolvency—Kemper has itself fallen victim to rising losses that have become more or less endemic to the entire industry.

Once losses begin to pile up, reserves have to be tapped in order to meet claims, and then have to be strengthened. This frequently weakens the capital structure of the company. The rating agencies, whose job is to let people know how strong—or how weak—any given enterprise is at any given time, began reviewing its financial strength. What they found at Kemper wasn’t good news.

On Dec. 20 both Moody’s Investors Service and Standard & Poor’s announced ratings downgrades on the members of Kemper’s Intercompany In-surance Pool—Lumbermen’s (77 percent), American Motorists Insurance Co. (15 percent) and American Manufacturers Mutual Insurance Co. (8 percent). S&P’s lowered the ratings to ‘BBB’ from ‘A’ and Moody’s from Baa1 to Ba1. A.M. Best followed a few days later, downgrading the pool to ‘B+’ from ‘A-.’ In addition the agencies also lowered their ratings on Lumbermens $700 million in surplus notes—S&P’s to ‘BB’ from ‘BBB’ and Moody’s from Ba1 to B2.

S&P’s then noted that it had removed the pool members from its CreditWatch and said their out look was “stable.” Moody’s indicated it had concluded a review begun on Nov. 26, “following the group’s reporting of its third quarter statutory results.” But it kept the ratings outlook in the negative category, and stated that, “the downgrade reflects the company’s strained capital position and its limited financial flexibility.”

If things had ended there, the situation might have been resolved, as the company continued its restructuring, exiting unprofitable lines, cutting costs and most importantly negotiated a cut through agreement with Berkshire Hathaway’s ‘A++,’ ‘AAA,’ rated National Indemnity Co. Things didn’t end there, however.

On Dec. 30 Kemper made the surprise announcement that its president and COO, William D. Smith, had “decided to retire effective year-end.” While senior management figures do retire now and then, Smith, who had been instrumental in restructuring Kemper over the last five years, was scheduled to take over as head of the company from long-time CEO David B. Mathis in two days. “We certainly didn’t see that on the horizon,” said S&P’s credit analyst Fred Sklow. Neither did anybody else and the news increased the size of the snowball considerably.

Kemper announced that an “Office of the Chairman” had been created under Mathis, who has agreed to continue in his position as CEO for the next 18 months, “to help lead the company.” The Board consists of Dennis R. Brand, Sr. VP and chief risk officer, Patricia A. Drago, executive VP and leader of Kemper’s Client Services Group, William A. Hickey, executive VP and CFO, Robert A. Lindemann Sr. VP and president of American Manufact-urers’ Mutual Insurance Company and Gary J. Tully, Sr. VP and president of Kemper Fin-ancial Protection and Kemper International.

Smith’s departure “for personal reasons” remains largely unexplained, but Sklow indicated that as he had been closely involved in making a number of management decisions, including exiting personal lines, “maybe things didn’t progress fast enough, or in the right direction, and he might have been held responsible.” Whatever the reasons were, they’re likely to remain largely unknown, but analysts view the current setup as temporary, and think it’s unlikely to assert the firm control the group needs.

“They’re more or less looking for someone [as the new CEO] from within the company,” said Sklow. “There’s less of a learning curve involved, and someone [from Kemper] could be expected to continue in the same direction. An outsider might make changes.” He indicated that one of the five members of the Office of the Chairman would probably be selected.

By now the snowball was becoming an avalanche, as the rating agencies refocused their attention on Kemper, and, with the onset of the renewal season, brokers and Kemper’s large commercial accounts began to take an earnest look at the group’s financial stability.

A new round of downgrades followed. On Jan. 7 Fitch announ-ced that it had lowered its ratings on the three underwriters to ‘B+’ from ‘BBB’ and Lumbermens from ‘BB’ to ‘CCC.’ Two days later S&P’s and Moody’s followed suit. S&P’s said it took the action to lower the ratings to ‘BB+’ from ‘BBB-,’ “because of unexpected changes in Kemper’s senior management.” Moody’s lowered the pool to Ba2 from Ba1, and Lumbermen’s from B2 to Caa1. Sklow observed that at those levels the group’s securities “are mostly below investment grade, and this affects their interest rate and the discount price.”

The strongest, and maybe the only, lifeline Kemper has to hold on to in order to avoid the avalanche is the Dec. 23 cut through agreement with Berkshire. Mathis observed that, “National Indemnity is the largest member of the Berkshire Hathaway group of companies [actually General & Cologne Re is] and we’re delighted to have their support and the strength of their ‘A++’ rating behind us. Under this agreement, we have the backing to continue operating our core businesses while we restructure our operations in preparation
for demutualization, a process which we believe will ultimately enable us to access the capital needed to improve our balance sheet, enhance our ratings and profitably execute our business plan.”

While still subject to regulatory approval, and to the completion of terms, the startup date for the cut through has been made retroactive to the date it was signed. Kemper issued a statement on Jan. 14 indicating that it “is now available to be added to applicable policies.”

Sklow characterized the agreement as being “quantifiable,” in the sense that it is somewhat similar to a reinsurance arrangement, but without any premiums being ceded. So far the only officially announced “compensation” has been Kemper’s statement that they will repurchase a $125 million investment Berkshire made in a joint venture agreement to set up an equity-based company. Eventually some shifting of reserves and premiums will no doubt occur.

In other ways Sklow noted that the agreement was “unquantifiable,” as so little was known concerning the details. “Will they be able to retain their book of business… the ones they want to retain?” he said. The cut through would allow policies to be sold and renewed with reduced concerns about Kemper’s financial strength, as it can point to the triple ‘A’ rated National [and Berkshire] as backing them up. But Sklow observed that “Berkshire wouldn’t get into this unless they were really comfortable with it… with the risk management and the compensation.” He added that now that the contract had apparently come into force it would be interesting to see if either company announced any further details, and particularly if “Berkshire anticipates any loss exposure, or puts up any contingent reserve.”

In view of the deteriorating situation, Kemper has accelerated the pace at which it’s exiting certain lines. On Jan. 15 it announced that it had reached a definitive agreement to sell the renewal rights to a significant number of its large risk national accounts, specified as “unbundled risk management accounts,” to Old Republic Insurance Company, a subsidiary of Old Republic International Corporation.

It also revealed that it had made an “agreement-in-principle” with Zurich Fin-ancial Services for its Zurich North America Environmental division “to acquire renewal rights to the existing policies of the Kemper Insurance Companies environmental casualty book of business.” Mathis indicated that the deal was “one in a series of steps Kemper is taking to become primarily a standard commercial lines insurance provider.”

He stressed that transferring the large risk commercial accounts was “good for both Kemper and Old Republic,” and was “in keeping with Kemper’s strategy to become a smaller, more profitable company, allowing us the opportunity to enhance our balance sheet and allocate capital and resources to support other lines of business.”

Disposing of these lines will boost Kemper’s capital, at least in the short term. It also indicates that Mathis did not idly mention demutualization, and that this remains a long-term goal. The return of Berkshire’s capital investment might also be part of such a plan.

Sklow saw virtually no possibility of a demutualization this year, “as [potential] investors will want to see a track record.” If the cut through agreement works out, however, and the financial problems appear solvable, it could happen in 2004.

Lumbermens’ ability to pay the accrued interest on its $700 million in surplus notes has also caused concern. $400 million matures in 2026. Another $300 million is due in 2037, and the last $100 million in 2097. They carry high interest rates, over 9 percent on the first tranche, and over 8 percent on the two others, amounting to a total of $61.6 million a year. Sklow noted that Lumbermens had duly applied for and received the permission of Illinois insurance regulators to make both the December and January payments. The next payments are due in June and July.

Kemper/Lumbermens is certainly not in a strong position. David Schiff, in recent comments in The Insurance Observer, calls it a “Death Spiral,” conjuring up visions of exploding “Death Stars” and airplanes spinning out of control. The actual situation may be a bit less melodramatic.

The company has made many changes over the last five years.

Unfortunately, Bill Smith was first and foremost in backing that restructuring, and his abrupt departure casts a pall over the company’s prospects that goes beyond the ratings downgrades. Sklow remains hopeful that the company will survive, and that an eventual demutualization could restore its finances. Berkshire has at least given its tacit support to that view by concluding the cut through agreement. Now it remains to be seen how well it will work.

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