DBRS Downgrades Kingsway Financial and Affiliates to BB (low), UR-Negative

DBRS has today downgraded the long-term debt ratings of Kingsway Financial Services Inc. (Kingsway or the Company) and its U.S. holding company, Kingsway America Inc., to BB (low) from BBB (low). The ratings remain Under Review with Negative Implications, where they were placed on February 9, 2009. Kingsway’s board of directors has installed a new management team that has been charged with restoring underwriting profitability by downsizing, refocusing and simplifying the organization and successfully managing a runoff operation at its Lincoln General Insurance Company subsidiary (Lincoln General), all in an uncertain economic and industry environment. Responding to the board’s demand to address the Company’s deficient profitability will effectively result in a shift in the operating culture of the organization. The execution risk in achieving these goals is reflected in the Under Review with Negative Implications status, which will remain pending a return to reasonable operating profitability, no further adverse impact on capital related to reserve development and the prospect of a successful resolution of the Lincoln General runoff situation. Over the next few months, DBRS will monitor the Company’s progress in addressing its financial performance, including prospects for additional adverse reserve development, with the goal of removing the Under Review status by either further downgrading the rating or stabilizing the rating at the current level.

The continued adverse reserve development at Lincoln General (11 consecutive quarters) – which is directly related to the aggressive rate of growth following its acquisition by Kingsway in 1998, in conjunction with continued underwriting deterioration in the Company’s Canadian operations and the poor investment environment that gave rise to the Company’s first-ever investment loss in 2008 – has combined in a “perfect storm” to reinforce our view of the historical weaknesses in the Company’s business model, its organizational structure and its board governance and oversight. Even though the senior leadership team that had engineered the Company’s growth by acquisition eventually came to recognize the overriding operating deficiencies at Lincoln General in terms of distribution, underwriting and claims management, the subsequent losses generated by adverse reserve development in both the trucking lines and the artisan liability lines have become excessively large, undermining the creditworthiness of the consolidated entity, especially in the context of the ambient risks faced by all insurance companies related to the insurance cycle, the weak economy and uncertain investment markets.

The poor earnings performance over the past two years has caused the Company’s financial profile to deteriorate. The consolidated debt ratio increased to more that 47% at the end of Q1 2009 from 39% at the end of 2007, despite the active repayment of $190 million of outstanding debt as shareholders’ equity was eroded by $570 million. The Company’s financial flexibility has been impaired as surplus regulatory capital was also eroded. At Lincoln General, the Company may have to inject an additional $39 million to restore the 200% minimum risk-based capital (RBC) ratio to relieve itself from direct oversight by the Pennsylvania regulator that has approved the runoff plan submitted by the Company. Consolidated surplus capital in regulated entities and in the off-shore reinsurance subsidiaries has been reduced to $160 million from $580 million at year-end 2007, following negative earnings and the repayment of debt.

An activist shareholder and a current director, Joseph Stilwell, had been lobbying the Company to eliminate unprofitable business lines and to focus on its core profitable operations since November 2008. In response, the Company put most of Lincoln General’s lines into runoff in Q1 2009; proposed a new organizational structure that will simplify and consolidate the Company’s 11 operating subsidiaries, giving rise to opportunities for revenue and cost synergies; and reduced the annual expense base by $120 million as the Company is once again rightsized for its lower anticipated volume of new business (expected to be about $800 million to $900 million in annual written premiums). The new board of directors, which is more closely aligned with the objectives of Mr. Stilwell, was elected on April 23, 2009, and has taken a firm hand with the Company, replacing members of the legacy management team who had been in place for most of the past 15 years. The newly appointed CEO was previously the CEO of one of the Company’s more successful operating subsidiaries and, more recently, the COO and Chief Transformation Officer of Lincoln General, suggesting to DBRS that the earlier announced rationalization and restructuring will continue, perhaps at an accelerated pace, which could remove some of the overhanging uncertainty in the rating.

Kingsway continues to have defendable markets in the non-standard automobile insurance markets in the United States and Canada, as well as in a variety of attractive niche markets. While the decision to focus on the Company’s profitable lines of business such as non-standard auto insurance is prudent, the Company’s business profile is now both smaller and less diversified, albeit more focused on areas of the Company’s traditional expertise. Having made the difficult decision to refocus and streamline itself while giving proper consideration to operational effectiveness and efficiency, the “new” Kingsway is better positioned to restore profitability and address its weakened capital structure by building on its core expertise in specialized insurance markets.

Note:
All figures are in United States dollars unless otherwise noted.

The applicable methodology is Rating Canadian Property and Casualty Insurance Companies, which can be found on our website under Methodologies.

This is a Corporate (Financial Institutions) rating.