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But don't think of Independent, just because it's involved in insurance, as dreary and unexciting. Well, not in terms of shareholder returns at least. After the company's floatation in late 1993, Independent shares have since soared sevenfold. Over the same period, operating profits have risen from £10.3m to £69.8m.
Just to recap, insurance companies generate profits from two sources -- underwriting and investments.
Regular premiums are paid to the insurer and occasionally claims are later paid out. If the premiums paid exceed the claims and expenses, then an underwriting profit is generated. If it's the other way around, then an underwriting loss occurs.
Most insurers, with Independent a notable exception, regularly produce underwriting losses. What saves their blushes is the accompanying investment income. Prepaid premiums and funds earmarked for incurred-but-not-yet-paid claims are collectively called "the float". The float is invested in equities and gilts and the subsequent investment returns hopefully exceed the underwriting losses, or in Independent's case, will add to the underwriting profits.
A notable exception
But why is Independent a notable exception? Simply, the company is very selective with the insurance risks it takes on board. To generate shareholder value from insurance, it's not the volume of policies an insurer takes on that counts, it's the ultimate profitability of the policies that's the key.
Independent focuses on commercial insurance, rather than insurance aimed at the general public, and is involved in what it calls "risk management". Michael Bright outlined how Independent takes a hands-on role within the industry, instead of being the traditional "passive" insurance partner. One example given was how Independent supplied free health and safety surveys for its clients. Then using the results from the surveys, Independent could focus on those customers who were proactively minimising the dangers to their business and employees.
"We are looking for clients who manage risk, who understand the risks they are managing and who take a very active view about people trying to help them," Bright concluded.
But what about other insurers trying to replicate Independent's success? Although by no means an impossibility, Bright pointed to the skilled and disciplined underwriting staff within his employ. "The barrier to doing business the way we do it is basically people. You cannot put together a team of risk managers such as we have overnight."
However, another interesting "barrier to entry" highlighted was the financial community's predilection for cost cutting within the insurance industry. Independent's proactive insurance role means increased upfront costs, not something most other insurers, or their shareholders, would welcome.
"The whole industry is totally over-focused on ripping the expense out of the equation" stated Bright, adding "That may well work for commodity motor and it may work for commodity life. But in general business commercial, the business that we are in, it is better to spend a pound now to save five pounds down the road."
Long-term policies
Apart from the company's underwriting discipline, another unique attribute of the Independent business is the use of long-term policies. As opposed to the more familiar one-year contract, Independent provides three- and five-year policies to its clients. Bright indicated how the multi-year contracts appeared to improve the predictability of Independent's income:
"It makes no sense to keep chasing a yearly review of the business that is already yours, just to protect it. By locking it in, we stop the whole renewal process, which in itself is quite disruptive... As at the end of August... we had 85% renewal retention. We've got an annual attrition of less than 5%, compared to the 37% that we were losing (in 1996)."
But could other industry rivals introduce their own long-term policies? Bright outlined how competition on this particular point wasn't on the immediate horizon: "Quite clearly, if you were one of our competitors, you wouldn't lock your current business in for five years because it is already highly unprofitable. But once they have re-underwritten their book, I'm quite sure that two or three of them at least will seek to do the same as we've done." And it would be "around 2003" before the potential competitors were expected to get their books "sorted out".
Foolishness
In terms of the company's investment income, Independent has adopted a very Foolish policy. Rather than become active equity investors, the company simply uses index trackers as its stock market vehicle. Although it's a principle that's reviewed every couple of years, Independent has recently re-affirmed a decision to remain a passive stock market investor.
"The risk management business is bad enough without us starting to play around with shareholders' funds in the (financial) markets," Bright sensibly remarked. Indeed, further comments from Bright appear to be straight out of the Fool's School:
"The only point about being involved in active investment is to make more money than you would do by tracking. Now it is a fact that the FTSE 100 itself always appears in about the upper quartile level. So we can virtually guarantee that by putting our money in a FTSE tracker, we are going to have the margin of an upper quartile performance."
Bright also suggested that, for those insurers who were more selective in their equity investments than their customers, this year could be tough...
"An active investor is going to have it 'all on' to perform well in the markets that we are in now. And he's going to have to add that difficulty to the fact that his underlying (insurance) product is bleeding him white anyway."
Internet war zone
The latest technological advances haven't passed Independent by. Perhaps the most significant online venture at Independent is that of expanding into the insurance market for small and medium-sized enterprises (SME), a market worth £3-4b of premiums per annum. Andy Hawkes explained why it had been difficult to successfully operate in the smaller commercial market in the past:
"The (SME) business... is highly profitable from a technical loss ratio point of view, but once expenses are attached, the overall position is one of loss. This is because (in terms of our costs), we treat a £1,000 risk the same way that we treat a £100,000 risk."
With a lower cost base created by using the Internet, Hawkes indicated that Independent could "maintain its approach to intuitive underwriting and risk control, but remove the administration burden" in the SME market. The lower costs would subsequently allow the all-important, but historically difficult to achieve, SME underwriting profit.
Apart from Studentworld, a non-core operation for online student insurance, Independent isn't inclined to get involved with Internet-based products aimed at the general public. Bright was quite blunt about how the Internet could affect the mainstream insurers:
"There are a lot of people wasting an awful lot of money, in our view, by going business-to-customer. The headlines in one of the papers earlier this week suggested that the traditional direct writers are going to lose half of their market share in the next four years. Because like it or not, the Internet is going to be the next personalised war zone. What people forget is that if you drive the price down too far, then you'll make a loss."
Reassuringly for Independent's shareholders, Bright added: "From our point of view, we are not going business-to-customer... We are business-to-business."
Cash is King
Turning to the financial performance of Independent, Bright was quick to acknowledge the expectations of his investors. "My ambition is quite simple" Bright declared, adding, "(It is) to keep the rate of shareholder return as the number one situation."
As well as maintaining the company's underwriting accomplishments, Bright encouragingly placed an equal importance on the company's cash performance: "Cash flow has been the single most-focused point within the company at any one time. Positive cash flow, as far as I'm concerned, is the lifeblood of what enables us to do what we do."
But with that in mind, it had been disconcerting to see Independent's cash flow deteriorating over the past few years. Bright admitted that his mistiming of an industry upturn in 1999 hindered the company's cash flow performance:
"We called the market wrong. We had invested, with the assumption that the turn would come, in a new operation in Spain, a new operation in Ireland and a huge investment in France. There was also a big forward investment in both staff recruitment and a big training college based up in Cheadle. Of course, the whole lot hit us considerably hard across a two-year period."
But Bright was confident that these large investments would soon bear fruit, with the insurance market improving over recent months.
"The turn has come twelve months after we thought it was going to happen... We went back into positive cash flow in the latest first half... As we go into next year, we will be getting the payback for the big investment in systems. That, combined with what we expect to be very substantial growth next year, will put us back to the cash flow model that we have been used to in the past."
The future's bright...
In terms of near-term growth, Bright had no argument with expectations that Independent would increase its gross written premium by 70% in the current year. He also intimated how "significantly higher levels of new business" combined with a large tranche of long-term policy renewals underpinned the near-term expectations.
The upbeat comments from Bright tallied with those made at interim results stage, when he explained how Independent expected to "generate significant organic growth going forward." Hawkes confirmed the optimistic outlook: "You've got huge examples coming through where, because we are delivering a combination of service, resource, expertise and capacity, businesses are coming to us because we can deliver."
And unlike most industries, where new entrants are a common problem, Bright revealed how those falling by the wayside were leaving Independent additional clients too: "We've got a number of competitors who have gone out of business or have made a statement like CGNU (LSE: CGNU) and are pulling out of medium and large commercial."
There was also a hint of what could be expected in a few years' time. After reporting just over £500m of gross written premium in 1999, Bright indicated how he could envisage Independent quadrupling in size over the next few years:
"I see us as being the largest commercial underwriter in the UK within five years. Five years down the road, I think we'll be significantly larger. I would be surprised if our premium income five years down the road did not exceed £2b. I would be very disappointed, very disappointed if it didn't."
Summary
Although the insurance sector is typically associated with remarks such as a "commodity" and "low-growth", the comments made by Independent's management indicated how their company was created in different mould. There were two indicators of the competitive advantages that Independent had carved out for itself.
Firstly, Independent's rivals reducing their involvement in the company's commercial insurance sub-sector. Having weary competitors leaving the field of play isn't the most enticing invitation for potential new entrants. There's obviously something in place at Independent -- be it management ability, underwriting skills or whatever -- that others find very difficult to replicate successfully.
And secondly, there are the long-term policies. The source of a "big competitive advantage" at the moment, Independent suggested that it wouldn't be until 2003 before others could really embark on the multi-year contract route. Several years' head start, with the prospect of locking the better clients in to their policies before the competition gets going, is another Independent long-term positive.
Couple those factors with Bright's bullish near and long-term expectations and Independent has the makings of an ideal long-term investment -- a company possessing distinct competitive advantages combined with identifiable and significant growth prospects. Certainly, there was nothing to suggest that the company's exemplary record was in any danger.
Also of note were the one or two welcome comments also about "shareholder value". Unprompted, Bright mentioned "shareholder return" as his number one priority and the importance of Independent's return on equity and cash flow performances. All good stuff.
And finally, when I reviewed Independent's latest interim results for the Qualiport, I said the financial performance gave me a "warm and optimistic feeling" towards the company. Subsequently speaking to Michael Bright and Andy Hawkes did nothing to dispel my earlier opinion. At a share price of 339p, Independent shares stand on a prospective price to earnings (P/E) ratio of 14.6. On the face of it, a reasonable valuation given the company's record, strengths and growth potential.
Where Next?
• The Qualiport reviews Independent's latest interim results
• Visit the Independent Insurance discussion board | website