Qualiport

Fool Buys
Wednesday, 21 October 1998

The Qualiport announces its 5th buy

Independent Insurance is one of the UK's most successful and innovative insurers. They specialise in providing commercial property and liability cover, together with non-standard and specialist personal lines cover.

The company was floated in 1993 at the equivalent of 45p per share. They currently trade at around 265p, meaning that since floatation they've grown at a compound annual rate of over 40%. In anyone's language, that's pretty good going.

The Insurance Business

Insurance companies are very different beasts from your average company. They do not make or sell products as a manufacturer or retailer would. They don't have sales income in the traditional sense of the term, nor do they have operating margins. But they are, of course, in this world to make money. I see them essentially as investment vehicles that raise funds for investment purposes through insurance underwriting activities.

Insurance companies cover people and businesses against the risk of loss arising from certain events. Take motor car insurance, for example. The insurer quotes you a premium to cover you in case of loss or damage to your car. The quote is dependent on many things, such as the value of the car, your age, your claims record, your driving record, where the car is garaged... the list seems almost endless. All this information is used by the insurer to calculate a suitable premium. If you accept, you reluctantly hand over your money and off you drive into the distance.

Even if your car is stolen the minute your cheque is cashed, it will be some months before the insurance company pays out on your claim. In that time, the insurer has the use of your money. Whilst acknowledging the need to eventually pay your claim, in the ensuing months the insurance company will invest your money with the express intention of having it earn as much income as possible. Now do you perhaps know why insurance companies take so long to settle your claims?

As I said earlier, insurance companies are essentially investment vehicles. As savers and stock market investors, we are a sort of investment vehicle. I raise money to invest in the stock market by selling my services to my employer. In return, my employer pays me a monthly fee. The cost to me of those funds is my valuable time. Insurance companies raise their investment income from underwriting activities.

The beauty of a good insurance company is that over the long term, it can raise its investment funds (from here on to be known as "float") at no cost to shareholders. The really good insurance companies can actually have a negative float cost. The traditional manufacturing company raises money through recourse to its shareholders, or through the debt market. Each of these courses of action has a cost involved. Raising funds through underwriting activities is usually cheaper than conventional methods of loan finance. If you obtain your float for free, and use that to generate above average investment returns, you're onto a winner.

For normal companies, the cost of capital varies depending on its source. The cost of equity capital (from shareholders) is usually put at about 15%. As shareholders, we demand a premium return because of the added risk of investing in equities. Raising debt finance costs a company anywhere between 6% and 10% at current interest rates. Yet good insurance companies get their investment capital for free or even less.

Many insurance companies make underwriting losses. They often chase business almost regardless of the premium versus risk-reward level. Whilst they are able to raise the overall level of their investment float, the chances are they will make underwriting losses, hence also raising the cost of that float.

Forgetting about the investment aspect of insurance companies, the actual core industry in which they operate is:

• highly competitive, with razor thin profit margins.
• commodity product based.
• low on brand loyalty.
• not typified by predicable or consistent earnings.

Are these the types of qualities we usually look for in a Qualiport company? I think not.

A hurricane could come in and make a mess of underwriting profits in one fell swoop. The April 1998 floods in Britain hit insurers hard. There are many more natural disasters lurking out there, just waiting to happen. They will happen -- no-one knows where or when, except that sometime in the future, something will happen to wipe out an insurer's profits in any given year or years.

Yet, even given all this, insurance companies are often misunderstood. The financial press and City will concentrate on the performance of their insurance underwriting almost to the complete exclusion of their investment performance. As we shall see, the majority of the gains insurance companies make over a period of time come from their investment portfolio.

Before we look closer at Independent Insurance, it should be remembered that the main business of Berkshire Hathaway, chaired by Warren Buffett, is insurance. The skill that sets Buffett apart from almost every other investor is his ability to invest the float into great companies, whether they be quoted or not.

Underwriting Profits

In every year from 1993 to 1997, Independent Insurance has made an underwriting profit. As we have seen, that means they are raising investment funds that cost less than zero. That is one of the reasons I was attracted to the company.

Anyone who has read through Warren Buffet's chairman letters, available at the external website http://www.berkshirehathaway.com, will have learnt a fair bit about the insurance industry. Buffett explains how GEICO, the fully owned low cost insurance subsidiary, doesn't chase volume just for the sake of it. GEICO refuses to get involved in insurance premium wars, preferring to keep its prices higher and live with the inevitable drop in business. Because the insurance industry is highly cyclical, Buffett knows it is only a matter of time before some of the low premium players are either forced out of the market because of long and sustained underwriting losses, or are forced to increase their premiums for the same reason. It's at these stages, when others are struggling, that GEICO's strength and patience comes to the fore.

The same theme comes flooding (no pun intended) through the Independent Insurance annual and interim reports. Also, in an industry typified by lumpy earnings, up to 1997 they've reported eleven years of uninterrupted profit growth, and the twelfth is virtually in the bag.

Independent Insurance differentiate themselves from their competitors in a number of ways:

• By writing insurance contracts with periods of 3 to 5 years. This allows them to retain business, offer price stability to policyholders whilst avoiding the annual tendering process, and gives some visibility to future earnings.

• By not competing directly against the direct insurers who concentrate on the motor and lower end of household insurance markets.

• By deliberately eschewing the pursuit of insurance premiums at the expense of profitability. This is done by quoting a premium commensurate with the risk and not just a premium that enables them to get the business.

• By dealing with a select group of brokers, chosen only after they pass exacting criteria.

• By increasingly looking to cover non-standard risks, where rates are firmer.

In the early part of October 1998, we have seen a couple of big international insurance companies comment on the general state of the market in which they operate. US giant St Paul Companies warned of third quarter losses from catastrophes. They also said that continuing deterioration in the condition of the general commercial property/casualty marketplace would also impact profits. To me, and to followers of Independent Insurance, the most telling statement was this:

"Unfortunately, [we] believe we have reached a point where we can no longer continue to sell any insurance at rates which are inadequate relative to the individual risk. Simply put, we will not sell insurance for less than an adequate rate... [and will] undertake corrective actions on individual's accounts we have determined to be significantly under-priced."

That statement should be music to the ears of sector aficionados. St Paul, one of the biggest insurance companies in the world, are effectively heralding the hardening of insurance rates. For the time being, they will not chase new business at any cost. The catastrophe losses and the intense competition in the marketplace have forced the company to increase their insurance premium rates.

Unlike St Paul, Independent Insurance is very selective about what insurance it writes and the premiums it charges. They will not take on a risk at any price, and have backed out of the highly competitive general motor and household insurance markets. In their interim report to shareholders, dated August 13th, Independent Insurance said that "... [we] believe that an upturn in [insurance] market conditions is not far away. Realism towards appropriate rating of risk should prevail as the newly merged insurance companies strive to achieve shareholder value and some of the weaker participants withdraw." Could it be that the upturn in rates has just begun?

A Qualiport Company?

Qualiport Fools will know that we've listed the 10 criteria we like to see in a company, and that can be found at this link. At the outset, we said that insurance companies are very much different from your average manufacturing or services company. I know they won't pass a few of our conventional tests, but we'll give them a try anyway.

1. Well managed

Michael Bright, the Chief Executive, is undoubtedly the driving force behind Independent Insurance. He owns almost 6% of the share capital, and that is currently valued at about £34m. He was appointed to the position in 1987. Since floatation in 1993, the share price has rocketed from 45p to around 250p. Above anything else, this company is undoubtedly well managed. There is a risk that much of its future success depends on Bright staying with the company and staying motivated.

2. Strong, and ideally increasing margins

Insurance companies don't have margins in the same way a traditional company does. They make profits from their underwriting activities and from their investment activities. One negative factor that does stand out here is the past increases in operating expenses in relation to gross premiums. In 1994, the ratio was 21.7%, which increased to 22.6%, then was 29.4% in 1996. In 1997, it headed back down again to 26.8%. The company is committed to working efficiently and is looking at ways to hit the cost base. In April 1998, they opened new purpose built offices in Manchester, equipped with the latest technology. Independent Insurance sees this as an opportunity to rationalise and cut costs.

3. Strong brand name and competitive advantage

Independent is well known in the industry, although it remains quite a small player. Insurance products rarely sell because of brand name. Price is usually the determining factor. Independent doesn't have a competitive advantage as such, but distinguishes itself from the opposition by targeting more specialised risks.

4. A company which you understand, and which has predictable earnings

Insurance companies make money through underwriting profits and investment returns. When we come to valuation, we'll get stuck into a bit more of the nitty-gritty and what makes Independent Insurance tick. Insurance companies rarely have predictable earnings. With discerning insurance companies like Independent, investors are able to make realistic assumptions about their future earnings.

5. A proven past growth record

Coming up to eleven years in a row of profitable growth, Independent sails past this one.

6. and 7. Minimal working capital requirements and a high return on equity

As we saw when we looked at the mechanics of good insurance companies, one of their great strengths is their ability to raise capital at zero cost. Their biggest asset is their people. People come relatively cheaply and don't require huge up-front capital outlays. All this adds up to a company with minimal capital requirements.

Independent Insurance's total return on average equity in 1997 was 31.7%. That places them very much in the upper echelon of all companies and is up from 24.0% in 1996.

8. Strong cash generator

Insurance companies generate investment float because their premiums are collected in advance of their claims being settled. The move in 1997 to longer-term policies has resulted in accounting profits being higher than cash profits. This is not a desirable scenario but is explained by the company as being due to the use of instalment plans, the payment at inception of the Insurance Premium Tax and more proactive claims settlement. Reassuringly, in previous years, cash flow from operating activities easily exceeded accounting profits.

9. Identifiable future growth prospects

Independent have the ability to grow organically, by acquisition, and regardless of those factors, should be able to keep growing their investment float. Buying insurance cover is essential for all individuals and companies. It is not going to go away in a hurry. As we saw at the top of today's report, insurance companies are coming under pressure as many are being hit by above average claims and intense competition. This will benefit Independent through a hardening of insurance premiums, but will also create opportunities for acquisitions at the right price.

10. An attractive valuation

Qualiport tradition says that we first decide we are looking at a quality company before looking at its valuation. There is absolutely no reason to waste time and effort looking at a company's valuation if you are never going to buy shares in it. To my mind, even if a poor company is trading at a significant discount to its net asset value, it is not a buy. Fools have a long-term investment time frame, and over an extended period of time, a poor company with poor economics trading in a commodity industry will never provide shareholders with a market-beating return, virtually regardless of the buy point. A case in mind is RJB Mining, which trades at a significant discount to its net asset value. Would you buy shares in that company, given the long-term economics of coal mining?

It is in this aspect that Warren Buffett differs from the traditional Ben Graham value approach to investing. The turning point for Buffett was his investment in the textiles company called Berkshire Hathaway. Buffett thought it was a bargain when he assumed control of the company, yet over the years, the textiles business required significant capital expenditure just to keep it going, let alone grow profits. Eventually, Buffett closed down the textiles business, having learnt a harsh investment lesson.

The question therefore becomes, do we think Independent Insurance is a quality company?

Plus points

• Well managed
• Proven past growth record
• Minimal working capital requirements
• High return on equity
• Investment float raised at a negative cost to the company
• Eschews the pursuit of premiums at the expense of profits
• Writes 3-5 year policies, giving some predictability to premiums.

Minus points

• Insurance is a commodity business
• Limited pricing power
• Earnings may not be predictable
• Poor cash generation in 1997
• Michael Bright is key to the business

Independent Insurance is a unique company in Qualiport terms, but that is due to the nature of the industry in which it operates more than anything else. It is superbly managed, has a great past record and an extremely high return on equity. On the downside, net operating expenses are high in comparison to gross premiums, 1997 cash flow was poor, competition is intense and they have little pricing power.

Having done my research, and knowing a bit about the insurance industry and how it works, I'm going give Independent Insurance the Qualiport thumbs up. As usual, I know the risks, and for Independent Insurance they are perhaps greater than they would be for a "normal" company. However, I feel the plus points outweigh the minus points. This is a personal decision, and not one all Fools will necessarily agree with.

Valuation

Traditionally, insurance companies are evaluated on a multiple of their net asset value. Because they are essentially investment vehicles, the theory goes that a fair valuation should be one times net asset value. However, this multiple doesn't take into account the company's full intrinsic value, and the fact that good insurance companies can raise their capital at a cost of less than zero.

You can value insurance companies in the traditional way, using earnings per share (EPS) and calculating a multiple of that to assign what you think may be a fair value to the company. Whilst this is a valuation tool not to be completely ignored and discarded, it doesn't take into account an insurance company's unrealised investment gains, which currently don't go through the profit and loss account.

An insurance company should be valued at net asset value if it regularly breaks even on its insurance underwriting business. Breakeven is known as having a combined ratio (the ratio of an insurance company's claims and expenses to its premiums) of 100.

However, as we have seen, Independent Insurance is a profitable underwriter of insurance. In 1997, on net premiums of £444m, they booked an underwriting profit of £21m. That means they had a combined ratio of 95 (1 minus 21.3/444), which is pretty good, as insurance companies go.

The fact that Independent are raising new investment capital at zero cost instantly means that they should trade at a premium to net asset value. The fact that they have consistently achieved this feat, and that they won't write new business that is too high a risk, means that they deserve a premium valuation.

Let's break down the numbers, from Independent's 1997 annual report.

Pre tax insurance profit -- £21.3m, after a £6m deduction for potential future losses. After tax of 31%, that gives net insurance profit of £14.7m. Capitalise that at, say, 15 times, which is less than the current market average price to earnings ratio (P/E), and we get £221m

Net realised investment income -- £43.8m less tax equals £30.2m. Let's give them a high capitalisation rate of 15%. Investment returns can vary form year to year, and as they say in the advertisements, "past performance is not necessarily a guide to the future." That gives us a capitalisation of £201m.

Unrealised investment gains -- £24.1m less tax provision of £6.7m equals £17.4m. Again, capitalise this at 15% and that leaves us with £116m.

Add the three together and we get a possible valuation for Independent Insurance of £538m. Some of the above assumptions may be a little conservative. If we capitalised net insurance profits before the provision for potential loses at 18 times, and lowered the investment return capitalisation rate to 12%, the possible valuation increases to £736m. What's a £200m difference between friends?

Independent Insurance's net asset value at June 1998 was £252m. As we've determined above, they deserve to trade on a premium to that ranging from a low point of £538m to a high point of £736m. At a current share price of around 270p, they are capitalised at about £635m, in the middle of our range.

Stated earnings per share (EPS) for insurance companies do not take into account unrealised investment gains, as they are not added to reported profits. Here's a breakdown of results:

 
                                £m
Underwriting profit            21.3
Investment income              32.3
Realised investment gain       12.8
Investment expenses            (1.3)
Tax charge                    (19.4)

Net profit                     45.7

This is the amount on which stated EPS is calculated. However, to get the full story, we need to add on the unrealised investment gains, which do not go through the company's profit and loss account.

Investment appreciation        24.1
Deferred tax                   (6.7)
Unrealised investment gains    17.4

Total profits                  63.1

Shares in issue, including unexercised share options were 242.6m, giving an adjusted EPS of 26p. Compare that to a share price of 265p and the shares trade on an adjusted trailing P/E of just 10.2.

Independent Insurance's total return on average equity (ROE) is an impressive 31.7%. If you assume that they can maintain an average ROE of 25% for the next 10 years whilst paying out 18% of their total earnings as dividends, they could generate 2008 total profits of £1,448m. Capitalise that at a conservative 10 times, add dividends of £341m, and you get a total potential valuation of £3,963m. Compared with a current market capitalisation of £635m, that's total appreciation of 524%, or a compounded annual growth rate (CAGR) of 19.9%. Compare that to an investment in the building society!

Doing my usual high/low tests:

ROE 18%, dividend payout 20%, 2008 P/E 8 = CAGR 8.4%
ROE 20%, dividend payout 20%, 2008 P/E 10 = CAGR 13.2%
ROE 30%, dividend payout 18%, 2008 P/E 15 = CAGR 31.0% (wow!)

We've (I've) decided that Independent Insurance is a quality company, and is a worthy new member of the real money portfolio.

Their current market capitalisation is about £643m and their net asset value is £252m, meaning they trade on a price to book value of 2.55 times. We've demonstrated why and how they deserve to trade at a premium to book value and calculated a conservative valuation of £538m and a not so conservative £736m. The current valuation puts them bang in the middle of those two numbers, indicating they may be trading at a fair value.

However, when we look at a company trading at a trailing P/E of 10 that is achieving a return on equity of over 30%, it looks an altogether more attractive option. A CAGR of over 20% is very impressive. On this basis, the current Independent Insurance valuation appears to allow a substantial margin of safety.

Fool Buys

Over the next 5 days, in accordance with the Fool's trading rules, we will buy £1,975 worth of Independent Insurance shares. The current mid price is around 265p, but we'll obviously be hoping for a temporary market crash so we can pick some up just that little bit cheaper.

As ever, this is not a recommendation to buy. This is our money, and we are happy investing some of into Independent Insurance, hoping that we will achieve market beating returns over an extended time period. We understand the company and the industry in which it operates. More importantly, we also know the risks. They are punctuated throughout this report. Also, unlike our current four companies, Independent Insurance is on the small side, valued at a mere £635m. (Compare that to Unilever, capitalised at almost £40 billion.) That in itself poses more of a risk.

Knowing all that, we've decided to buy shares in the company. Here's to the next 10 years -- unless Rupert Murdoch takes them over in the meantime.

Any thoughts or comments are welcome on the message boards. Did you know that we are selling half our current holdings?

Bruce Jackson (TMF Googly)

Qualiport Numbers

                    21/10/98 Close

                 Company   Change    Bid
                  EMA      0.30    10.55
                  MKS     -0.10     4.27
                  RTO     -0.08     3.53
                  ULVR    -0.08     5.66 

Qualiport Stocks

Last Rec'd  Total #  Company  In At  Current  Change
 19/12/97    783       RTO     2.55    3.53    38.4% 
 17/04/98    169       EMA    11.85   10.55   (11.0%)
 17/07/98    298       ULVR    6.72    5.66   (15.8%)
 11/05/98    368       MKS     5.54    4.27   (22.9%)


Last Rec'd  Total # Company  In At    Value     Change
 19/12/97    783      RTO   2046.53  2763.99   717.46 
 17/04/98    169      EMA   2052.57  1782.95  (269.62)
 17/07/98    298      ULVR  2052.54  1686.68  (365.86)
 11/05/98    368      MKS   2054.11  1571.36  (482.75)


Cash:                                    £7,897.80
Current Total :                         £15,702.78

Total Invested:                         £16,250.95
Profit/(Loss) :                           (£548.17)

Value Per Share

                    Day    Month   Year    History
Qualiport         -1.13%   4.99%  27.98%   30.87% 
FTSE 100          -1.08%   2.81%   1.38%    3.71%
FTSE All Share    -0.79%   2.42%  (0.39%)   1.71%

For an explanation of Value Per Share accounting, please click here.