Qualiport

[ July 5, 2000 ]

Independent Inspection

By Maynard Paton (TMFMayn)

Carburton Street, London -- Last Wednesday, I turned my attentions to Lloyds TSB (LSE: LLOY). In that feature, I admitted "when it comes to banks, I have an investment blind spot". However, my lack of understanding of the banking industry was largely offset by the current low valuation of its members, valuations determined by using the simple dividend yield.

If you also consider that Lloyds TSB is as blue a blue-chip as you can get, that it will have a "progressive" future dividend policy and it shouldn't present too many company-specific problems, I think it all means that I've just about scraped by on the company's overall investment qualities.

So, onto this week's declaration. I possess a second investment blind spot -- insurance. The reasons for my aversion to this sector are similar to the banking sector -- namely complex accounting and the rather commodity and cyclical nature of the industry. And with there being (as we'll see) only one worthwhile quoted operator within the sector, so I've never considered the insurance industry as being an investment goldmine. Warren Buffett may have made a packet from insurance, but he's Warren Buffett.

Unlike Lloyds TSB, there's no blue-chip or valuation-inspired escape route to help me avoid delving deep into our holding of Independent Insurance Group (LSE: IIG). At a share price of 285p, Independent is valued at just £682m, sits on a prospective price-to-earnings ratio (P/E) of 12.2 and has a prospective dividend yield of 2.0%. It's no obvious bargain. I'm afraid I can't put it off any longer. An examination of Independent Insurance is required.

The business of insurance

In theory, the business of insurance is simple. 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 over way around, then an underwriting loss occurs.

Most insurers, with Independent a notable exception, make regular 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.

Bruce has explained about the delights of the insurance in far more detail in the past. For those wanting a further fix on the ins and outs of the industry, and the background to what makes Independent such a sector star, I would recommend a visit to the Qualiport archives. The must-read features include Independent's Qualiport proposal Part I, Independent's Qualiport proposal Part II, Independent's Valuation, Independent becoming flooded with claims, Independent's 1999 interim figures and a preview of Independent's 1999 annual results.

Recent financials

That's the "theoretical" business of insurance done with. The second part of getting to grips with Independent means digging into the accounts. The ground work done here will lay the foundations for subsequent considerations over the Independent's business quality and valuation.

For this feature, I'll pick my way through the main financial statements presented by Independent for the year ended December 1999. Nothing's ever simple though. There's many an accounting spanner in the works, with two changes in the financial reporting presentation and an "exceptional" reinsurance provision within the figures. So, just for now, I'll try to explain the basic figures and straighten out the overall performance. On Friday, amongst other things, I'll attempt to put some comment on the forthcoming numbers. Warning -- this feature may become a bit complicated.

Getting technical

Here's the top half of the 1999 "technical account".

                           1999      1998
                           (£m)      (£m)

Gross premiums
 written                  506.9     457.5
Outward reinsurance
 premiums                 (71.4)    (47.5)
Change in gross provision
 for unearned premiums    (36.1)    (17.3)

Earned premiums,
 net of reinsurance       399.4     392.7

The figure to concentrate on is the "earned premiums, net of reinsurance" number. In 1997, Independent broke ground within insurance circles. It started to offer policies that remained in force over a number of years, as opposed to the rather more familiar twelve-month timescale.

Premiums relating to these multiple-year policies are accumulated and accounted within the "gross premium written" figure at the policy's year of inception. For example, say I took out in 1999 a policy with premiums totalling £10m payable over two years. Even though my payments may be spread out over that period, the whole £10m figure would be included in the 1999 gross premiums total.

To give a pro-rata basis of premiums relating to the reported year, an accounting charge is applied, this being the "change in gross provision for unearned premiums". After subtracting the premiums passed on for reinsurance with third parties too, we arrive at the net business that Independent has generated. The 1.7% increase in this figure, to £399.4m, hardly inspires. Although having said that, the £71.4m reinsurance figure of 1999 includes a £20m "exceptional" reinsurance cost. This stems from some recently discovered underwriting problems of a few years ago. The charge is said to now have "drawn a line" under the troubles in a specific market the company withdrew from in 1998.

Claims

So, that's the premiums. How about the claims?

                           1999       1998
                           (£m)       (£m)

Earned premiums, 
 net of reinsurance       399.4      392.7
Other technical income      4.1        3.2
Total technical income    403.5      395.9

Claims incurred,
 net of reinsurance      (256.3)    (221.0)

Change in the provision
 for claims, net of
 reinsurance               74.1       25.3

Change in other technical
 Income                       -        1.0

Net operating expenses   (179.1)    (174.9)

Underwriting profit        42.2       26.3

At the bottom line, an underwriting profit is created. This is good, and the 1999 performance continues Independent's exemplary record. What must be taken into account this year is the first change in accounting policy, a change concerning net operating expenses. In prior years, costs to gain insurance business were accrued over the life of the policy. Now, commissions and internal costs are "amortised more accurately over the period of policy exposure". The change in book-keeping gave Independent an additional £13.4m of accounting underwriting profit in 1999. On the prior basis, underwriting profit of just £28.8m would have been produced in 1999.

Lumpy or smooth?

Accounting change number two revolves around the construction of the operating profit. In years gone by, the figure was simply struck by adding the underwriting profit to the "float investment return" of that year. From this year, aligning itself to industry counterparts, Independent now calculates its operating profit using an "estimated" return based on some long-term investing assumptions.

This change smoothes the natural ups and downs of investment returns, although it could mask any long-term "float" reinvestment underperformance. Thankfully, investors can still refer to the profit before tax figure that contains the actual, but lumpy, investment returns. Here are the figures:

                       1999       1998
                       (£m)       (£m)

Underwriting profit    42.2       26.3

Net investment income  24.6       69.1
Other charges          (5.3)      (3.8)

Profit before tax      65.5       91.6

Then adjust for:

Short-term fluctuation
in investment returns   3.1      (34.5)

Claims equalisation
 provision adjustment   5.2       (1.3)

Operating profit       69.8       55.8

Using the traditional "lumpy" method of determining profits, we can see that profits before tax slumped 30% to £65.5m in 1999. The cause of the drop was the large investment returns (£69.1m) created in the prior year. In applying the "smooth returns" presentation method, Independent has to determine a suitable long-term rate of return. Rates of 6.0% and 8.5% have been used for fixed interest security and equity returns respectively.

The accounting adjustment to reconcile the "lumpy" profit before tax to the "smooth" operating profit is contained within the "short term fluctuation in investment returns" provision. Thus for 1999, investment returns at Independent undershot the anticipated float reinvestment figure by £3.1m. In 1998, the float reinvestment return exceeded the anticipated amount by £34.5m. After the accountants ironed out all the "uneven" investment returns, operating profits were reported to have increased by 25% to £69.8m for 1999. It's amazing what change in bean counting can provide!

Summary

So there you go. Depending on your view of the two accounting changes, underwriting profits either increased by 60.4% or 10% and operating profits increased by 25% or decreased by 30%. Take the two book-keeping changes together and the divergence will be even greater. On Friday, I'll delve deeper into the Independent accounts, and look further at underwriting profit performance, how the accounting jiggery-pokery matches up to cash flow and attempt a wild stab at valuation.

In the meantime, I'll also try and decide which of the profit performances described above I should concentrate on. If you think you can help, then please let me know on the Qualiport discussion board.

What Next?

Take a look at the following Qualiport archives for further information on Independent Insurance.

• All about Independent Insurance
• Independent -- Qualiport bound?
• Independent's Valuation
• Independent are Flooded
• Independent's Day
• Independent Insurance 1999 annual results preview