Qualiport

[ July 7, 2000 ]

A Further Inspection of Independent

By Maynard Paton (TMFMayn)

Rochester, Kent -- On Wednesday, I started to review the 1999 annual results from Independent Insurance Group (LSE: IIG). At the end of the feature, I stated how the recent accounting changes have caused a complex set of annual financial statements to become, well, even more complex.

After a little consideration, here's my take on things. Firstly, the operating expenses change. The reporting of costs associated with Independent's multi-year policies were altered to be "amortised more accurately over the period of policy exposure". The end result is that an extra £13.4m was credited to the 1999 underwriting result. Although I'm naturally suspicious of any reporting alterations that "create" profits, there's nothing to suggest that this change is inappropriate.

With Independent being the only multi-year insurer around, I guess investors have to rely on the management's industry experience and reputation (which is good) to set a "true and fair" accounting view. But, as time goes by, so the year-on-year comparisons will even out, and eventually the true underlying picture will shine through. So, I'm not too worried on this particular score at the moment, unless a similar change suddenly appears in the near future (Having said that, you may wish to read this post from HarrysDad, himself an accountant. He provides a much more doubtful view. Am I being too complacent?).

The other accounting alteration concerned the investor's use of either the operating profit (including an "expected" investment return) or the profit before tax (including the actual investment return). In my view, it makes sense to monitor the "real life" profit before tax figures. In that way, over time, any consistently abnormal investment returns (good or bad) can be factored into Independent's underlying financial performance. Solely keeping an eye on the operating profit performance will lead investors to miss any unusual float reinvestment performances, these returns being crucial to Independent's overall profits.

Overall, I'm declaring that Independent made an overall profit of £61.5m in 1999. And so that's that.

Underwriting Analysis

As we saw on Wednesday, Independent produced an underwriting result of £42.2m during 1999, compared to the £26.3m recorded in 1998. It's worth delving a bit deeper into how each insurance division contributes to these figures.

Source             Underwriting Result
                      1999     1998
                      (£m)     (£m)

Commercial Property   12.9     16.6
Commercial Liability  22.5     28.4
Commercial Other       2.5     (0.8)
Marine                   -    (11.3)
Personal Lines        (6.0)   (17.6)
International          0.5     (1.2)
Other                  9.8     12.2
Total                 42.2     26.3

The impression generated here is that underwriting profits haven't improved as such, but instead underwriting losses have been stemmed. A new approach to maritime insurance has halted continual losses in that division, while a move to a greater quality of risk within the personal lines division (covering home and motor insurance) has arrested that particular outflow. I'm quite surprised that a niche operator such as Independent still competes within the competitive home and motor insurance arena, especially after not having made an underwriting profit in this one division since 1995.

With net earned premiums (adjusted for multi-year policies and including the £20.3m "exceptional" reinsurance charge) rising just 2% during 1999, that rise alongside a chunky underwriting profit increase, a parallel can be drawn to a normal trading company that exhibits pedestrian sales growth but can drive profits upwards by reducing costs. Unfortunately, this scenario sounds all too familiar at the Qualiport.

Cash

The complexities of Independent's accounting are magnified by the underlying cash situation. The thought of premiums being paid upfront and claims being settled down the line should leave any insurance company as a veritable cash fountain. As we'll see below, this was the case at Independent up until 1997, the point at which the company introduced multi-year policies.

(to 31st December)    1995   1996   1997   1998     1999
                      (£m)   (£m)   (£m)   (£m)     (£m)

Reported earnings     24.1   36.5   45.7    66.9    46.3
Working capital
 change               78.6   11.9  (43.6) (116.2) (133.1)

Free cash earnings   102.7   48.4    2.1   (49.3)  (86.8)

Free cash/reported
 earnings (%)        426     132     5     (74)   (187)

Over the last five years, a total of £219.5m of reported earnings has been generated. In the same time however, there has been a worrying net £202.4m outflow of cash. In other words, only £17.1m of reported earnings could be considered "genuine" over that time. This view could be a little harsh though, bearing in mind the natural insurance business cycle.

An average annual "cash conversion" ratio may be a more indicative performance guide. Making the grand assumption that reported earnings are essentially cash (apart from changes in working capital), so adding together reported earnings and working capital changes will give a rough proxy for free cash earnings. The average annual conversion of reported earnings into free cash earnings is 60.4%. Not a sparkling figure.

Independent has stressed that additional expenses in the run up to an industry upturn had impacted on the most recent cash flow performance. Indeed, the company reported at its April AGM that the favourable industry trend had continued, with Independent recording a positive rather than a negative operating cash inflow performance in the first quarter.

In general, I've no real idea as to the exact reasons for the sudden deterioration of the cash flow and the impact (if any) of multi-year policies, other than that the whole picture looks distinctly bleak. Needless to say, the cash situation at Independent must be monitored carefully in the future.

Valuation

I have to admit that, after making some sense of the Independent financials, the subject valuation isn't one I have particularly looked forward to.

The traditional benchmark for valuing insurance companies is the price to book value (P/BV) ratio. At 285p, Independent stands on a P/BV of just over 2, with a P/BV of 1 typically being declared as "fair value" in this sector. But Independent isn't your typical insurer, in that it consistently makes an underwriting profit, and so earnings-based measurements have to enter the fray.

At 285p, the shares stand on a prospective price to earnings ratio (P/E) of 12.4. However, as we've seen, earnings at Independent are one thing and cash is strictly another. After applying the 60.4% earnings-to-cash conversion rate against the anticipated profits, Independent shares then sit on a forward free cash earnings multiple of 20.6. Not cheap.

In fact, the concern about the lack of cash generation raises many a question over whether a stab valuation should be attempted at all. The recent cash situation leads to a lack of overall predictability in terms of Independent's business. When a company is heading for trouble, problems usually start appearing within the cash flow. Although there will be the inevitable ups and downs within the insurance and cash cycles, it's very difficult to judge from the outside any underlying business deterioration using the current cash flow perspective.

Summary

In this and Wednesday's articles, I've done my best to figure out what has happened, financially at least, at Independent during 1999. It's not been pleasant. A perplexing set of accounts, financial reporting changes and a distinct lack of cash hasn't made me too excited over the group's recent operating performance. Couple that with my inherent dislike of complicated and commodity-type businesses, and the lack of enthusiasm for Independent is complete.

But, like many aspects of investment, just as it seems things are at their darkest, they turns around for the better. At the April AGM, Independent announced the continuing hardening of insurance rates and that gross written premiums were running 32% higher than at the same stage last year. The long-anticipated upturn in the industry looks to be on the cards, with Independent recently stating that they "remained convinced that there is huge scope for further growth".

Certainly at this stage, I'm prepared to put my doubts and misgivings to one side, and place my faith with the proven and established management team and their historically superior operation. I think it would be wrong to dismiss Independent at this point, especially after applying my limited industry knowledge. There is the distinct possibility of misinterpreting an underperforming business with one going through a natural industry cycle. Indeed, for the time being at least, it would be silly for the Qualiport not to benefit from the apparent sector revival. Independent's interim results are due on August 15th, at which point a further Qualiport inspection will take place.

Where Next?

• Review Wednesday's Independent Insurance feature...
• ...and then let everybody know your thoughts on the Qualiport or Independent Insurance discussion boards.