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Premiums
Remarks from Chief Executive Michael Bright suggest that ongoing improvements at the core divisional operations can still be achieved. Commercial Property should benefit "as competitors are impacted by tougher reinsurance conditions" whereas the future of Commercial Liability "continues to look bright". Other good news is the company's continuing withdrawal from the commodity home and motor insurance market, a move reflected in reduced losses in those divisions. Elsewhere, French storms took their toll on Independent's fledgling international operation.
(For those wanting a primer on insurance and its accounting jargon, you may wish to read this inspection, and this further inspection, of Independent's 1999 annual results.)
The financials
Here's how Independent presented its latest six-month profit and loss account.
Six months to
30/06/2000 30/06/1999
(£m) (£m)
Gross premiums written 427.5 270.9
Net premiums written 374.4 257.1
Net premiums earned 244.1 203.0
Underwriting result 24.0 17.3
Investment return based
on longer term rates
of return 11.5 14.3
Operating Profit 35.5 31.6
Short term fluctuation
in investment returns (11.4) (3.6)
Change in
equalisation provision (4.9) (3.4)
Pre-tax profit 19.2 24.6
Given that Independent commenced writing its 3 and 5 year term policies in 1997, it's not too surprising that the effect of renewing these long-term policies is starting to filter through in 2000. Independent reported an 85% retention rate for contracts invited for renewal, with those policies being renewed having their premiums increased by an average of 6%.
The 58% surge of gross premiums written highlights the dramatic effect of clients renewing the first tranche of long-term policies. This sudden leap of gross premiums written, an amount effectively containing "deferred premiums" that cover future years, underpins the future visibility of net premiums earned. And in terms of underlying performance, it's the net premiums earned figure (covering only premiums that relate to the period under review) that investors need to focus on.
The gross premiums written surge equated to a 20% leap in net premiums earned. Indeed, doubling up the interim £244m figure and then comparing it to the 1999 net premiums earned figure (£400m) also presents an underlying indication of 20% premium growth.
Underwriting profits jumped 39% to £24m. As we'll see, this was largely through an improved performance in the group's Commercial Property operation. On the face of it, a robust increase of business coupled with an improved underwriting performance. All very good. But where the financial performance starts to wobble is the investment part of the profit equation.
Investments
Prepaid premiums and funds earmarked for incurred-but-not-yet-paid claims are collectively called "the float". The float is invested in equities and government bonds and the return is added to the group's underwriting profit.
The "investment return based on longer term rates of return" contribution is a figure determined by applying a notional return on the float. This contribution has declined from £14.3m to £11.5m over the past twelve months, the cause being Independent's significant cash outflow of recent years. Since June 1999, the float has shrunk from £405m to £329m as claims had to be met by liquidating investments.
The reality of Independent's investment performance is somewhat different to the "smoothed" notional return. After receiving £9m of investment income, realising £3.7m of investment losses and paper losses increasing by £5.2m, actual investment income was only £0.1m. The difference between the "smoothed" and real-life "lumpy" performances is reflected in the £11.4m short-term fluctuation provision within the profit and loss account.
In short, although operating profit rose 12% using the "normalised" investment return, pre-tax profits slumped 22% to £13.5m after considering the actual investment performance.
The dilemma for investors is whether to concentrate on the short-term investment fluctuations or ignore them to instead believe Independent will, over time, match the long-term assumptions. Given that Independent invests solely in tracker funds and fixed income securities, I suspect there's little scope for long-term investment "underperformance". However, the undershooting of the notional investment returns over the last eighteen months, alongside the declining float, does cause me some concern.
Divisional performance
From the table below, it's obvious how the improvement in the Commercial Property operation had an enormous impact on the group's overall underwriting result.
Underwriting result in the six months to
30/06/2000 30/06/1999
Division (£m) (£m)
Commercial Property 11.2 1.4
Commercial Liability 12.0 13.6
Commercial Other 1.6 0.1
Home (0.7) (1.6)
Motor (0.1) (1.7)
Schemes & Affinity 2.3 1.3
International (5.8) 0.8
Other 3.5 3.4
Total 24.0 17.3
Cash
One notable feature missing from Independent's recent results has been a positive operating cash flow. The last few years has seen operating cash flow totally diverted into working capital requirements, rather than increasing the size of the float. This unfavourable situation now looks to be on the turn.
Independent hasn't disclosed the reconciliation between operating profits and cash flow derived from operating profits (i.e. divulged the working capital movements), but it does inform investors that £8m of positive operating cash flow was generated in the latest six-month period. This achievement is a much-welcomed improvement on recent years. Independent's directors are confident that the cash flow situation "will continue to improve going forward". They need to be.
Summary
The results statement is littered with upbeat trading remarks, typical examples being:
"We are exceedingly well placed to take full advantage of the current (industry) upswing."
"We believe the business opportunity going forward is huge and we now have the right team to fully exploit this potential."
"I am confident that we will become a significantly larger business through organic development. It is unlikely that we will divert resources away from our growing core operations to handle an acquisition or enter new markets..."
Any prospects of "huge organic developments" are to be welcomed with open arms by the Qualiport.
Within my previous Independent inspection, I wrote: "There is the distinct possibility of misinterpreting an underperforming business as 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."
From the latest figures, there is indeed a sector revival. Or at least a revival of fortunes at Independent. Surging premium growth, an improved underwriting performance and even the sight of cash being generated underpin the company's bullish forecasts.
At the current share price of 305p, Independent stands on a forward price to earnings ratio (P/E) of around 15, assuming you refer to the "smoothed" prospects of investment income. Should cash flow continue to improve, enabling the size of the float to stabilise and investment income to plateau, premium income should be the sole driver of growth. With this growth running at an annualised rate of 15%-20%, perhaps the forward P/E valuation appears a little mean.
In summary, I like Independent for its acquisition-free history and medium-term prospects. But I still remain uneasy when peering deep into any insurers' financials. However, even for an insurance layman like me, there are promising financial signs that warm my heart. All the rosy remarks from the company make me optimistic too. For the time being at least, the Qualiport will enjoy Independent's upturn.
Where Next?
• Perform an Independent Insurance inspection
• See what other Fools think of the results on the Independent Insurance discussion board