QUALIPORT
Losing Our Independents

By Maynard Paton (TMFMayn)
February 12, 2001

Carburton Street, London -- Fresh from the disposal of Dell Computer Corporation (Nasdaq: DELL) a fortnight ago, the Qualiport is again waving goodbye to another of its members. This time it's Independent Insurance (LSE: IIG). In accordance with the Fool's Trading Rules, the Qualiport will sell its entire Independent holding within the next five trading days. Today's move stems from a trading statement given by the insurer on Thursday. It was an update that cast a dark shadow over the company's operating predictability and its management's credibility.

Profit warning

There were three parts to Independent's statement: the good, the bad and the downright ugly.

The good...

"Looking forward, the Group is pleased to report that the rating environment remains positive. Gross written premium for the year ended 31 December 2000 increased by 64% to £830m. Experience in the first few weeks of the year supports the view that these conditions will continue for some time. Expenses within the UK operation only increased by under 5% meeting the expectation of improved productivity from investment made in previous years."

These comments were pretty much as expected and consistent with the company's previous statement.

However, here's the more significant negative news, the factors that will lop off £20m from Independent's reported operating profit for 2000 (brokers had been previously expecting around £60m of operating profit).

The bad...

"At the half year, the Company noted that the performance of the International Division had been impacted by poor results from the French operation. Against previous expectations, there was a further decline in the last quarter from certain unprofitable classes within the motor, property, and subscription fire accounts. The new general management team introduced last year have now cancelled or severely curtailed these lines of business and adopted a more prudent reserving policy as part of the year end review. The impact of these items accounts for over 50% of the shortfall of Group operating profit."

The news from Independent's small French operation was very disappointing. While it was flagged in August that this particular division would report a loss in 2000, Independent did say at that time that they were "confident that the new management team will soon return the French operation to profit".

After Thursday's news, an interim loss of £4m produced by the French division will now balloon into a £16m loss for the full-year. Independent stated on Thursday that the "result [from the French division] for the current year is expected to show an improvement". Or in other words, a reduced loss. It looks like 2002 is the very earliest a profit can be expected from operations in France.

And the ugly

"Since 1998, the Company has sought to address the significant problems that evolved from participating in London Market subscription business in 1997 and prior years. The Group sought to draw a line under this matter with the purchase of a stop loss reinsurance arrangement. However, as
reported last year, the nature of the emerging issues made it difficult to apply traditional actuarial techniques. Several external factors have caused the Company to revisit these assumptions, not least of which is the increased number of commercial organisations offering "no win, no fee" services and
proactively encouraging claims"

"As a result of the above, the Company has concluded that the level of stop loss reinsurance protection should be increased and extended to cover the total exposure on all liability business written to date in both the London Market and Provincial accounts."

This is the ugly part, as Independent had already levied a surprise, but "one-off", £20m charge in relation to its problematic London Market business for the 1999 accounts. When commenting upon that earlier decision, Independent believed they had "drawn a line under this painful [London Market] experience". Having said that, the necessary waiver ("it is possible that significant further liabilities could arise") was given deep within the 1999 accounting notes.

Predictability

Predictability comes to mind when reflecting upon the latest update. While Independent will always have a "lumpy" underwriting profit profile (caused in part by weather-related claims) and an element of operating "surprise", Thursday's statement goes beyond just the normal industry uncertainty.

Instead, the latest statement highlights the unpredictability surrounding internal operational issues. For the second year running now, Independent has issued unexpected charges in relation to the underprovision of historic insurance business. This puts into question Independent's primary investment attraction -- the company's historical underwriting performance.

The seemingly unpredictable nature of Independent and those unexpected accounting charges create three investment question marks:

* Management credibility: The latest update is in direct contrast to the comments made by Independent's management throughout last year. While the installation of new management in France could, in hindsight, have signalled the possibility of further provisions across the Channel, there's little to excuse the situation with the London Market business.

If the Chief Executive implies that the London Market situation is cut and dried, only to say one year later that it wasn't, what can investors conclude? Well, either the company takes an over-aggressive view of underwriting, or more likely, some parts of the industry are so inherently unpredictable that not even the most experienced of insurers can accurately judge the provision of future claims.

Either way, it's not good news for investors.

* Increasingly prudent reserving policies:  The recent developments could (or perhaps, should) inspire a more cautious view towards the reserving of future liability claims. Will the company revert back to its historical underwriting achievements after the introduction of a more conservative accounting approach?

* Further surprises: Simply, will there be any more undiscovered claims or charges suddenly coming out of the woodwork?

Summary

In my mind, the management issue is by far the most serious. Management credibility has to be top of the investment criteria list in this most opaque of sectors. I've never been entirely comfortable when peering into Independent's accounts, and so most of my Qualiport investing faith with Independent has been underpinned by the bullish noises from the management. Talk of "huge organic developments" outweighed my concerns over poor cash flow and changed accounting policies that created one-off profitable gains. In short, I gave Independent's management the benefit of the doubt over the accounts. Trouble is, the latest statement knocks the stuffing out of such reliance.

To be frank, insurance just falls out of my circle of competence. Independent's business isn't particularly visible and I've always admitted to not being able to get a genuine handle on the finances. And from recent events, there just doesn't seem to be same scale of certainty from the insurance industry as elsewhere. There are few other industries where today's profits can suddenly become cut short because of a product sold many years ago. While Warren Buffett may feel comfortable within the sector, it's just not for me. And so, not for the Qualiport either.

I'm aware that my lack of insurance knowledge could be doing me no favours at this time. To those in the know, this all may be an unfortunate two-year "blip" for Independent and an opportunity to purchase a great company undergoing an operational glitch. However, I'd prefer not to take the risk and continue the Qualiport's involvement. There are just too many uncertainties.

Where Next?

An Independent Inspection -- Independent Insurance' s full-year results reviewed
Independent's Interims -- Independent Insurance's half-year results reviewed
Independent Insurance's discussion board