VALUE INVESTING
Independent Insurance Group

By Stephen Bland (TMFPyad)
March 16, 2001

Independent Insurance (LSE: IIG) is a tiny company by insurance standards: most insurance companies are very substantial FTSE 100 size businesses. Independent has gone through a hard time of late. Here are the fundamentals:

• Share price 159p
• High/low this year 402/157
• High/low five years 402/119
• Market cap £383m
• Earnings per share year ended 31/12/00 6.6p normalised actual
• Earnings per share year ending 31/12/01 lowest forecast 21.6p
• Earnings per share year ending 31/12/02 lowest forecast 26.5p
• P/E ratio historical 24.1; on 2001 forecast 7.4; on 2002 forecast 6.0
• Yield on historical dividend 3.6%; on 2001 forecast 4.3%
• Price/Tangible Book 1.2
• Gearing not available
• One year relative strength –7% (i.e. negative)
• Directors own 8.5%, other majors 24.6%

Independent transacts general insurance business. The industry is divided broadly into two major classes, life and general. The former includes life insurance, pensions, annuities and so on whilst the latter consists of every other kind of insurance for example property, motor, professional indemnity and other stuff like that. Some companies sell one or the other class alone, others will carry out both. The majors tend to be composites.

The company was known in the industry for having a claims ratio of under 100%: that is, it made a profit on underwriting. That is actually quite unusual in the insurance business where the norm is to make an underwriting loss, the profits being derived from investment income on the funds available. Royal & Sun Alliance (LSE: RSA) for example, a composite major with a leaning towards general insurance, has stated its aim of reducing the claims ratio to 103% from a somewhat higher figure. In other words its target is merely to reduce underwriting losses rather than make a profit for the time being. Royal does in fact make a profit, once investment income is brought in.

The funny thing about claims ratios is that they do not necessarily indicate investment quality. Royal proved a great investment in 2000 whilst Independent was the opposite. Not quite what you might expect if you don't really know what to look for in figuring out these complex animals. People misunderstand the importance of using this ratio in evaluating an insurance company as a short-term play. My belief is that it is of little consequence. Earnings per share, assets and yield are far more important, as with any value play. As so often, overanalysis proves counterproductive.

Independent's favourable claims ratio did not stop it having a very poor year in 2000, with normalised EPS at 6.6p, down from 18.5p in 1999 to where it had risen from a figure of 9.4p in 1997. The reasons given for the 1999 slump in profits include storm/flood claims, poor performance from its French operation and provisions against certain losses that were under-reinsured. The latter include insurance claims by customers arising from no-win, no-fee legally supported cases.

Insurance is of course a risk business, not dissimilar in some ways to a gambling operation like a bookmaker. The general concept is that of spreading the cost of the misfortunes of the few amongst the many, based on statistical probabilities of the prevalence of the insured events. Every so often the incidence of the insured events will be much higher than the norm, causing a higher level of claims and consequently a reduced profit. This gives rise to a cycle covering a period of years, good bad and indifferent.

As you might expect, since this is a value shares column, the time to buy insurance shares is in a bad patch. That is now, as far as Independent is concerned.

In the recent announcement of the 2000 results, the directorspeak included the following:

"Traditionally, the first quarter is a good indicator of trends for the forthcoming year and current analysis of renewals, rate increases and new business levels suggest that gross written premium for 2001 will increase substantially."

Quite encouraging, you might think. However, note the following comments a year ago, in respect of the likely turnout for 2000:

"This year I am confident or our ability to benefit significantly from the hardening of market rates and of being able to report to you increased growth for 2000."

Looks pretty sad now. So this suggests that the directorspeak is not too credible. Insurance company results may be harder to predict than some other industries because of the ever-present risk of disasters. But if so this tells me that Mr Bright, the director concerned, perhaps ought to be a little more cautious and conservative in his outlook statements.

And there lies one major risk factor with Independent as a value play. It has got the fundamentals but the forecasts for 2001 may be questionable. As for 2002, well, I am always ultra-cautious about the second year out when the current year still has some way to go.

However there is a reasonable safety margin built in here at the current price of 159p. As value players know, the market always overdoes things and nowhere is this more evident than in the trashing of a former growth star like this which back in 1998 traded on a P/E of over 30. If the forecasts are near the mark, then growth looks pretty good and the share is a clear buy.

The risk is in the big question of how close the company comes to achieving the EPS forecasts. Another slip up and there is further downside in store. Book value is about 136p per share but it could go below that if the anticipated EPS does not materialise.

Not a pyad share: but not that far off it, maybe.

More: Value investing discussion board | What is a pyad share? | Why the Qualiport sold Independent Insurance