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Independent Insurance -- Qualiport Bound?
Wednesday, 14 October 1998

We put them to the test.

We continue our look at Independent Insurance. This carries on from articles last Wednesday and Friday.

The last few days have seen a couple of big international insurance companies comment on the general state of the market in which they operate. Late on Monday, US giant St Paul Companies warned of third quarter losses from catastrophes. They also said that continuing deterioration in the condition of the general commercial property/casualty marketplace would also impact profits. To me, and to followers of Independent Insurance, the most telling statement was:

"Unfortunately, [we] believe we have reached a point where we can no longer continue to sell any insurance at rates which are inadequate relative to the individual risk. Simply put, we will not sell insurance for less than an adequate rate... [and will] undertake corrective actions on individual's accounts we have determined to be significantly underpriced."

That statement should be music to the ears of sector aficionados. St Paul, one of the biggest insurance companies in the world, are effectively heralding the hardening of insurance rates. For the time being, they will not chase new business at any cost. The catastrophe losses and the intense competition in the marketplace have forced the company to increase their insurance premium rates.

Unlike St Paul, Independent Insurance is very selective about what insurance it writes and the premiums it charges. They will not take on a risk at any price, and they have backed out of the highly competitive general motor and household insurance markets. In their interim report to shareholders, dated August 13th, Independent Insurance said that "... [we] believe that an upturn in [insurance] market conditions is not far away. Realism towards appropriate rating of risk should prevail as the newly merged insurance companies strive to achieve shareholder value and some of the weaker participants withdraw." Could it be that the upturn in rates has just begun?

Qualiport Fools will know that we've listed the 10 criteria we like to see in a company, and that can be found at this link. At the outset, we said that insurance companies are very much different from your average manufacturing or services company. I know they won't pass a few of our conventional tests, but we'll give them a try anyway.

1. Well managed

Michael Bright, the Chief Executive, is undoubtedly the driving force behind Independent Insurance. He owns almost 6% of the share capital, and that is currently valued at about 34m. He was appointed to the position in 1987. Since floatation in 1993, the share price has rocketed from 45p to around 250p. Above anything else, this company is undoubtedly well managed. There is a risk that much of its future success depends on Bright staying with the company and staying motivated.

2. Strong, and ideally increasing margins

Insurance companies don't have margins in the same way a traditional company does. They make profits from their underwriting activities and from their investment activities. One negative factor that does stand out here is the past increases in operating expenses in relation to gross premiums. In 1994, the ratio was 21.7%, which increased to 22.6%, then was 29.4% in 1996. In 1997, it headed back down again to 26.8%. The company is committed to working efficiently and is looking at ways to hit the cost base. In April 1998, they opened new purpose built offices in Manchester, equipped with the latest technology. Independent Insurance sees this as an opportunity to rationalise and cut costs.

3. Strong brand name and competitive advantage

Independent is well known in the industry, although it remains quite a small player. Insurance products rarely sell because of brand name. Price is usually the determining factor. Independent doesn't have a competitive advantage as such, but distinguishes itself from the opposition by targeting more specialised risks.

4. A company which you understand, and which has predictable earnings

Insurance companies make money through underwriting profits and investment returns. When we come to valuation, we'll get stuck into a bit more of the nitty-gritty and what makes Independent Insurance tick. Insurance companies rarely have predictable earnings. With discerning insurance companies like Independent, investors are able to make realistic assumptions about their future earnings.

5. A proven past growth record

Coming up to eleven years in a row of profitable growth, Independent sails past this one.

6. and 7. Minimal working capital requirements and a high return on equity

As we saw when we looked at the mechanics of good insurance companies, one of their great strengths is their ability to raise capital at zero cost. Their biggest asset is their people. People come relatively cheaply and don't require huge up-front capital outlays. All this adds up to a company with minimal capital requirements.

Independent Insurance's total return on average equity in 1997 was 31.7%. That places them very much in the upper echelon of all companies and is up from 24.0% in 1996.

8. Strong cash generator

Insurance companies generate investment float because their premiums are collected in advance of their claims being settled. The move in 1997 to longer-term policies has resulted in accounting profits being higher than cash profits. This is not a desirable scenario but is explained by the company as being due to the use of instalment plans, the payment at inception of the Insurance Premium Tax and more proactive claims settlement. Reassuringly, in previous years, cash flow from operating activities easily exceeded accounting profits.

9. Identifiable future growth prospects

Independent have the ability to grow organically, by acquisition, and regardless of those factors, should be able to keep growing their investment float. Buying insurance cover is essential for all individuals and companies. It is not going to go away in a hurry. As we saw at the top of today's report, insurance companies are coming under pressure as many are being hit by above average claims and intense competition. This will benefit Independent through a hardening of insurance premiums, but will also create opportunities for acquisitions at the right price.

10. An attractive valuation

Today, we will start looking at ways to value Independent and carry that into Friday's report. Traditionally, insurance companies are evaluated on a multiple of their net asset value. Because they are essentially investment vehicles, the theory goes that a fair valuation should be one times net asset value. However, this multiple doesn't take into account the company's full intrinsic value or the fact that good insurance companies can raise their capital at a cost of less than zero.

You can value insurance companies in the traditional way, using earnings per share (EPS) and calculating a multiple of that to assign what you think may be a fair value to the company. Whilst this is a valuation tool not to be completely ignored and discarded, it doesn't take into account an insurance company's unrealised investment gains, which currently don't go through the profit and loss account.

We will investigate various valuations for Independent Insurance on Friday.

So there it is. Independent Insurance is a unique company in Qualiport terms, but that is due to the nature of the industry in which it operates more than anything else. It is superbly managed, has a great past record and an extremely high return on equity. On the downside, net operating expenses are high in comparison to gross premiums, 1997 cash flow was poor, competition is intense and they have little pricing power.

What do you think, Fools? Are they Qualiport material? Let us know either on the Qualiport message board or the company's own individual board on the web.

Bruce Jackson (TMF Googly)

Qualiport Numbers

                     14/10/98 Close

                  Company   Change    Bid
                   EMA     -0.08     8.60
                   MKS      0.06     4.31
                   RTO     -0.02     3.32
                   ULVR    -0.10     5.62 

Qualiport Stocks

Last Rec'd  Total # Company  In At  Current  Change
 19/12/97   1565      RTO     2.55    3.32    30.2% 
 17/07/98    595      ULVR    6.72    5.62   (16.4%)
 11/05/98    736      MKS     5.54    4.31   (22.1%)
 17/04/98    337      EMA    11.85    8.60   (27.4%)

Last Rec'd  Total # Company  In At    Value    Change
 19/12/97   1565      RTO   4040.63  5195.80  1155.17 
 17/07/98    595      ULVR  4048.38  3343.90  (704.48)
 11/05/98    736      MKS   4052.24  3172.16  (880.08)
 17/04/98    337      EMA   4043.37  2898.20 (1145.17)

Cash:                                       67.82
Current Total :                         14,677.88

Total Invested:                         16,184.62
Profit/(Loss) :                         (1,506.74)

Value Per Share

                   Day    Month    Year    History
Qualiport        -0.50%  (2.61%)  18.72%   21.39% 
FTSE 100          0.97%  (0.51%)  (1.89%)   0.36%
FTSE All Shares   0.83%  (1.25%)  (3.96%)  (1.94%)
For an explanation of Value Per Share accounting, please click here.