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QUALIPORT
Insights From Independent's Insolvency

By Maynard Paton (TMFMayn)
June 21, 2001

Rochester, Kent How can a portfolio, investing in quality companies, happily hold shares in a business that goes bust six months later?

Of course, I'm referring to the Qualiport's investment in Independent Insurance (LSE: IIG).  To recap, the Qualiport initially bought its Independent stake in October 1998, then topped it up in October 1999, and eventually sold out in February 2001.

Earlier this week, Independent announced it would be going into administration. This followed an investigation revealing wide-scale under-reserving at the insurer. To put it mildly, the premiums from the policies Independent had been writing did not fully cater for the claims and liabilities that subsequently arose.

Lessons

What can investors learn from the Independent experience? While hindsight always provides perfect 20/20 vision, there were clear signs a few months ago that all was not well.

In February this year, Independent warned of "emerging issues" that had made traditional actuarial techniques "difficult to apply" to certain liabilities. Those issues would lead to a "one-off" charge to profits for 2000. However, Independent had made a similar charge the previous year in relation to the same liabilities, stating at the time a line had been drawn under the matter.

The Qualiport promptly sold out. I questioned the company's reserving at the time:

"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."

"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?"

That said, I never considered that Independent would liquidate four months later.

Basic rules

In terms of forming some basic investment tenets to help avoid the likes of Independent in the future, it's worth revisiting this Fool's Eye View and this one on Versailles. Versailles was a quoted trade-finance company that suddenly went bankrupt in 1999.

Know what you own

"If you own shares in an unfamiliar company with an incomprehensible business, how do you know if their products are competitive?"

Did anybody really understand how Independent consistently generated underwriting profits when most other industry counterparts couldn't? I never did.

When I asked Michael Bright, the former Chief Executive of Independent, he replied: "We develop a relationship with both the broker and the client, with the combined objective of improving the client's risk and the management of that risk. In doing so, we reduce the client's long-term real insurance cost and it makes us an above-average return on the premiums we write."

It would be difficult for the ordinary investor to establish the nature and durability of these broker and client relationships. And if you can't pinpoint and assess the company's competitive advantage, you court investment danger. So, question your company's perceived competitive advantage does it actually exist?

In fact, Bright also remarked that I could be helping Independent's cause: "The barriers to other people doing [what we do] are people like you, financial advisers and commentators, who all focus on expense."

That in itself suggested Independent's business moat was less than secure!

Where's the cash?

"Companies should generate "cash" profits, as opposed to just "accounting" profits."

Companies in trouble tend to have terrible working capital characteristics. Any business with a severe cash haemorrhage in this respect is bad news.

Independent, like Versailles (and indeed, like Helphire (LSE: HHR) and Claims Direct (LSE: CLA), two other troubled specialist finance operators), scored well in this department.

Here's my analysis of Independent's reported profits and cash flow, and subsequent comment, from July 2000:

(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)

"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"

Huge movements in working capital cash flows, which absorb the company's reported profits and more, should put investors on red alert.

On its own, Independent's poor cash flow didn't suggest imminent bankruptcy. But it certainly should have warranted further consideration before any recent investment was made.

Blame the management

But the opaque business and dubious cash characteristics failed to stop me from keeping Independent in the Qualiport. Oh no. I wrote remarks like this for a good year or so:

"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"

You see, Michael Bright was regularly upbeat about Independent's prospects.

He declared at the interim stage last August: "We believe the business opportunity going forward is huge and we now have the right team to fully exploit this potential"

He then told me later in the year, when Independent's premium income then stood at 500m: "Five years down the road, I think we'll be significantly larger. I would be surprised if our premium income five years down the road did not exceed 2b"

Well, that's all right then. Not.

So the third lesson is simply:

Don't rely entirely on the company's management to justify your investment decisions, especially when other aspects of the business give concern.

Summary

To summarise the key points to help avoid "the next Independent":

  • Ensure you can pinpoint and assess the company's competitive advantage;
  • Huge movements in working capital cash flows, which absorb the company's reported profits and more, should put investors on red alert. In this respect, it is always better to be safe than sorry, and;
  • Don't rely entirely on the company's management to justify your investment decisions, especially when other aspects of the business give concern.

Finally, it's also worth making this additional point:

  • Don't expect the stock market to agree with you should you have any concerns about a company. The stock market never questioned Versailles and it never, for a long time, questioned Independent.

More: Qualiport sells Independent Insurance | Interview with Michael Bright | Independent Insurance discussion board