Are Insurance Stocks at Bargain Prices?
by Joseph L. Petrelli
The more I read about other industries, the more I like the insurance business. I think it is time for publicly-traded property and casualty insurance companies to stop focusing on September 11 property losses and K-Mart surety exposure and, instead, promote the quality and quantity of the financial scrutiny that they endure and withstand.
If the Enron situation has caused investors concern about revenue estimates and the quality of earnings, insurance stocks may be the value they are searching for. Four fundamental financial issues at Enron were:
How is top-line revenue calculated?
How is bottom-line revenue calculated?
How are assets valued?
What is disclosed on the balance sheet and what is not?
I have read that Enron and its auditors were involved in these discussions, in part, because Enron was on the cutting edge of its industry. Accordingly, there was limited guidance or precedent. Contrast the cutting edge of an industry with the established scrutiny that publicly-traded insurance companies must endure:
Independent audits
Internal audits
Financial examinations by the insurance department of its state of domicile
Market conduct examinations by insurance departments
Review of loss and loss adjustment expense (LAE) reserves by its corporate actuary
Review of loss and LAE reserves by its auditors actuary
Review of strategy and operating results by at least two of the major insurance rating agencies
Review of 10-Qs, 8-Ks, and 10-Ks by the Securities and Exchange Commission
Scrutiny of Wall Street analysts
Scrutiny of reinsurers
The knock on insurance companies used to be (yes, I used the past tense) that they were risky because they charge a premium today to protect against unknown future losses. In other words, they may not know the ultimate cost of their product until many years after they sell their product.
Guess what? Within reasonable boundaries, insurance companies know the cost of their product. Whether they charge the appropriate premium is influenced by other factors – investment income opportunities, marketing strategy, insurance department negotiations and their market leadership position, or lack of position.
The interesting thing about insurance companies is that their claims personnel, regulators, actuaries, and auditors focus on the ultimate cost of the product (loss and LAE ratio and related reserves) with an extensive array of standard financial disclosures applied by trained professionals, disinterested third parties, regulators, and rating agencies. When material differences in the estimates of liabilities appear, the news travels fast.
With the issue of liabilities fairly well addressed, I turn my attention to the other fundamental financial issues referenced above.
For an insurer, top line revenue is net premium earned. Not what they wrote without regard for their reinsurance costs, not what they took in cash, rather insurers only get credit for premiums that they do not have to refund. Not only do they establish a reserve for that unearned premium, but that reserve includes a provision for operating expenses. These operating expenses have already been paid!
Bottom line income is impacted by the conservatism of the top line revenue. However, income is fairly conservative in its own right because the insurer’s cost of sales -- losses and LAE expenses -- have not been adjusted to reflect the time value of money.
As for asset valuation, the National Association of Insurance Commissioners Securities Valuation Office assigns the value for virtually all publicly-traded bonds or stocks owned by insurers. Other asset safeguards imposed by insurance accounting:
Buildings are carried at cost, less depreciation, not market value
Office furniture and fixtures can be expensed but are carried at no value
Automobiles, from the President's brand new Lexus to the mailrooms’ Chevy van, are carried at no value
Are insurance companies indestructible? No, some do fail. Even publicly-traded insurers do, and will, fail. However, the underlying accounting and financial issues that rang the death knell for Enron have long been silenced in the insurance industry.
If I ran a publicly-traded insurance company, or if I owned the stock of one, I would expect it to be traded at a higher multiple than it currently is. As an insurance company’s market coverage reduces the risk of its policyholders, the insurance industry’s “cost of regulation” has become a badge of honor and should provide investors with some comfort that insurance stocks will not follow the Enron cycle.
Joseph L. Petrelli is the President and founder of Demotech, Inc. Mr. Petrelli is an actuary and has earned a Masters of Business Administration from The Ohio State University. He has been employed in the property and casualty insurance industry since 1969.
Since 1985, Demotech, Inc. has been a financial analysis and actuarial consulting firm serving the needs of the property and casualty industry. Demotech was the first company to have its rating process formally reviewed and accepted by Fannie Mae, Freddie Mac, and HUD.
Visit www.Demotech.com for more information about Joseph L. Petrelli and Demotech, Inc.
