A Brief Note on Insurance Company Net-Nets

Seasoned professional investors will probably say the below is obvious.  It’s probably something you can find in Securities Analysis if you look carefully. But those following along at home may find this note useful.

I recently looked at a life insurance company which came up in a negative enterprise value screen.  After throwing away everything except the cash and marketable securities on the asset side of the balance sheet, subtracting the total liabilities line and accounting for employee share dilution I came up with a number that was well above the current share price.  It was too obviously a net-net, on an exchange which has only one or two very non-obvious NCAV stocks.  Something had to be wrong.

That something was hinted at by the notes on the regulatory capital.  Under the regulatory rules something called deferred acquisition costs (DAC) are not included in the calculation of available capital.  Even more strangely, these deferred costs turn out to be a cash payment (for commissions etc) already made, forming part of the cash on the balance sheet but not yet expensed.

After a bit of digging I found out that the issue is this:

  • Insurance companies are a reverse-production business.  They collect money in advance and produce the product (benefits for claimed losses) later.
  • Future claims, expenses, policy lapses and profit margins are modelled by actuaries as a series of future cash flows then discounted back to the present.
  • These cash flows, combined, make up the policy liability.  In the event that the company has experienced claims and expenses no higher than modelled, the liability should be negative.

So that is what was wrong in this case.  There was a large negative policy liability, which once deducted from the assets drastically reduced the NCAV.  Is that the right way to go about calculating the liquidation value?  Probably not.  Firstly, if an Australian insurer experiences financial stress it appears that the most likely outcome is regulatory intervention with the aim of protecting policy holders rather than creditors.  Things have changed since the HIH debacle.

Secondly, if the company were to be liquidated by running off the policies then the outcome probably isn’t going to result in any residual for equity holders, nor is it predictable from the publicly reported figures.  For an insurer involved in only short-tail business, one year’s worth of claims expenses might be a reasonable estimate.  In this case that would wipe out the equity.

So this stock didn’t turn out to be a net-net.  As a going concern it was still very interesting though.

Some further reading that I found useful: 

https://www.actuaries.asn.au/Library/Education/Research/Transactions/1994/tiaa1993vol2.pdf

http://www.actuaries.org/CTTEES_INSACC/Documents/IAAInsDAC.pdf

https://data.allens.com.au/pubs/pdf/InsuranceandInsolvency18July2012.pdf

Disclosure: This is not a recommendation to buy or sell any securities, nor is it financial advice.  All information presented is believed to be reliable and is for information purposes only.  Do heaps of your own research before purchasing any security.