The Role of Insurance in Security Analysis
Insurance is most often a missing link in fundamental security analysis.
For example, despite BP’s strong credit health (was rated “A” by credit trends) to date, its lack of adequate coverage related to the spill ($1 bil. per occurrence) has caused us to raise our cost of of capital on the firm by 500 basis points. By so doing, the stock has become over-valued at these levels, despite producing over $ 18 bil. in free cash flow during 2008 and $9.7 bil during 2009. Recall our free cash flow model includes the addition of a portion of discretionary expenditures.
If however, the price of crude, a sensitivity analysis reveals, were to rise to $98/bbl, cash flow from operations over the coming two years would approximate $70 bil, when including the added efficiencies of working capital, capital spending, and other discretionary expenditures.
Insurance and Litigation
The role of insurance is an often underappreciated and under-analyzed area of security analysis, which could affect the cost of capital if it was insufficient or its cost grew greater than the rate of growth in operating cash flows.
Regarding uninsured losses, current accounting rules require a company disclose “specific quantitative and qualitative information” about loss contingencies, but does not require them to provide for the fair value impact losses would have on earnings or cash flows. Insurance adequacy is, unfortunately, rarely discussed during investor conferences.
Needing to be uncovered are:
• How is the company protected in the event of major damage to its computer system or warehouse?
• What is their coverage for product liability?
• How are they protected for worst case scenario in the event of a cyber attack, business interruption, due to strike, fire, or power outage?
• Is key man life insurance required to attract a replacement executive?
• Are they attempting to save cash and under-insuring?
• Does the firm require back-up facilities or other redundancies? Are they adequate to allow them to continue providing goods and service?
Example
Murphy Oil had large uninsured damage, impacting free cash flow, during 2006:
Uninsured damages, higher insurance premiums, settlement of the class action oil spill litigation and other hurricane-related pretax costs in the company’s North American operations were $3.0 million in 2007 and $107.3 million in 2006. The hurricane expense in 2007 was caused by a downward adjustment of expected insurance recoveries based on an updated loss limit published by the company’s primary insurer.
Security analysts are typically late in their evaluation of insurance adequacy, relegating their questioning to an event that has already occurred or is forecast, necessitating a review. Not true for the entity itself. For this reason, all large companies have dedicated employees, if not departments, whose sole purpose is to handle the insurance for the organization. If not for insurance, many companies would have filed for bankruptcy, the policies allowing them to collect cash resulting from large lawsuit awards or other catastrophic events. Many firms with facilities on the Gulf Coast of Louisiana would certainly have been out of business had it not been for property and business interruption insurance, resulting from Hurricane Katrina. If an entity not having the resources to cover potential claims exposes its productive capital by being underinsured, its cost of capital should be increased.
Companies have lost large awards resulting from non-awareness of legal liabilities pre-dating their acquisition of a business and for which they did not possess adequate insurance coverage. Other times, new scientific studies determined a company was selling a product which was later found to be unsafe. Such was the case with asbestos, which drove scores of previously financially healthy companies into bankruptcy, including Armstrong World Industries, which did not recognize the problem at its asbestos division at the time it was purchased. In fact, the US Government, at the time Armstrong acquired the company, required their buildings contain asbestos. Armstrong was a very strong and consistent producer of free cash flow, but eventually the asbestos liabilities became too great for their balance sheet and calls on capital. When the lawsuits began, Armstrong did not buy sufficient insurance, estimating they could work their way out of the problem with their strong operating cash flows.
When the price of insurance rises, entities may choose to self-insure part of the risk; the analyst must determine the soundness of self-insurance given a catastrophic event.
Example:
Self Insurance: The company utilizes a combination of insurance and self insurance for a number of risks including workers’ compensation, general liability, automobile liability and employee related health care benefits (a portion of which is paid by its employees). Liabilities associated with the risks that the company retains are estimated by considering historical claims experience, demographic factors, severity factors and other actuarial assumptions. Although the company’s claims experience has not displayed substantial volatility in the past, actual experience could materially vary from its historical experience in the future. Factors that affect these estimates include but are not limited to: inflation, the number and severity of claims and regulatory changes. In the future, if the company concludes an adjustment to self insurance accruals is required, the liability will be adjusted accordingly.
Source: Bed Bath & Beyond, 2009 10K
Example:
The marketing and sale of our products may involve product liability risks. Although we currently have product liability insurance, we may not be able to maintain our current coverage at an acceptable cost, if at all, and there is no guarantee that our insurance coverage will be adequate to meet all types of product liability claims we may encounter. In addition, our insurance may not provide adequate coverage against potential losses. If claims or losses exceed our liability insurance coverage, we may go out of business.
Source: ecoSolutions, 2009 10K
Most companies have key man whole life insurance on its top executives. Such policies are a tax deductible expense while the cash surrender value most often grows significantly over time. These policies belong to the company, and, as such, their cash surrender values are placed on the balance sheet, although the amount is often hidden with “Other Assets.” This cash can be called on by the entity at any time, if needed, but normally is used to fund key executives retirement benefits.
Not only must the current adequacy of insurance be considered, so too must the risk of litigation that, if took place, would result in a weakened financial condition. Some industries are, by their nature, more subject to lawsuit, while other industries may evolve to become of a higher risk. An increase in such risk is not to be taken lightly, as was seen by the toy industry during 2006 when lead paint was found in many of their products, resulting in free cash flow that could not be reasonably estimated. As was discussed earlier under “Contingent Liabilities,” a thorough review of such prospects (including adequacy of product liability insurance) needs to be explored.
If legal costs exceed, or are expected to exceed 5% of normalized (3 or 4-year) cash flow from operations, a penalty is assessed. If, in the opinion of the analyst, an existing lawsuit, or the threat of one for which the analyst believes has merit, which will result in a payment of greater than 5% of normalized operating cash flows, a penalty is assessed.
Potentially large payments which could emanate from manageable small lawsuits for which a payment has been made would result in a large penalty. Often, however, a firm is reluctant to discuss payment associated with a lawsuit to discourage publicity.
Insurance inadequacy will penalize cost of capital, the amount dependant on the risks involved. Firms that under-insure workers compensation are especially at risk.
