A Simple Way to Spot Conservative Accounting in the Insurance Industry
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An investor's ultimate dream is to discover a great company that the market undervalues because it uses conservative accounting. However, few investors actively seek these opportunities because, well, accounting is boring. However, there are certain instances in which it is easy to determine how conservative a company has been in accounting for its performance. Accounting for insurance loss reserves is one such estimate that investors can easily evaluate.
Investors should always be wary of insurance reserve estimates. Determining the proper reserve requires a high degree of judgment on the part of management and actuaries. Furthermore, there is a significant time lag between initial liability estimation and actual payment on policies, so it may be several years before investors realize that management has been too aggressive. As a result, the only way to get comfortable with today's estimates is to judge how good the company has been at estimating its liabilities in the past.
Luckily, insurance companies disclose data that makes evaluating past reserve estimates easy to do. Each company publishes a table in its 10-K called 'Loss Reserve Re-estimates' or 'Analysis of Loss and Loss Adjustment Expenses Development' or something to that effect. This is what the table looks like in Progressive's (NYSE: PGR) 2011 10-K (click to enlarge):
The most important data in this table are the initial estimate of the insurance liability net of reinsurance ('Liability for Unpaid Losses and LAE - Net') and the difference between the original estimate and the current estimate ('Net Cumulative Development Favorable/(Unfavorable)'). By dividing the latter by the former, we can calculate in percentage terms how conservative management's original estimate was.
The following table calculates the degree to which five companies erred in the original calculation of insurance liability. A positive percentage indicates that the company overestimated its liability, while a negative percentage indicates that the company originally underestimated its liability.
The Progressive Corporation
Progressive consistently overestimates its future liability on policies it underwrites. As a result, the company routinely reduces its reserve for insurance losses. In addition, management targets a combined ratio of 96, but has come in well below that target in all but one year over the past decade. This consistent outperformance on policy underwriting is likely why the company's original estimates nearly always prove too conservative.
The Allstate Corporation
Allstate (NYSE: ALL) consistently underestimates its future liabilities. While this is concerning, the biggest underestimates were for policies written during 2001 and 2002; payments on these policies spiked in the middle of the decade, causing liability estimates to increase. Allstate's estimates in subsequent years have been more accurate.
American National Insurance Co
American National Insurance (NASDAQ: ANAT) is even more conservative than Progressive in estimating its future liabilities. On average, its original estimates are 8.7% greater than currently estimates. As a result, investors can trust that ANAT is not under-reserving for the policies it writes today.
The Hartford Financial Services Group
The Hartford (NYSE: HIG) had a rough first-half of the decade when it underwrote policies that far surpassed its original loss estimates. So far, its estimates for the latter-half of the decade have been more accurate.
The Travelers Companies
Travelers (NYSE: TRV) also fell victim to poor underwriting in 2001 and 2002, but has since made more conservative estimates.
Looking at reserve revisions is not a perfect way to judge underwriting performance, nor is it an indication of whether a company is a good investment. But, when looking over long periods of time, reserve revisions can give investors insight into how conservative or aggressive management is in its assumptions about underwriting performance. From the data discussed above, it appears that Progressive, ANAT, and Travelers are more conservative than Allstate and The Hartford. Investors should combine this information with traditional measures of value to determine which insurance company represents the best investment.
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