Country: United States
Current Price: $77.79 a share / 2.38B market cap (as of 4:24 PM CST, 10/24/2011)
Periods Analyzed: 2004 to 2010
The ProAssurance Corporation (PRA) is a holding company for property and casualty insurance companies focused on professional liability. While the corporation’s client mix traverses the gamut of healthcare professionals—from physicians, dentists, and surgeons to podiatrists, chiropractors, and even home healthcare—ProAssurance writes the vast majority of its premiums from physicians and dentists, who represent 66% of the 69 thousand policyholders it covered on 2010 year-end.
Its presence in the United States is phenomenal, considering the insurance industry is highly fragmented and very competitive. The National Association of Insurance Commissioners (NAIC) considers ProAssurance as one of the Top 5 MMPL insurance companies nationwide, along with Medical Liability Mutual, Medical Protective (a Berkshire Hathaway subsidiary), Doctors Company, and AIG.
Incorporated in Delaware during the second quarter of 2001, ProAssurance is the offspring of Medical Assurance Inc. and the Professionals Group Inc. Since then, the company has engaged in a flurry of mergers and acquisitions, virtually one year after another. In the past seven years, ProAssurance has assimilated at least six companies, one of them being a professional liability insurer for lawyers... an understandable decision considering the background of the CEO who stepped into power on 2007.
It was written on ProAssurance’s 2010 annual report (page 15) that it is “…the successor to eighteen insurance organizations….”
Nothing else clearly delineates ProAssurance’s nature as a serial acquirer.
II. Executive Summary
Admittedly, ProAssurance is a stock the market pays little attention to. Though shares outstanding were never beneath a robust unit count of 30 million, the volume it has normally traded for was less than 5%. In fact, even during the debacle of ’08 and ’09, volume did not breach 10% of shares outstanding, and the price did not drop below the $50 range it had been trading in the pre-crisis period.
This company first got my attention after a short discussion about it with someone from LinkedIn, who informed me of its low P/B and P/E ratios, its high net profit margins in recent years (above 30%), and a safety net from debt thanks to most of its equity being in short-term bonds.
Obviously, a further study of the case gave me a tremendous insight on the risk it poses to investors.
While it is easy to discern ProAssurance’s excellent credit and the impressive efficiency it exhibited in the past, and even easier to add a premium to the target price for participating in an industry that would never go away, no matter how notable is PRA’s reported profitability as found on websites such as Google or GuruFocus, the profit figures enshroud the crutches on which it leans. Concealing the questions on loss reserve adequacy and the sustainability of investment returns.
Furthermore, future prospects are weak. The MMPL industry is a dog-eat-dog world. There are so many competitors, ranging from big-time insurers and other MMPL coverage providers to cooperatives and unions. The top five in the field do not even control more than 30% of the premiums written nationwide.
A zero-sum game, organic growth is almost impossible without aggressive M&A. While the volume of healthcare practitioners and the occupations supporting them have grown since 2004 despite the debacle that had cost the United States thousands of jobs, the fact remains ProAssurance’s major client base, physicians and dentists, have averaged one billion across the United States in the past seven years (Bureau of Labor Statistics Tables).
To put it laconically, the sustainability of ProAssurance’s conservatism and investment returns combined with a feeble outlook on growth left me with the impression this medical malpractice liability insurer represents a MODERATE LEVEL OF RISK, translating to a discount rate of 17.41%.
Although I find its risk rating unattractive and disconcerting, PRA nonetheless has a rather compelling valuation.
An analysis of market-implied growth rates suggests the market is assuming a lofty expectation on PRA’s float over the long-run. At the same time, the study shows book value is expected to grow at a rate that could only be described as “modest” in lieu of its historical record. The investing collective appears to emphasize business operations more than its investments, yet every other valuation technique weights the investments far more than the insurance business.
The entirety of ProAssurance’s investment portfolio, almost every bit of it placed in fixed maturities of medium-term duration, net of current loss reserves, long-term debt, and dilution, was worth almost $60 as of the 2nd quarter of 2011: a significant portion of fair value. Under pessimistic and zero-growth conditions, the underlying business does not even contribute more than 30% to the intrinsic value.
Even so, when the two are combined, I arrived at an EPV of $70.23, with the current price representing an 11% overvaluation—an acceptable level considering the high discount rate. This value is approximately 69% higher than the firm’s net reproduction costs: an ostensible indication of competitive advantages that, I believe, arise from its impressive efficiency and approach towards M&A. As of writing, the market price assumes a negative 3% margin of safety on pessimistic growth conditions, and a 16% figure on neutral growth conditions—items of interest in light of the high discount rate.
III. Risk Assessment
Before I begin, I’d like to stress to and remind my readers how important risk assessment is in my system. It influences the discount rate directly as well as the standards I set on the estimated margin of safety inherent in the market price.
As I have done before with Autoliv—and, for those who frequent the PinoyMoneyTalk forum, some companies listed only on the Philippine Stock Exchange—the risk assessment is a walkthrough of five elements: creditworthiness, efficiency, profitability, inherent stability, and future prospects. It is a comprehensive, Du Pont style analysis that incorporates quantitative and qualitative factors alike with the intent of molding my perception, and that of my readers, of how much risk is present in the security’s underlying company.
Financial strength is a crucial component of an insurance company’s business, and without it, ProAssurance would not be able to “deliver every day on the promise to give our insureds a defense of their claim….” (2010 Annual Report)
In the past seven years, PRA’s credit has been nothing but great. I noted a declining level of debt relative to the assets owned by the company. Loss reserves have never fallen beneath 50% of all assets owned and long-term debt has fallen to nothing.
A brunt of liability, at least in the early years, has its roots in a business segment sold on 2005. It is only natural to see the debt ratio fall after its sale; even more so considering net income inflated retained earnings rapidly in the ’06 to ’10 period.
Delving into solvency, one thing I’d like to point is the uselessness, the futility, in basing it on long-term debt as one might do with a typical corporation. As of the most recent annual filing (fiscal year 2010), long-term debt had a fair value of $51.1 million.
Even if we assume the worst case scenario for the debt pegged on floating rates (a 7% 3-mo. LIBOR, never seen before the 2000’s; and a 12% US Prime Rate, never seen since the 80’s), the present value of debt does not exceed $55 million. Principal, interest, and lease payments are not going to surpass $20 million through 2019, not without ProAssurance taking in more debt.
What makes the assessment of solvency from debt a complete and utter waste of time is the fact its long-term debt has little impact on the amount of money ProAssurance ends up paying year-on-year. It is thus more important to look at reserves… or specifically, the write-offs.
As far as liquidity is concerned, all current investments of the company, fixed maturities and equity securities available for sale and trading, held at fair value, are notches above the level of reserves. ProAssurance is obviously capable of its claims losses, assuming the reserves are an adequate estimation of potential payoffs.
Adding all other current assets will definitely boost the ratio.
An earnings coverage ratio taking into consideration occupancy costs (rent), principal payments, interest payments, and actual claims losses is an even better indicator of ProAssurance’s financial strength.
The table right above this paragraph shows four different profitability metrics, each compared to the required expenses and disbursements for the given year. One cannot deny PRA’s earnings have been above obligations in the past seven years. The ratios’ observed decline arose from heightening write-offs, increasing occupancy expenses, and a temporary leap in interest expense. Income itself, of course, has fallen as well.
I’m splitting efficiency into two different sections: one devoted to business operations, and the other dedicated to the loss reserves.
The dichotomy is necessary because, through the course of my analysis as well as discussions with professional analysts and a few GuruFocus users, I have learned that loss reserves are significantly related to profitability. Insurance runs on an engine of estimations and actuarial assumptions, and because one can only assess reserve adequacy through the rear window, accurately forecasting loss trends over the medium-term is extremely difficult if not impossible.
Frank O’Neil, ProAssurance’s investment relations officer, likened it to “driving down the road only being able to see out of the rear view mirror” (Email, 12 Oct 2011, 2:35 PM). I, on the other hand, would opt for silence instead of a witty remark and merely point at Wall Street analysts and their projections for quick comparison.
Although ProAssurance does not provide its key performance indicators in its annual filings, an investigative exploration of its investor relations archives, or its Form 8K’s to be more specific, unearthed multiple operating metrics useful in assessing PRA’s business activities, involving:
1) Claims Processing
2) Employee Utilization
3) Insured Retention Rate
4) Premium ROC
5) Average Written Premium
An overview of claims processing can be easily obtained with figures the company happily provides: the average reserve amount devoted to every open MMPL claim, the number of claims opened during a given year, and the number of claims tried in the given year. This first metric is crucial as ProAssurance did not start disclosing the number of open claims on year-end until their ‘09 conference call.
An examination of the table above will reveal ProAssurance generally processes 26 to 40 percent of their open claims for the year. This has averaged 33% over the given time frame, and FY2010’s performance was better than FY2005’s. The company has definitely improved.
Still, of all the open claims, roughly 3.3% end up going to court each year. In the legal battlefield, these cases face four scenarios: dismissal, defense verdict, out-of-court (OOC) settlement, and a plaintiff verdict. From the investor’s point of view, one would be more inclined towards the first two than the latter, precisely because these are outcomes that are favorable for both the company and the policyholder, i.e. a dismissal and a successful defense results in zero liability for the two parties.
Once again, ProAssurance’s transparency in its Form 8K’s has provided the frequency of outcomes it has experienced with tried claims, comparing it to industry figures sourced from the Physician Insurers Association of America (PIAA). The figures shown below represent the average over data covering four years: 2006 and 2008 to 2010.
As seen on the column graph, ProAssurance’s figures are arguably better than the industry. PRA has a higher probability of securing a favorable outcome, even though it has experienced higher frequencies in plaintiff defense. This sheds a positive light on either the quality of doctors underneath its banner or that of their legal defense.
It is a notable fact that ProAssurance has maintained a customer retention rate above 80% since ’04 and has inflated this to 90% by ‘09 year-end and sustained it over the next fiscal year. More and more of PRA’s customers opted to stay under their banner, even as the serial acquirer descended upon the company they had been loyal to.
I find this impressive in light of the high competitiveness of the industry.
The only financial indicators I actually glanced at were the usual asset turnover ratios, aside from Days’ Sales Outstanding. DSO, when computed on net premiums earned and premiums receivable, suggests an average waiting period of 75 days with little variation—a consistent behavior. DSO for 2010 had been slightly worse than average, but other than that, it isn’t likely to fall.
Total Asset Turnover is a ratio I found useless for this analysis, simply because it inflates total assets too much that it doesn’t point at the efficacy of operations. Separating the balance sheet from everything related to reserves, LT debt, investments, and excess cash, and comparing it to revenues from the insurance business alone, I found it had increased 20% to 1.42× on ’07 from ‘04’s 1.19×, a number it has retained through the most recent fiscal year.
The increase in efficiency seen in the other KPI’s is corroborated by the overall decrease in net operating assets, which arose from the disposal of assets and liabilities of discontinued operations sold in ’05, followed by declines in premiums receivable and receivable from reinsurers ‘til ’08.
Loss Reserve Development
The section on efficiency ends on Loss Reserve Development, a crucial portion of efficiency and a determinant of future profits.
Historically, ProAssurance charged, on average, 80% of direct premiums written to the loss reserve. Although Frank O’Neil, the insurer’s authority on investor relations, told me filed claims typically have a lifespan of four to five years (personal communication, 12 Oct 2011: 2:35 PM), an analysis of the reserve development spreadsheet in the 44th page of their 2010 annual report implies PRA’s cumulative net reserves paid bloom in the first four to five years—mirroring Frank’s statements—before the growth rate withers as the net paid approaches the total amount reserved for claims losses.
The graph above displays the amount of reserves on the end of the given fiscal year, along with the cumulative amount of reserves paid out as losses as of 2010 year-end. We could see that reserves going as far back as ten years haven’t been fully exhausted. The downward-sloping line represents the amount of reserves paid out—while this is clear evidence of the long-tail nature of PRA’s business, more importantly, it signifies that loss reserves drop at a rate of 10.4% a year on average.
In other words, reserves should be expected to approach full depletion after approximately 9.6 years.
I also observed that adjustments to reserves from prior years, labeled “net favorable adjustments” by the annual report, have been going up since the very beginning of the seven-year time frame, running up from an $8.7 million deduction to loss reserve charges to $234 million by ‘10. A vast majority of these adjustments, particularly the ones reported in the 10-K’s of more recent years, stemmed from accident years ’04 to ’07. This curious behavior signals conservatism, and an effective one at that.
Frank goes so far as to confirm it.
“By ‘rising adjustments to loss reserve charges’, I assume you are speaking of the release of loss reserves. Those are up because our loss experience has proven better than what we estimated when we established those reserves. We always reserve eight-to-ten points higher than our indicated pricing as we establish our reserves. That is done because of the inherent volatility in our line of business and our desire never to get caught short on reserves and have to dip into equity to replace them.” (Email, 12 Oct 2011, 2:35 PM; emphases added)
Despite this favorable “loss experience,” recent years appear to challenge the degree of conservatism ProAssurance has followed to date. I’m talking about accident years 2008 and 2009, when the net cumulative redundancy fell from the decade high of $636 million to about 37% of that amount in only two years.
Neither the annual reports nor Frank O’Neil himself supplied a reason behind this deduction, with the latter merely giving me the response of “2008 and 2009 are not done developing. ….As to the degree of development… we report the data but have a policy against predicting or commenting on qualitative measures of our reserves” (Email, 12 Oct 2011, 5:26 PM).
Needless to say, that “even in the height of the 08/09 debacle, there was no increase in claims in the worst hit areas of Ohio, Indiana, and Michigan [three of PRA’s top 5 states]” (Email, 12 Oct 2011, 7:27 PM) does not help solve the puzzle behind the hit taken by cumulative redundancy, regardless of its merits.
So what does this mean for investors?
To put it simply, ProAssurance’s history of conservative loss estimation can be compared to a defective security blanket made in China. An investor puts it on, thinking, no, implicitly assuming, net favorable developments would either grow some more or plateau around $200 million, not knowing how fragile—how vulnerable it is to deviations from projections and forecasts.
Exacerbating the dangers is ProAssurance’s sheer dependency on its investments. Had net investment revenues not been around to save the day, the company’s operating income—premiums less unadjusted loss charges for the year and other operating expenses—would have gone red.
Moving on to the next element, the question of profitability lies on ProAssurance’s ability to rein in expenses consistently.
As seen in the table, operating expenses retain over 80% of revenues. Even under the NOPAT income statement, which I recast to preclude investment income from operating revenues, this very observation applies.
Readers should give interest and taxes a fleeting glance. Interest expenses have never been significant as far as ProAssurance’s profit is concerned, yet in recent years their impact dwindled down to the point it can be compared with a bee sting, a minor wound assuaged by the (usually) positive effect of net realized gains and other unpredictable items in the income statement.
The taxman has never asked for more than the statutory tax rate of 35% and, owing to the fact 35% of PRA’s investment portfolio—representing 26 to 30 percent of total assets—is invested in state/muni bonds, all of which yielded an average of 5% over a tenure of 11 years and a remaining life of around six (PRA’s 2011 2nd quarter supplemental info), the burden on ProAssurance’s income has not exceeded 30% since ’04.
Because ProAssurance only begun giving away dividends early 2011, that leaves the loss reserves, again, as the game-changer in profitability.
Anyone who looks at the reported figures, whether it be on Google, on Yahoo, on GuruFocus, or on its annual reports, the income statements to date insist ProAssurance is highly profitable: from $43M on ’04 to $232M on ’10, without skipping a beat. A steady increase, even as revenues—as net premiums earned—stumbled on ’07 and ’08.
Even the typical insurer ratios perused by analysts and newbie investors alike—loss, expense, combined, operating, and NII ratios—ALL proclaim the same thing: profits are rising, and all looks good for ProAssurance. It is a wonderful company that’s been growing steadily for the past God knows how many years, going up even as the economy tanked.
Sifting through the income statement reveals adjustments to prior loss estimates have been responsible for a very significant portion of this wonderful and glowing story. I don’t think a reminder is needed when the table in the previous section (efficiency) clearly unveils both of ProAssurance’s crutches.
When one substitutes the actual write-offs for these estimated charges “net of favorable development,” one would start seeing rising loss ratios, falling operating ratios, in conjunction with a stellar performance of the net investment income ratio, whether net realized investment gains (losses) are included. These observations point to an increasing reliance on investment income for buttressing the business against payments charged against the reserve.
Obviously, the ability to estimate losses is invaluable!
Now, I am of the opinion ProAssurance has shown an adequate level of conservatism to date. Write-offs, while they are rising, have yet to break through $400 million a year. $350 million, even. In contrast, PRA has reserved no less than $400 million—than 82% of net premiums earned—in a given year. At an average of $300 million in yearly payouts and $450 million in current year reserve charges, we’re looking at a 50% margin of safety. This opinion is bolstered further by the growing favorable developments along with PRA’s custom of “reserving 8 to 10 points higher” than what actuarial analysis recommended.
However, as 90% of these payouts are disbursed for claims made in prior accident years, there’s no way of knowing if this reserve amount is indeed sufficient, not until a few years from now when ’08 and ’09 developments and write-offs start pouring in. The section on Future Prospects, however, questions this conservatism as much as the ’08-’09 reduction in net cumulative redundancy did.
Keeping in mind these issues and concerns on the loss reserves, let’s advance to overall returns. So far, return on assets averaged 3.5%, with enough debt to pull it up above 11% on the ROE level, at least for years after ’05. RNOA, however, has been extremely high, breaching 30% in the three most recent fiscal years, owing mostly to NOPAT margins above 20%.
But if RNOA exhibited a behavior described to be “extremely high,” why does it fall from grace when it is translated to ROE? Spread provides the answers.
Here, we can see that net financial obligations have been negative for all seven years. Net financial expense has been negative as well, yet the amount becomes more and more insignificant over the years.
In other words, yields are falling yet investments are being inflated.
To add a disturbing insight to this conjecture, consider downloading ProAssurance’s most recent supplemental investor information (2011, 2nd quarter), which compiles the company’s investment portfolio in its entirety. Filter the PivotTable to display only fixed maturities, excluding asset-backed securities so bonds and short-term investments are present.
Since the file was last edited on August 3 this year, compute each investment’s time to maturity so long as maturity date wasn’t before 8/3/2011. Calculate the present value of coupons and the lump sum payoff at term end, using a 10% assumed YTM for easier computation. Get the market value of these investments, and employ Goal Seek to obtain YTM necessary to equate PV of bonds to that number.
The result should be a negative 1.5%. Blame can be placed on the fact bonds were bought at a premium—about 3.7% above par value.
Notwithstanding my reservations on ProAssurance’s efficacy in estimating claims losses and its increasing dependence on investment revenues going forward, I find the industry rather compelling despite its very competitive nature.
ProAssurance and its competitors are in the business of covering the potential liabilities medical professionals may face in the course of their work. Although the variability of premiums are vast and expansive—from as little as $650 a year from a home healthcare nurse to a minimum of $125,000 from a neurosurgeon (Frank O’Neil, email, 12 Oct 2011, 2:35 PM)—the industry typically covers the pecuniary costs of litigation and funds the policyholders’ defense, irrespective of the outcome.
Securing this industry’s existence is the fact every healthcare occupation, even the low-risk ones, face a malpractice claim at least once over the entire career life at a probability of 75% and upwards. High-risk professions, particularly surgeons, are virtually guaranteed, with a cumulative probability of 99% (Sue McGreevey, Medical News Today article, 19 Aug 2011).
Needless to say, this revelation should not be a cause for concern for investors: despite the high rate of lawsuit filing, less than 30% of tried claims result in payoffs, a fact corroborated not only by PIAA industry percentages supplied by ProAssurance but also McGreevey’s article, which pegged the smaller rate of 20%.
And even IF the payoffs occurred, the liability imposed on the insurer averages $275,000, ranging from $118,000 in dermatology to $521,000 in pediatrics (Kraft Sy, online article in Medical News Today article, 18 Aug 2011).
An October 2011 article by Sean Carr, uploaded on Insurance News Net, reveals the possibility for malpractice claims to be capped at $275,000 on “noneconomic damages” along with “strict limits on punitive damages, a ban of subrogation by collateral sources, and a sliding fee schedule for attorney contingency fees” due to the recent debt-ceiling deal demanding cost-saving avenues accumulating $1.5 trillion. However, Congress has obstructed this and even Brian Atchinson, president and CEO of the PIAA, admitted this scenario has little chance of proceeding, given the tremendous damage and injustice something like this would inflict on victims of malpractice.
It’s obvious the death of the medical malpractice industry is a scenario only deranged lunatics would consider.
A more realistic possibility, rather, is the demise of an existing insurer, considering the competitive nature of the field. With the question of inherent stability falling on the laps of individual firms, what equipment does ProAssurance possess to minimize its chances of falling from grace?
After a thorough reflection on what I uncovered through a combination of research and an analysis of the company’s SEC filings, I’ve come to realize the factors assuring the continued survival of PRA and the other top players of the MMPL industry are established in four fronts: (a) A favorable market position, (b) high barriers to entry keeping both new entrants and minor competitors out of the main game, (c) excellent customer service, and (d) scale economies that further impede advancement by the smaller players.
Position to Consolidate
The largest market players of the MMPL industry—Berkshire Hathaway (via a subsidiary), The Doctors Company, Medical Liability Mutual, CNA Insurance Companies, and ProAssurance itself—all control a minimum 5% of the market. Given the improbability of organic growth of the physician-dentist-surgeon pool, a primary revenue source (refer to Future Prospects), dominant players have no choice but to pursue industry consolidation insofar as this pool is concerned.
High market shares relative to the rest of the fragmented industry enable the largest companies to afford the strategy of buying out its competitors. For example, PRA has been active in the past seven years, absorbing at least six companies into its body using only the proceeds from its investments and operations. Debt was not written on these transactions and in fact, the company has plowed money into share repurchases.
Even the competition indulged in acquisitions. The Doctors Company, for instance, acquired the American Physicians Assurance Corporation in late 2010 (Richard Anderson, Website Publication, 2010 Q4). Almost three years before, Doctors bought out the 3rd largest MPL insurer in California (Website Publication, 4 Jan 2008). Medical Protective, under the guidance of renowned value investor Warren Buffett, acquired on 28 Sep 2011 the Princeton Insurance Company—the largest medical professional liability in New Jersey.
Destructive Barriers to Entry
From a conceptual standpoint, new entrants are impeded by the immense competition with industry incumbents, even as they steal from or cannibalize each other for the sake of growth.
“We [PRA] have lost some insureds due to aggressive, price-based competition which we face in virtually all our markets. This competition comes mostly from established insurers that are willing to write coverage at rates we believe do not meet our long-term profitability goals. We believe many competitors are also employing less-stringent underwriting standards than they have in the past and they appear to be offering more liberal coverage options.” (2010 Annual Report, 11; emphases added)
Elasticity is a problem that isn’t going to go away.
Furthermore, aspiring start-ups face the high costs (money and time) of setting up actuarial processes, not to mention the inevitable funding of claims losses, of which size is a medium-term uncertainty. Establishing the business infrastructure also takes time and trial runs, and by then, it is sensible to think the new player would have succumbed to competitive pressure by then, folding their cards or giving them away to a small-time incumbent.
Excellent Customer Service
If the policyholders are price-sensitive, if they can be so easily wooed by competitors on the basis of premiums alone, and if they have the ability to switch insurance policies at any given time, what’s keeping the biggest players afloat? What allows them to provide market shares better than the rest of the industry?
My conjecture here is the excellent service they provide to the customer.
Below is a table of services provided by the ProAssurance, Doctors Company, and Medical Protective, compared to that of two smaller players in Texas, Capson and Texas Medical Liability Trust (TMLT; one of the largest MMPL insurers in the state) The information is by no means comprehensive, as these were compiled after only a quick peek at the company websites.
While some of the services would vary across providers, the fact remains risk management programs and ancillary services are crucial to maintaining high insured retention. Compare Capson versus the other four; no matter how much I perused its website, I found nothing useful that would help policyholders mitigate the possibility of claims.
Capson touts its customer survey service as a unique method of reducing risk, while TMLT reimburses legal expenses incurred by the physician subject to disciplinary proceedings, yet the major insurers provide different complements. One permits reduction of the premium and tries to improve operations insofar as safety is concerned. Another promotes supplementary services to help mitigate costs of operating the practice.
ProAssurance, and its rivals in the business, possesses the advantage of scale, as higher number of policyholders lowers costs up to an extent.
Adding to the top incumbents’ advantage is the versatility of insurance coverage: they can serve not just physicians, surgeons, and dentists, but also other occupations in healthcare. Capson, for instance, only extends its business to physical therapists, physician assistants, and nurses, whereas PRA can serve more branches of healthcare (e.g. podiatrists).
The future prospects of the business—its catalysts for growth—arise from two fronts: the insurance business and the future performance of its investments.
I’m expressing doubt on ProAssurance’s prospects for organic growth. While government statistics indicate the median wages of the company’s primary revenue source, physicians and dentists, have been growing at a rate of 2.9% for the past six years and thereby reducing income elasticity across the board, the main problem with the physician-surgeon-dentist pool available to all market players is that employment figures aren’t rising.
With the volume of clients for the industry stagnant, it is clear the market isn’t going to have drastic growth. ProAssurance and companies of its ilk are more likely to continue their pursuit of value-adding mergers and acquisitions.
However, the question of growth is further challenged by rising costs to defend. I’ve observed an increasing level of underwriting, policy acquisition, and other operating expenses—a 6-year CAGR of 7.64%. The unidentifiable portion of those expenses (i.e. excluding D&A, rent from operating leases, and share-based compensation) have been going up faster, at 13.71%.
One reason why this has been on an uptrend could be traced to “the rising costs of defending physicians accused of malpractice,” which can be explained by increased plaintiff sophistication, i.e. plaintiffs and their attorneys are hurling more complex cases at the court, hiring expert witnesses, and employing animation technology (Robert Lowes, Medscape Article, 5 Oct 2011).
Regardless, the incline in operating costs is pressuring firms to grow, and in a competitive industry where M&A transactions are the norm. Aggravating the strain on MMPL insurers are consumer consolidation trend and the stagnation/decline of premiums.
Consumer Consolidation Trend
An increasing threat to the business is “a trend towards hospitals purchasing physician practices” (2010 Annual Report, 11), where the hospitals assume the risk exposure themselves in its own insurance program, having assimilated the practicing doctor into its employee roster.
The migration of independent physicians to large groups and hospitals is “the most worrisome threat to market share” (Michael Marray, Web Article, 5 Oct 2011). According to ProAssurance, a whopping 50% of physicians today are employed or affiliated with hospitals and large groups.
Troubling for investors are the irresistible incentives for doctors to ditch their insurance policies and ride on the hospital/group seeking them out. Rodd Zolkos’ article posted on 16 Oct 2011 at Business Insurance, provides us with some harrowing details:
- Doctors are increasingly put under the group’s insurance policy, making me think it lowers their expenses by reducing, if not eliminating, the amount they pay for malpractice coverage.
- MMP claims involving independent physicians often set their sights on both the hospital/clinic and the doctor being sued. The assimilation process essentially reduces whatever would be awarded to the plaintiff.
- Assimilated doctors gain the ability to evade career-killing, reputation damage not covered by MMPL insurers but inherent in all malpractice claims.
Furthermore, the government is encouraging this trend. W. Stancil Starnes, CEO of ProAssurance, wrote in his letter to shareholders that hospital-employed physicians have an enhanced insurance or government reimbursement for procedures performed and aren’t as burdened as independent doctors are with federally mandated electronic documentation (2010 Annual Report, 4).
So if this trend is likely to go on, just how is this “the most worrisome threat to market share”?
Picture a buffet table filled not with open canisters of food but with small and large plates, each with a variety of steaming delicacies on top. Imagine a table big enough for over hundreds of people. Warren Buffett, Stancil Starnes, Robert Menotti of MLMIC, Richard Anderson of Doctors, and Thomas Motamed of CNA Insurance can be seen sitting down on one end, with 30% of the food supply reserved for them and them alone.
Now visualize an increasing number of the small plates levitating by themselves and dumping their content on the larger ones, before vanishing of their own accord.
Unrealistic? Unfortunately not, for this is exactly what’s happening to the MMPL industry.
Although hospitals and large groups are still available for insurers to feast upon, the aforementioned parties as a whole are hoarding independent practitioners, effectively decreasing supply and increasing the aggression inherent in the industry.
Stagnation and/or Decline in Premiums
If that isn’t enough, one’s imagination could be directed towards the wallets of each person manning the buffet table, as insurance premiums have been declining for the past four years. Chad Karls, a consulting actuary from Milliman, expects rates to remain flat in the near future.
Karls attributes the recent downward curve in premium rates to several causes. One is a wave of tort reform legislation passed by various states in the preceding 10 years that, among other things, limits how much plaintiffs in a malpractice case could collect for noneconomic or pain and suffering damages. A $250,000 cap found in California, Texas, and other states is what organized medicine seeks on a national basis. Advocates of caps say they discourage frivolous lawsuits and prevent runaway jury awards.
Those laws, Karls said, have led to fewer malpractice claims being filed, which in turn has lowered premiums — a pattern attested to by a number of academic articles. However, premiums also have decreased in states, such as Oregon, that do not cap noneconomic damages.
"So caps can't be the only reason," Karls said. "I think the push for patient safety and risk management also has played a role" in reducing claims and premiums. (Robert Lowes, Medscape Article; emphases added)
The Medscape article warns that MMPL insurers have been recently lax on their underwriting standards, possibly undercharging physicians to increase revenues. PRA has also noted this tradeoff (see the quote from page 11 of its annual report in the section on Inherent Stability).
Despite this trend, the reason why the diners at the table are still wearing their suits and gowns could be found in the reserve releases. Reread the section on efficiency and profitability, and pay close attention to the number presented as “net favorable developments,” as adjustments to the reserves. Michael Murray, editor of the Medical Liability Monitor, observed the clarity of insurers holding on to their suits by “releasing past reserves, artificially inflating the industry’s profits” (Michael Marray, Web Article, 5 Oct 2011).
That profits are expected to drop when excess reserves have been released is the general idea here, and as far as ProAssurance is concerned, the business climate as of present time is challenging the accuracy, if not the integrity, of their estimates.
Considering the economic climate today, investment performance probably might not save ProAssurance as well as it had in the past.
As noted earlier in the section on Profitability, yields on investments have been falling, even as the amount of money put into work rose. I’m expecting the 5% average yield on investments (computed using the financial statements or statistically describing the portfolio’s coupon rate distribution) to be diluted once the reinvestment risk kicks in.
After all, fixed maturities comprise 90% of the investment portfolio, with a vast majority—above 65%--flowing into state/muni and corporate bonds. 16% of these are expiring through ‘13, 29% on ’14 and ’15, and 44% on ’16 to ’19. In other words, almost the entire portfolio matures in 8 years. If the economy hasn’t improved by then and investors in the capital markets aren’t more confident by ’13 at the latest, PRA’s yields are certain to drop, not unless the company does something to keep its portfolio from undermining future profitability.
Signs that markets aren’t going to fare well in the medium-term abound.
One: German Chancellor Angela Merkel conceded the search for an end to the European debt crisis “extends well into next year,” making it clear “dreams that are taking hold again now that with this package everything will be solved and everything will be over on Monday won’t be able to be fulfilled” (Bloomberg, The Economic Times, 18 Oct 2011).
On October 23, 2011, Reuters reported EU leaders have advanced toward a strategy on bank recapitalization and leveraging the rescue fund, though final decisions have been deferred AGAIN, uncertainty still taints implementation, and the solution isn’t likely to be something that will impress the markets (Julien Toyer and Andreas Rinke, Reuters, 23 Oct 2011).
Two: Remember the debt ceiling crisis of August 2011? It isn’t over yet. Dagong, China’s largest rating agency, asserted that the lift the debt ceiling had on August may have bought the United States two years, but did nothing to improve solvency. Growth of the US economy is weak, with the government unable to improve its financial conditions (Mu Xuequan, Xinhua article, 3 Aug 2011), unable to make a deal that would satisfy both Democrats and Republicans.
That Merill Lynch forecasts another downgrade by year-end isn’t a good omen (Walters Brandimarte, Reuters, 23 Oct 2011). Neither is the 23 Oct 2011 article about US companies beating analyst expectations on Yahoo! Finance, which cites John Butters (senior analyst at FactSet) as saying Wall Street analysts have been cutting estimates in the months leading up to the reporting season.
IV. VALUATION ANALYSIS
When viewed on GuruFocus’s little screener, the key stats on ProAssurance look good. Even at $77 a piece, I’m looking at a company being traded for 20% above book value, armed with profit margins above 30%, very strong growth rates, not to mention a decent F-Score. That sticker price gives us a P/E below 11, and that is very attractive for a company with a significant market control in a competitive industry that’s never going away.
At least, only at first glance.
Remember, even though ProAssurance operates in a stable business and has exhibited an impressive track record of operational efficiency and financial strength, the current business climate is challenging the efficacy of ProAssurance’s ability to estimate losses. Future prospects are very weak, increasing the risk posed to investors.
These factors have led to a MODERATE risk rating and with it, a steep discount rate of 17.41%. This is almost double the market return of 9.8% (combining the 2.13% “risk-free” rate of a 10Y US T-Bond with the 7.64% implied equity risk premium computed by Aswath Damodaran), assuring the immense conservatism placed here.
The section on valuation begins first with a look on what the current market price implies. There are two ways I approached this: the expected growth of ProAssurance’s float, as well as that of its book value.
Since I wasn’t working with revenues and profit margins, knowing how unreliable the reported figures are, the earnings on which the net present value was calculated from were derived from the average after-tax return on float or equity, depending on which item I was looking at.
Terminal growth was set at the 2.47% inflation rate seen through the growth of America’s Consumer Price Index over the past ten years.
I computed PRA’s float using its reserves, adjustments to prior loss charges, unearned premiums, premium receivables, deferred policy acquisition costs, and its deferred taxes, and eventually calculated a 6.3% 6-year CAGR for it, applicable over the ’04 – ’10 time frame.
When I spared a glance at the market-implied statistics, the only adjective I could attach to the market’s expected growth of the float was simply “absurd.” How could it not be? Using the after-tax return on the float of 3.83%, the market price is assuming a fantastic growth rate of 32% a year until 2016!
Ah, but what if I’m being too strict? Too unforgiving? What if the discount rate’s too high?
Obviously, relaxing my standards does not change a thing.
In contrast, the expectations placed on book value appear to be more modest than its historical performance.
At approximately 12% return on equity, a starting book value of $1.86B, along with the same assumptions on discount rate and terminal growth as before, we arrive at a 13.1% expected yearly growth for ProAssurance’s book value. Considering that the ’04 to ’10 time frame saw a 6-year growth rate of 20%, the result is certainly conservative, seemingly realistic in lieu of what has been accomplished before.
Reducing the ROE by 33% to account for lower real returns arising from unsustainable loss reserve adjustments causes a drastic spike in the growth rate, from the modest 13% to a surprising 23%.
Clearly, the market is assuming an unrealistic lofty expectation on the ProAssurance’s investment performance, whereas the same price incorporates a more modest outlook towards the returns generated by the insurance business... at least until someone tries to be more realistic with its profits.
Intrinsic Value Estimate
As a reminder, I employ a valuation analysis mirroring Bruce Greenwald’s, assessing the assets of the business, its sustainable earnings, and its growth.
Note on the colorful graph above that the value of zero growth—the value of ProAssurance’s earnings power—exceeds the company’s reproduction costs. While this discrepancy confirms the existence of competitive advantages, the estimates are affirming this MMPL insurer is trading at a bargain, even at the high price of $77 a share. That the market price is slightly above EPV and still lower than DCF(P) is impressive, taking into account the tall hurdle I’ve set.
Going through the analysis, it is clear the fair market value of ProAssurance’s investment portfolio, specifically its fixed maturities, drives the majority of all estimates computed. If I went by the market value of the portfolio as of 2011 Q2, the business’s estimated value rises by approximately $60 per share, taking into account dilution, LT debt, current reserves, and cash in hand.
Recall the yield to maturity assumed by the market price, compared to the book value—the costs—is a negative 1.5%, acquiring its integer sign from the premiums above par value.
While the perpetuation of the downtrend yields have followed to date will definitely inflate the portfolio’s market value, I’m more concerned with the possibility of rising yields, which might occur should miracles facilitate the recovery of the world’s macroeconomy. If the yield somehow reverses signs, the net adjustment to NPV declines from an additional $60 per share to $42. Reversing it instead and doubling it to 3% YTM would result in a $35 adjustment to NPV per share.
While people can easily say ProAssurance—or any other institutional investor—would just switch out its lower-yield investments, doing so would result in realized losses that could bring down net income.
Net Asset Value
Under net asset value, considering the perpetuity of the MMPL insurance industry and the advantageous market position controlled by ProAssurance, liquidation is unlikely and assessing NAV through the business’s net reproduction costs (NRC) is a more prudent way of studying the assets.
Key assumptions on the computation of NRC are as follows:
- Premiums Receivable are reduced 20% to account for a new entrant not doing as well as incumbents
- Fixed maturities are increased by approximately 2.55% to reflect market value of fixed maturities on 2011 Q2.
- Equity securities reduced by 15% to reflect lower investor confidence from macroeconomic and political developments
- Goodwill bumped up 30%. PRA’s acquisitions were purchased on the basis of low P/E ratios. The investing climate is different now, and the aggravated competitiveness of the industry probably raises the price, considering the American Physicians Insurance Company was purchased at a 13 P/E ratio.
- Reserve for claims losses and loss adjustments underwent 30% increase to reflect a new entrant’s excessive conservatism, arising from lack of historical information.
- Unearned premiums down 20% to address inferior performance compared to market incumbents
- Long-term debt down 16% due to the lower present value arising from the high discount rate
- Dilution adds approximately 365.9 thousand shares, reducing intrinsic value (NRC, EPV, or NPV) by $28.2 million based on current price.
- Value of customer relationships assessed by the premium spent by the new entrant on each policyholder.
- Value of business development is worth almost $110 million, a number that assumes 10% and 5% of LLAR charges and other operating expenses are spent on reserve development and improvement of operating infrastructure.
With everything else remaining the same, the net reproduction cost of the ProAssurance Corporation after discounting it at the cost of equity is roughly $1275 million--$41.65 a share.
Value of Zero Growth
Pegging a number on ProAssurance was done only on its insurance business, as assessing how much the investments are going to earn over the medium-term when reinvestment kicks in is a pointless endeavor. Besides, I am more interested in the company’s operations.
The computation of operating revenues assumes zero growth on the number of policyholders and an 86% retention rate (the average, zero CV), meaning the business is doing enough sales and marketing to keep operating at a level of 69,000 clients every year no matter how many switch insurers. The written premium per policyholder is $7,300, reflecting the current level. It is assumed that 97% of written premiums have already been earned.
These presumptions result in operating revenues of $422.31 million, deliberately alienating the investment income. This number is 20% lower than average NPE over the past seven years.
Operating expenses are based on the 91% retention of revenues when accounting for all other operating expenses except LLAR charges. It is a historically reliable average, with variation close to zero. LLAR charges for the current year are fixed at $500 million a year, which is far beyond the highest value seen in the past seven years, but there is an assumed $150 million in favorable adjustments. In other words, I am implicitly assuming ProAssurance is conservative with its loss estimation and expecting this to produce $150M a year in adjustments.
Growth operating expenses is equivalent to the depreciation observed during the computation of the value of business development in the subsection on Net Asset Value. Moreover, I wasn’t merciful towards PRA’s tax management and slapped a 35% statutory tax rate on their projected operating income.
The estimated OCF before working capital is roughly $52.3 million. When capitalized at the discount rate stated earlier, the result is an unadjusted EPV of $300 million: $9.81 a share. Once all the other adjustments are taken into account—cash, LT debt, reserves, dilution, and all investments—the EPV computation spits out $2148M: $70.23 a share.
Value of Growth
Last but not the least, the value of growth. I’m not fond of relative valuation, even if its use is prevalent and almost customary for many of the freelance analysts on GuruFocus. As Aswath Damodaran pointed out—forgive me if I can’t exactly recall whether I read it on his blog or his book—the danger of relative valuation is the mere fact its use makes implicit assumptions on growth.
As a consequence, I lean heavily towards discounted cash flow computation, and to compensate for inaccuracies I seek an adequate level of precision insofar as the determinant variables—the risk factors, in Monte Carlo speak—are concerned, employing a scenario analysis to compensate for prejudice.
What I used for assessing the value of ProAssurance’s growth naturally bars investment income—and interest expense—from operating revenues, as I am only interested in the growth of its core business. That is to say, PRA is an insurance company, and frankly, its investment portfolio and debt shouldn’t obstruct the evaluation of its potential contribution to fair value.
Makes perfect sense, doesn’t it?
To start off, because CAPEX is near-impossible to eke out from the insurer’s financial statements, and because the financial aspect of the company has been precluded, the unadjusted net present value is really based on operating cash flows before working capital, as I had done with EPV in the preceding subsection.
Insurance Revenues take into account the (disappointing) growth of the physician-dentist-surgeon market pool, the market share controlled by ProAssurance over the long-term (accruing or depreciating over the six year period), the average premium per physician and its growth, and finally, how dependent PRA is on physicians to generate business.
Delving into operating expenses, LLA Reserve expenses are based on estimated charges, with an arbitrary value of how conservative the reserves are, based on how much is released during the year. I opted for this approach rather than the actual write-offs because I think there’s no way of knowing how committed ProAssurance is to its underwriting standards in the short run, accounting for a business environment provoked by market erosion and insurers so distressed they’re willing to swallow poison.
My major assumptions for the pessimistic scenario are as follows:
These assumptions coalesce into an unadjusted NPV of $455M ($14.9 a share). When adjusted further, roughly $60 is added and the estimated intrinsic value of ProAssurance under pessimistic growth conditions is $75.3, with insurance NPV representing 20% of the total value, and medium-term profits dominating it.
What if the business environment was more lenient towards PRA, and allowed it to grow, even a little bit? I’ll adjust the risk factors to the following values to represent a more neutral outlook:
Under these conditions, the NPV of the business is slightly more dependent on terminal value (59% of NPV comes from medium-term profits), adding almost $31.8 per share to the unadjusted fair value. Throwing in the other adjustments, the estimate inflates to $92.18 a share.
Whipping up a recommendation for ProAssurance took much rumination. Although I could’ve slapped a “BUY” rating, justifying it with the 10% overvaluation on EPV, 3.4% overvaluation on pessimistic growth, and a 16% undervaluation on neutral growth, leaning on the callous discount rate for support, I still find myself wondering how to approach this company.
That there is still a discount for the neutral scenario is remarkable, even more so when the magnitude of the margin of safety breaches 15%.
Even so, the future prospects worry me.
Remember the catalysts! The industry is inflating profits with reserve releases to sweep out of sight the trouble formed by premium stagnation, plaintiff sophistication, and market erosion. ProAssurance itself has released a growing number of reserves, challenging the conservatism it operates with, going forward. Furthermore, investment yields are falling and are still expected to fall as the false hopes propping up the markets are washed away, revealing the true face of the economy.
Even if ProAssurance and the other key players survive a business contraction and seize the market share controlled by exiting firms (probably through M&A transactions), the business climate permeating the MMPL industry and the investing world isn’t a good omen for the next couple of years.
When I first found PRA a month ago, it was trading for about $68. A little lower, even. That number was down from the mid-70s of July and August: no doubt a product of the volatility caused by the pervasive fear of the times. A purchase at that price level would’ve secured a 4% discount to EPV and a 10% discount to pessimistic growth, margins of safety that don’t sound so safe until one recalls the unforgiving discount rate used to compute the PVs.
Only a few weeks have passed since then and PRA has gained 15% so far, eliminating the margins of safety once available to the investor. A window of opportunity shut closed.
So what happens now?
Is the ProAssurance Corporation still something worth looking into for a value investment?
The answer is a definite yes.
Because the company is slightly overvalued from the EPV and NPV(P) standpoints, the advice here is to step through the door and assume a guarded stance. The excessive caution as expressed through the 17.41% discount rate provides some comfort.
However, in this case the most appropriate method is to keep watch on the company’s price and invest when it falls—provided the drop would not be attributable to a permanent loss in market control or efficiency. Doing so would allow the investor to ride the slow and steady uptrend, without committing too much of his funds. Without becoming terribly reliant on the high discount rate.
A more aggressive tactic, I believe, would be shorting. The catalysts are in place, yes, but the MMPL industry has done an excellent job disguising the problems with reserve releases. Put options would certainly limit the unlimited risk, and may provide some insurance should the investor opt for a long position.
1. I do not hold any PRA shares as of writing.
2. This is my first time analyzing an insurance company.
3. The original report is 27 pages long with almost 11,000 words. If you wish to see the whole thing, please contact me for the PDF file.