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As scandal shakes insurers, steer clear
Not all insurance stocks are being punished for the Marsh & McLennan price-fixing scandal, but the investigation is just getting rolling. There's more volatility ahead.
By Jim Jubak
Heres the juicy irony of insurance broker Marsh & McLennans (MMC, news, msgs) alleged price-fixing scheme, disclosed last week by crusading New York Attorney General Eliot Spitzer: Insurance companies essentially were making illegal payoffs to Marsh to buy an insurance policy that would keep the industry from competing itself to death.
Sure, you can call the $845 million Marsh got from insurance companies a bribe. But more accurately, it was a service fee. Unfortunately, the service itself -- price fixing -- happens to be illegal. But when you look at the history of the insurance industry, its pretty clear that the folks paying Marsh & McLennan werent simply dupes: They knew what they were paying for and got their moneys worth.
At least until Marsh & McLennan started to get greedy.
If you understand that about this scandal, youll also understand why this isnt a good time to be buying insurance stocks, especially the shares of insurers selling property and casualty policies, even if the Wall Street panic over Spitzers investigation has knocked stock prices down to what look like bargain levels.
Marsh: 2 commissions better than 1
The scheme uncovered by Spitzer and his relatively small team of hard-working investigators was very simple. Marsh & McLennan is the worlds largest insurance broker, serving clients that represent about 20% of the total world market. (Marsh's insurance brokerage revenue in 2003 came to $5.3 billion; No. 2 broker Aon (AOC, news, msgs) had 2003 brokerage revenue of about $3.2 billion.) These clients, primarily corporate, pay Marsh & McLennan a commission to search through the insurance market and find them the insurance policy that best fits their needs at the best price.
Some executive or combination of executives at Marsh (we dont know exactly who or how many -- its one question that should get answered in Spitzers probe) had a bright idea: Why collect just one commission from the client when the company could collect two, one from the client and another from the insurance company Marsh selected to win the clients business? Marsh would decide what insurer would get the business and then charge that insurer a commission -- without the knowledge of the client, who thought that Marsh was working to find the client the best coverage at the best price.
And just to make sure no client ever got wise and wondered if they might be paying too much for their insurance, Marsh arranged for other insurance companies to put in fake bids for the clients business at prices above that bid by the favored firm.
To play in this system, an insurance company had to 1) pay Marsh a commission, and 2) submit phony bids on business it knew it wasnt supposed to win.
You can certainly understand what Marsh got out of this arrangement. The companys total income in 2003 came to $1.5 billion on total revenue of $11.5 billion. (Besides the insurance-brokerage business, the companys revenue comes from its Putnam mutual fund and the Mercer Human Resources Consulting businesses. Both have run afoul of regulators in the last 12 months or so.) Marsh doesnt break out the profit margins on these under-the-table commissions charged to insurance companies, but its a fair bet that most of the $845 million it reaped from that source in 2003 went straight to the income line. These commissions might well represent about half of the companys total profit for that year.
Insurers piece of the pie
But what did the insurance companies gain? At first glance, nothing but expense and headaches. First, to play they had to pay those commissions. Second, to keep the game going they had to prepare false bids and sometimes even send their own executives to attend meetings with clients to keep the pretense of competitive bidding alive. Third, low-cost companies couldnt actively compete for new business since Marsh was making the decisions on which firm got which account.
If you know the history of the insurance industry, you can understand why going to all this trouble and expense to help create a rigged market was attractive. The problem is that the insurance industry creates its own boom and bust cycles. In good years, such as 2003, insurance companies write more policies at higher prices. That results in quarters like the second quarter of 2003, when net written premiums (a measure of how much insurance was written and at what price) climbed by 11% in the property/casualty insurance sector. Those good times result in growth in the industrys capital. That would be a good thing (more capital usually is) except that this capital results in an increase in the supply of insurance because companies can use that extra capital to back up new policies. Prudential Equity Group uses a number called policyholders surplus as a proxy for supply: It grew by 19% in the second quarter of 2004 from the same period in 2003.
Historically, most insurance companies have used any surplus to write more policies, even if the only way to sell more insurance was to capture customers from competitors by cutting the price of insurance. Now, theres no reason insurance companies have to write more insurance policies if the premiums they can charge wont make the policy profitable. But historically, this industry has done just that. The good years of 2002 and 2003, for example, followed what Standard & Poors characterizes as a decade of extremely competitive premium prices amid excess underwriting capacity.
Put in that context, the alleged bid-rigging schemes by Marsh, Aon and other insurance brokers have a certain logic: By limiting competition on each bid, the brokers would limit the industrys tendency to compete itself into the poorhouse at regular intervals. That would be especially valuable for a sector, such as property/casualty, which was just getting its legs after a long period of extreme price competition.
Excessive fees
Thinking about that $845 million in commissions as a fee for providing anti-competitive services also helps explain the strange behavior of American International Group (AIG, news, msgs), a huge insurer that, according to Spitzers investigation so far, both paid commissions to Marsh to get business and submitted false bids to keep the scheme going. In 2002, AIG went to the New York State Insurance Department for guidance about the payment of this kind of commission. That in itself was odd because the department had sent out a letter in 1998 to insurers and brokers saying that these fees were improper unless they were disclosed to clients. AIG repeated its request for guidance in 2003. In an interview with The Wall Street Journal, Gregory Serio, New Yorks superintendent of insurance, characterized AIGs letter as a complaint that Marsh was pressuring the insurer to pay larger commissions in order to win business.
Heres how Id interpret that. As a simple business proposition, an illegal one in New York State, mind you, under the states Donnelly Act, which specifically cites bid-rigging and price-fixing as antitrust violations, the fee that Marsh was charging to order the market had become excessive from AIGs perspective.
The insurance industry isnt the only industry to have this kind of cyclical pricing problem. The airline industry clearly does: New entrants attracted by recent profits add capacity, driving prices lower until nobody makes any money. And it certainly isnt the only industry that has attempted to find some kind of extra-legal way to curb its own competitive excesses. The federal government put a stop to what it called collusion by airlines to set prices long before JetBlue Airways (JBLU, news, msgs). Major league baseball owners colluded to set player salaries because they knew that in a truly competitive marketplace, they wouldnt be able to stop themselves from driving salaries ever higher, even if it meant their own bankruptcy.
Should you invest in insurers?
Seeing the $845 million collected by Marsh as a fee for services rather than a bribe can also help you see your way clear to whether you, as an investor, should snap up the shares of any of the insurers that have taken a beating on Wall Street in the days after news of Spitzers investigation broke. Investigation or no investigation, it looks like premium growth in the property and casualty insurance sector is slowing: In the second quarter, it dropped to its slowest pace since the second quarter of 1999, according to Prudential Equity Group. With surpluses growing and putting downward pressure on premiums -- and with the anti-competitive bid-rigging apparatus in disarray -- this wouldnt seem a good time to be bargain hunting in that part of the insurance industry.
Instead, keep an eye on insurers such as Allstate (ALL, news, msgs) that do business in personal insurance (such as car insurance) where the premium trends are still positive. Or take a look at some of the big re-insurers where losses from hurricanes Charley, Frances, Jeanne and Ivan have eaten up surpluses that had begun to drive down premium rates in the second quarter of 2004. (But since the state of Florida will pick up much of the insurance bill this time, thanks to changes legislated after Hurricane Andrew, the re-insurers wont take huge hits this time around nor will the market see the 100% hikes in premiums that followed that storm.) Now it looks like re-insurers will be able to hold rates steady or even raise them in 2005. Re-insurers to watch include Endurance Specialty Holdings (ENH, news, msgs), IPC Holdings (IPCR, news, msgs) and Platinum Underwriters Holdings (PTP, news, msgs).
Of course, stocks like Allstate havent been punished by the market so far as a result of Spitzers investigation.
But it looks like Spitzer is just getting warmed up. The sector is likely to be in turmoil for quite a while yet.
New developments on past columns
5 stocks for the coming technology rally
I think the earnings announced by Texas Instruments (TXN, news, msgs) on Oct. 18 are just good enough. For the third quarter, the company earned 32 cents a share, up 28% from the third quarter of 2003. That was solidly ahead of the Wall Street consensus estimate of 27 cents a share. But the news wasnt as good when the company started to talk about the fourth quarter. For the upcoming quarter, the company expects earnings of 24 cents to 28 cents, below the level of the third quarter, and revenue of $2.96 to $3.2 billion. At the upper end of that range, revenue would be about flat with that of the third quarter. The problem seems to be inventories: Theyve built up at customers and distributors and Texas Instruments will reduce production in the fourth quarter so that it can exit the year with lower inventory levels. At the end of the quarter, the company had 69 days of inventory on hand compared to 66 days at the end of the second quarter. As I wrote in my Oct. 5 column, "5 stocks for the coming technology rally," I think the technology sector has bottomed and is starting to show the kind of upward momentum that often precedes an end-of-the-year rally for the sector. These results are good enough to let Texas Instruments join that potential rally. The stock is an institutional favorite and should pick up end-of-the-year buying from institutions looking for a way to participate in any rally. As of Oct. 22, Im keeping my February 2005 target price of $31 a share.
Im insuring my portfolio with land
On Oct. 20, The St. Joe Co. (JOE, news, msgs) reported earnings of 34 cents a share, a 14% increase from the third quarter of 2003, and 7 cents a share above Wall Street projections. Revenue climbed by 25% and real estate sales were up 22%. Importantly, sales of commercial property, a key in my mind to continuing to build the value of the companys land holdings, doubled in the quarter. In the conference call after earnings were announced, the company confirmed its earlier projections of at least a 25% increase in earnings per share for 2004 to at least $1 a share. Wall Street is expecting more: The consensus for 2004 now stands at $1.25 a share. These are very solid revenue numbers for a period when Florida has been repeatedly attacked by hurricanes. As of Oct. 22, Im raising my target price to $54 a share by February 2005 from my prior target of $52 by December. (Full disclosure: I own shares of The St. Joe Co.)
Editor's Note: A new Jubaks Journal is posted every Tuesday and Friday.
E-mail Jim Jubak at jjmail@microsoft.com.
At the time of publication, Jim Jubak owned or controlled shares of the following equities mentioned in this columns: American International Group and The St. Joe Company. He does not own short positions in any stock mentioned in this column.
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