Independence Holding Company (“IHC”) is a specialty insurance company that focuses on niche insurance markets largely abandoned by larger insurers.  IHC is actually poised to benefit from expansion of health coverage and the current turmoil in the healthcare insurance marketplace resulting from Obamacare.  With these benefits driving earnings growth, significant cash flows due to NOLs, and the closure of a valuation gap, I believe that IHC could be worth over $22/share.

Why does this opportunity exist?

• It’s a small-cap with very little trading volume:  Despite a market cap of $230m, IHC only trades ~$200K/day. 
• It’s overlooked, hard to get to know, and confusing:  IHC has no brokerage analysts and no conference calls (hence no transcripts), but it has multiple lines of business, all of which are somewhat arcane in their own right.
• Controlled company status keeps activists away:  IHC is 52% owned by Geneve Holdings, which is owned by the Netter family.  Edward Netter founded the company in 1980, and it continues to run like a family-run business.
• Real assets are not on the balance sheet:  IHC not only has significant value in NOLs on the balance sheet of American Independence Corp. (“AMIC”), but it also could turn its health insurance internet assets into valuable operating businesses.

IHC now owns 90% of AMIC, which has been a creeping buyout so as not to violate change of control restrictions under Section 382 of the tax code.  AMIC still has $271m in NOLs, mostly generated from its time as a dot-com in the 1990s (seriously).  With the sale of an insurance subsidiary to AMIC in 2002, IHC became a minority investor in AMIC, and has been buying it out ever since.  Now IHC is putting its most profitable new lines of business in AMIC to take advantage of the NOLs.  Note that for comparison purposes, IHC only started to consolidate AMIC’s financials in mid-2010.

IHC (including AMIC) has five lines of business: Medical Stop-Loss (33% of gross premiums written) , Major Medical (28%), Group Life and Disability (17%), Supplemental and Ancillary (17%), and Individual Life and Annuities (5%).  They largely take risk via three A- carriers with a focus on higher margin niches of the insurance market.

The biggest growth area for IHC has been and will continue to be Medical Stop-Loss, which is benefitting from some changes as a result of the implementation of Obamacare.  There are two key components of the Affordable Care Act that are driving their success in this business.  First, under the law, self-insured companies are exempt from some health insurance requirements.  This is surely due to the lobbying efforts of very large companies, most of whom are self-insured.  Second, in order to get the popular support needed, Congress could not allow older people (pre-Medicare, so think ages 50-64) to have premiums that actually reflected the risk in covering them.  So they limited the level of premiums for the old relative to the young to a level that is artificially low.  In sum, relative to actuarial analysis, the old will be getting a great deal under Obamacare; the young – not so much.

So what is a small company with a relatively young workforce to do?  Self-insuring with a stop-loss policy makes a lot of sense.  If they stay with their current insurance, they will see significant rate increases as a result of cost-shifting from the old to the young.  Or they can self-insure, giving their employees a similar coverage level (and likely even including some of the consumer-directed health programs that help control costs by making the employees cost-sensitive to healthcare decisions).  This should be a significant benefit to the employee as well, since an alternative to being in a self-insured plan through their employer is going into the state or federal exchange, which shifts the costs from the old and sick to the young and healthy.  If the employer does end up with one or two catastrophic claims, they can get a stop-loss policy to mitigate the outlier risk.  That’s where IHC comes in. 

Another reason why IHC is doing so well is because of some changes they made to the business structure a number of years ago.  Over a decade ago, medical stop-loss insurance was sold through independent Managing General Underwriters (MGUs).  Think of these as another level of independent insurers who made underwriting decisions backed by a reinsurer.  Starting in 2001, IHC began to buy their MGUs and bring the underwriting and risk in-house into a subsidiary called IHC Risk Solutions.  With a streamlined structure, IHC could make better underwriting decisions with a more efficient operating structure.  At this point, third-party administrators and brokers don’t want to work with MGUs because if an MGU starts to produce losses, their reinsurance carrier will drop them, and the broker/TPA will have to start all over with a new relationship.

What has been the result of these two factors?  Medical Stop-Loss is growing over 20% per year, with IHC Risk Solutions growing greater than 30% with better margins, while IHC’s MGU business (they still do business with 4 MGUs) is shrinking.  Keep in mind that IHC has seen this growth prior to the implementation of the largest part of the law, which will come into effect on January 1, 2014.

The implementation of health reform is bringing other challenges and opportunities to IHC.  In 2014, they will cease selling major-medical policies for individuals and families (the subsector that has been the subject of a lot of media attention lately) since these policies do not comply with the law’s requirements.  In the meantime, they will expand their sales and distribution of a host of other niche insurance products, ranging from pet insurance, dental, short-term medical insurance, and overseas travel.

Interestingly, IHC’s greatest hidden asset may be from AMIC’s ownership of the URL www.healthinsurance.org.  Within a few years, the selection of health insurance will be much more driven by individual consumers rather than human resources professionals.  If the lessons of other types of complicated products like auto insurance, mortgages, or higher education is any guide, the opportunity for significant lead generation revenues from a website like that is real, but unquantifiable at this point.  This URL has seen a 25% increase in visits from 2010.

Valuation Summary:

On an LTM basis, IHC trades at about 11.2x EPS and P/E of 0.8x, which compares to 1.3x Accident and Health Insurance and 1.4x for Life Insurance.  Despite the significant discount, IHC has some attractive valuation features that are not incorporated into that valuation. 

Let’s start with AMIC.  AMIC has a market cap of $91m, with no debt.  Investments exceed insurance liabilities by $30m.  NOLs total $271m, which will not begin to expire until 2019.  If we assume that the NOLs are valued at only 25% of the face, that’s $67m.  So to be conservative (and make the math easy), let’s adjust the market cap by only $61m.  That leaves us with adjusted market cap of $30m relative to a book value of $102m and LTM EPS of $1.26.  That would be a P/E of approximately 3x and a P/BV of 0.3.  Now it makes sense why IHC is buying in AMIC shares as quickly as they can without restricting the NOLs.

Now turning to IHC (standalone): IHC owns 90% of AMIC, so the AMIC value embedded within IHC is $82m (not adjusting for excess cash and NOLs, as described above).  So the implied market cap of IHC is $148m with standalone book value of $186m (backing out the AMIC book value since they’re consolidated).  This is a P/BV of 0.8.  P/E is meaningless, since IHC attempts to book all profits at AMIC, since that is where the NOLs are.  IHC is left with more corporate costs and lower-margin lines of business.

So in summary, IHC is a stock representing a specialty insurer with a low 0.8x P/BV plus 90% ownership of a specialty insurer trading at 0.3x P/BV.  Plus, its biggest and most profitable line of business is growing greater than 20%/year prior to the acceleration of some significant tailwinds from the implementation of health reform.

Finally, IHC is run by a capable management team that has decades of industry experience and the backing of a long-standing family that has demonstrated that it is focused on creating value in the long run.

Risks:

• Underwriting quality
• Lack of liquidity in the stock.  If someone wants to get out for some reason, it could take a while.
• Increases in interest rates.  With an average duration of ~6 years, IHC shouldn’t get hit too hard if interest rates increase on a mark to market basis, but they’ll get hit nonetheless.

Catalysts:

• Greater growth from trends brought about by the implementation of Obamacare
• If valuation gap persists, IHC will likely use its excess capital to buy back stock.