Description

IHRC is a simple life insurer. It trades at 37% of TBV excluding AOCI.  A major part of the businss is preneed insurance sold through funeral homes. The company also fronts credit insurance with certain financial institutions, under which 100% of the premium is ceded and the company receives a fee. Lastly, the company provides third-party administrator (TPA) claim service to other life insurers.

*** Note: This idea is probably only suited for small funds and personal accounts. ***

Let me delve into the three main knocks on the company, which, in summary, are:

1. Wildly fluctuating book value.

2. Large insider ownership.

3. Annuities.

1. Wildly Fluctuating Book Value: Normally, insurers only trade this cheap when they are in serious trouble. IHRC is profitable but its book value has fluctuated significantly due to investing in oily and mining bonds that were reflected in All Other Comprehensive Income (AOCI). Still, that has not impacted tangible book value, as seen over the past 12 quarters:

It is worth noting that AOCI has always been positive, except for 2008, and that it is relatively small on a $470 million investment portfolio.

2. Large Insider Ownership: The CEO, Harry Lee Waterfield II, is the son of the founder and is 73 years old. He controls 45% of the outstanding stock through a variety of companies, family trusts and benefit plans. There are two nephews on the board of directors and one is general counsel for the company. There were more family members working at the company in the past, including the CEO’s son, Harry Lee Waterfield III, but are no longer there. Other directors and officers own 12%, so there is no chance that the company is bought by another without the consent of the CEO.

The insurance company was started in 1960 by Waterfield's father. Along the way, the company became a holding company, and owns three minor subsidiaries. Two of these subs are insurance related. One is an in-house underwriting organization and the other is a third-party administrator (TPA) for life insurance claims. The last sub is a printing shop that was shut down in 2015.

Here is the pre-need premium distribution by state:

So, 67% of pre-need premium is concentrated in three states.

The company also sells annuities and traditional life products that make up another $29 million in gross written premium. The company does not provide much detail on this but it is about $8 million in annuities and $20 million in life. IHRC also fronts credit life and disability for various financial companies which is included in the previously mentioned $20 million. The risk is 100% ceded to the financial company and the company earns a service fee. The company is not very helpful in providing information on this. For 2015, the administrative and financial segment shows $1,357,000 in revenues. Yet, the 2015 Annual Statement shows that the company received about $2 million per year in ceded commissions and expense allowances. Granted, expense allowances are not exactly revenue but if you're leveraging your existing work force, it kind of is.

I did email the CFO, Larry Johnson with questions and received a reply. However, his response did not go beyond anything said in the Q's and K's (Yes, despite the nano-cap, it files with the SEC). With regard to my questions in trying to reconcile some figures in the 10-K with the Annual Statement, here is his exact response: "While we appreciate your inquiry, you may need to consult with someone outside of our company who is familiar with the differences in GAAP and SAP accounting."

3. Annuities: Low interest rates over the past six years have been taken a toll on annuities. Ten years ago, insurers gladly sold annuities guaranteeing 4-5% yields. In a ZIRP world, this creates a mismatch of assets to liabilities.

Recently, the company entered into a reinsurance agreement on 9/30/2016 that ceded $44 million of annuities, which represents 76% of the outstanding annuity reserves as of 12/31/2015. The company's SEC filings do not provide that breakdown but the regulatory insurance filings do. This is significant because I believe that company earnings have been impacted by annuities over the past few years. Going forward, earnings should improve, as evidenced by 3rd Quarter 2016 EPS jumping to $1.44 after this transaction. Based on the 10-Q foot notes, I estimate that $0.52 of the 3rd Quarter EPS reflects one-time gains from realized gains from selling investments. The company elected to defer the ceding commission over 20 years, so that will have minimal impact to earnings. The coming quarters will tell more.

Earnings: You will see that earnings have been all over the place:

In 2011, the company made several strategic changes, including buying a large block of in-force policies from a bankrupt Texas life insurer. This caused a jump in premiums, investments and assets, but over time, the premiums have decreased as policies lapse or people die. Pre-need policies tend to have shorter duration because these policies are generally purchased by older people. Most senior living facilities now require prepaid funerals as part of admission. In the 2004 interview at the bottom, you can see how the company has pursued this strategy in the past.

About five years ago, the company also entered into a partnership agreement with Puritan Life. This allowed the company to expand into other states. However, there is little visibility as to how much this partnership generates.

The company has been trying to offset the premium decreases by reducing expenses, but there is only so much it can do. In looking at the income statement, the key to the success of the company really depends on the investment portfolio. So let's discuss that.

Investments: The company says that it maintains a conservative portfolio but it seems like yield is important. Here is how the distribution of the fixed income portfolio has changed since 2008:

The great thing about the statutory annual statements is that they list all the holdings, so you can see what the company owns. After 2008, the emphasis shifted away from asset-backed securities to industrial bonds, particularly energy and mining. That is what has caused the gyrations in AOCI.

The company also invests in residential and commercial mortgages. Part of the political subdivision investments include lottery winnings.

The one thing that has been holding the company is the current interest rate environment. Every one basis point (bp) increase in the fixed income portfolio translates into an additional after-tax EPS increase of $0.02. It won't happen overnight, as the average duration on the fixed income portfolio is currently 5.2 years. Still, the company will benefit from rising interest rates.

Risks:

-       Illiquid

-       It is a mediocre business in terms of ROA and ROE.

-       Large insider ownership.

Normally, I tend to structure my write-ups into various compartments, like some German theologian (but please do not mistake me for a German unicorn), but this write-up was a departure from that.

Below is an interview with the CEO and The Wall Street Transcript:

HARRY LEE WATERFIELD II is President, Chief Executive Officer and Chairman of the Board of Investors of Heritage Life Insurance Company and Kentucky Investors, Inc. Mr. Waterfield graduated from the University of Kentucky in 1965. He served five years as an officer of the National Association of Life Companies, the last of which was Chairman of the Board. He received the Association's Poindexter Award in1990. He was one of three founders of the National Alliance of Life Companies and served as the first president of the organization, a position he held two years. In 1995, he received that organization's first Governor's Award. Currently he is Director of the State National Bank, Frankfort, Kentucky; a member of the Board of Trustees, Murray State University Foundation, Murray, Kentucky; a member of the Board of Trustees of Lees College Foundation, Jackson, Kentucky; and a member of the Board of Regents, of Kentucky State University, Frankfort, Kentucky, serving as Vice Chairman of the Board and Chairman of the Finance and Administration Committee. He is Past President of the Frankfort/Franklin County Chamber of Commerce and Big Brothers/Big Sisters of Frankfort, and Vice Chairman of the Frankfort Tourist and Convention Commission. He is a former Board member of Junior Achievement of Frankfort, the Kentucky State Fair Board and the Kentucky Chamber of Commerce. In 1975, he was named one of Kentucky's Five Outstanding Young Men. –

TWST: Would you begin with a brief historical sketch of Kentucky Investors and then a picture of the things you're doing at the present time?

Mr. Waterfield: My father started the company in 1960. It actually started as a life insurance company. We sold our first insurance policy in April 1961. He had started this company for some people from out of state, and in 1963 we organized Kentucky Investors, Inc. We sold stock and bought the out-of-state people out and kind of went from there. We had two stocks up until December 31, 1999. We consolidated the organization in 1999 and now Kentucky Investors owns 100% of Investors Heritage Life Insurance Company, which is 95% plus of our operation. Kentucky Investors, Inc., also owns a small printing operation. We also have a small marketing arm. Most of the things I'll talk about would be in conjunction with Investors Heritage Life Insurance Company, because that's where all of our action is. Currently, the biggest line of business that the life insurance company is in is the funeral home market, with pre-need insurance and final expense. We've been doing that since about 1975. The pre-need market really became a big item in about 1988-1989. The second largest marketing operation we have is through financial institutions, primarily in Kentucky. Our company is licensed in 30 states. We primarily do business in about 15 of those 30 states. But the financial institution market is primarily in Kentucky. There are a few accounts outside the state. The third and smallest arm of our marketing operation is what I will call ordinary life insurance sales through regular insurance agents.

TWST: What is the outlook in each of these areas?

Mr. Waterfield: The outlook has been real good. Last year for the first time in about 13 years, we didn't have record sales in the pre-need market. It had been a steady increase every year. We attribute it primarily to the international situation. The terrorism concerns and the war in Iraq and Afghanistan seemed to affect the older-age market. Of course, the pre-need market is made up of older people, and we saw our first downturn in the first three months following 9/11/01. Immediately we had three months of lower sales (about a 20% decrease) and then it started right back up in the latter part of December 2001. 2002 was another record year. The latter part of 2002 did, however, slow as the buildup began to go to Iraq. Many of our competitors indicated they saw the same thing. Then the economy becomes a concern with a lot of people, particularly in the fixed income, older-age market. We think that's also had an effect. Competition is tough. It's a very competitive market. But we're holding steady. We're not back up to our 2002 levels, but we held steady through last year. We feel that we still have ourselves positioned pretty well. The financial institution market has always depended on the economy. While interest rates are still at historic lows, lending practices (at least in Kentucky) were tightened by most lenders last year, having a direct effect on credit insurance production. That along with new state regulations hurt sales. We're now seeing increased sales as lenders have become more comfortable in dealing with the new regulations. The talk of interest rates beginning to rise again may also have people going ahead and applying for loans before that happens. A couple of key accounts really reined in their lending for a period of time but are now back and aggressively seeking loans. This should also have a positive effect on sales. We have been very proactive in new product development to deal with these scenarios. It's interesting. We probably have fewer complaints in the financial services and pre-need markets than in anything we've ever done. There just never seem to be too many problems in that, as far as we're concerned. We try to keep up with any complaints pretty closely and have to and want to, anyway. I think when the economy turns around, we'll see some improvement and I think as the international issues clear up (if they ever do) it would certainly help us.

TWST: Are you adopting any new strategies to deal with the current situation?

Mr. Waterfield: Our strategies haven't changed a great deal. In the financial institution area, we're creating some product changes that we think will be more acceptable. We're finalizing some of that. In the pre-need market, I think we just have to keep working hard with the current accounts. Of course, we're always trying to get new accounts and try to learn if there's anything that we can do differently marketing- wise. There's one example of an account in a total retirement community in the Southwest. His business was really good, but it just dried up following 9/11. We haven't seen anything that dramatic in our other accounts. They're scattered around 15 states and they're not all in retirement communities. But we're trying to determine what changes need to be made and I'm not sure we've hit on what that ought to be. Interest rates are affecting this market. It's an interest sensitive product and of course the interest rate that we can invest money at is really low and has been for a couple of years. That affects what we and other companies can pay, and that has an affect on the funeral homes that are selling the products. It's a battle along those lines, trying to maximize what you can earn and what you can pay. I think the key thing from our standpoint is to make sure that our accounts and the people we work with know we're dedicated to the market and intend to stay in it for the long run and are positioning ourselves to that. We've seen some companies come in and out of that market because they don't understand it. We've been in it long enough where we think we understand it and we think we know how to try to weave through some of the pitfalls.

TWST: Do you feel you have some advantages over your competitors?

Mr. Waterfield: At our size and with the people we have to compete against, what we've tried to do is to commit to service. We think that from the administration, internally and from our marketing executives that call on these accounts in these various states, we have to provide the best possible service. We have a reputation for awfully good service from the standpoint of having quick turnaround on claims payments to trying to give our agents and funeral home accounts all the modern techniques to look up information at a moment's notice. Customers can get online and get policy information. If someone dies over a weekend and we're not open, they can get online and find out what the policy value is so they know what they're dealing with at that moment. We've tried to provide outstanding service throughout the history of the company. We've been pretty attuned to keeping service at the top. We've tried to be very personal in our relationships with our salespeople. No matter what arm of our marketing operation it is, whether it's a regular insurance agent or a pre-need counselor of the funeral home owner himself or a bank representative, we've tried to build very personal relationships with them from all of our staff. That's been pretty successful for us.

TWST: Have you given any thought to mergers and acquisitions?

Mr. Waterfield: We have. We have bought a company or two in our past. We've bought some blocks of business in the past. In 2002, we bought a very small company in Maryland. More than anything else, it helped us get in the state, rather than just filing and getting in. This company was owned by another type of operation. It was not really an ongoing, new business type of operation. They wanted to spend their energies and money on other things. I think the Department of Insurance really wanted somebody to take them over, so we did that and it got us into the state. It wasn't a big block of business, although there were some nice policies for us to manage. We do look at blocks of business maybe more than companies. We purchased a sizable block of preneed business from a guaranty association in 2000. Then we are also doing some outsourcing and administration for other companies. That's something we want to try to grow. For a company our size, we have and have had for a number of years some pretty sophisticated administrative operations. From the computer standpoint, we've invested a lot of capital in that. We've developed almost all of our own programs and we have capacity to do a lot. Our manpower internally has gone down considerably but we can manage so much more business with fewer people. We've not had to fire anybody, but we've not had to replace some people as they leave, retire or whatnot. We have the capacity to manage other blocks of business. We just recently signed a contract to do all the administrative work from policy development to underwriting to claims payment for a new company that's just been organized.

TWST: Would handling administrative business for other companies be a major opportunity for the company, going forward?

Mr. Waterfield: We're going to try to make it that, yes. We've talked a lot about doing it. Another thing we do on our financial services side, where we sell credit life and ordinary life through banks, particularly on the credit insurance side, starting about 10 years ago, we re-insured 100% of that business away. But then we manage that block for the re- insurers. We also manage a few little blocks of business for some companies that maybe didn't have enough that they wanted to continue doing it. Third party administration is an area that we've tried to develop. We're going to dedicate much of a particular employee's time to seeking that type of opportunity.

TWST: You said that the pre-need insurance has been your biggest element and that the regular insurance is much less. How did those proportions come about? Is there more you could do with regular insurance?

Mr. Waterfield: It just developed over time. Back in the 1970s, we started writing a small final-expense policy, along with our rate book product. For a company our size, particularly back then and even now, it was very difficult to compete selling ordinary life insurance products against the big giants. So from an ordinary life standpoint, we've tried to have a basic product or two (and still do have) and then in the mid- to-late 1970s, we got involved pretty heavily in the final expense market. We went to North Carolina to do something else, but had that product in our portfolio. It was just one of those things where we were at the right place at the right time. We found a marketing group that was working with some funeral homes there, and so we started selling our product down there and did very well with it. Then another company that had been in that market for a while wanted their agents to sell one of our products. About a year after that, that company decided they wanted to sell that block of business. We bought it, and that got us in about 100 funeral homes, where they had been selling that type of insurance for years and even had a collection system. They were kind of running a debit operation out of their funeral homes. We bought that and that really got us off and running in the funeral home market. That was in the mid-1970s. We did that for a good while. In about 1988, 1989, I'd never heard the word pre-need or pre-arrangement and I'd been in the funeral home market for about 15 years and had just never heard of it. I can remember getting my first call from one of my district managers in North Carolina. He described what he needed and I said, 'It sounds like you need to sell an annuity' because the client was way beyond our age limits, even on our final expense policy. To make a long story short, we were able to dovetail into the pre-need market. It just became a good marketing tool for us, where we didn't have to compete against New York Life and those type of folks selling all the big stuff. We still sell some basic whole life product and some basic term products, but with that kind of business you have to finance agents and we just can't do that. We try to sell where we think we can sell and compete and survive, and prosper, for that matter.

TWST: What would you expect the company to look like three years from now and what would be the milestones along the way for investors to notice?

Mr. Waterfield: The interest rates are going to have to go up some to look real good. Right now, there are signs that the worm is turning, maybe, and interest rates are going to start going up. We were having really good, steady growth and the pre-need market looked very promising to us. We still have great hopes for it. We just think we're in a period we need to fight through until interest rates go up. I think that would help us a dramatic amount. A 1% increase in our investment rate makes a dramatic difference. We see ourselves in those same markets and we see ourselves doing more partnerships and joint ventures and things of that nature. In addition to that, we see ourselves trying to expand the third-party administrative activity. We'll probably be spending more time on those types of things. We spent so much time developing our sales and positioning ourselves just with the hard-knocks of selling insurance that maybe we'll have a few of our key people spend a little more time on joint ventures, partnerships and that type of thing.

TWST: Do you see any need to improve the company's capital structure?

Mr. Waterfield: We're going to try to do that. We're talking about that a lot. We haven't decided how we want to do it, but we are looking at it.

TWST: You've been with the company since you were very young?

Mr. Waterfield: I got out of high school and started working. I went to college and worked part time. It's all I've ever done.

TWST: Were you studying insurance in college?

Mr. Waterfield: I studied business and commerce. I think my degree was in commerce. I don't know whether they do commerce degrees anymore, but I think that's what it said. There were no insurance courses of any consequence. I think there might have been one or two courses and that was it. But I never did go anywhere that had anything like that back then, so I just kind of grew up in it.

TWST: What about your colleagues? Could you tell us about a couple of the key people in the company?

Mr. Waterfield: Our CFO and Chief Administrative Officer is Raymond Carr. He's just outstanding. He is an accountant by education and has become an expert in computer matters, so he knows insurance accounting backwards and forwards. He's become head of our administration mainly because it's so computerized that he oversees all of that. Raymond is a real asset to us. Our General Counsel is Rob Hardy. He's my nephew. He practiced in a large, diversified law firm for a few years and then joined us. He handles all of our real estate mortgage lending. We have a portfolio that has run about $25 million over the last five or six years, average. We've had outstanding results in our mortgage loan portfolio. Our marketing man is Don Philpot. He had an extensive background in ordinary life before he joined us. He's been with us for 30 years. He handles all of our pre-need and ordinary insurance sales. He's at retirement age but in good health and loves to work and will probably stay on for three to five more years. Even if he retires, he'll probably do some contract work with us that will be very valuable. On the bank side, Michael Dudgeon is our marketing officer there. He's also a nephew. We've several family members working for us. I've got two nephews and two sisters and a daughter who work for the company.

TWST: How many employees do you have overall?

Mr. Waterfield: We have 95. Eight years ago we employed 125 and maybe three or four people on the road doing sales and calling on accounts such as banks or funeral directors or insurance agencies. Now we've probably got 84 administrative people here and 11 on the road in North and South Carolina, Kentucky and other states doing marketing. There's been a change there because with the administration we can do with the computer systems we have, we were able to cut down the employees that crunch the paper, and we've been able to concentrate more on those that are out trying to get sales. We handle much more business with fewer administrative people.

TWST: Does this mean that you can increase revenues without adding more people?

Mr. Waterfield: Yes, and that's what we've been doing for several years and the people we added were people getting the sales. But that number has been pretty steady for six or seven years. We haven't chosen to add any. We're licensed in New Mexico, for instance. It just hasn't made any sense for us to go to New Mexico, hire somebody, spend X number of dollars on salary, benefits and travel expense to try to develop anything there. If we find somebody who has good accounts and can bring them to us, we'll do that. But that's kind of how we've decided to go into other states; when there's a real reason to be there and if it shows some signs of quick returns, rather than going and spending a lot of money. We've just tried to develop where we knew we could pretty quickly.

TWST: How much effort do you put into investor relations at this time?

Mr. Waterfield: Because there is not a large volume of trading activity in our stock, we don't spend a significant amount of time with investor relations, probably not as much as we should. We have about 4,650 shareholders. Once you get outside board members and the original investors, most of the stockholders have a very small number of shares. But we're in touch with them. Our corporate Secretary is usually the person who talks with shareholders when they call us with questions about their stock and the company. We are our own transfer agent, but we don't do a lot of promotional type work.

TWST: What is your feeling about your current stock price?

Mr. Waterfield: Our stock price has been very steady over the years. It has always traded at a discount to book value primarily due to the fact that there is not a large number of shares outstanding and the trading activity is fairly thin. We have had few complaints from our shareholders and we are constantly reviewing the situation to provide the best value possible to our shareholders. One of the things that we think about when we consider raising capital is whether we want to issue any more shares which may ultimately increase activity.

TWST: How is it that you're on the bulletin board?

Mr. Waterfield: Our stock was traded on NASDAQ's over-the-counter system for many years. As you may recall, the requirements for listing over- the-counter were changed several years ago to mandate minimum trading volume or to significantly increase listing and listing maintenance fees. We received a call from J.J.B. Hilliard & W.L. Lyons, Inc., a regional broker and one of our market makers, suggesting that the bulletin board and the pink sheets were sufficient for our current needs and we would significantly reduce costs by making the switch. So we elected to do that. And it appears to be serving our needs well at this time.

TWST: Could you give us the two or three best reasons why the long-term investor should take a good look at Kentucky Investors?

Mr. Waterfield: We believe there is good value in our stock. As I mentioned earlier, it has always traded at a discount to book. That fact, coupled with our long-term goal of continuing to build a strong insurance company could be a great opportunity for a long-term investor. For anyone who does invest in us, I wouldn't advise them to look for any dramatic, quick turns. I don't see anything quick happening. We've been in it for the long haul. We're dedicated to building the insurance company and therefore, Kentucky Investors, Inc. It's long-term and we want the organization to stay in operation and continue to grow. We'venot sold out or been bought out. That's been a goal since we started, to build a long-term operating company. We're dedicated to doing that, and obviously we want to see the stock grow and see the value grow. Everything I've got is in this, as well as my family, and so we're very interested in doing well. We've had many of opportunities to sell the company, but we haven't wanted to sell because we have wanted to develop a strong, lasting company. We have a lot of pride. We're Kentuckians and we've seen nearly all the domestic insurance companies in Kentucky either consolidate or liquidate. I think any investor should know we have that pride and we want to build.

TWST: Is there anything you want to add, particularly with regard to your long-term objectives?

Mr. Waterfield: We're in this for the long-term, to build solid growth. We don't want to go out of business. We don't have any interest in selling out. We want to build a Kentucky-based operation. If I were based in some other state, I'd be saying the same thing. This just happens to be our home. It's always been our goal and our dream to build a solid, long-term company. We're 43 years old now, and we want to be going strong in 40 more years. We want to be successful. We're not pie in the sky. If we had wanted to run in and run out, we could have done that a long time ago. That's the way we operate.

TWST: Thank you. (MC)

HARRY LEE WATERFIELD II Chairman, President & CEO Kentucky Investors, Inc. 200 Capital Avenue Frankfort, KY 40601 (502) 223-2361 (800) 422-2011 - TOLL FREE (502) 875-7084 - FAX www.ihlic.com e-mail: ihlic@ihlic.comCopyright 2004 The Wall Street Transcript Corporation All Rights Reserved

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