A lot of people are concerned about the insurance industry, and many analysts expect its troubles to worsen. Insolvencies are on the rise.
Which companies will be next?
That's hard to say, since many analysts may not know how to interpret the industry's financial statements properly.
Irving Kellogg of Los Angeles-based Kellogg Associates, a CPA and one of the most perceptive readers of corporate reports, specializes in uncovering hidden dirt in balance sheets and income statements. He thinks that the insurance industry, because of the complexities of its accounting methods, is "wide open to abuse and fraud."
He says that this opinion is underscored, in part, by recent experience: the failure of state regulators to detect financial problems prior to insolvencies. This "has proven that regulation is inadequate," Kellogg says.
In a sobering, 116-page report, Kellogg says that the insurance industry's financial health is obscured by the use of different accounting methods in reporting to state and federal authorities and investors.
"Even for investors with advanced backgrounds in accounting, ferreting out the facts is, at best, perplexing," he says.
Kellogg is particularly troubled by aggressive managers who, he says, have twisted standard accounting methods to "create illusions of solvency."
Close analysis, he says, shows that bankrupt companies were able to keep up "an illusion of solvency for years after they should have been declared insolvent."
Investment portfolios of many insurance companies are "hidden
minefields," he continues.
While the major life-insurers don't have large holdings of junk bonds, he notes, the holdings they do have could lead to big problems if there are defaults.
Still worse, he says, is the reliance by many big insurers on the "upstreaming" of dividends from subsidiaries. The money is used to pay debts, cover expenses, and pay dividends to shareholders of the parent company.
Sometimes upstreaming makes the parent's cash flow -- the difference between money coming in and going out -- look artificially strong.
Particularly troublesome to Kellogg is the case history of Drexel Burnham Lambert, the sorely troubled investment-banking firm. After federal regulators banned it from siphoning cash from its subsidiaries, it was forced to file for bankruptcy.
Kellogg says that if state insurance regulators made a comparable move by prohibiting the upstreaming of cash flows from subsidiaries to parent insurance companies, they could be caught in an equally deadly cash squeeze.
BANKRUPTCY BETTING: "It used to be that you could find a troubled company with a decent business, buy some of its bonds for a few cents on the dollar and stick them in a drawer," says George Putnam 3rd, of the Boston-based Turnaround Letter. "After a year or two, you would almost be assured of a good profit."
"Now you have to do more digging to find the good companies, watch their securities trade for awhile to make sure the short-term players have been shaken out, figure out how many creditors come ahead of you and what they are likely to leave on the table, and finally, be ready to ride out the volatility before the ultimate value is realized," Putnam says.
He cites a number of reasons, including a sharp rise in the supply of distressed companies and the influx of institutional investors, who used to avoid bankruptcies.
"There are probably more bargains than ever out there," he says, "but there is a lot more dross to go through before you find the gold."