Is Citizens Life Insurance A House Of Cards? Strong Sell
Summary
- Citizens Inc. is a low-quality life insurance company trading at sky-high valuations of 66X P/E and 4.5x Price/Tangible Book, yet faces multiple total wipeout risks.
- CIA sells insurance overseas without a foreign presence with questionable legality - while a questionable "Stock Investment Plan" artificially generates temporary demand inflating CIA's stock.
- When foreign insurance regulators wake up, there could be huge fines that could completely wipe CIA out - Brazil fined peer company NWLI $6 billion.
- CIA has -75% to -88% downside just to trade at a similar valuation as superior peer company NWLI. Multiple additional risks create potential for -100% overnight loss and total wipeout.
- The economies of CIA's largest end-markets in South America are imploding, creating serious macro headwinds for CIA.
Citizens Inc. (NYSE:CIA) is a life insurance company that trades at sky-high multiples of 66X P/E and 4.5x Price/Tangible Book, despite anemic low-single digit ROE and nominal growth prospects. I believe the stock is grossly inflated by artificial and temporary demand generated by the company using policyholder money to buy its own stock. Furthermore, the threat of regulation, devastating fines and an unraveling of its business all have the potential to completely wipe out CIA stock overnight. Even if CIA somehow manages to avoid all the ways it could be wiped out, when it re-rates to a rational valuation, CIA has -88% downside from valuation alone.
This is how I see CIA's scheme, and I seriously question its legality:
- CIA sells life insurance in developing countries where it has no legal presence, using intermediaries where they "do not determine whether our independent consultants are required to be licensed to sell insurance".
- CIA then lends some of the cash from policy revenue BACK to the policyholder under its "Stock Investment Plan".
- The policyholder (in part through a Panamanian trust) then buys CIA shares in the open market!
(chart by me)
How big is this scheme in proportion to CIA's total business?
- I estimate 95% of CIA's life insurance is sold to non-US customers.
- CIA states it has no international offices or licenses, and does not determine whether independent consultants are licensed.
- I estimate over 60% of the shares outstanding are now owned by these policyholders (The 85 y/o CEO controls the company with super-voting "B" shares).
- A shocking 75% of CIA's tangible common equity[1] is the $52mm of policy loans
- In 2013, 52% of CIA's pre-tax earnings came solely from interest on these policy loans.
Anything where common stock is used as collateral for a loan reminds of Enron's famous "special purpose vehicle" schemes Whitewing or Raptors that would buy junk assets using Enron's own stock as collateral: when the stock began to decline in 2001, the whole scheme unraveled with the rapidity of a margin call.
Why would policyholders need or want to borrow money from CIA at 7.5% to buy stock in the open market, when they can get a margin loan from a broker today for <1% given how low interest rates are? Why would they want to buy CIA's stock using this loan? Something seems very fishy to me...
Is CIA Selling Insurance Policies Overseas Without a License? Isn't this illegal?
Insurance, especially life insurance, is a highly regulated business, where you need a license to sell, underwrite or basically have anything to do with the business. When a family has a death, they need to know that the company behind a promise made to them is truly solid. Citizens earns 95% of its policy revenue overseas (as of the most recent Q), and yet admits in its own SEC filing 10-K that it has:
"no offices, employees or assets outside of the United States" and "we do not determine whether our independent consultants are required to be licensed to sell insurance in the countries in which they market our policies".
CIA lists as a risk factor:
"If our independent consultants were not in compliance with applicable laws, including licensing laws, they could be required to cease operations, which would reduce our revenues. We have not obtained any advice of counsel in any foreign jurisdictions with respect to these matters."
In developing countries, where CIA gets its premiums (Venezuela and Colombia are the two largest sources, representing 22.3% and 19.5% of its total premiums respectively), insurance regulators are unfortunately not as vigilant as in the developed US market.
If the regulators in these countries woke up and demanded all CIA associates be licensed, could the existing premiums be rescinded, or could CIA be forced to cease operations in these countries? Given the precarious set-up using CIA's own common shares for policy loans, could this lead to a devastating "run on the bank" and wipe CIA stock out completely?
I believe investors buying CIA stock at 66x earnings and 4.5x tangible book value are not appropriately analyzing the potential for total stock wipeout and complete loss.
What extra risks do foreign citizens have in collecting claims from a company without a license to even sell insurance in their country? There has been at least one class action lawsuit where consumers sued in Texas, in an attempt to recoup their policy payments. The lawsuit alleged that certain life insurance policies CICA made available to non-U.S. residents, when combined with a policy feature... were actually offers and sales of securities that occurred in Texas by unregistered dealers in violation of the Texas securities laws. The remedy sought was rescission and return of the insurance premium payments.
Is CIA Also Selling Securities Without a License Overseas? Isn't this illegal?
In addition to turning a blind eye to whether its agents are licensed to sell insurance, CIA also appears to neglect whether these agents are licensed to sell securities.
According to the 10-K Risk factors:
"The majority of our foreign policyholders choose to invest their policy dividends or other cash benefits in our Class A common stock through the Citizens, Inc. Stock Investment Plan (the"Plan"). If a securities regulatory authority were to deem the Plan's operation contrary to applicable securities laws, we risk facing fines and penalties and cease and desist orders which would create a reduction in the amount of Class A common stock purchased on the open market through the Plan."
It wasn't until January 2013 that CIA filed the proper documents with the SEC to allow it to operate such a stock investment plan; therefore, I believe it's possible that all stock sold under the Plan prior to this time period was illegally sold, and that the SEC could take action against the company.
Potential Fines Could Be Enormous If Overseas Insurance Regulators Wake Up?
CIA could also get completely wiped out if overseas regulators get smart to what is going on, and fine CIA for selling insurance without proper licenses. In fact, a very similar company, National Western Life Insurance (NWLI), was issued a $6 billion fine after Brazil realized it was selling insurance without proper licenses:
"On October 26, 2011 the Brazilian Superintendence of Private Insurance ("SUSEP") attempted to serve the Company with a subpoena regarding an administrative proceeding initiated by SUSEP in which it alleged that the Company was operating as an insurance company in Brazil without due authorization. The Company has been informed that SUSEP is attempting to impose a penal fine of approximately $6.0 billion on the Company."
NWLI appears to be a larger, much more profitable company than CIA, with a similar business model (except for CIA's uniquely questionable "Stock Investment Plan" that I believe is temporarily dramatically inflating the price of CIA's stock). In fact, the CEO/founder of CIA started his career at NWLI, and literally runs CIA across the street from NWLI's offices! CIA's CFO also previously worked at NWLI.
Given the risks inherent in issuing international insurance without a license, as demonstrated with the Brazil outcome, NWLI trades at a discounted valuation: a P/E of 8X and P/Tangible Book of about 1.0x vs. CIA's astronomical 66X P/E and 4.5x Price/Tangible Book. How else can one explain the massively higher valuation without the source of temporary and artificial demand for CIA's stock generated by its "Stock Investment Plan"?
How Big Could a Fine be if Regulators Woke Up? - Venezuela Example
Brazil regulators woke up to NWLI selling insurance without a license, and in 2011, fined the company $6.0 billion. CIA's biggest market is Venezuela, with about 22% of premiums. I estimate that Venezuela alone could fine CIA amounts ranging from $110-882m. This is an impossibly devastating amount for CIA, who only has $320m market cap and ~$70m of tangible common equity.
A legal opinion we received estimates that:
"foreign insurance companies not licensed in Venezuela that insure risks "located in Venezuela" are 1) unenforceable and 2) subject to a fine of one thousand (1,000) tax units (approximately US$ 20,158.73 at the official exchange rate of Bs. 6.30 per 1 USD) to eight thousand (8,000) tax units (approximately US$ 161,269.84 at the official exchange rate of Bs. 6.30 per 1 USD). Moreover, performing insurance activities or insurance brokerage activities without a license issued by the Insurance Superintendence, may subject the violator to criminal prosecution"
Using this framework, I estimate below that CIA could face a $880m+ fine from Venezuela alone.
(chart and estimates built by me)
Policy Loans for the "Stock Investment Plan" Appear Unsustainable
CIA, like many life insurers, issues policy loans, which are loans originated by an insurer to a policyholder, backed by the cash value of the insured's policy. While these loans are usually benign, due to the previously described risk of policy rescissions at CIA, these loans could prove to be toxic for the company. Because the collateral for such loans is the underlying value of the life insurance policy (which accrues value with the payment of premiums), if CIA is required to refund its customers' premiums, then the collateral against which these loans were underwritten ceases to exist.
With no collateral backing these policies, CIA could run into major solvency issues, particularly since the debtors are not US citizens, and CIA, as previously discussed, has no offices, employees or assets outside of the US - which I believe makes collection on these loans virtually impossible. With these policy loans now representing 75% of CIA's tangible common equity (up from 38% just 3 years ago), losses on these loans could be disastrous for CIA.
Additionally, in recent years, CIA appears to be relying on these high-interest loans to pad its anemic earnings (as well as, reportedly, to enable policyholders to continue paying their premiums, and in turn, buy more CIA stock). What's more, the interest rate "earned" on these loans is well above normal at 7.4% vs. 3.8% for the rest of its investment portfolio; accordingly, in 2013, 52% of all of CIA's pre-tax earnings come solely from interest on these policy loans (in 2009, this figure was only 12%).
The enforceability of foreign laws to a US-domiciled company is a double-edged sword for CIA. If you argue that it is not at risk of paying (potentially massive) foreign fines because it lacks a foreign presence - you also realize that it could have a tough time collecting on foreign policy loans that represent 75% of its tangible common equity!
"Stock Investment Plan" shares
It appears to me that CIA first used a Panamanian Trust for virtually the whole administration of its "Stock Investment Plan", and according to a 2005 13D filing, this Trust owned 17.4mm shares, or about 45% of the total shares outstanding. Today, this Trust only officially owns about 10% because there was an administration shift to putting the shares into the names directly of the policyholders for reporting purposes. Estimating 1.5mm shares bought per year through the program (pg. 8 of 2013 10-K), I estimate that today over 60% of the total shares are owned via this plan.
(chart and estimates built by me using public information)
South America Facing 2014 Recession and Riots: Could This Be The End for CIA?
It is no secret that South America is facing serious economic headwinds in 2014. Brazil, Argentina and Venezuela seem to have all entered recession in 2014, and I believe the other countries in the area will be deeply affected.
Venezuela Riots: "Not The Best" for Defaults or Collecting on Policy Loans
(picture credit PressTV)
Columbia: Molotov Cocktail Bombs Likely "Not Good" For Business in 2014
(picture credit Guardian)
In addition to all the legal, regulatory, structural, valuation and other countless risks CIA shareholders face, the largest markets and drivers of CIA are all entering recession, and will be a headwind for CIA's business.
What happens to CIA stock if CIA's policyholders stop paying premiums, cancel insurance plans and consequently remove demand for CIA stock? What happens to CIA if this occurs while people are defaulting on policy loans?
Public Shareholders Have NO Voting Control Over Their Company
Perhaps most concerning, what do CIA public shareholders even own? Because the potential insurance violations are occurring outside of the US - and therefore, not directly harming US citizens - the Colorado Division of Insurance and other domestic regulators have so far allowed CIA to continue to operate with near impunity in CIA's South American markets (95% of its business). Moreover, because of special provisions in the Class B shares, the company's founder, 85 y/o Chairman and CEO Harold Riley, who owns all of the B shares which control the Board seats and thus the company - draws a salary of $1 million per year. Given that the publicly traded "A" shares are mostly mopped up by the trusts and policyholders via the "Stock Investment Plan", this mechanism allows the scheme to continue, while Riley can maintain control via the B shares.
Why is CIA Management Running CIA This Way? What is the True Purpose of This Company?
CIA insiders have collected an absolutely shocking $29.1m (so far) in total compensation (per CapIQ) since 1998. CEO Harold E. Riley alone has collected an astounding $11.5m, and just the four Rileys listed by CapIQ have collected over $20m from this "business".
(chart built by me using CapIQ publicly available data)
Management Response:
I spoke with CIA's IR department, and was surprised by the lack of details and financial assistance they were willing to provide. Initially, they tried to pass me on to the transfer agent, an entity I believe would likely know virtually nothing about the details of CIA's business. I have never had that happens to me before, and I found this quite suspicious.
Then, when I asked about CIA's international business, the person at CIA could not even give any facts or figures to help explain CIA's exposure. When pressed for any information about the policy loans CIA is making, the individual's response was "that is also not my area of expertise". If the individuals at CIA appointed to help shareholders claims have little or no understanding of the international business (95% of premiums) or the policy loans (I estimate at ~75% of CIA's tangible equity), what exactly are they there to do? If you are a shareholder of this company, I would encourage you to immediately call the company and ask them for detailed answers about the international regulatory environment they operate in, and I hope you get useful answers, because I certainly did not.
In the past, there have been many sudden shareholder wipeouts resulting from the toxic combination of financial leverage, regulatory risk and a lack of transparency. I urge caution.
I encourage you to read CIA's internal "Purpose, Principles, Philosophy & Beliefs" statement:
"The principles which guide our actions are: the ethical standard, morality, integrity and spirit of our conduct should at all times be at a high level"
I personally find this ironic and more than a little offensive.
The "Plungerine" Makes His Call: CIA Is A Long-Term $0.00
(picture by me)
Conclusion: -88% Downside with Potential for Total Wipeout
I think that CIA's transfer agent, Computershare, should seriously investigate what is going on with this "Stock Investment Plan"; and I believe the SEC and insurance regulators in the US, Venezuela and Colombia also should take a deep look at this as well. I do not think people should have to worry about trusting the livelihood of their family upon their death to an insurance policy that may be sold without a license, which may be unenforceable, from a company that appears to drive demand for its own stock with "shaky-looking" methods.
Just to trade in line with comparable NWLI (which is much larger and more profitable), CIA's stock would have to decline between -75% and -88% (depending if you use a P/TangBook or P/E multiple).
Even more concerning, I see multiple ways CIA stock could get totally wiped out and go to $0 overnight. When this comes unwound, I believe it will happen virtually instantaneously, and I urge you to be cautious.
Lastly, CIA has abundant borrow at cheap rates, and so I view shorting CIA stock as an essentially free option on the various ways CIA stock could go instantly to $0. There has already been one lawsuit and inquiry, and I believe it is simply a matter of time before CIA comes completely unraveled. In the mean time, you are short a low-quality insurance company at 4.5x tangible book value that has negative retained earnings, where the majority of the business is in imploding South American economies.
[1] Tangible common equity = $70.5mm = Total common equity ($265mm June 30, 2014) - Deferred Policy Acq. Costs ($151mm) - Goodwill ($18mm) - Cost of Customer Acquisition ($26mm)
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Analyst’s Disclosure: The author is short CIA. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it. The author has no business relationship with any company whose stock is mentioned in this article.
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Comments (15)
Hi, PS --Definitely some funky stuff going on here, but it seems like a tough short. They've been doing this for years, and have a built-in pipeline for equity sales above book, when and why should anything ever change?Yours,
RP
