The Art of Short Selling - If You Can't Read It, Short It

Most companies write reports that are comprehensible to a person with a fair knowledge of accounting terminology. Some companies write reports that are impossible to follow, even for accounting experts. Experience suggests that if you cannot understand a report, officers are hiding something worse than you expect. It is almost an iceberg phenomena: If you find five or six serious questions in financial statements, you can be sure that there are many more that you cannot see. If a call to the company for explanation receives a garbled response that sounds suspiciously like the company official is speaking in tongues, you have got a live one.

The simplest form of financial obfuscation is detected by tracking the growth in receivables versus the growth in sales. Outsized growth leads the analyst to search out policies on booking revenues and collecting cash.

Any asset that does not have a ready market value is fair game for asset shuffling. The following are the most important points about insurance company financial statements:

1. All insurance companies are required to file annual financial statements with the state insurance department (filed in March).
2. These statements require different accounting practices ("statutory accounting") so they don't match GAAP. The driving force of statutory accounting is liquidity. The spirit of the rule is the determination of solvency or of claims paying ability. 
3. All this fits together in one number called surplus (similar to net income). 

The proper valuation of assets and liabilities is most important to the accuracy of the surplus total. Surplus provides the cushion for surprises and the funds for expansion. It is the heart of an insurance company. It also determines how much an owner can take out and whether the regulators take over.

Insurance companies have a lot of leeway on the carrying value of securities, particularly when the assets do not have a public market value. As a critical bystander, all you have to do is cast doubt on the quality of some of those assets to avoid owning the parent stock. If you question a significant number of assets relative to surplus, short the parent.