Friday, August 26, 2011

Spotlight on Insurers

For stock analysts, insurance is typically an industry that doesn't get much attention.  Of course, all that changes a few times a year when a hurricane is barreling towards the eastern seaboard.  For those brief moments, everyone likes to look at insurance companies.

On CNBC this morning they're throwing around a $10B loss estimate (Katrina was a $40B loss event for comparison).  Below is a comp table for some of the largest property casualty insurers in the US, "EqTotA" is the book value of the equity on the insurer's balance sheet.  This group has a combined capitalization of $367B, so $10B is just a drop in the bucket, especially considering that a large portion of  any losses will be shared with reinsurers not listed here.  So, the hurricane shouldn't move the needle too much for insurers, but while the insurance industry has our attention, I took the opportunity to put some non-hurricane related data in front of readers.

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Insurance companies, like the rest of the financial space are trading at multi-decade low multiples.  Insurance analysts will tell you that this is because the industry is overcapitalized and as a result there is too much money chasing too few policies.  This negatively impacts pricing and causes insurers to underwrite policies at a combined ratio above 100%.  This means that insurers aren't making an underwriting profit or are losing money on every premium dollar that they take in.  In addition, an insurer makes a high percentage of its profits from investing its float in fixed income markets--with yields at multi decade lows, this is another headwind for insurance company valuations.  

Still, there's a strong argument to be made that at prices well below book value, these concerns are already priced into the stocks.  The largest personal lines insurers TRV, CB, ALL and PGR have had admirable ROEs over the last 5 years compared to current valuations, and if there's one thing that the insurance industry knows how to do well, it's return capital to preserve ROE.  Since 2007, TRV for instance has bought back almost 40% of shares outstanding, taking share count from 668m to 418m today.  Such massive returns of capital indicate a willingness not to chase market share in a poor pricing environment.  

The prices of these companies seem to indicate that the markets don't agree.  Prices seem to be indicating that the property casualty business lacks discipline and will write policies chasing market share until a negative event causes the industry to blow up.  

And prices may be correct, but consider this: securities analysis and insurance analysis are like yin and yang, two sides of the same coin.  Both arts are successfully practiced by individuals effectively pricing risk.  Therefore, securities analysts pointing the finger at the insurance industry for a state of overcapitalization may do well to examine their own industry and specifically fixed income markets.  

Overcapitalization and excess liquidity are different terms for the same concept.  In the insurance industry too much capital forces risk premia to unsustainable lows until a negative event proves that the underwriter wasn't being fairly compensated for catastrophe risk.  In the securities industry excess liquidity forces prices higher and yields and risk premia lower until a negative event proves that the buyer wasn't being fairly compensated for credit and inflation risk.  

In fact, both industries exist in a state of overcapitalization, but only the securities of one industry are pricing in the risks associated with that environment.  If the goal of a securities investor is to buy the security that is properly priced for its risk, then perhaps the property/casualty business may be a good place to look.  At least in that industry, buyers are returning capital to maintain ROE.  I can't remember the last time PIMCO behaved in a similar fashion.

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