Property Casualty insurance and reinsurance (which I collectively refer to as (re)insurance) is an interesting sector for investors, in that performance can be highly diversifying within an equity portfolio. Valuations are currently low, with the sector trading at close to book value, and growth prospects are strong. However the sector is quite unique, and there is some complexity behind the business model that investors need to understand to make informed decisions.
Diversification stems from two areas:
Firstly, one of the key risks insurers run is that they insure large natural catastrophes, events that happen randomly and with little stock market correlation.
Secondly, insurers have large balance sheets with long-term policyholder liabilities, and they hold assets to balance their liabilities - often in bonds, a further diversification to an equity portfolio.
These two areas also reflect the two ways that insurers create value for their shareholders :
Underwriting result - paying out less, in claims and operating costs, than bringing in in premiums.
Investment result - generating a return on invested funds. This is the "float" made famous by Warren Buffett at Berkshire Hathaway (BRK.A), where the insurance operations focus is to underwrite risk, which generates cash for investment at a lower cost than other sources of capital.
The following chart shows the current valuations of a sample of the sector: ACE, AIG, GLRE, XL and PRE. These show some consistency around modest forward p/e multiples of 10 -11, cheap compared with the broader market at current valuations, with XL having broken out dramatically in the last quarter.
ACE Forward PE Ratio data by YCharts
The sector offers significant growth, with insurance demand, especially in the property segment, growing faster than GDP, as the cost of natural disasters has risen exponentially to economic growth, as demonstrated by this article from New Scientist.
Different risk drivers for different companies.
To understand the variety of risk profiles in the sector, consider the chart below, which plots the stock price changes over the last five years between ACE and PRE, compared to the S&P 500 (SPY).
PRE data by YCharts
In 2009, ACE share price closely followed SPY in the sharp asset sell-off. PRE was also affected, but fared much better. Conversely, in 2011, PRE lost significantly more value than SPY, as the losses on the asset side were compounded by a bad year on the risk side caused by the Japanese Tsunami, New Zealand Earthquake and Thai Floods. On face value, the stocks are broadly similar, but underlying differences in their business models generate dramatically different outcomes.
Important areas for analysis
Analysis of this sector follows the 'combined ratio' as a key performance indicator. The combined ratio of an insurance company reflects the percentage of premium income that is paid out in claims and expenses. The lower the combined ratio, the more profitable the underwriting activities of the business. However, the business mix of the company plays a critical part in evaluating the quality of performance. Insurers refer to 'short tail' and 'long tail' lines of business. The 'tail' refers to the time that elapses between receiving the premium, and the payment of the average claim. Typically property business has a shorter tail, and casualty longer.
This is important, as the longer tail lines of business generate more investment 'float' and thus a company with a longer tail business mix can generate strong earnings even with a high combined ratio. The downside to longer tail business is that it is harder for the insurer to calculate the right price for its product, and the insurer is more exposed to changes in investment yield.
By comparison, a company with a higher weighting to property has more exposure to large single events, such as Hurricane Katrina or Superstorm Sandy. Their results are more volatile, with lower 'float' and thus they need to run their business at a lower combined ratio.
Geographical and product mix is also important. Insurance works as a mechanism to spread risk between policyholders, and the bigger the pool of policyholders, the more efficiently the risk is spread. If insurers operate in a range of different countries and sell a variety of products, they have better diversification of risk, and thus have less risk of negative overall underwriting results. Insurers with lower diversification use more reinsurance as a way to manage underwriting risk. More on reinsurance follows below.
As insurers, especially those with a longer tail portfolio have large provisions for future claims, they have assets, which are usually multiples of their annual turnover. Management of the asset base is a vital function of the business given that, as mentioned above, asset management is one of the key value drivers of the business model. When you invest in a insurer you are buying a share of its investment portfolio. Think of the analysis needed to invest in a closed-end fund - an investor in a insurer should exercise similar diligence in understanding its asset strategy.
In addition to the considerations on asset management faced by any investor, insurers have some additional factors at play:
Asset liability matching - With the assets under management earmarked for paying future claims, insurers need to invest their assets to minimize the risk of mismatch between liquid assets available and claims due for payment to policyholders. This requires careful matching of duration and currency.
Regulation - The industry is highly regulated, with one of the major areas of oversight being on the asset side. Different regulatory domiciles have different rules for asset management. It is important to understand how domicile impacts a insurer's asset strategy. Some regulators may be overly restrictive, others too lax.
Market pricing cycles
Insurance pricing is much more cyclical than other markets. Uniquely this business doesn't know when it sells its product (sets premiums) what it will cost to produce it (cost of claims plus expenses less investment return). Both long tail and short tail classes have high uncertainty of their production cost. In long tail classes this is because claims are subject to cost inflation over time, and for property and marine insurance there is the uncertainty of the costs of earthquakes or extreme weather. While much is made of sophisticated actuarial models, in reality these rarely make a totally accurate estimation of claims costs. As a result, when the models get it wrong, and claims exceed expectations, insurers lose money. Prices rise. This attracts new capital to the sector, and until the next surprise, prices fall.
The critical success factor for insurer profitability is management of this pricing cycle - the company with the best pricing technology and cycle management discipline will outperform. This means that, although it is counter-intuitive, the company that grows the fastest in a period with low claims isn't always the best long term bet. The most profits are made in the years after periods of poor results.
Reinsurance is essentially insurance for insurance companies. To cap earnings volatility, and maintain capital efficiency, insurers purchase reinsurance. Reinsurers, in their turn, buy their own reinsurance, either traditionally, which is referred to as retrocession, or by hedging with financial instruments.Typically these take the form of Insurance Linked Securities such as Cat Bonds.
Understanding reinsurance arrangements can be challenging. The arrangements are complex, and often not well disclosed. It is important to understand reinsurance purchases, as they control the true volatility of the business. A highly conservative reinsurance purchase is capital efficient, but can be a costly strain on earnings, however,with too little reinsurance, volatility spikes.
Carefully study disclosure of reinsurance arrangements. If there is little transparency, look at the gross to net premium ratio (the difference is the cost of reinsurance) and compare similar companies gross and net claims costs in large events. As mentioned above, the more diversified the risk profile of the company, the less reinsurance is needed. The quality of reinsurance counterparty is also important - this is a product that responds to extreme events, so choosing reinsurers with strong claims paying ability is a must.
Reserves are the funds that insurers set aside for the payment of future claims. These constitute the largest part of an insurance balance sheet. The adequacy of reserving is a key risk for the value of an insurance company - only invest in a company which you believe to be well reserved. In order to assess this, consider the following aspects:
Claims paying ability - insurers obtain a claims paying ability rating from one or more of the external rating agencies, S&P, A.M. Best, and Moody's. The agencies assess the reserve levels as a critical component of the rating, and assign a rating partly on the capital held above reserves for future liabilities.
Portfolio stability - a company that has grown by acquiring competitors has usually assumed the liabilities of that company. Surprises frequently crop up in the 'back book' of acquired insurers. Be careful when considering an investment in a company that has acquired significant blocks of long tail business.
Reserving practice - insurers will usually detail their reserving practices. The main elements here are the 'probability of adequacy' and the 'risk margin'. The 'probability of adequacy' is an actuarial term describing the reserve quality, the 'central estimate' is a 50% probability of adequacy (the best guess of the future claims). The 'risk margin' is the amount by which the reserves exceed the 'central estimate'. Both refer to the conservatism of the reserving estimate - high numbers are good.
Prior years' development - if the 'central estimate' of future claims is exactly right, the 'risk margin' will be released gradually as claims are paid. This is disclosed as prior years' development. A well reserved business will have stable prior years' development reserve releases. Watch out for negative development (claims have been underestimated) or very positive development in years of poor underwriting performance (reserves might be plundered to keep earnings up).
The bottom line.
This article seeks to simplify a highly complex sector by exploring the key risk drivers at a high level. Many analysts seem to miss some of the key issues when they recommend stocks. There are specialized analysts who cover the sector, and they should comment on these key areas. My advice:
- If you are attracted to the sector by asset diversification alone - buy bonds.
- The best risk diversification is from companies with shorter tail portfolios - more property than casualty.
- The sector offers growth and value - current price levels are due to past underperformance, you need to pick the winners.
- Key ingredients are : best in class underwriting, asset management, distribution, capital management and diversification.
- If you aren't confident about navigating this complexity, an ETF such as KIE should follow the sector quite well. KIE has a mix of P&C, life insurers, reinsurers and insurance brokers.
I will be looking at some stocks in this sector in upcoming articles to evaluate some of these areas.
Additional disclosure: I am a personal investor, sharing analysis of the sector for information purposes.