Flavors of Insurance, Part I

by: David Merkel, CFA

I view the insurance industry as a loosely related group of sub-industries, where knowing something about one sub-industry tells little about any other sub-industry. Even within each sub-industry, companies can be very different from each other. This article will attempt to go through the vast wasteland that is the insurance industry, and attempt to point out some of the more interesting aspects of it.

There are three major risk factors with insurers: the underwriting cycle, investment returns, and expense control.

1) The Underwriting Cycle

The property/casualty insurance industry, like all mature industries, is a cyclical business. Cyclical businesses revolve around pricing, which involves the relative degree of capacity available in the industry.

The P/C industry derives its capacity to write business from the amount of surplus available to support business. This creates a four-phase cycle for the industry.

  1. When surplus is abundant, rate-cutting is prevalent, and generally poorer-quality business gets written in an effort to retain market share. Terms and conditions for insurance are loose. During this period, the prices of P/C companies fall relatively hard, as prospective estimates of profitability fall.
  2. After enough poor quality business gets written, and premium rates decrease meaningfully, high quality companies exit lines of business, or buy reinsurance, and low quality companies begin to look impaired. At these times, the stock prices of high quality firms fall a little, and low quality firms fall more.
  3. As the results of bad business become evident, reserves get raised, sometimes drastically, and surplus declines. When surplus is deficient, premium rates rise, and the stocks of companies that have survived the cycle rise dramatically. The best business from both a profit and risk control standpoint, gets written in this phase of the cycle Terms and conditions for insurance are tight.
  4. When surplus becomes adequate, premium growth rate slows, and stock prices rise slowly, at roughly the rate of retained earnings. This continues until surplus is abundant.

Catastrophes, when they happen, temporarily reduce surplus, and improve pricing. The companies least affected by the cat rally, and those most affected, tend to fall, or rise little. Major catastrophes can cause the cycle to bottom, or extend the positive side of the cycle, because surplus is diminished.

The rating agencies tend to cut ratings near phase 2, and raise them near phase 4. Diminished ratings decrease the amount of business that an insurer can write, and further limit the willingness of prospective purchasers of insurance, particularly long-tailed coverages, who want to be sure that the company that they buy insurance from will be around to pay claims.

2) Investment Returns

Strong investment returns increase surplus. In a bull market, some companies become more aggressive about writing business so that they can earn money from investments. This is particularly true of companies that sell coverages that result in long-tailed liabilities. Strong investment returns prolong phases 1 and 4 of the cycle. Investment returns were so strong throughout the 1990s that insurers often compromised underwriting standards, leading to much of the troubles that occurred in the industry from late 2000 to early 2003. Not only were investment returns low or negative, but the results of prior poor underwriting were realized through reserve adjustments that diminished surplus.

3) Expense Control

Every time a premium gets calculated, there is an estimate embedded in the premium for expense. Expenses typically take three forms: policy acquisition, claims adjustment, and operational. There is a tendency for expenses to drift higher when investment returns are strong, and when the market is softening due to greater competition.

Now I will discuss each sub-industry separately. Included in each discussion is a description of products, risks, and industry performance over the last ten years. The graphs show the performance of each sub-industry over the last ten years, derived from my own proprietary indexes. At the end, I give my outlook for each sub-industry.


Bringing It to the Present:

This series was written seven years ago in an all-nighter for my new boss. The piece never saw the light of day, which annoyed me, though I liked my boss, and I never complained about it.

As I publish the ten-or-so pieces of it, because it was long, at the end of each installment, I will try to update the insurance subindustries to the present. But it would be useful for anyone reading this to look at my presentation to the Southeastern Actuaries Conference on the "Amazing Decade for Insurance Stocks." Aside from that, I have lost the graphs of the original presentation. My apologies.

Insurance is an amazing business. Insurers make promises. Many of the promises are uncertain with respect to amount and/or timing. That makes the accounting complex. This is one of the reasons why examining the qualitative aspects of an insurance company to understand how a management team makes decisions is so valuable.



Life insurance probably has the most complex accounting of any of the sub-industries. Part of this comes from the complexity of the contingencies underwritten, and most of the rest from producer compensation and the length of the contracts underwritten.

Life insurance and annuities are sold, not bought. In general, people have a mental bias toward thinking that they aren’t going to die in the immediate future. Annuities are often sold to people who won’t otherwise plan for their retirement. To overcome those biases, life insurance companies pay agents handsomely to originate policies. The commission is large enough that if the company expensed it, it would lose money on a GAAP basis every time it issued a policy. That’s why policy acquisition costs are deferred, set up as an asset, and amortized in proportion to the gross profitability of the business over the life of the business.

Reserving for term policies isn’t very complex, but reserves for cash value policies are set as the expected present value of future benefits less future premiums. Small changes in interest, mortality, and lapse rates can make large changes to reserve values. Other contingencies can affect different classes of policies as well; variable and indexed contracts rely on returns of the stock and bond markets. Higher assets under management mean higher fees.

There is a second business that most life insurance companies engage in. Since the companies would not be profitable if they invested in Treasury securities, they typically invest in corporate bonds, mortgage-backed securities, and other risky forms of debt. Some also invest in commercial mortgages and real estate. When there is stress in the credit and mortgage markets, life insurance companies do poorly.

In reviewing the performance of life companies as group from March 1994 through March 2004, one can see the effect of the major drivers of profitability. Underwriting was typically profitable for companies throughout the entire decade, so that was not a differentiating factor. Most of the shifts in profitability came from investment results. The credit cycle was generally positive to the beginning of 1999, negative 1999-2002, and positive after that. The equity market supported variable life and annuity writers until the bull market peak in March 2000, punished them until March 2003, and has rewarded them since then. The only period that deviated from this description was after the bubble popped in March 2000; life companies temporarily did better as equity investors fled technology stocks for the safety of stodgy sectors like life insurance.

The outlook for life insurance is no different than the past; it is tied to the outlook for the asset markets. If the credit and equity markets do well, so will life companies.


Bringing It to the Present:

Many of the things that I wrote back in 2004 regarding life insurers have proved prescient. Life insurers have prospered as the asset markets have prospered, and suffered during the bear markets. On average, life insurers have done better than other financials, and better than the market as a whole since 2004.

One advantage the life insurers had 1999-2003 was that they got burned on CDOs and did not get caught in the bubble. Even with other types of structured lending, life insurers got more conservative 2003-2005, unlike most of the rest of the financial sector. Life insurers noticed the poor underwriting, and stayed away.

It should be noted that there are life insurers that do a lot of variable business, and those that don’t. Those that write a lot of variable life and annuities will be more sensitive to the stock market than those that don’t write a lot of variable business.

One final squishy spot: secondary guarantees. With Universal Life and Variable Annuities, there are secondary guarantees where the reserving is questionable. Also true of long-dated term policies… be aware that there might be some bombs lurking there, that will manifest in severe economic scenarios.


Personal Lines

If someone wants to drive a car or take out a secured loan, personal lines insurance typically needs to be bought to protect the interests of other drivers, and lenders, respectively.

Personal lines coverages are simpler in their form, in that they typically renew annually. Commissions are smaller than for life products. Reserves divide into two classes, those for the premium paid but not yet earned, and those for claims incurred. Incurred claims fall into two categories: those reported to the company, and an estimate of those incurred but not yet reported to the company [IBNR].

Personal lines insurers have two sources of profit, underwriting and investment income. The track record of the industry has been less than stellar. Most companies over the past fifteen years have lost money on underwriting and made money on investments. In general, the best managed, and most profitable personal lines writers give up sales growth in order to have an underwriting profit.

This has been less true of homeowners’ insurance, where personal lines writers have consistently lost money on underwriting. Part of the reason for that is homeowners is often treated as a poor stepchild to auto insurance, and only used to generate additional automobile premium.

Performance of the personal lines insurers over the past ten years reflects the relatively hard market through 1997, with strong investment performance through 1999 not getting reflected in stock prices. Money was flowing away to technology stocks. In March of 2000, the next hard market began, and the stocks personal lines insurers rebounded, despite relatively poor performance in the investment markets.

At present, the personal lines insurers are entering phase 1 of the underwriting cycle. Premium rates are trending flat in automobile, and rising in the low single-digit percents for homeowners, but the increases are slowing. Valuations are not excessive, so there should not be a major selloff, unless premium rates soften dramatically. We expect premiums to remain flat for a while, so personal lines stocks should perform at roughly the rate of the return on equity for now.


Bringing It to the Present:

We are back to Phase 1 of the underwriting cycle. There have been no big disasters, God-given or man-made to deplete surplus, for a long time.

My view is that the personal insurers should always trade at a premium to the commercial insurers because they are safer. It is always easier to run a short-tail company than a long-tail company. At present, that relationship is normal.

Personal lines companies have a tailwind in that the zeitgeist has policymakers taking actions to prevent accidents — graduated licensing, anti-drunk driving, making cars safer for drivers even it creates more cars that get totaled, while passengers survive better.

Valuations are reasonable-to-cheap in aggregate here, and the same is true of the life sector. I am overweight insurers by a factor of six, relative to their weight in the indexes. They comprise all of my exposure to financials.



I am rarely a fan of commercial lines insurers. Over the past ten years, it has been the lowest returning sub-industry in insurance. There are several reasons for this: first, asbestos has been an open-ended drag on the industry’s surplus. Second, many commercial lines companies underwrote coverages where those insured understood the risk better than the companies. Examples of this include directors and officers, errors and omissions, surety, environmental, and political risk. Third, the devolving legal landscape has often left commercial lines insurers at a disadvantage in the courtroom. Policies get interpreted as providing coverage in ways not contemplated at the contract’s inception. Fourth, wars over market share depress premium levels.

Commercial coverages are typically larger in size, and do not share in the law of large numbers to the same degree that life and personal lines do. Underwriting results have a greater degree of variability because of this. The greater degree of profit and loss potential attracts less cautious insurance executives, underwriters, and investors. This can lead to tremendous results in the stock market if you buy the commercial lines stocks just as the underwriting cycle shifts from phase 2 to phase 3, such as in 2000. It can be equally bad if you buy them as the underwriting cycle shifts from phase 4 to phase 1, such as in 1998-1999.

Reserving for commercial lines insurers is similar to that for personal lines insurers, but the main difference comes from the uncertainty of claims reporting in long-tailed coverages. With auto and home coverages, most claims are filed and settled within a few months. Almost no claims extend over two years. Now considerable environmental damage coverage: claims could be filed decades after occurrence, settlement could take years, and the size of the claim could be significantly larger than anticipated. This makes reserve setting for commercial lines insurers more of an art than a science.

Secular shifts in society can utterly change the probability and severity of claims. As an example, consider directors and officers [D&O] coverage before and after 2000. Many of the events in the corporate scandals investigated in the last few years came from events in the 1990s. Insurers writing D&O coverage in the 1990s had to raise their reserves for accident years the 1990s but the financial result was felt between 2001 and 2003.

Many industry analysts, including the rating agencies, still believe that reserves are insufficient by roughly $50 billion, and that this black hole is spread among the commercial lines insurers and reinsurers of the world. The soft market accident years of 1997-2001 are blamed for this insufficiency. The question that wins the big money for this space goes to the clever analyst that can figure out to whom the black hole belongs.

The $50 billion insufficiency is probably why the stocks of the commercial lines insurers have gone nowhere over the past six years, even in the face of a very hard insurance market over the past three to four years. Commercial lines insurers are in phase 4 of the underwriting cycle, with modest valuations at present. Until the insufficiency is dealt with, or proven false, it is our belief that commercial lines stock will remain rangebound.


Bringing It to the Present:

Well, in 2004, I was wrong here. Leaving aside AIG (NYSE:AIG), and its losses, and understated reserves, the commercial lines sector did quite well. Yes, it is very difficult to value commercial lines insurers, because the reserving is less than scientific. But the difficulties alleged by the rating agencies failed to appear, unless they were somehow sloshed into the hurricane disasters of 2004-5, or like eating an elephant — one bite at a time.

Earnings quality of commercial insurers is always lower than that of personal lines insurers, so the group should trade at a discount to personal lines, as it does now. And all that said, personal lines insurers did outperform the commercial insurers, even excluding AIG.



Reinsurance takes on the risk profile of the insurers that they reinsure. Put simply, reinsurers pay a portion of the claims reinsured in excess of a threshold, in exchange for a premium paid to assume the risk.

Ten years ago, the major European reinsurers, together with Lloyd’s of London (NYSE:LYG) dominated reinsurance. Many major US companies had significant reinsurance operations. These statements are less true today. The European reinsurers have been downgraded because of past poor underwriting, reducing their current reinsurance capacity. US firms have tended to specialize over the last decade. Many companies closed, sold, or spun off their reinsurance operations.

There has been a tendency for reinsurers to migrate to Bermuda over the past ten years. There is a combination of professionalism, favorable regulation, and low taxation that encourages reinsurers to set up shop in Bermuda. A great deal of opportunistic capital shows up and forms new companies after major disasters, in order to take advantage of the higher premium rates available. This has had the effect of making it hard for older reinsurers to heal after a major catastrophe, such as Hurricane Andrew or 9/11. They bear the claims, but get less of the benefit of higher premiums because of all of the new competition.

This makes the character of a reinsurer’s management team all the more important. It is very difficult to bounce back from big underwriting losses, so conservatism in reserving and rate-setting is required for long term financial success. One key to assessing conservatism is whether a reinsurer will slow down in a soft market, and return capital to shareholders. It takes humility and discipline to sit back when market conditions aren’t favorable, and your competitors are growing their premium volumes rapidly.

In one sense, because of opportunistic capital, the reinsurance industry resembles a series of Lloyd’s syndicates. After a major catastrophe, new companies form that have no legacy liabilities, and write fresh business at high premium rates. They are similar to Lloyd’s syndicates at their start. Old reinsurers tagged with claims from the catastrophe resemble Lloyd’s syndicates with open years that they can’t close, because the claims have not settled, or the claims impair their capital. The older reinsurers, once hobbled, will have a tendency to slow down, and perhaps merge their way out of existence.

One more new issue is reinsurance receivables. With all of the credit downgrades, many insurers find themselves with reinsurance receivables from claims that they submitted, but have not settled yet. There are quite a few insurers and reinsurers that have reinsurance receivables greater than their capital and surplus. In a crisis, where prompt payment from reinsurers is needed, a high degree of reinsurance receivables from low rated insurers could result in ratings downgrades, and possibly insolvency. This has led many insurers to request collateralization of reinsurance when dealing with lower rated reinsurers. To the extent that reinsurers agree to collateralization, it makes their assets less flexible, and reduces the degree of leverage that they can operate at. Most reinsurers are resisting posting collateral, but so long as reinsurance receivables don’t get paid rapidly, and credit quality is low, the demand for collateral can only grow.

Investment policy for reinsurers is similar to that of the companies that they reinsure. Most reinsurers run conservative portfolios, because they take enough risk underwriting reinsurance. Some newer reinsurers are using hedge funds as part of their investment strategy, thinking that they can earn more investment income, but with lower risk. The jury is still out on this approach. We fear that some of the reinsurers are taking on what we call “too smart for your own good” risk, and that hedge fund investments will prove to be less diversified than they expected in a crisis, perhaps even a crisis with insurance claim applications, like 9/11.

Reinsurers mirror the hard and soft P&C markets globally, but with greater volatility. The hard market 1994-1997, gives way to a soft market 1998-2000, followed by the 2000-present hard market. Property reinsurance rates are slowly falling at present, but rates are adequate for profitability. Casualty and Life reinsurance rates are rising but at slowing rate; the amount of rise varies considerably by line of business. In general our outlook for reinsurance stocks is positive, but highly selective. Stick with conservative management teams and you will do well over the full underwriting cycle.


Bringing It to the Present:

This was written before the hurricanes of 2004 and 2005. Think about it. After 2005, there was a belief, supported by the concept of global warming, that hurricanes would be far more than in the past. I did not buy that. Two years of bad hurricanes is not a trend; four might be.

Cut to today. Five wimpy hurricane seasons. No earthquakes. Few huge European Windstorms. Few hurricanes hitting Japan.

That doesn’t mean the future will be good. In fact for reinsurers, because surplus is so adequate, premiums may be too low. But valuations of reinsurers are low, reflecting that risk. I ind the sector reasonable but not cheap.

>> Continue to Part II

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Disclosure: Author long ALL, SAFT, CB, PRE and RGA