Insurance and a Potential Turn in the Underwriting Cycle

Includes: AOC, MMC, TRV, WLTW
by: Gloria Vogel, CFA

The property-casualty industry is very cyclical, with new capacity entering when prices are rising, and leaving when underwriting losses become apparent. Typically, the property-casualty underwriting cycle doesn’t turn until industry capital is depleted by a significant amount. The catalysts for the drop in capital can be catastrophic events such as hurricanes or earthquakes, or loss of capital from investments. It may come as the result of a single large event such as 9/11 or Katrina, or from a combination of events that eventually tip the scale towards premium price firming. It is the relationship of the loss relative to capital or surplus that matters.
Historically, hard markets have lasted for much shorter periods than soft markets, and have followed negative surplus growth. Hard markets occurred from 1975-78, 1984-87, and 2000-2003. As for the current market, net written premiums have renewed at downward rates since 2003, and declined from 2007-2009, the first 3-year drop in written premiums since the 1930s.
While property-casualty and reinsurance stocks move with interest rates and overall financial markets, they also react to premium rates and underwriting losses. The stocks are especially sensitive to the rate of change in premiums – the second derivative of price change. Initially following an underwriting event, the stocks drop as investors try to anticipate where the losses will be greatest. Then as premium rates firm, the stocks advance in anticipation of improved earnings.
January 2011 commercial policies mostly renewed at lower rates, as insurers were hit by a still weak economy, and there was more than adequate capacity available. Premiums are a function of premium rate and unit growth, and correlate closely with GDP. However, personal lines started to show modest price firming late last year.
Following the BP oil spill in 2010, there was some speculation that the underwriting cycle would turn, and rates did firm in the marine energy sector, but not for the industry as a whole, due to excess capacity. Moreover, most of the BP losses were paid by BP and its partners, as the company was self-insured. But, in recent weeks, the insurance industry has been hit with an abundance of bad weather globally, a second major costly earthquake in New Zealand (estimated insured loss of $8 billion), and now a very sizeable quake and tsunami in Japan. With low interest rates keeping investment income growth down, it is likely that the tipping point may finally have been reached. At lower investment yields, underwriting losses need to be lower to earn the same return, placing a greater burden on underwriting and pricing discipline.
Japan is one of the largest insured markets after the U.S., with significant market penetration. There will be extensive property damage and loss of life from the quake/tsunami event that just occurred – most likely well north of $10 billion. Notably, Japan has seen many quakes before and it is the most prepared for quakes, but 8.9 on the Richter scale is a monster quake that ranks as the fifth largest globally since 1900. Despite Japan’s preparations, there are fires burning, and two of its nuclear facilities are out of control (one building has already exploded), potentially resulting in widespread radiation contamination. Also, a major airport has been closed, and the tsunami has torn apart homes, cars, boats, etc. in the affected region. While Tokyo has been largely untouched, there are bound to be significant aftershocks that could yet cause business disruptions and damage.
Much of the insured loss from the Japanese quake will be borne by the Japanese insurers and global reinsurers, and those stocks sold off on Friday on the initial news. However, many of the cat bonds issued in recent years have been designed to transfer major catastrophic loss for Japanese and/or U.S. earthquake to investors, so the reinsurers will not bear the full burden of the losses. Indeed, in recent years insurers have used alternative financing vehicles to raise capital and spread risk -- cat bonds, insurance-linked securities, and sidecars – with funds coming from hedge funds or private equity sources.
According to the Wall Street Journal, the Japan quake or tsunami
may affect more than $1.5 billion of specialized securities called natural catastrophe bonds, leaving investors scurrying to determine their potential losses. … At least eight cat bonds have exposure to the Japanese earthquake….About $12.1 billion of nonlife catastrophe bonds are outstanding globally.

This event thus has the potential to alter the appetite of investors for cat bonds, putting a greater future burden for losses onto reinsurers, who will then be more inclined to raise rates.
It is still too early to see official loss estimates of insured damages from the Japanese earthquake and tsunami, but a Hannover Re Group spokesperson noted in Business Insurance that:
it will turn the prices in Japan…. it seems this earthquake could also have implications on worldwide capacity and spring a market change.
With Munich Re’s 2011 profit goal already hurt by the New Zealand quake, and with Swiss Re’s hit from the New Zealand quake already breaking its 2011 budget, it is likely that this event will represent a market turning point. S&P also believes that it could spur a market turn, with first quarter 2011 catastrophe losses nearly matching full year 2010 cat losses. If so, then investors might want to take another look at investing in insurance stocks after the losses are known. Insurance brokers, and primary insurers or reinsurers with limited exposure to Japan and New Zealand, would be the preferred investments after the dust settles.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.