Improving Visibility in the Insurance Sector Post-Japan's Earthquake

Includes: ACE, SCOR, TKOMY, XL
by: Alicia Damley, CFA

Last Friday’s earthquake in Japan continues to take an enormous toll on that nation, its people, its insurance sector, and global reinsurers. Grim images of the damage and a still-heightened nuclear risk continue to be reported.

Historically, an opportune time to purchase insurance and global reinsurance stocks is following a large catastrophe – for example, after Hurricane Andrew, the World Trade Center, and Hurricanes Katrina/Rita/Wilma. Key to the investment decision is a working estimate of the total insured cost, individual company loss and, importantly, the impact on industry pricing trends.

An external assessment of actual loss by companies in this event is difficult. Instead, a review of the market environment fills in large gaps. Broadly, damages related to nuclear risk, unique to this event, are the responsibility of the Japanese government, as the event was triggered by a “grave” natural catastrophe. Insured losses will arise from earthquake-related damage to insured property (residential, commercial, auto), marine and aviation vessels and business interruption costs. Domestic stocks that account for most of this business are Tokio Marine Holdings (OTCPK:TKOMY), MS&AD Insurance Group, and NKSJ Holdings. Foreign insurers focus on commercial lines, but Japanese exposure does not account for a significant portion of their overall business.

For the domestic insurers, while the magnitude of company losses is mitigated, the growth opportunity is capped. Despite high earthquake risk, Japanese insurance penetration in residential property and auto is surprisingly low. While reinsurance arrangements limit losses for primary insurers to a maximum of JPY425.8 billion ($ 5.4 billion), with less than half of homeowners purchasing this insurance, losses tend to be further limited. For example, the industry’s worst earthquake cost was JPY78.3 billion ($1.0 billion) in Jan. 1995.

Commercial property and business interruption coverage are the other large categories. Again, underlying commercial insurance penetration is low, with many businesses self-indemnifying. Business interruption coverage, which can be a source of larger loss claims in North America, is also lower and must be purchased separately.

Consequently, while the three Japanese stocks have corrected in line with the market index, continued low insurance penetration limits growth. Post this event, whether more Japanese customers demand higher earthquake-related coverage remains to be seen, making it too early to conclude on the investment opportunity.

Reinsurance, on the other hand, stands to benefit directly from rising pricing trends. First, Japan’s reinsurance business, which accounts for approximately 15% of global reinsurance premiums, renews this month with negotiations just beginning. Price increases, which will be determined by the size of this insured loss, will immediately begin to benefit the P&L. This increase would build on already-rising prices following large industry losses from last month’s New Zealand earthquake.

Furthermore, to limit future losses, reinsurers are responsibly assessing whether this year’s sequence of earthquakes is an emerging trend and if they should further reset pricing upwards. All this matters because higher pricing trends signal higher profit expectations, which drive stocks higher.

Several reinsurance companies have already indicated that they are unlikely to have reliable estimates of losses quickly, hampered by personnel availability and access to the affected area. However, analysis suggests that insured losses may be manageable. As reliable loss estimates emerge, global reinsurers (Munich Re, Swiss Re, Hannover Re, comScore (NASDAQ:SCOR), ACE, XL) are the group likeliest to benefit from increasing reinsurance prices. The best positioned player among these is Munich Re, which remained strong through the recent financial crisis and has the strongest franchise and balance sheet to take advantage of upward pricing trends.

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

Additional disclosure: Long Munich Re (MUV2 GR)