Insurers: Catastrophes to Hit Earnings

Includes: ACE, ALL, CB, HIG, TRV
by: Gloria Vogel, CFA

Hurricane season begins June 1, but the insurance industry is already reeling from catastrophe losses before the major cat season even begins. Including the estimated $30b-$45b of insured losses from the Japanese earthquake and tsunami, there have been record tornadoes in Alabama and North Carolina, and most recently killer tornadoes in Missouri and Oklahoma. These losses come on top of the New Zealand and Chilean quakes last year, Australian flooding, and recent floods in the Midwest from the Mississippi River overflowing its banks. So far, U.S. weather-related losses of around $10b are far in excess of the average $2b-$4b, with global losses totaling up to $55b, according to cat modeling firm EQECAT. There may yet be more spring flooding from snow runoff in the West, following a cold and wet winter. As more of these events occur, there is building expectation that insurance pricing momentum will pick up, setting the stage for improved profitability in the future, even as losses hit current earnings.

The catalyst for a turn in the underwriting pricing cycle of the property-casualty industry is not just catastrophic loss, but the amount of that loss relative to industry capital or surplus. With the industry showing high policyholder surplus or capital levels at year end, there has been some skepticism about a cycle turn in anything but the lines most affected by the losses. According to the naysayers, insurers have more than adequate capital to write the current volume of premiums, so there is little incentive for a change in pricing in general commercial liability lines. Those skeptics see the losses as earnings events and not as capital events.

But, those cynics are perhaps not taking into account some other factors.
  • Solvency II rules in the EU plus more financial regulation in the U.S. could force insurers to keep more capital on hand to support claims payments;
  • Reserve cushions may no longer be sufficient to cover developing losses;
  • Reinsurers are already starting to raise rates;
  • New cat models suggest losses might be higher so more capital may be needed to support claims;
  • Inflation in claim costs could rise as economic recovery proceeds;
  • Low yields will keep a lid on investment income growth, eliminating the investment earnings cushion from loss events, and;
  • The magnitude of cumulative losses relative to capital levels could exceed the 5%-10% hit that historically has been the agent for price change. Industry surplus at year-end 2010 totaled $557b, and losses to date are already at or close to the inflection point.
Insurers are in the business of protecting policyholders from catastrophic losses. They are able to do so by the law of large numbers – insuring large numbers of individuals with the expectation that only a few insureds will actually suffer a loss. It is the lottery ticket that nobody wants to win. But, there is nothing like seeing your neighbor lose everything in a catastrophic event to getting yourself motivated to buy more insurance protection. As such, following loss events, there is usually a pick-up in demand for insurance products, which tends to increase unit premium growth. Since premiums track closely with GDP, an improving economy also tends to spur top line growth. The Insurance Information Institute currently projects premium growth of 1.4% for 2011, but growth could exceed that target as more loss events occur. Already, this year there have been over 1,151 tornadoes, and the National Weather Service is predicting an active hurricane season.
The reasons for large storm activity are many: Global warming, changes in the ozone layer, volcanic activity, acid rain, sun spot activity, or ocean currents. El Nino or La Nina are driving forces, along with planetary alignments or changes in magnetic field. These affect the jet stream, which in turn creates flood conditions in some locations with droughts in other regions, and varying degrees of either extreme hot or cold. Depending on one’s location, the past year certainly has been memorable in its weather extremes.
Insurance stocks tend to swoon after a catastrophic event before loss amounts are forecast, and thereafter may selectively falter based on earnings hits. The stocks rally when premiums pick up from subsequent rate hikes and increased purchases of coverage. With so many loss events this year, loss estimates are becoming more frequent, and hits to earnings more apparent. For most property-casualty insurance carriers, second quarter and first half underwriting results will show a loss. As a result, we are beginning to see some re-emergence of side-car deals along with some cat bonds, and could also see fewer share buybacks or dividend hikes announced as insurers preserve capital going forward.
As a group, the financials recently have been weak, with the S&P Insurance Index flat year-to-date, thus underperforming the market. Factors that will influence future performance include interest rates, further catastrophe losses, and progress on an underwriting price turn. Going into hurricane season, investors should look past the storms at attractive valuations and dividends, and at the rally that will occur once pricing improves along with demand for coverage.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.