Hurricane Sandy won't have any permanent effect on the P&C Insurance industry. Insurance stocks normally respond to catastrophes with a dip, followed by an increase as the implications of future higher rates are priced in by the market. For short-term traders, the usual strategy is to buy on the dip and sell as prices recover, while long-term investors look to accumulate additional shares at attractive prices.
Nevertheless, the event should be considered in the context of the industry cycle, as well as the overall market level. Also, it should be noted that an occurrence outside the usual probability parameters is a stress test for management competence in managing risk and reinsurance. Some players will be better prepared than others, as hindsight provides wisdom.
The P&C insurance pricing cycle is on the upswing. Major players such as Chubb (NYSE:CB), Travelers (NYSE:TRV) and Hartford (NYSE:HIG) are systematically raising rates, after multiple years when increases, if any, didn't match projected loss costs. As such, it's likely that the industry has several years of improving performance ahead of it. This expectation has been reflected in recent share price performance.
The third quarter didn't have much in the way of catastrophe losses, resulting in blow-out quarters for a number of companies. To illustrate the result, here's a 3 year chart for Travelers:
Here we have very pretty linear regression sloping upward and to the right, culminating in a blow-off top on earnings. Now we have an event that dramatizes the catastrophe risk that didn't materialize during the third quarter. A chart of Chubb is similar:
Most fact-driven analysis sees the overall market as slightly below fair value. After hitting multi-year highs, it's reasonable to look for some sort of retreat or correction.
Following the financial crisis, P&C insurers were generally undervalued and often traded at a discount to Book value. They have since recovered: CB has a P/B of 1.3; TRV stands at 1.1. I'm bullish on the long-term prospects of quality P&C Insurers. However, I personally would resist the urge to add to existing positions at prices above the trend lines.
When the Tide Goes Out ...
I was holding a substantial position in Allstate (NYSE:ALL) in August 2005 when hurricane Katrina homed in on New Orleans. As the situation developed, emergency planning and management was inept, and searing images of the unnecessary loss of life and property filled the airwaves.
As an investor, I was shocked to learn that Allstate didn't have reinsurance. A careful reading of the 10-K revealed a disclosure on the topic that was artful, to put it kindly. Edward Liddy, CEO at the time, soon became an advocate of federal government involvement in backstopping the insurance industry on catastrophes. He went on to further achievements as CEO of American International Group (NYSE:AIG) in the wake of the financial crisis.
Earnings, when reported in October 2005, reflected a loss of $2.52 per share, with the stock trading in the $53 area. By October 2006, shares were at $61, some 15% higher. Allstate bought the farm on Katrina, but investors who held through or added to positions were amply rewarded.
What's Different this Time
Homeowners insurance covers windstorm, but not flood. In the wake of Katrina, there was considerable controversy on the subject, since the losses from the two causes were more or less simultaneous. Insurance companies will get some bad press, and litigation may ensure.
While total economic loss will be substantial, much of it will not be covered by private insurance. The insurance industry has developed considerable expertise in bringing resources to bear on catastrophes, and estimates of losses will be available ahead of fourth quarter earnings.
Commercial insurance for large and sophisticated companies will often include flood coverage, since risk managers are well informed on the exposures and the coverage is widely available. It's possible, when the tide goes out, that management at one or two insurance companies may have saved some money on reinsurance, similar to what Allstate did in Louisiana.
Companies with a past history of mismanagement and over-reaching are less desirable holdings until the scope of the damage from Sandy has been assessed. Hartford Financial is one such carrier. AIG is another.
Reinsurance is about catastrophes. As a general rule, share prices decline in the wake of catastrophes, and subsequently increase in anticipation of higher rates. I did a favorable write-up on Everest Re (NYSE:RE) back in May last year, with shares in the $90 area. The company is now trading in the area of $113, for a 25% gain. Reinsurance companies, in common with the industry as a whole, were trading at discounts to book value.
R/E is trading at a P/B of .87. Looking at a ten year history on that metric, the company traded above book value from 2002 to 2007. As such, it continues under-valued.
Here's a three year chart:
This is similar to the pattern displayed by CB and TRV for the same time period, as discussed above. The difference would be, RE is trading below book, while the two primary carriers are trading above book.
Hurricane Sandy has no long-term effect on P&C or Reinsurance companies. As a general rule, it has been profitable to buy on dips in the wake of catastrophes. Because P&C companies appear fully valued and above trend, some caution is in order due to the possibility of better entry points.
Partner Re (NYSE:PRE), to provide another reinsurance example, is trading at a P/B of .76 and a P/E of 8.71. Similar to RE, it traded above book value from 2002 to 2007, a level it hasn't reached since the financial crisis. Given the valuation in this part of the industry, an investor who buys on any dip has a reasonable expectation of above average long term profits.