Let's start with a series of backtests:
A total of nine backtests were run, on a matrix including time periods of 5, 10 and 15 years, and drawing on all P&C stocks from within 3 universes - the S&P 500, the S&P 1,500, and all stocks other than OTC. The portfolios were rebalanced annually. The results, as shown, show an average alpha of 4.5%.
Chronic Low P/E Multiples
The ten year average P/E, based on TTM earnings excluding extraordinary items, works out to 13.5. P/E for the S&P 500, when using the harmonic mean rather than a regular average, works out to 21.2. for the same period. The harmonic mean is helpful when working with ratios, particularly when some of them are extremely high, as was the case in late 2008 and early 2009.
Generating substantial profits, and deploying them to benefit shareholders, whether by increasing dividends, buybacks, or generating more revenue, these companies in the aggregate have been able to drive very acceptable returns for shareholders.
The question comes up, why don't they trade at higher multiples?
Stigmatized as Financials
In the wake of the financial crisis, financial service companies broadly have fallen under considerable suspicion. While most of this can be attributed to the big banks, AIG (NYSE:AIG) and to a lesser extent Hartford Financial (NYSE:HIG) among the insurance companies have also been part of the problem. AIG is a multi-line, and got in trouble writing CDS protection in a banking subsidiary. HIG is also a multi-line, and got in trouble guaranteeing equity returns on annuities written by their life insurance subsidiaries. HIG's P&C operation has been healthy at all times.
The P&C business is fairly straightforward. Insurance is provided against comprehensible risks such as fire, car accidents, and workers compensation claims. The premiums are invested, primarily in bonds, until they are needed to pay claims. Companies that charge adequate rates, set reserves accurately and invest conservatively generate reliable profits.
The Life insurance business can become complex. The risks of premature death and/or excessive longevity are comprehensible, and easily insured, based on the law of large numbers. The trouble starts when these risks are packaged with investment products, and especially products that guarantee equity market returns. Sales commissions are high, which creates difficulty in justifying investment returns. The companies attempt to hedge with derivatives, which generates an intimidating amount of complexity.
Go to the SEC website and draw up a 10-K for Prudential (NYSE:PRU) or MetLife (NYSE:MET). Then do a word search on "derivative." You will get over 100 occurrences, the same as you do for a big bank. If you read the text surrounding the magic word, you will rapidly become either confused or bored.
Many Multiline insurers developed when P&C companies decided to try their hand at life insurance. It's like anything else where naïve capital finds its way into the marketplace: soon enough there is trouble. Allstate (NYSE:ALL) has a large life business, which has been a millstone around the neck of a company with a fine auto insurance franchise. Hartford Financial has a good quality P&C business, encumbered by a life insurer that wrote a large amount of annuity business in Japan, while guaranteeing the equity market returns. Not good.
P&C Insurance companies have seriously outperformed Financials as a whole, as well as other types of insurers.
Insurance as a Commodity
Many pundits disparage the business as a commodity, where competition prohibits adequate profits. There is some truth to that assertion.
However, there are numerous specialty niches where the advantage of understanding the business and having the right contacts provides something of a moat. As an example, Chubb (NYSE:CB) has a niche in high-end personal lines. The wealthy need and can afford broader coverages, and are more likely to buy from agents who have the proper contacts and expertise.
As another example, Chubb has a niche in professional liability. Directors E&O (Errors and Omissions) would be an example. While company directors from time to time do stupid things, and get sued in due course, the company has consistently made money on the line.
On the other end of the spectrum, Progressive (NYSE:PGR) writes personal auto insurance for drivers with bad records. The customers are frequently at the bottom of the economic totem pole, and shop by phone every time they get a renewal bill.
Berkshire Hathaway (NYSE:BRK.A) has a large insurance business. Buffett is well aware of the profitability of niche specialty businesses. Here's what he had to say in the 2013 letter to shareholders:
In addition to our three major insurance operations, we own a group of smaller companies, most of them plying their trade in odd corners of the insurance world. In aggregate, these companies are a growing operation that consistently delivers an underwriting profit. Moreover, as the table below shows, they also provide us with substantial float. Charlie and I treasure these companies and their managers.
P&C Insurance companies routinely drop in price as hurricanes close in on the mainland. Adroit speculators trade the dip, and some investors add to positions at discount prices. The shares generally recover rapidly. For serious catastrophes, shares trade higher after the rate increases go through.
The question is: what about "the big one?" The companies use computer modeling to estimate catastrophe exposure, and they buy reinsurance when it is available on economic terms. Travelers (NYSE:TRV) and ACE (NYSE:ACE) provide information on the modeled risk of catastrophe loss in excess of reinsurance, and it's worth studying, as a limited window into this difficult area. The chronically low share prices of these companies may prove to be justified when the big one hits.
Here's a snip from Travelers' 10-K, followed by one from ACE.
The format is the same here: the probability that catastrophe losses after reinsurance will exceed a given threshold is presented, and the amount involved is related to shareholder's equity, as a percentage.
The probability can be interpreted as an expected loss percentage. As an example of how I'm thinking about it, for Travelers the probability of a loss exceeding $1.3 billion is 1%: the probability for $2.2 billion is 0.4%. So, for a tranche of $0.9 billion one could interpolate an expected loss of 0.7%.
Catastrophe bonds are a growing part of the reinsurance scene. The investor gets a bond with a generous yield, subject to the contractual provision that he will lose his principal if a catastrophe of the designated type occurs. SA contributor Steve Evans of Artemis is well-informed on the area and provides the following information on his website:
My takeaway from this chart is that the yield required for catastrophe bonds is well in excess of the expected losses, although it has been coming down lately. This reflects the reinsurance market generally: tail risk is expensive to transfer, at least when the counterparty is knowledgeable.
Reinsurance against a 100 year hurricane, or a 1,000 year hurricane, may not be available on economic terms. Under the circumstances, shareholders shoulder the risk, and get the benefit of the discounted share price, weighed against the remote possibility of a large loss.
Can the Risk of Catastrophe Loss be Quantified?
Travelers and ACE are doing the right thing by presenting information on modeled probability estimates of catastrophe losses in excess of reinsurance. I haven't seen other companies do that.
In a recent article, I estimated the intrinsic value of Chubb at $125 per share, before considering catastrophe risk, for which I deducted $6. Applying a similar methodology to Travelers, I estimate intrinsic value, prior to considering catastrophe risk, at $140, based on the observation that the bulk of the earnings come from a high quality bond portfolio. By way of testing for reasonableness, that works out to a TTM P/E of 13.9. The stock closed Friday at $106.54, and a P/E of 10.3.
For my own purposes, using the data provided by Travelers, I would deduct $11 to compensate for the catastrophe risk. Applying the markups inherent in the information provided above by Artemis, the deduction would be $35, reflecting an estimate of the cost of a cat bond or bonds sufficient to cover the exposure.
The alpha generated by P&C insurance companies may be interpreted as a result the market's reluctance to pick up catastrophe tail risk. If that is correct, the investor is getting a nice return for bearing that risk, since the stock is providing income and loss exposure similar to a cat bond.
Catastrophes aren't correlated with financial crises or the economic cycle. Bearing an appropriate amount of catastrophe risk can improve diversification, and there is a good markup over expected losses. Cat bonds aren't available to the individual investor, and would not be suitable, for lack of liquidity as well as an information disadvantage, if they were. But P&C insurance stocks are widely available at attractive prices, in markets that provide a level field for the retail investor.
The companies under discussion here sailed through the financial crisis with flying colors. They were not affected by the dot.com bubble. They have good defensive performance, and beat the S&P 500 by 6% or more in down markets.
Buffett on Catastrophes
Here's Warren again, from the 2013 letter:
...if the insurance industry should experience a $250 billion loss from some megacatastrophe - a loss about triple anything it has ever experienced - Berkshire as a whole would likely record a significant profit for the year because of its many streams of earnings. And we would remain awash in cash, looking for large opportunities if the catastrophe caused markets to go into shock. All other major insurers and reinsurers would meanwhile be far in the red, with some facing insolvency.
The Oracle is not troubled with false humility, nor by an over-estimation of his competition. I think he's talking about a "1,000 year" catastrophe, which would be a 20% hit to Travelers shareholders equity, and maybe 15% to ACE, based on their share of the industry. I couldn't resist bringing it into the article. Buffett gets his information from computer modeling, the same as everyone else, and he's talking about Berkshire as a whole, not just the insurance operations.
How Shareholders are Rewarded
There is some variation among companies, as to how they deploy excess capital on behalf of shareholders. Here is a listing of P&C Insurers that are currently in the S&P 500:
ACE has a concentration in niche or specialty lines. The company retains a fair amount of earnings, and deploys them into increased premium writings, while maintaining underwriting profitability. Share counts increased over the 10 year period analyzed, but have been declining in recent years. Headquartered in Switzerland, with subsidiaries in tax-advantaged locales, the company is tax efficient. Growth in retained earnings drives capital appreciation.
Allstate has a large Life insurance operation, and has discontinued the writing of spread oriented business. The company had too much RMBS and structured finance during the financial crisis, which seriously reduced performance over the 10 year period.
When Katrina hit New Orleans, Allstate didn't have reinsurance, a costly mistake in risk management, amounting to approximately 7% of shareholders equity.
Chubb has niches in high-end personal lines and professional liability. The company maintains a low growth profile, with fine underwriting profits. They have responded to low interest rates by doing some equity and private equity investing, focusing on capital gains from this source. The company has dividend growth credentials, but the yield is not that large. The bulk of excess capital is used for buybacks, which over time can be expected to provide capital appreciation.
Cincinnati Financial (NASDAQ:CINF) attempts to hold the combined ratio between 95% and 100%, and underwriting profits are negligible. A conservative bond portfolio has performed extremely well during difficult times. Equity securities make up a rather large part of the investment portfolio, with the focus being on dividend growth type stocks. Unrealized capital gains on these investments make their way into Accumulated Other Comprehensive Income. The dividend is generous, and capital appreciation is likely, due to the equity portfolio.
At one time Cincinnati had an outsize position in Fifth Third Bank (NASDAQ:FITB), which is also headquartered in Ohio. Regretfully, they didn't right size the investment, and a good part of the unrealized capital gains evaporated. They now keep their positions balanced.
Progressive writes primarily automobile insurance, much of it non-standard. This is a competitive, commodity type business. Bad driving records are more common among persons of low socio-economic status, leading to a constant battle between the need for basic coverage and the difficulty of paying for it.
Travelers pays a moderate dividend, and does heavy buybacks. Again, the emphasis is on share price appreciation. A strong focus on analytics has given them an advantage in maintaining price discipline and controlling claim costs.
XL Group - There has to be a story behind this sorry performance history. I don't follow it, since there are a sufficient number of very reliable companies to choose from.
I like TRV, CB and ACE, although CINF should be a good holding for dividend growth investors who are more interested in yield than capital appreciation.
Disclosure: The author is long CB, TRV.
The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it. The author has no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: The computer modeling of catastrophe risk involves multiple estimates and is inherently uncertain. As a retail investor, I'm talking shop, not giving advice.