As a follow-up to my previous article about investing in reinsurance companies, I wanted to delve into how to assess the profitability of these companies. The combined ratio is the most accepted measure of an insurance or reinsurance company's underwriting profitability. For review, the combined ratio, or CR, is a combination of the loss ratio and the administrative overhead. Lower is better for the CR.
Another component of profitability is the investment income, but since most portfolios are mostly bonds, that income has been diminished lately in the zero interest rate policy.
Combined ratio is available from several sources. While I normally obtain CR figures from each individual company's quarterly earnings statement, they are also available in summary form from several sources. You may be able to access research reports through your stockbroker. Also, there is an industry group, Association of Bermuda Insurers and Reinsurers. This association publishes semi-annual updates as shown below, which include a number of metrics such as premiums written and combined ratio. You can also go to their website and obtain data from prior years.
Looking even longer term
While 6 months is better than a single quarter, you may also wish to look at a number of these to get an idea of the longer term underwriting trends. Wikinvest charts this for annual data as shown in this example for Axis Capital Holdings (NYSE:AXS)(although they seem to stop updating the numbers after 2008!). I haven't found other sources, so I just track it myself.
While comparing combined ratios, it is also important to note how the company compared to peers. For example, in a year with major catastrophes such as 2011 which had earthquakes in New Zealand and also the Japanese tsunami, companies that avoided these tragedies and stayed more profitable might deserve a look. However, the flip side of this may be that the company was simply pursuing different (more conservative) lines of risk, which will ultimately make the company less competitive in years without major catastrophes - especially as pricing rebounds in markets such as those affected by the NZ earthquakes, or the Hurricane Sandy affected areas. In other words, companies that pursue less risk (an example would be Maiden Holdings (NASDAQ:MHLD)) will look better in years of catastrophes compared to companies that took more short-tail catastrophe risk, such as Montpelier Re (NYSE:MRH). It is not necessarily skill in underwriting, so much as chronic risk aversion and lower average profitability.
My reinsurance company list is shown below, current as of January 5, 2013, and updated with 3rd quarter 2012 book value and combined ratios, and current percentage of 52-week high:
|company||current price||Q3 BV||Q3 P/B||Q3 CR||% of 52wk hi|
|Arch Capital (NASDAQ:ACGL)||$44.63||$36.79||121%||90%||99%|
|Aspen Insurance Holdings (NYSE:AHL)||$33.26||$41.53||80%||87%||99%|
|Axis Capital Holdings (AXS)||$36.15||$43.57||83%||85%||93%|
|Endurance Specialty (NYSE:ENH)||$41.72||$54.95||76%||100%||97%|
|Greenlight Capital (NASDAQ:GLRE)||$23.10||$23.57||98%||114%||88%|
|Montpelier Re Holdings||$23.76||$26.61||89%||73%||99%|
|Partner Re (NYSE:PRE)||$82.89||$99.54||83%||81%||98%|
|Platinum Underwriter (NYSE:PTP)||$48.01||$54.60||88%||61%||100%|
|Everest Re (NYSE:RE)||$112.78||$131.22||86%||87%||98%|
|Validus Holdings (NYSE:VR)||$34.96||$33.91||103%||70%||93%|
|XL Group plc (NYSE:XL)||$26.01||$32.82||79%||92%||100%|
A few key observations:
- Price to book value ranges from 76% to 121%
- Combined ratios for this single quarter range from 53 to 114%, a wide range of profitability!
- Most companies are close to 52-week highs, and only one has sold off more than 10% off the 52-week high
- There is not an obvious link between more richly P/B valued companies and favorable CR. Arch Capital with the richest P/B has a middling CR for this quarter, for example.
Possible next steps would be to chart out combined ratios over a longer period of time. However, as discussed below, I am not aware of proof that this would necessarily result in a superior investment decision.
It is impossible to completely separate out risk when investing in the reinsurance sector. This industry earns its very profits from risk itself. Yes, there is skill involved in underwriting, but after 7 years of following this industry I can tell you it is nearly impossible to truly assess this. This is because all combined ratios are rear-looking. They tell you nothing about the current book of risk, although they may hint at it, as noted above comparing MHLD to MRH. Another point is that there can be reserve releases or charges which essentially retrospectively change the combine ratio in a subsequent quarter based on longer tail claims data. I would caution the investor to not get overconfident in their understanding of any single company, because there can always be an earthquake or hurricane the next quarter in an geographic area in which your favorite insurer was overexposed - something that none of the previous combined ratios could have possibly told you.
Contrary to what some Seeking Alpha commentators have posted about assessing underwriting skill, I feel that the best antidote to company-specific risk is to diversify in several companies. I choose to invest in the top 4 or 5 based on my own metrics, as hinted above. This is where I have faith in the competitiveness of underwriting labor and the pricing of risk. I think there is not much alpha available from underwriting skill in this space. Capital is very fluid and once a profitable area is found, it will rapidly attract more risk capital and bring more competitors -which brings down price, which inherently makes the combined ratio less favorable in that segment or geography. Much more important, I feel, is the broader industry-wide pricing factors of hard versus soft market, for example.
Also, going too far back in analyzing companies can be counter-productive or give a false sense of confidence, for several reasons:
- Underwriting personnel can change
- Company coverage policies can change over time, in response to changes in management or perceived market conditions
- Pricing conditions change year to year
- Perils change year to year, whether earthquakes, hurricanes, or crop failures for example
- Even if a company overcame ALL of the above, this should quickly be factored into stock prices and price to book value, as investors acknowledge a truly superior company. This would bring forward-looking returns back into line with industry averages.
Earnings season for reinsurers largely will start the first week of February. I will be watching closely and posting updates. Thanks for reading, and I hope I achieved the right balance of informing without getting too esoteric.
Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in AXS, PTP, ENH, AHL, RE, PRE over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.