Investing in insurance companies

Many analysts say the insurance market is in better shape than banking, and it may be an ideal time to invest with some cheap deals to be had. But is this the right time to invest with such an uncertain market? Rodrigo Amaral investigates.

You live by fear, die by fear too. That could well be the motto of the insurance market today. On the one hand, an unprecedented financial and economic crisis brings several revenue opportunities for insurers. Companies have become more eager to transfer their risks, while alternatives to insurance – like credit default swap (CDS) contracts – have fallen into disrepute. On the other, the volatility in the financial sector, fueled mostly by the excesses in banking, have frightened investors off from any kind of financial stocks, including those of insurance companies.

As a result, in 2008, insurance stocks posted the third worst performance since 1933, according to the AM Best’s Global Insurance Composite Index. The rating agency noted that, traditionally, property/casualty and life/health insurance stocks have outperformed the Dow Jones Industrial Average (DJIA). But last year the latter dropped 33.8%, while the insurance index fell 47.2%.

And that was before capital markets submitted insurance stocks to a mighty pounding in the first two months of the year. By mid-March, stocks of general insurance companies had dropped in average 52% of their value in the year to date, according to Morningstar, while life insurers had dropped 29.9%. Some insurers have had a particularly torrid time. The shares of Swiss Re, a Swiss-based reinsurer, fell 74.2% in the same period, while life insurer Hartford Financial Services Group saw its shares take a 59.8% tumble. Not to mention disgraced AIG, an insurance titan that has made its best efforts to destabilise financial markets. By mid-March, its shares had fallen an astounding 98.3 percent from its 52-week peak.

The market’s bad blood toward insurance companies would have been plainly justified, had insurers been posting 2008 results as bad as many of its peers in the banking market. But, with a few dishonourable exceptions, that has not been the case. Nonetheless, they have got punished because of the general dislike felt by the markets at the moment towards financial companies. “Stockmarkets are gripped by fear. When they are, rational thought is the loser and then it is guilt by association,” says Alec Foster, who manages the Hiscox Insurance Portfolio Fund. “Property casualty insurance companies are not in the difficulties that a lot of other financial stocks are, particularly banks. But if there is just a whiff that there might be some form of collateral association, insurance stocks get clobbered unfairly.” In the survey “Insurance Banana Skins 2009”, York-based Centre for the Study of Financial Innovation (CSFI) has highlighted that reputational risks rank high among the major risks facing the industry today, and insurers are as exposed to it as banks.

There has not been much unfairness in the case of AIG, a once venerable, giant insurance company with businesses all around the world which, for several months, has been under the spotlight for all the wrong reasons. Many experts argue that AIG was not brought to its knees by its insurance business, once the envy of the industry. The culprits, according to this analysis, were mostly units engaged in other kinds of activities where the firm had diversified, like a London-based outfit that sold fancy, structured products that ended up causing losses of tens of billions of dollars to the mother company. But the dramatic humbling of a colossus of the insurance market has raised the alarm among investors that began to question whether other companies might have ugly skeletons in their cupboards too. Analysts say that it is unlikely that similar cases come to the fore in the future, although the current crisis has taught that no hypotheses should be discarded. Anyway, the damage has been done. And, as insurance is far from an uncomplicated business, its tendency to get muddled with banking and other financial activities in investor’s minds is all too real.

“Insurance is a black box for a lot of people,” says Peter Eliot, an insurance analyst at MF Global Securities. “There have been concerns about the solvency of insurers and the value of their investment portfolios, and also rumours that regulators might be about to require that they increase their levels of capital. Basically, there are lots of questions and not many answers,” he remarks.

Not even the disclosure of annual results that more often than not have been far from disastrous has been able to soothe investor’s jitters. “It doesn’t matter what numbers are telling you. Investors are terrified,” Foster says.
Take Mapfre, a Spanish-based insurer, as a case in point. In early February, the firm reported that its net profits increased by an impressive 23.2% in 2008. But the positive news was unable to put a brake on the slide of stock, which a couple of weeks later bottomed out at €1.37 (£1.29), a 66.8% drop from its five-year peak. (Mapfre’s stock has subsequently recovered a little). Market paranoia was given a boost when it emerged that Mapfre’s net equity had been hit to the tune of €763m in 2008 owing to the loss of value of fixed income investments and currency fluctuations in foreign markets, where it operates.

But analysts pointed out that the loss, although a reason for concern, is by no means large enough to threaten Mapfre’s solvency. María Paz Ojeda, an insurance analyst at Madrid-based Ahorro Corporación Financiera, remarked that the market was also nervous about Mapfre because the group owns half of a bank, always a risky proposition nowadays, and has interests in the property market, which is deep crisis in Spain. But she said that Mapfre’s exposure to such businesses is very small compared to the size of the group, and that overall, Mapfre remains a healthy company, with a leading position in the insurance market in Spain and emerging markets like Brazil and other Latin American countries. “Therefore, Mapre’s shares have become cheap,” she said.

Even accepting that the market, in the case of Mapfre and maybe other insurers too, lost sight of the whole by focussing on a few worrying issues, it is not difficult to gauge why investors are concerned about the performance of the investment portfolio of insurance companies. As a matter of fact, the CSFI survey found out that investment performance is the most pressing concern of insurance companies themselves today (it ranked 11th in 2007). And with good reason too. For example, Hannover Re, a German reinsurer, reported net losses of €127m in 2008, even though underwriting of new policies, the core of its business, performed “satisfactorily” during the year, according to Willhelm Zeller, its chief executive. “The fact that 2008 was a lost year for our company can be attributed entirely to the problems on the investment side,” he told investors.

Of course, “investment side” woes are far from banal when you are dealing with companies that rely on the performance of their portfolios to make sure that they are able to meet commitments to policy holders, if so required. Better managed insurance companies focus on investments with very low levels of risk. Spanish-based insurers, for instance, kept 61% of their portfolios in fixed income products by the end of 2008, and only a mere 5% in equities, according to ICEA, a Madrid-based insurance research institute. “But recently even fixed income investments have been suffering a battering” notes Didac Leiva, an insurance expert at DBA Audiberia, a Barcelona-based consultancy.
Leiva points out that, in uncertain times, it is not enough to focus on the results of an insurer to be confident about its future. Recently adopted accounting rules have established that estimated losses of value of long term investments need not be disclosed along with the annual results. That is why Mapfre’s net equity hit only came to light when analysts perused its audit report, a few days after results were published. But in order to have a clearer idea of the solvency of an insurer, such information is paramount, and of late investors look to be digging ever deeper to find traps in the balance sheets of insurance companies.

Analysts at Keefe, Bruyette and Woods pointed out that investors were looking for “tangible balance sheet measures” – cash, for starters – when they reacted negatively to the release of results by Aviva, a British-based insurer. KBW noted that the Aviva share fell by 33% in a single day, despite having presented the markets with a set of earnings that the KBW team called “incremental positives for fair value”. But the focus looked to be more on intangibles, which had suffered losses due to currency fluctuations. This only strengthens the point that doubts about the strength of balance sheets have been a major issue in the valuation of insurance companies, according to KBW. “The current investment climate is driven by scepticism relating to the capitalisation of the insurance industry,” the firm said in another report.

Confidence in the insurance industry was not boosted either after it emerged that several America-based life insurance companies have been lobbying the American government to allow them to tap into the Troubled Asset Relief Program (Tarp), which was created to bailout the country’s crooked banks. Life insurers are more exposed than their non-life peers to the fluctuations of asset prices, as many of the products they offer to their clients are linked to the evolution of investments. But to many investors, an insurer is an insurer, and the case only added to arguments to keep a safe distance from the industry as a whole.

The view that the market is always right has had better times, and experts believe that this is a case when investors are missing the point altogether. “Our view is that those concerns are misplaced,” Eliot says. “There has been an overreaction. Companies are showing good levels of solvency. They are not about to have to sell their assets, and in most assets the policy holders take the risks, not the shareholders. And we don’t believe regulators are about to increase capital requirements: the noises they’ve been making point just to the opposite,” he said.

Eliot’s opinion is not an isolated one. Other analysts believe that the insurance market is not in as bad a shape as banking, and some stocks could offer bargains to the savvy (and brave) investor. “Insurance stocks are cheap today,” says Foster. “At the moment, the average price-to-book for property casualty insurance companies in America is 80%. The mean average for that same group of insurance companies over discreet periods to 20 years is 140%. They are cheaper now than at any period for a very long time. You’ve got to take advantage of current opportunities, because they only come around once every 20 or 30 years,” Foster stresses.

Eliot agrees that insurance stocks like good deals right now. “But then again we thought the same thing a month ago, not to say a year ago,” he warns. “Fundamentally, we think absolutely they are cheap. But whether is this the right moment to get into the market, that’s another question. There could be even better opportunities in the future.”
A certain amount of optimism may be justified if investors concentrate their attentions on the business side of insurance companies – basically, their activities of underwriting risks and collecting fees for the service.

That is where the current climate of fear helps to improve the prospects of the insurance industry, particularly in the non-life side of the business. Analysts have noted that many companies have been more inclined than ever to transfer risks to the insurance market, as they try to mitigate their potential losses in a moment when their businesses can barely withstand new problems. Some lines, like directors and officers liability insurance, known in the market jargon as ‘D&O’, have witnessed an increase of demand thanks to the higher risk of executives being sued by investors and shareholders, who are unhappy with the management of underperforming companies. The opening of the executive-bashing season, typified by the furore concerning bonus payments in failed firms like Royal Bank of Scotland and AIG, is certainly contributing to companies to seek stronger protection for their top people. Other lines, like natural catastrophe reinsurance, have seen rates get under pressure after a year when, in addition to financial disasters, nature did its best to cause havoc in the market. Events like hurricanes Gustav and Ike in America and a big earthquake in China turned 2008 into the third most devastating year on record, according to Munich Re, a German reinsurer.

The double blow of financial and natural disasters reached non-life insurers at the end of an extended soft market that allowed buyers of coverage to achieve significant reductions in the cost of their contracts for several years in a row. “The signs of an impending hard market abound,” Marsh, a broking firm, wrote in its US Insurance Market Report 2009. “Yet the financial crisis is making it difficult to see just how it will evolve, and likely that it will look and feel different than previous hard markets once it arrives,” the firm said. Marsh has forecast, somewhat tentatively, that property insurance rates should see increases of up to 10% in the course of the year, while casualty lines could go up by single digit rates.
Hard markets certainly constitute bad news for companies that have to transfer an ever growing number of risks in times of uncertainty. But higher prices are obviously music to the ears of insurance companies and their shareholders. “Insurance at the moment is in a sweet spot,” Foster says, referring mostly to non-life insurers. He points out that not only prices and demand are going up, increasing the revenue potential of well-managed insurers, but the excess of capacity, that haunted the sell-side of the industry in previous years, has become a thing of the past. In the liquidity drenched world that prevailed until recently, investors were always happy to provide capital for established players and new entrants in the insurance market. As a result, the market suffered oversupply, and buyers usually had the upper hand when it came to renewing contracts or purchasing new policies. If a company did not bend to their demands, buyers would simply take their custom elsewhere.

Even if the optimist’s forecasts for insurance turn out to be true, the fact is that not all activities are seen as safe propositions even by the most sanguine market players. Sectors like credit insurance, where insurers provide companies with protection against default by their clients, are going through tough times as the volume of claims explodes as a result of the economic crisis. Not surprisingly perhaps, the share of Euler Hermes, the biggest specialist credit insurer, has fallen as much as 75.6% from its peak last year. Analysts highlight motor insurance as another activity where results are unlikely to be stellar in 2009, following the worldwide slump in sales of new cars. And providers of private health insurance could experience a flight of clients in countries where public health systems, although imperfect, are deemed sufficiently good enough to take care of basic needs, like Spain and Britain.
Even at the best of times, the insurance industry carries several risks of its own, like the probability that huge natural or man-made disasters create an enormous volume of claims. Important examples were the terrorist attacks in New York and Washington in September 2001 and Hurricane Katrina in America in 2005, which put several companies under enormous levels of stress as claims spiralled. Insurers have also complained for some time already about increasing government meddling into the industry and an ever growing load of regulatory requirements. Although not all new regulations are seen as harmful to the competitiveness of the sector. For instance, the new European accounting and reporting directive Solvency II has been hailed as a tool that will make EU insurers more competitive than their rivals in other countries. “The crisis has strengthened the need for Solvency II,” said Jean Christopher Menioux, the chief risk officer at Axa, a Fre­nch-based insurer, in a recent meeting. “No wonder that the Americans and the bankers are doing all they can so that Solvency II does not succeed,” he said.

But all forecast and expectations are being subjected to a constant re-evaluation owing to uncertainties generated by the credit crunch, and this situation is unlikely to change for some time yet.

“Everyone wants to know what the current financial crisis will mean for the insurance marketplace, but for all of the opinions, there is no absolute answer available,” said Brian Duperreault, the chief executive of MMC, the parent company of Marsh, in the firm’s latest US Insurance Market Report. “Its an asset-driven crisis, and that makes it
difficult to predict the end-game with any certainty.

Performance of selected insurance shares

Price-to-book - US Property casualty insurance companies

Solvency position of UK insurers