2012: Commercial Insurer Growth Remains Uncertain
February 2012
This article is an update to my
February 2010 article,
Growth and Uncertainty in P&C Insurer Valuation, which discusses
the growth prospects and risk profile of the property-casualty (P&C)
insurance industry.
by
Jeff Balcombe
The BVA Group
LLC
The impact of recent industry trends on the growth prospects
and risk profiles of firms operating in the P&C industry are discussed
below.
Growth Prospects
As noted in my previous article, growth for P&C insurers is predominately
driven by premium increases and investment earnings. Typically,
growth from investments earnings is not as sustainable or consistent
as growth from premium increases, as the former mainly depends on
factors beyond the control of the company. Thus, generally, stable
premium increases are necessary to achieve sustainable growth.
Unfortunately, premium pricing suffered greatly in 2011. According
to Robert P. Hartwig, president and economist of the Insurance Information
Institute, "The industry posed the worst underwriting results since
2001 last year, and returns on equity sunk into the low single digits."1
The past several years have been a soft market in the P&C insurer
industry, typified by oversupply and/or low demand. In a soft market,
P&C insurers are typically driven to discount premiums and are at
risk of employing insufficiently rigid underwriting practices in
an effort to generate business. In markets with higher demand, P&C
insurers generally attempt to maximize profitability by increasing
premiums and focusing on expanding capacity.
Some believe that the soft market may be coming to end in light
of a longer-than-normal period of low rates and risk tolerance.
However, contrary to a typical hard market, the anticipated market
is not expected to bring large rate increases or less stringent
underwriting standards. Rather, as some have described, the industry
will likely continue to practice more "careful" underwriting and
raise prices nominally to capitalize on the increased demand but
avoid potential large losses.2 As such,
growth prospects for the industry are subdued even though it may
be transitioning out of an extended soft market period. As discussed
later in this article, while expected growth remains suppressed,
multiples in the P&C insurer industry have risen in apparent expectation
of a transition to a hard market.
Additionally, in another sign of general economic improvement,
the jobless rate fell to 8.3 percent in January 2012 from 8.5 percent
in December 2011. This decrease in the unemployment rate reflects
a near 3-year low and the largest gain in employment since April
2011.3 The Federal Reserve had previously
expressed that it expected the unemployment rate to fall to as low
as 8.2 percent for the year 2012. According to the Federal Reserve,
a rate between 5.2 and 6 percent would be consistent with its goal
for a healthy economy.4 Expectations
for a larger employment base generally indicate an increased customer
base for P&C insurers which, all else being equal, likely increases
the amount that investors and potential acquirers are willing to
pay for interests in such P&C insurers.
Despite the extended soft market, the P&C industry has survived
large underwriting losses with enough capital to continue to pay
future claims. The P&C industry is thus poised to take advantage
of growth opportunities. Going forward, the industry is anticipated
to "adjust rates higher and be more conservative in what they insure."5
This would have a positive impact on multiples as, generally in
a rising premium environment, valuation multiples of P&C insurers
increase as investors are willing to pay more for positive trajectory.
Uncertainty
As noted in my previous article, in 2009, P&C insurers saw a
rebound in profitability from the recession of 2007–2008 on strengthening
of stock and bond markets, which lowered market participants' perception
of risk and inflated valuation multiples. Through the first 9 months
of 2011, global catastrophes have produced record losses of $350
billion, breaking the previous record of $230 billion set in 2005.6
Generally, an increase in losses decreases consumer risk tolerance
and thus increases the demand for insurance.
As the U.S. stock market declined throughout the third quarter
of 2011, P&C insurers reported an annualized statutory rate of return
on average surplus that was 1.9 percent lower than the return over
the same period in 2010. The decline erased prior gains for the
year and brought the overall return of the market negative through
September 2011. The decline also had a negative effect on the risk
profile of the industry, as stock investments make up approximately
one-sixth of the P&C industry's invested assets. However, bond prices
spiked as a result of lower interest rates, providing insurers with
some opportunities to realize capital gains on the sale of appreciated
bonds.7 The fourth quarter of 2011 showed
some improvement as the S&P 500 increased 11.8 percent during the
quarter.8
Some in the P&C industry see opportunity, even in a soft market,
to generate profit through operational improvements. According to
one source, "Insurers must keep transforming their operations to
improve margins and drive more profit to the bottom line by adopting
new technologies and management strategies to squeeze unnecessary
costs out of the system, as well as employ their people and capital
more productively."9 Higher levels of
profitability correspond to lower levels of risk and decreased probability
that the company will not be able to meet its ongoing obligations,
such as debt service. Accordingly, if all goes as expected, the
market rewards operational improvements with higher valuation multiples,
which is consistent with the trends exhibited by P&C insurer valuations
in recent months, as discussed below.
The passage of new legislation also affects the P&C industry
as well as the general economy. Legislative reform may impact the
valuation of insurance companies through further regulations being
imposed on the industry and increased cost of compliance. Alternatively,
simplification of the regulatory framework typically lowers the
associated cost of compliance.
In conclusion, the P&C insurance industry appears to be taking
a turn for the better, although growth and profitability enhancement
may initially be limited to companies that are able to take advantage
of the still-limited opportunities.
Increased Valuations
Below is a group of publicly traded companies (the "Industry
Group") that are representative of the P&C insurance segment of
the insurance industry.
| • The Chubb Corporation
("CB") |
• RLI Corp. ("RLI") |
| • Cincinnati Financial
Corp. ("CINF") |
• Safety Insurance
Group Inc. ("SAFT") |
| • Donegal Group
Inc. ("DGIC.B") |
• Selective Insurance
Group Inc. ("SIGI") |
| • Erie Indemnity
Co. ("ERIE") |
• Specialty Underwriters'
Alliance Inc. ("SUAI") |
| • First American
Corp. ("FAF") |
• The Hanover Insurance
Group Inc. ("THG") |
| • Hallmark Financial
Services Inc. ("HALL") |
• The Travelers
Companies Inc. ("TRV") |
| • Harleysville
Group Inc. ("HGIC") |
• Tower Group Inc.
("TWGP") |
| • Mercer Insurance
Group Inc. ("MIGP") |
• W.R. Berkley
Corporation ("WRB") |
| • Progressive Corp.
("PGR") |
• Alleghany Corp.
("Y") |
As the economy and stock market began to turn around in early
2009, valuations for P&C insurers steadily improved, and multiples
have exceeded historical levels.
Figure 1 illustrates the average forward price to earnings (P/E)
multiples from 2009 through 2011.
The average multiple was 10.5 times for the 13 months from December
2007 through the end of 2008 as seen in
Figure 2. These multiples were likely depressed by the increased
risk relating to the prevailing economic conditions and lower expected
long-term growth in P&C insurer earnings.
Subsequently, in the first half of 2009, despite relatively unchanged
expectations for growth, valuations continued to decline, resulting
in an average forward P/E multiple of 10.1 times. The persistent
downward trend was likely influenced by the significant perceived
risks relating to lack of profitability.
Conditions in the P&C industry began to improve in the latter
half of 2009 despite lowered growth expectations, as profitability
returned and the stock and bond markets improved. This resulted
in an increase in the average forward P/E multiple to 11.3 times
between July and December 2009.
Between January 2010 and December 2011, conditions in the P&C
industry continued to improve and, despite lower estimated growth,
multiples expanded, which is likely a result of expected increases
in profitability, general economic improvement, and lower perceived
risk. This resulted in an increase in the average forward P/E multiple
of 13.8 times, as show in
Figure 2.
Conclusion
Increased profitability and general economic improvement drove
the increased performance of the P&C industry in 2011. Valuation
multiples increased to pre-recession levels, after several years
of economic downturn and reduced profitability in the industry,
which would be in line with a possible end of soft market conditions
for P&C insurance. However, expected growth remains lower than pre-recession
levels, indicating that, despite improved market conditions and
increased profitability potential, the P&C market has not yet transitioned
to a hard market.
Nonetheless, hard market conditions are apparently expected,
which would typically go along with increased premiums and thus
growth. Despite legislative changes, the industry seems poised to
capitalize through improving operational efficiency and maintaining
lean operations. It will be interesting to observe the P&C insurer
valuations in the near future as the market reacts to actual profitability
performance relative to expectations.
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