2012 P&C Insurer Valuation Outlook

Typically, insurer values are derived from the growth and profitability that a company can achieve and the risk it is willing to take on to do so. As described below, each of these factors is affected by the insurance pricing cycle, which is categorized by soft or low premium pricing periods and hard or high premium pricing periods. Fluctuations in the insurance cycle, as well as a company's value, are captured in the respective price-to-earnings (P/E) multiple.

Growth

Within the P&C insurance industry, growth is dependent on policy volumes and premium prices. Recently, growth within the P&C insurance industry appears to have been stifled, likely due to the industry's maturity and the continuing soft market trend. With nearly 98 percent of premium revenue attributable to current policyholders renewing their policies, it is evident that the industry is highly saturated.¹ The rarity of new policies highlights insurers' sensitivity to the pricing cycle.

Capital surplus generated by decreased demand during and following the recession is a contributing factor to persisting soft market conditions. In such years, consumers are more likely to take the risk of self-insuring, resulting in fewer claims and less demand for industry capital. Although some growth was achieved with the increase in demand as the economy recovered after the recession, typically insurance is not seen as a discretionary purchase and thus is not generally affected by fluctuations in the economy, similar to utilities. For this reason, a comparable spike in demand for new policies is not to be expected in the foreseeable future.

More recently, demand generated from catastrophe claims was not strong enough to reduce the capital surplus to a level that would drive the industry into a hard market. Although the United States experienced one of the deadliest tornado seasons in 2011 and saw the landfall of Hurricane Irene,² one of the most costly hurricanes in the nation's history, which caused higher claims numbers to harden market pricing temporarily, surplus in capital quickly returned the industry to soft market conditions. Overall, policyholders' surplus dropped just 2.5 percent from the record-high level on March 31, 2011, to $550.3 billion at year-end 2011.³

Profitability

With the soft market challenging top-line growth for P&C insurers, profitability has become more reliant on investment income and cost-cutting strategies. Investment income is used to pay for claims as they arise and thus serves as a gauge for the stability of a company. Because investment income is essential to operations, many insurers invest primarily in low-risk, fixed-income securities to ensure cash flows. However, low interest rates have reduced the income that can be achieved through these investments and have provided insurers with the motivation to seek returns elsewhere.

For instance, equities, which make up approximately 17.0 percent of investment income in the industry, are likely to see gains as the economy recovers.⁴ In 2011, net investment income rose approximately 3.0 percent and consisted primarily of interest earned on investment-grade bonds.⁵ Income from fixed income securities will see greater increases with a rise in interest rates, which the U.S. Federal Reserve has stated is not expected to occur until mid-2013.⁶

The recent poor investment performance and limited top-line growth has resulted in much of the industry placing greater importance on cost-cutting, primarily in the form of reducing underwriting losses. Although surplus capital has in the past encouraged insurers to take on riskier projects to drive growth,⁷ net written premiums are actually expanding at a slower rate as the soft market continues. Compared to 3.8 percent growth in net written premiums in the fourth quarter of 2011, premium growth declined to 3.1 percent in the first quarter of 2012.⁸

Advancements in actuarial technology as well as growth in available customer information should assist insurers in targeting customers with the greatest profit potential. Analytical estimates suggest that companies that price policies in a way that successfully deters risky policy-seekers can see improvements to their combined ratio of 3 to 5 percent and premium growth of 5 to 15 percent.⁹

Risk

Industry risk consists of interest rate risk, reserve risk, and the risk that premium pricing will inadequately account for claims losses, known as underwriting risk.¹⁰ Inherent in the P&C insurance industry is the risk related to underwriting policies. In soft market times, insurers have been known to participate in riskier underwriting practices to strengthen demand for capital and ultimately drive up premium prices. Although the combined ratio, a measure of underwriting profitability, recorded underwriting losses in 2011,¹¹ the low performance of investments suggests that insurers will want to be more cautious with their underwriting practices. With lower income from investments to pay for claims, the pricing cycle may not weigh so heavily on insurers' underwriting policies, likely resulting in a continuation of the soft market.

Conversely, in an attempt to reduce excess surplus and improve profitability, some insurers are contributing to their bottom line by releasing loss reserves. This activity adds to the risk of the insurer by establishing the possibility that enough reserves will not be available should a significant catastrophic loss be incurred. Additionally, should this trend reverse in the future, when a company chooses to strengthen its reserves, it will appear less profitable and suffer consequences in capital markets.

Current Valuation Trends

I analyzed the following publicly traded companies for the purpose of this article as I believe they accurately reflect valuation trends within the P&C segment of the insurance industry.

• AmTrust Financial Services, Inc. ("AFSI")
• The Allstate Corporation ("ALL")
• CNA Financial Corporation ("CNA")
• EMC Insurance Group Inc. ("EMCI")
• Meadowbrook Insurance Group Inc. ("MIG")
• The Chubb Corporation ("CB")
• Cincinnati Financial Corp. ("CINF")
• Erie Indemnity Company ("ERIE")
• Progressive Corp. ("PGR")
• RLI Corp. ("RLI")
• Safety Insurance Group Inc. ("SAFT")
• Selective Insurance Group Inc. ("SIGI")
• The Hanover Insurance Group Inc. ("THG")
• The Travelers Companies, Inc. ("TRV")
• Tower Group Inc. ("TWGP")
• W.R. Berkley Corporation ("WRB")
• Alleghany Corp. ("Y")

Data depicting the average forward P/E multiples for these companies is reflected in Figure 1. The multiples shown in the graph are based on forecasted 2012 earnings with an average multiple of 13.8 times.

Figure 1:

Variations across the representative companies can be attributed to both qualitative and quantitative factors, including those discussed above. I noted that the 5-year average long-term earnings growth for these companies was 9.3 percent compared to 11.2 percent at the time of my August 2009 article. This decline in growth expectations for earnings per share reflects the maturing and saturation of the industry. Levered betas for each of the companies analyzed are below the market beta, reflecting a low sensitivity to fluctuations in the market, similar to utility securities. During the recession, the perception of insurers' securities as low-risk contributed to the surplus capital in the industry as many investors were following a low-risk investment strategy at that time.

The average forward P/E multiples over the past 2 years are shown in Figure 2. This graph depicts the insurance pricing cycle at work. In the second half of 2011, the soft market hardened to reflect the active tornado season and the landfall of Hurricane Irene in North Carolina, which occurred on August 27, 2011. As a result, the P/E multiples spiked, tracking the increased demand. Early in 2012, prices, as well as multiples, returned to previous soft market levels due to the surplus capital in the industry.

Figure 2:

Outlook

With interest rates likely to remain low through mid-2013, it is possible that the soft market will continue. This factor, along with the competitive and maturing nature of the industry, could continue to make top-line growth a challenge for insurers. However, overall strengthening of the economy has the potential to cause declines in the industry's combined ratio due to increases in demand and income from equity investments. Uncertainty regarding catastrophes and premium prices going forward should have a direct effect on industry risk and may indirectly affect profitability by encouraging insurers to strengthen reserves.

¹"IBISWorld Industry Report 52412 Property, Casualty and Direct Insurance in the US," Doug Kelly, September 2012.

²"How the Market Performed in 2011," Lloyd's of London, 2011.

³"2011—Year End Results," Insurance Information Institute, April 16, 2012.

⁴"IBISWorld Industry Report 52412 Property, Casualty and Direct Insurance in the US," Doug Kelly, September 2012.

⁵"2011—Year End Results," Insurance Information Institute, April 16, 2012.

⁶"Top Insurance Industry Issues in 2012,"  PWC, 2012.

⁷"The State of the Commercial P&C Market," Advisen Ltd., April 2012.

⁸"ISO: P/C Insurers' Profits and Profitability Rose in First-Quarter 2012, Propelled by Improvement in Underwriting Results," Insurance Information Institute, June 27, 2012.

⁹"The P&C customer rediscovered through analytics," Bain & Company, September 13, 2012.

¹⁰"How the Market Performed in 2011," Lloyd's of London, 2011.

¹¹"Industry Economic and Ratings Outlook: Stable Demand And An Ability To Withstand Losses Should Support U.S. Property/Casualty Insurers' Financial Performance," Standard and Poor's Financial Services, May 30, 2012.