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.