First, I present various factors and trends that have
recently impacted the industry. Specifically, I discuss key
updates concerning the state of the US economy, bond yields,
government regulation, catastrophic events, and technology, all
of which have affected the P&C insurance industry. Next, I
analyze recent prospects for growth and profitability, as
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. These factors are affected by the insurance pricing
cycle, which is dependent on whether premium pricing periods are
soft or hard. After touching on industry risks, I discuss the
valuation of P&C insurers based on current market trends and
industry performance.
Factors Impacting Current Market Conditions
P&C industry performance, among other factors, relies on the
state of the economy. Gross domestic product (GDP) growth
improved moderately over the past year, as favorable financial
conditions were experienced at the end of 2013 with equities
increasing while bond yields and mortgage rates were lower. The
performance of the economy largely impacts movements in interest
rates, making this a significant factor in P&C market trends, as
the majority of P&C investment income is related to fixed‑income
securities. The other significant income source is stock
dividends, representing approximately one-sixth of the
industry's invested assets.
The industry's net investment income declined every year
since 2007 due in part to economic stimulus plans implemented by
the Federal Reserve.1 Corporate bond market yields,
as evidenced by Moody's AAA-rated seasoned bond index, averaged
3.85 percent for the first 5 months of 2013.2
However, when the Fed announced it would begin to taper off its
stimulus plans, June 2013 yields jumped to an average
4.27 percent, which has had a positive impact on investment
income in the P&C industry.3 The yield on the Moody's
AAA-rated seasoned bond index continued its rise to
approximately 4.60 percent by 2013 year end.
Aside from economic activity, government regulation also
affects the activity and profitability of the industry. Despite
discussions this past year about the potential impact of various
US and foreign regulatory reform initiatives on the insurance
industry, 2013 saw relatively few changes directly affecting P&C
insurers. Insurance regulation remains state-based, despite the
implementation of the Federal Insurance Office (FIO) as part of
the Dodd-Frank Act in 2010. Other forms of regulation, such as
the Securities and Exchange Commission (SEC) overseeing publicly
traded insurance companies, have enhanced competition and
therefore kept pricing in line across the industry.4
Furthermore, catastrophes are an integral factor of P&C
insurer profitability. The United States experienced a number of
severe weather incidents, with the most costly being the tornado
in Moore, Oklahoma, in May 20, 2013, which caused an estimated
$2 billion in losses, though overall catastrophic losses were
fewer and lower in 2013 than in 2012.5 The third
quarter is historically the most costly for P&C insurers, as
these are the peak months of tropical activity. However, the
industry experienced minimal claims this year to further help
industry profits. This is in contrast to a year prior with
Hurricane Sandy, which represented a $19 billion industry event.6
Lastly, technology has played a large role in the efficiency
and competition of the industry, ultimately affecting prices and
profitability. Developing strategies to better integrate and
leverage existing and emerging data sources within current
technology platforms has been a challenge for the industry.7 However, as discussed in a previous article,
advancements in actuarial technology as well as growth in
available customer information should assist insurers to more
accurately assess policy risk.
Growth and Profitability
The trends mentioned above all influence the growth and
profitability of the industry. Generally, companies with greater
prospects for growth are more valuable than companies with less
growth potential, holding all else equal. P&C insurers generate
growth by underwriting more insurance policies and/or through
rising premiums. The main drivers of profitability for the P&C
insurer are the number of written contracts, the amount of
premiums, the level of investment returns, and the occurrence of
catastrophic events. While these events generally affect most
P&C insurers, the ultimate impact on the valuation depends on
each individual insurer's exposure to the product line in which
the event occurred. In general, changes in profitability
relating to claims-related payments are not controllable by the
companies.
Growth for P&C insurers has been stifled in the past 5 years
due to a soft pricing cycle, historically low interest rates,
increased competition, and volatile equity markets. However, the
P&C industry has improved in the past year as a result of the
overall rise in premium volume in part due to higher prices and
the expansion of insurable exposures in a slowly growing
economy.8 Though premium volume has risen, pricing
power for insurers has weakened due to a higher number of
entrants into the market from nontraditional sources such as
hedge funds and pension funds.9 Profitability
rebounded in 2013, making it the best year since the financial
crisis and the heavy catastrophic losses in 2011 and 2012. This
improvement was fueled by growth in premiums, a reduction in
catastrophic losses, and favorable prior year reserve
development.
These positive factors caused the industry combined ratio to
fall to 95.8 in the first 9 months of 2013 from 100.7 the year
before, which led to an industrywide underwriting profit of
$10.5 billion.10 However, the improvement in underwriting and
investment results was partially offset by a drop in
miscellaneous other income and higher taxes. In addition, the
catastrophe losses for the first 9 months were $11.7 billion,
far below the 10-year historical average for the first 9 months
of $20.0 billion.11
Favorable reserve development has strengthened as claims
reserves totaled $13.9 billion in the first 9 months of 2013,
much higher than the $8.4 billion experienced in the first 9
months of 2012. As a result, industry return on average surplus
rose to 9.5 percent in the first 9 months of 2013, up from 6.5
percent the year before, and well above the 5.9 percent and
3.5 percent returns for the entire years of 2012 and 2011,
respectively. The ratio of net premiums written to surplus, a
common measure of capital adequacy, was approximately 0.78 in
2013, which is high relative to long-term historical averages.12
Risk
There are several risk factors that can be critical when
analyzing a company in the P&C industry, including the risk of
underwritten premiums, the effects of reinsurance of the
company's exposure to claims-related expenses, and the risks
associated with the insurer's investment portfolio.
Additionally, analyses of the company's liquidity and leverage
provide insight into the overall risk of the company.
The risk
of underwritten policies should generally be considered in the
context of the company's growth in premiums written. Higher risk
policies will tend to have a negative effect on the value of the
insurer. However, the benefit of higher growth associated with
underwriting riskier policies will generally have a positive
effect on value; thus, an analyst would often weigh these two
effects in the valuation analysis. A helpful tool in analyzing
this risk is the loss ratio. The loss ratio measures the
historical amount of losses relative to premiums earned and is
typically between 60 and 80 percent.13
During periods of catastrophic events, loss ratios in the
industry can rise significantly.
A factor that can reduce the
risk of an insurer is the utilization of reinsurance. Greater
use of reinsurance generally lowers the risk of an insurer and
will have a positive effect on value. However, a higher level of
reinsurance means that premiums the company would otherwise
receive are shared with a reinsurance company.
Insurers are
also exposed to risk associated with their investment
portfolios. While higher risk may result in greater investment
income, it could also result in less investment income,
depending on overall market performance. Typically, insurers
will hold relatively liquid investments, allowing the company to
access the funds quickly if needed for claims-related expenses.
Given that catastrophic events can quickly and significantly
change the insurer's need for cash, liquidity can be an
important factor with respect to the company's risk profile. An
insurer with greater resources and cash flow to cover its
potential claims and other liabilities will likely be more
valuable. The increase in the company's leverage, while allowing
its equity holders to benefit from additional sources of
financing, increases the company's risk profile by creating an
additional layer of cash outflow required to service its debt.
Current Valuation Trends
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)
| |
- 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)
| |
- Mercer Insurance Group, Inc. (MIGP)
| - W.R. Berkley Corporation (WRB)
|
| |
Fluctuations in the insurance cycle, as well as a company's
value, are captured in the respective price-to-earnings (P/E)
multiple. Figure 1 below illustrates the average forward P/E
multiples from 2008 through 2013.
This graph depicts the insurance pricing cycle at
work. In the second half of 2012, the soft market hardened to
reflect the landfall of Hurricane Sandy in late October 2012. As
a result of Hurricane Sandy, the P/E multiples spiked, tracking
the increased demand. Throughout 2013, prices, as well as
multiples, returned to previous soft market levels due to the
surplus capital in the industry.
In 2012, P/E multiples
increased significantly, as greater gross domestic product (GDP)
growth and optimism in the markets spurred economic activity.
The average multiple for 2011 was 16.1 times, while the average
multiple for 2012 rose to 19.5 times, as shown in Figure 2
below. Though the average multiple in 2013 slightly decreased to
18.1 times, the long-term earnings per share (EPS) growth rate
is projected to increase from its small dip in 2012.
Outlook
Because of the P&C industry's robust performance in 2013, it
will be challenging to match similar results in 2014. It is
anticipated that 2014 will return to more normalized
catastrophic losses and insurers' growth prospects will be
impacted by the strength and staying power of the economic
recovery. Though GDP growth remains well
below historical trends, growth is expected to continue in 2014
as real GDP growth reached 4.1 percent in the third quarter of
2013.14 In terms of interest rates,
Barclays Capital projects that the 10-year US Treasury yield
will gradually rise from 2.85 percent to about 3.5 percent by
the end of 2014, as the Fed announced it would taper off its
program of buying long-maturity Treasury and agency bonds in
January of 2014.15
Conclusion
In
conclusion, market trends are favorable, including positive
underwriting results and strong industry capital coupled with
stable demand. However, a weakening reinsurance environment and
less underwriting discipline point to a soft market where prices
are pushed lower. It will be interesting to observe the P&C
industry valuations in the near future as the market reacts to
these trends. As previously noted, there are many factors that
affect the valuation of P&C insurance companies, and with the
recent volatility of market conditions, there is a high level of
speculation regarding the future of the insurance industry.
Overall, companies that manage cyclicality effectively,
consistently practice conservative underwriting, and diversify
investments to minimize risk will outperform compared to others
in the industry.
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Match 2013 Results in 2014,"
Insurance Journal, January 15, 2014.
2"2013—First Nine Months Results," Insurance Information
Institute, December 23, 2013.
3"2013—First
Nine Months Results," Insurance Information Institute, December
23, 2013.
4"Industry Surveys,
Insurance: Property-Casualty," S&P Capital IQ McGraw Hill
Financial, September 2013.
5"Industry
Surveys, Insurance: Property-Casualty," S&P Capital IQ McGraw
Hill Financial, September 2013.
6"P/C
Insurers Face Challenge to Match 2013 Results in 2014,"
Insurance Journal, January 15, 2014.
7"2014 Property and Casualty
Insurance Industry Outlook," Deloitte Center for Financial
Services, January 6, 2014.
8"2013—First
Nine Months Results," Insurance Information Institute, December
23, 2013.
9"2014 Property and
Casualty Insurance Industry Outlook," Deloitte Center for
Financial Services, January 6, 2014.
10"2013—First
Nine Months Results," Insurance Information Institute, December
23, 2013.
11"P/C Insurers' Bottom
Line Through Nine Months Improved As Growth in Premiums and Drop
in Losses Boosted Underwriting Results," Insurance Information
Institute, December 23, 2013.
12"2013—First
Nine Months Results," Insurance Information Institute, December
23, 2013.
13"Insurance:
Property-Casualty," Standard and Poor's Industry Surveys, July
26, 2007, p. 27.
14"Zacks Economic
Outlook," Zacks Investment Outlook, January 20, 2014.
15"P/C Insurers Face Challenge to
Match 2013 Results in 2014," Insurance Journal,
January 15, 2014.