2014 P&C Insurer Valuation Outlook

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.

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.

^1"P/C Insurers Face Challenge to 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.