Capital in the insurance industry is likely to remain restricted in 2003 and the industry is going to have to behave itself for some considerable time or risk extinction, says Chris Hitchings.
Most insurers and followers of this industry must have raised a glass on New Year's eve to bid good riddance to 2002. We presumed that, while 2003 may not be much better, it could hardly be any worse. Two months on and we are not so sure. The stock market continues to plummet - with the average European equity index down 15% so far - and insurance share prices down an average of 27%. The panic, of course, is on what falling equity values may do to the capital base of insurers, not to mention demand for savings products and, thus, the margins on selling them. To this is added the fear that insurers, desperate to shed risk as their balance sheets dwindle, will be forced to sell equities. With few investors prepared to buy as US troops mass on the Iraqi border, this would push equity markets down further and so, for the moment, the spiral of despair looks set to continue...
Although much of the stock market's concern has been about life insurers - which are hit two ways by falling prices - the news from the property/casualty (p/c) and reinsurance sector has not been positive either. Asbestosis problems have been bubbling for some time but a series of substantial provisions by major insurers and reinsurers has raised the issue to centre-stage again. Added to this are concerns about where all the credit risk, that banks insist they have sold on, has ended up. More worrying has been the rapid spread of adverse development on more recent years. For most of 2002, we could imagine that the issue was limited to a handful of lower-grade businesses that had written what they did not understand in the heady days of the last downcycle. American International Group (AIG) hardly fits into that category and its shock announcement has prompted concerns across the whole sector. Judged by lacklustre earning indications across the industry - from Swiss Re downwards - this concern looks more than justified.
Capital concerns may be making the stock market more short term in its outlook than usual but the increasing irritation towards the p/c sector is palpable. 2001 was supposed to be a year of recovery, only spoiled by the horrors of September 11. "No worry," said insurers and reinsurers as they gulped a wadge of new cash, "capacity shortages post that event will make 2002 a year to remember." It certainly was that, although not in the way we had imagined. Now, as the `jam tomorrow' mantra is trotted out again, the insult is multiplied as we see the outcome of the January 2003 reinsurance renewal season. Competition for aviation and property business seems to have broken out and rates are flat or down. This industry, it would appear, has started to compete away its hard-earned upturn in margins before we have even seen it!
Against that background, it might be a brave insurer who tried asking investors for more capital now and, thus, the industry is going to need to learn to live within its means. As those means dwindle in the market, the background looks increasingly testing. There is no doubt that existing companies are short of capital. Not only that, there is the problem of what happens to interest rates. Most insurers have tried to secure what capital they have by dumping equity risk and moving cash into bonds. As noted, this has pushed down equity values but it has also pushed up bond values. The insurers' dilemma is that, if bond yields stay at present levels, it is doubtful that even the current high insurance rates will deliver sufficient overall margins. However, if yields rise, the consequent fall in bond values will lead to large investment losses. These will be only partly offset by the recovery in values of the companies' much reduced equity portfolios.
In truth, capital in this industry is likely to remain restricted until it is rebuilt by accumulated retained profits. Thus, the industry is going to need to behave itself for some considerable time or risk extinction. Such long-term structural arguments are not persuading many investors at present but there is little doubt that, when this bear market ends - and they all do eventually - there will be some bargains to be had in the insurance sector.
By Chris Hitchings
Chris Hitchings is a European Insurance Analyst at Commerzbank Securities.