Is the reinsurance sector a victim of an inevitable industry cycle or does it have a more fundamental image problem?
It all comes down to perception. Valuations of reinsurance companies appear to be trapping trading in the sector at historic lows. Investors are hesitant to commit capital to reinsurers while analysts issue relatively few ‘buy’ recommendations.
Admittedly, the industry is sailing into some pretty strong headwinds as investment returns and underwriting profits come under significant pressure.
But beyond these factors, does the industry have an image problem and how can investors be made to see its inherent charms? Perhaps it could do a better job of making itself understood and overcoming the fallout from catastrophes that have wiped out its capital by promoting itself more actively. Or is this just a product of participating in a cyclical industry during the soft market?
“Historically there have been a few reasons why valuations have lagged,” says one industry analyst.
In today’s market, however, the tough economic climate is thought by many to be partly responsible for the depressed share prices, particularly as there remains uncertainty as to exactly where on the cycle the industry is.
Guy Carpenter global head of business intelligence David Flandro writes in a report: “There is a belief that softening reinsurance pricing will become softer. Lower pricing of varying degrees has been seen in the most recent reinsurance renewals. This creates several areas of downward earnings pressure, both now and in the longer term.
For carriers exposed to particularly soft prices, top-line premium growth could slow or decrease.”
He adds: “Worse, if companies are too aggressive in a softening market, adverse reserve development – that great destroyer of reinsurance capital – may soon rear its ugly head. Investors remember the events of the last soft cycle: significant reserve strengthening, particularly on longer tail lines. This has caused them to be nervous about owning reinsurers’ shares.”
The industry analyst agrees. “Reinsurance companies post loss reserves against future claims and there’s a feeling that companies are too optimistic about the levels required. So they will have to strengthen them at some point. But I do not think we are at a point where liabilities are understated.”
Dealing with losses
Reinsurers have suffered a year of heavy losses. The Chilean earthquake and European storms have triggered industry-wide losses of $22bn.
However, dealing with such losses is part and parcel of the industry – capital is plentiful at reinsurers despite them. So without a major catastrophe, sector valuations look set to remain at multi-year lows. Fitch Ratings estimates that total excess industry capital is $330bn.
Numis Securities analyst Nick Johnson says: “We have reduced debt leverage. Anticipation of Solvency II has meant capital has been retained rather than returned to shareholders through special dividends or share buy-backs.
“One area where there would be an element of investor frustration is Solvency II and the lack of information and understanding around that. Investors do not really understand how capital requirements relate to reinsurers because it is not very prescriptive.”
Flandro asks: “Why are these companies’ forward returns on equities (ROE) so low? Is it fear of overly aggressive growth followed by reserve strengthening? Is it heavy exposure to low-yielding assets? Is it unusually high catastrophe exposure?”
He adds: “Why, in a softening market, do the favoured few trade at such a premium? Is it their unique underwriting acumen, superior risk protection, or careful and well-advised capital allocation?”
The problem is that high levels of industry capital depress prices. So while the likes of Everest Re are reallocating capital from property to more profitable healthcare lines, others, such as Munich Re and PartnerRe, have returned cash to shareholders this year, but in buy-backs of less than $1.5bn.
“It is because their business models are not very clear and they show a lack of growth,” the analyst comments. “If you are not a growth prospect at the moment you need to become a value play, but reinsurers are a bit hit and miss. Munich Re has done a superb job of returning capital but once the current plan ends nobody knows what is going to happen next.”.
According to Fitch: “As long as uncertainty over capital requirements under upcoming Solvency II regulation remains, most reinsurers will maintain high capital buffers. That makes
them reliant on a catastrophe with losses exceeding $30bn-$50bn – in the same league as 2008’s Hurricane Ike – to stem declines in premium rates.
Until then, a persistent discount to book value for listed players remains the dismal forecast.”
The valuations are such that, technically, many firms would be worth more if they discontinued underwriting today and went into run-off, which would also relieve pressure on management to provide growth in a soft market.
The industry analyst says: “If you think about the cost of capital, it is around 10%. Investors and analysts are focused on the marginal returns and coming to the conclusion that returns will not exceed the cost of capital.
“If you were to stop writing business today, the company would be worth more because of the loss reserves and the time value of money.”
Underpinning this truth is the pressure on both investment income and underwriting profits. It is such that, according to research by Credit Suisse, most lines of business will be unprofitable by the end of next year if premium pricing rates and fixed income yields do not improve.
“Investment returns are as low as they have ever been,” Johnson says.
According to Flandro, a key factor is the low value of investment-grade bond yields, which reinsurers now rely on for returns.
“In many regions, these bonds trade at or near 40- to 50-year lows. With the heavy focus on underwriting in the reinsurance sector comes the danger of forgetting that well over half of carriers’ earnings are supplied by investment income over the cycle,” he says. “When fixed income securities yields are low, this crucial income stream diminishes.
“This scenario has existed in varying degrees since the depths of the financial crisis and shows few signs of abating.”
Even if the investment picture were rosier, some reinsurers may still have a problem, believes one reinsurance broker. “The investment community does not have any confidence in the assets of reinsurance companies. That may have been fair enough before the credit crisis, when some firms held credit default swaps and mortgage-backed securities, but now assets are pretty stable,” he says.
While the wider investment environment is beyond reinsurers’ control, in theory at least underwriters do have a greater say over rates and pricing for the business they write.
However, despite first-half losses this year, rates remain flat or continue to slide in most geographies and classes. It appears that client retention is more important to reinsurers than underwriting discipline as most will not jeopardise relationships with major cedants by raising prices. Market share is once again trumping underwriting profit.
“Reinsurers in general are competing with their clients, the primary insurers, which have an advantage over them in that they require less capital,” the analyst says.
But the market is cyclical and it was not that long ago that rates were hard and reinsurers were reporting healthy profits every quarter.
“What matters more than simply looking at results is returns on net tangible assets [NTA], and by and large that return is mid-teens at the moment, whereas historically it has been up to 25%-30%,” Johnson says.
Haggie Financial senior partner David Haggie agrees. “Because they are reinsurance companies, investors look at the NTA; they don’t look at profits. If they were engineering companies making these profits, people would be dying to back them.”
So could the reinsurance sector do a better job of attracting and retaining investors?
“The reinsurance industry overall does quite a good job of investor relations,” Haggie says. “Investor relations is about talking to investors and making sure they are in the loop about what and how you are doing. That takes resources, and chief executives do not always have the time to do as much of it as they would like. Hence the role of the investor relations officer.”
He continues: “There are some very good investor relations people out there, but investors do want to talk to the chief executive or the chief financial officer as well. Your major shareholders need to be spoken to on a one-to-one basis. You need to give investors a clear message explaining what your business is all about. Then they will back you.”
Johnson agrees. “Reinsurers put a lot of effort into investor relations but it is the industry itself that is the problem. It is more down to the fundamentals of the industry we are in, and I’m not sure investor relations can get round that.
He concludes: “Investors do not like risk and uncertainty.”
Yet that is always going to be an occupational hazard for reinsurers operating in the business of risk. The challenge is to ensure investors focus on their “best” side. GR