I view the insurance industry as a loosely related group of
sub-industries, where knowing something about one sub-industry
tells little about any other sub-industry. Even within each
sub-industry, companies can be very different from each other. This
article will attempt to go through the vast wasteland that is the
insurance industry, and attempt to point out some of the more
interesting aspects of it.
There are three major risk factors with insurers: the
underwriting cycle, investment returns, and expense control.
1) The Underwriting Cycle
The property/casualty insurance industry, like all mature
industries, is a cyclical business. Cyclical businesses revolve
around pricing, which involves the relative degree of capacity
available in the industry.
The P/C industry derives its capacity to write business from the
amount of surplus available to support business. This creates a
four-phase cycle for the industry.
- When surplus is abundant, rate-cutting is prevalent, and
generally poorer-quality business gets written in an effort to
retain market share. Terms and conditions for insurance are
loose. During this period, the prices of P/C companies fall
relatively hard, as prospective estimates of profitability
- After enough poor quality business gets written, and premium
rates decrease meaningfully, high quality companies exit lines of
business, or buy reinsurance, and low quality companies begin to
look impaired. At these times, the stock prices of high quality
firms fall a little, and low quality firms fall more.
- As the results of bad business become evident, reserves get
raised, sometimes drastically, and surplus declines. When surplus
is deficient, premium rates rise, and the stocks of companies
that have survived the cycle rise dramatically. The best business
from both a profit and risk control standpoint, gets written in
this phase of the cycle Terms and conditions for insurance are
- When surplus becomes adequate, premium growth rate slows, and
stock prices rise slowly, at roughly the rate of retained
earnings. This continues until surplus is abundant.
Catastrophes, when they happen, temporarily reduce surplus, and
improve pricing. The companies least affected by the cat rally, and
those most affected, tend to fall, or rise little. Major
catastrophes can cause the cycle to bottom, or extend the positive
side of the cycle, because surplus is diminished.
The rating agencies tend to cut ratings near phase 2, and raise
them near phase 4. Diminished ratings decrease the amount of
business that an insurer can write, and further limit the
willingness of prospective purchasers of insurance, particularly
long-tailed coverages, who want to be sure that the company that
they buy insurance from will be around to pay claims.
2) Investment Returns
Strong investment returns increase surplus. In a bull market,
some companies become more aggressive about writing business so
that they can earn money from investments. This is particularly
true of companies that sell coverages that result in long-tailed
liabilities. Strong investment returns prolong phases 1 and 4 of
the cycle. Investment returns were so strong throughout the 1990s
that insurers often compromised underwriting standards, leading to
much of the troubles that occurred in the industry from late 2000
to early 2003. Not only were investment returns low or negative,
but the results of prior poor underwriting were realized through
reserve adjustments that diminished surplus.
3) Expense Control
Every time a premium gets calculated, there is an estimate
embedded in the premium for expense. Expenses typically take three
forms: policy acquisition, claims adjustment, and operational.
There is a tendency for expenses to drift higher when investment
returns are strong, and when the market is softening due to greater
Now I will discuss each sub-industry separately. Included in
each discussion is a description of products, risks, and industry
performance over the last ten years. The graphs show the
performance of each sub-industry over the last ten years, derived
from my own proprietary indexes. At the end, I give my outlook for
Bringing It to the Present:
This series was written seven years ago in an all-nighter for
my new boss. The piece never saw the light of day, which annoyed
me, though I liked my boss, and I never complained about it.
As I publish the ten-or-so pieces of it, because it was long,
at the end of each installment, I will try to update the
insurance subindustries to the present. But it would be useful
for anyone reading this to look at my presentation to the
Southeastern Actuaries Conference on the "
Amazing Decade for Insurance Stocks
." Aside from that, I have lost the graphs of the original
presentation. My apologies.
Insurance is an amazing business. Insurers make promises.
Many of the promises are uncertain with respect to amount and/or
timing. That makes the accounting complex. This is one of the
reasons why examining the qualitative aspects of an insurance
company to understand how a management team makes decisions is so
Life insurance probably has the most complex accounting of any
of the sub-industries. Part of this comes from the complexity of
the contingencies underwritten, and most of the rest from producer
compensation and the length of the contracts underwritten.
Life insurance and annuities are sold, not bought. In general,
people have a mental bias toward thinking that they aren't going to
die in the immediate future. Annuities are often sold to people who
won't otherwise plan for their retirement. To overcome those
biases, life insurance companies pay agents handsomely to originate
policies. The commission is large enough that if the company
expensed it, it would lose money on a GAAP basis every time it
issued a policy. That's why policy acquisition costs are deferred,
set up as an asset, and amortized in proportion to the gross
profitability of the business over the life of the business.
Reserving for term policies isn't very complex, but reserves for
cash value policies are set as the expected present value of future
benefits less future premiums. Small changes in interest,
mortality, and lapse rates can make large changes to reserve
values. Other contingencies can affect different classes of
policies as well; variable and indexed contracts rely on returns of
the stock and bond markets. Higher assets under management mean
There is a second business that most life insurance companies
engage in. Since the companies would not be profitable if they
invested in Treasury securities, they typically invest in corporate
bonds, mortgage-backed securities, and other risky forms of debt.
Some also invest in commercial mortgages and real estate. When
there is stress in the credit and mortgage markets, life insurance
companies do poorly.
In reviewing the performance of life companies as group from
March 1994 through March 2004, one can see the effect of the major
drivers of profitability. Underwriting was typically profitable for
companies throughout the entire decade, so that was not a
differentiating factor. Most of the shifts in profitability came
from investment results. The credit cycle was generally positive to
the beginning of 1999, negative 1999-2002, and positive after that.
The equity market supported variable life and annuity writers until
the bull market peak in March 2000, punished them until March 2003,
and has rewarded them since then. The only period that deviated
from this description was after the bubble popped in March 2000;
life companies temporarily did better as equity investors fled
technology stocks for the safety of stodgy sectors like life
The outlook for life insurance is no different than the past; it
is tied to the outlook for the asset markets. If the credit and
equity markets do well, so will life companies.
Bringing It to the Present:
Many of the things that I wrote back in 2004 regarding life
insurers have proved prescient. Life insurers have prospered as
the asset markets have prospered, and suffered during the bear
markets. On average, life insurers have done better than other
financials, and better than the market as a whole since
One advantage the life insurers had 1999-2003 was that they
got burned on CDOs and did not get caught in the bubble. Even
with other types of structured lending, life insurers got more
conservative 2003-2005, unlike most of the rest of the financial
sector. Life insurers noticed the poor underwriting, and stayed
It should be noted that there are life insurers that do a lot
of variable business, and those that don't. Those that write a
lot of variable life and annuities will be more sensitive to the
stock market than those that don't write a lot of variable
One final squishy spot: secondary guarantees. With Universal
Life and Variable Annuities, there are secondary guarantees where
the reserving is questionable. Also true of long-dated term
policies… be aware that there might be some bombs lurking there,
that will manifest in severe economic scenarios.
If someone wants to drive a car or take out a secured loan,
personal lines insurance typically needs to be bought to protect
the interests of other drivers, and lenders, respectively.
Personal lines coverages are simpler in their form, in that they
typically renew annually. Commissions are smaller than for life
products. Reserves divide into two classes, those for the premium
paid but not yet earned, and those for claims incurred. Incurred
claims fall into two categories: those reported to the company, and
an estimate of those incurred but not yet reported to the company
Personal lines insurers have two sources of profit, underwriting
and investment income. The track record of the industry has been
less than stellar. Most companies over the past fifteen years have
lost money on underwriting and made money on investments. In
general, the best managed, and most profitable personal lines
writers give up sales growth in order to have an underwriting
This has been less true of homeowners' insurance, where personal
lines writers have consistently lost money on underwriting. Part of
the reason for that is homeowners is often treated as a poor
stepchild to auto insurance, and only used to generate additional
Performance of the personal lines insurers over the past ten
years reflects the relatively hard market through 1997, with strong
investment performance through 1999 not getting reflected in stock
prices. Money was flowing away to technology stocks. In March of
2000, the next hard market began, and the stocks personal lines
insurers rebounded, despite relatively poor performance in the
At present, the personal lines insurers are entering phase 1 of
the underwriting cycle. Premium rates are trending flat in
automobile, and rising in the low single-digit percents for
homeowners, but the increases are slowing. Valuations are not
excessive, so there should not be a major selloff, unless premium
rates soften dramatically. We expect premiums to remain flat for a
while, so personal lines stocks should perform at roughly the rate
of the return on equity for now.
Bringing It to the Present:
We are back to Phase 1 of the underwriting cycle. There have
been no big disasters, God-given or man-made to deplete surplus,
for a long time.
My view is that the personal insurers should always trade at
a premium to the commercial insurers because they are safer. It
is always easier to run a short-tail company than a long-tail
company. At present, that relationship is normal.
Personal lines companies have a tailwind in that the
zeitgeist has policymakers taking actions to prevent accidents -
graduated licensing, anti-drunk driving, making cars safer for
drivers even it creates more cars that get totaled, while
passengers survive better.
Valuations are reasonable-to-cheap in aggregate here, and the
same is true of the life sector. I am overweight insurers by a
factor of six, relative to their weight in the indexes. They
comprise all of my exposure to financials.
I am rarely a fan of commercial lines insurers. Over the past
ten years, it has been the lowest returning sub-industry in
insurance. There are several reasons for this: first, asbestos has
been an open-ended drag on the industry's surplus. Second, many
commercial lines companies underwrote coverages where those insured
understood the risk better than the companies. Examples of this
include directors and officers, errors and omissions, surety,
environmental, and political risk. Third, the devolving legal
landscape has often left commercial lines insurers at a
disadvantage in the courtroom. Policies get interpreted as
providing coverage in ways not contemplated at the contract's
inception. Fourth, wars over market share depress premium
Commercial coverages are typically larger in size, and do not
share in the law of large numbers to the same degree that life and
personal lines do. Underwriting results have a greater degree of
variability because of this. The greater degree of profit and loss
potential attracts less cautious insurance executives,
underwriters, and investors. This can lead to tremendous results in
the stock market if you buy the commercial lines stocks just as the
underwriting cycle shifts from phase 2 to phase 3, such as in 2000.
It can be equally bad if you buy them as the underwriting cycle
shifts from phase 4 to phase 1, such as in 1998-1999.
Reserving for commercial lines insurers is similar to that for
personal lines insurers, but the main difference comes from the
uncertainty of claims reporting in long-tailed coverages. With auto
and home coverages, most claims are filed and settled within a few
months. Almost no claims extend over two years. Now considerable
environmental damage coverage: claims could be filed decades after
occurrence, settlement could take years, and the size of the claim
could be significantly larger than anticipated. This makes reserve
setting for commercial lines insurers more of an art than a
Secular shifts in society can utterly change the probability and
severity of claims. As an example, consider directors and officers
[D&O] coverage before and after 2000. Many of the events in the
corporate scandals investigated in the last few years came from
events in the 1990s. Insurers writing D&O coverage in the 1990s
had to raise their reserves for accident years the 1990s but the
financial result was felt between 2001 and 2003.
Many industry analysts, including the rating agencies, still
believe that reserves are insufficient by roughly $50 billion, and
that this black hole is spread among the commercial lines insurers
and reinsurers of the world. The soft market accident years of
1997-2001 are blamed for this insufficiency. The question that wins
the big money for this space goes to the clever analyst that can
figure out to whom the black hole belongs.
The $50 billion insufficiency is probably why the stocks of the
commercial lines insurers have gone nowhere over the past six
years, even in the face of a very hard insurance market over the
past three to four years. Commercial lines insurers are in phase 4
of the underwriting cycle, with modest valuations at present. Until
the insufficiency is dealt with, or proven false, it is our belief
that commercial lines stock will remain rangebound.
Bringing It to the Present:
Well, in 2004, I was wrong here. Leaving aside AIG (
), and its losses, and understated reserves, the commercial lines
sector did quite well. Yes, it is very difficult to value
commercial lines insurers, because the reserving is less than
scientific. But the difficulties alleged by the rating agencies
failed to appear, unless they were somehow sloshed into the
hurricane disasters of 2004-5, or like eating an elephant - one
bite at a time.
Earnings quality of commercial insurers is always lower than
that of personal lines insurers, so the group should trade at a
discount to personal lines, as it does now. And all that said,
personal lines insurers did outperform the commercial insurers,
even excluding AIG.
Reinsurance takes on the risk profile of the insurers that they
reinsure. Put simply, reinsurers pay a portion of the claims
reinsured in excess of a threshold, in exchange for a premium paid
to assume the risk.
Ten years ago, the major European reinsurers, together with
Lloyd's of London (
) dominated reinsurance. Many major US companies had significant
reinsurance operations. These statements are less true today. The
European reinsurers have been downgraded because of past poor
underwriting, reducing their current reinsurance capacity. US firms
have tended to specialize over the last decade. Many companies
closed, sold, or spun off their reinsurance operations.
There has been a tendency for reinsurers to migrate to Bermuda
over the past ten years. There is a combination of professionalism,
favorable regulation, and low taxation that encourages reinsurers
to set up shop in Bermuda. A great deal of opportunistic capital
shows up and forms new companies after major disasters, in order to
take advantage of the higher premium rates available. This has had
the effect of making it hard for older reinsurers to heal after a
major catastrophe, such as Hurricane Andrew or 9/11. They bear the
claims, but get less of the benefit of higher premiums because of
all of the new competition.
This makes the character of a reinsurer's management team all
the more important. It is very difficult to bounce back from big
underwriting losses, so conservatism in reserving and rate-setting
is required for long term financial success. One key to assessing
conservatism is whether a reinsurer will slow down in a soft
market, and return capital to shareholders. It takes humility and
discipline to sit back when market conditions aren't favorable, and
your competitors are growing their premium volumes rapidly.
In one sense, because of opportunistic capital, the reinsurance
industry resembles a series of Lloyd's syndicates. After a major
catastrophe, new companies form that have no legacy liabilities,
and write fresh business at high premium rates. They are similar to
Lloyd's syndicates at their start. Old reinsurers tagged with
claims from the catastrophe resemble Lloyd's syndicates with open
years that they can't close, because the claims have not settled,
or the claims impair their capital. The older reinsurers, once
hobbled, will have a tendency to slow down, and perhaps merge their
way out of existence.
One more new issue is reinsurance receivables. With all of the
credit downgrades, many insurers find themselves with reinsurance
receivables from claims that they submitted, but have not settled
yet. There are quite a few insurers and reinsurers that have
reinsurance receivables greater than their capital and surplus. In
a crisis, where prompt payment from reinsurers is needed, a high
degree of reinsurance receivables from low rated insurers could
result in ratings downgrades, and possibly insolvency. This has led
many insurers to request collateralization of reinsurance when
dealing with lower rated reinsurers. To the extent that reinsurers
agree to collateralization, it makes their assets less flexible,
and reduces the degree of leverage that they can operate at. Most
reinsurers are resisting posting collateral, but so long as
reinsurance receivables don't get paid rapidly, and credit quality
is low, the demand for collateral can only grow.
Investment policy for reinsurers is similar to that of the
companies that they reinsure. Most reinsurers run conservative
portfolios, because they take enough risk underwriting reinsurance.
Some newer reinsurers are using hedge funds as part of their
investment strategy, thinking that they can earn more investment
income, but with lower risk. The jury is still out on this
approach. We fear that some of the reinsurers are taking on what we
call "too smart for your own good" risk, and that hedge fund
investments will prove to be less diversified than they expected in
a crisis, perhaps even a crisis with insurance claim applications,
Reinsurers mirror the hard and soft P&C markets globally,
but with greater volatility. The hard market 1994-1997, gives way
to a soft market 1998-2000, followed by the 2000-present hard
market. Property reinsurance rates are slowly falling at present,
but rates are adequate for profitability. Casualty and Life
reinsurance rates are rising but at slowing rate; the amount of
rise varies considerably by line of business. In general our
outlook for reinsurance stocks is positive, but highly selective.
Stick with conservative management teams and you will do well over
the full underwriting cycle.
Bringing It to the Present:
This was written before the hurricanes of 2004 and 2005.
Think about it. After 2005, there was a belief, supported by the
concept of global warming, that hurricanes would be far more than
in the past. I did not buy that. Two years of bad hurricanes is
not a trend; four might be.
Cut to today. Five wimpy hurricane seasons. No earthquakes.
Few huge European Windstorms. Few hurricanes hitting Japan.
That doesn't mean the future will be good. In fact for
reinsurers, because surplus is so adequate, premiums may be too
low. But valuations of reinsurers are low, reflecting that risk.
I ind the sector reasonable but not cheap.
>> Continue to Part II
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Author long ALL, SAFT, CB, PRE and RGA
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