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Rising rates to boost Lancashire

SHARE TIP: Lancashire Holdings (LRE)
March 1, 2012

Insurance companies were hit hard in 2011 from claims arising from a string of catastrophes – earthquakes in New Zealand and Japan; floods in Australia and Thailand. So investors may be inclined to sidestep their shares. But that would be to miss an opportunity. True, big claims are bad news for profits in the short term, but they also enable insurers to hike their premium rates in order to rebuild their reserves, which is good news for longer-term earnings. Lancashire wasn't hit nearly as hard by 2011's catastrophes as most rivals, so it looks especially well-placed to take advantage of that trend.

IC TIP: Buy at 790p
Tip style
Speculative
Risk rating
High
Timescale
Long Term
Bull points
  • Avoided hefty catastrophe losses
  • Exposed to hardening premium rates
  • Decent investment portfolio
  • Committed to returning capital
Bear points
  • Shares not cheap by sector standards
  • Uncertainty about dividend flows

Obviously, Lancashire didn't avoid catastrophe losses altogether. It suffered $139m (£88m) of them during 2011, largely from Thailand's floods and the earthquakes in Japan and New Zealand, then a $35m hit in 2012 from the Costa Concordia cruise ship disaster. But those losses weren't bad enough to dramatically undermine Lancashire's performance. For 2011, Lancashire reported a combined ratio (of claims to premiums) of just 64 per cent. That signals an impressive level of underwriting profitability at a time when Lancashire's rivals are generally making hefty underwriting losses. Moreover, Lancashire's underwriting performance looks set to improve further. Broker Numis Securities reckons its combined ratio for 2012 will hit a sector-beating 58 per cent.

A big factor behind the anticipated improvement in underwriting profits will be the boost that comes from premium rates that are firming fast. Last month, Lancashire reported that rates overall had risen three percentage points in 2011; within that, rates on the group's off-shore energy book rose 10 percentage points and eight points on its property retrocession and reinsurance account. Lancashire is also heavily exposed to those catastrophe-related business classes where rates are rising fastest – 80 per cent of its gross premiums are for underwriting property and energy risks.

LANCASHIRE HOLDINGS (LRE)

ORD PRICE:790pMARKET VALUE:£1.25bn
TOUCH:789-790p12-MONTH HIGH:805pLOW: 491p
DIVIDEND YIELD:1.2%PE RATIO:9
NET ASSET VALUE:535pCOMBINED RATIO:64%

Year to 31 DecGross premiums ($m)Pre-tax profit ($m)Earnings per share (¢)Dividend per share (¢)†
200863897.655nil
200962838922315
201068933920815
201163221913815
2012*68825813615
% change+9+18-1nil

*Numis Securities estimates

Normal market size: 3,500

Matched bargain trading

Beta: 0.6

†Excludes special dividends: 125¢ in 2009, 140¢ in 2010 and 80¢ in 2011

£1=$1.57

The group's investment portfolio looks in reasonable shape, too. It's entirely focused on cash and safe-looking bonds and delivered a 1.8 per cent return during 2011. Admittedly, some insurers are making better returns – Catlin, for example, managed a 3.1 per cent return last year. But Lancashire's isn't the worst. Amlin managed just a 0.4 per cent return in the 10 months to the end of October.

However, Lancashire's dividend flows look less certain. Typically, shares in Lloyd's insurers yield between 5-8 per cent, but Lancashire's bosses think that, given the cyclical nature of the business, it's unwise to promise big payouts each year. Rather, Lancashire distributes surplus capital to shareholders through share buy-backs and frequent hefty special dividends. In fact, add in 2011's 80¢ special dividend and Lancashire's shares would have yielded a tasty 7.7 per cent (see table). So management is committed to returning capital when possible but, with premium rates firming fast, this year capital may be better used to support new business. That means there's no certainty of a special dividend in 2012.