At first glance, all seems well in the non-life insurance sector. Trading statements from the Lloyd's insurers in late autumn, for instance, emphasised a generally benign claims environment amid a lack of big loss-inducing catastrophe events. And without hefty loss events to drive claims, insurers' earnings prospects look good, leaving most reporting impressively profitable combined ratios (of claims to premiums). But with premium rates continuing to soften, and after an impressive share price run since early October, the good times could be coming to an end.
Benign claims
Admittedly, 2013 wasn't entirely void of loss events. Last summer's European hailstorms are estimated by the reinsurance arm of insurance broker Willis (Willis Re) to have generated a combined loss of about €3.5bn (£2.9bn). German floods are likely to have cost another €4bn, while Moody's estimates October's northern European windstorm will have meant a £500m loss in the UK alone. But such losses aren't large compared to the sector's historic experience. In 2010, for example, and driven by such events as an earthquake in Chile, global insured losses reached around $38bn (£23bn). The main burden of last year's claims is also likely to fall on big European reinsurers such as Munich Re (MUV2), or Hannover Re (HNRX), with most UK-listed players escaping fairly lightly.
Even November's Typhoon Haiyan, which killed over 6,000 people in the Philippines, generated a fairly modest loss by sector standards (around $500m-$700m). "Exposures in the affected regions are uninsured or underinsured," states Willis Re, meaning that insurance losses should be relatively small. By way of contrast, 2005's Hurricane Katrina, which was far less deadly, yielded a loss of around $70bn. Indeed, last year's Atlantic hurricane season was also a notable non-event, with Willis Re pointing out that the hurricane count was "the lowest since 1982".
Softer pricing
Bizarrely, however, a benign claims backdrop isn't all good news. Sure, not paying out on claims does mean a short-term earnings boost for underwriters. But losses force insurers to hike premium rates in order to rebuild reserves and it's that hardening rate environment that ultimately drives long-term earnings growth in the sector. A period of low claims, however, leaves insurers competing for business by slashing prices. Those pressures are only heightened by the arrival of new capital like catastrophe (CAT) bonds, insurance-linked securities, or new vehicles sponsored by existing insurance brokers.
Bronek Masojada, chief executive of Lloyd's insurer Hiscox (HSX), has already flagged "increased competition and a benign claims environment" as key factors that will put pressure on rates. In fact, Willis' outlook report for 2014 anticipates a fall of 5-10 per cent for property catastrophe premium rates during the first quarter and 10-12.5 per cent slide for non-catastrophe property rates. Willis also anticipates generally softening rates for energy lines and marine business, and for airline rates which could fall as much as 25 per cent.
There's already plenty of evidence for softening. In the year to end-September, Hiscox saw reinsurance rates fall 10 per cent, while Novae (NVA) flagged-up a fall in mid-year US property treaty renewal rates of between 5 and 20 per cent. Moreover, January's insurance renewals have revealed more pressure and analysts at Berenberg point out that US catastrophe rates fell 15 per cent, while rates dropped 10 per cent and 15 per cent, respectively, in Europe and the UK. Some business lines, however, are holding up, but largely to the benefit of Beazley (BEZ) and Novae.
Neither can insurers look to their investment portfolios, usually dominated by bonds and cash, to bolster earnings. Big fixed income portfolios have inevitably suffered as bond yields have risen, while today's ongoing low interest rate world doesn't help. That's led to wafer thin returns in recent years - Novae's, for instance, reached just 0.7 per cent in the nine months to end-September, compared to returns of nearer 5 per cent for the sector prior to the financial crisis.
Special dividends
With rates softening, opportunities for growth are set to become more limited in 2014, leaving insurers carrying more capital than they need. But splashing that cash on big takeovers isn't so likely. That's significantly because it's the expertise of underwriting teams that count in this business and there are easier ways of obtaining talent than buying a rival. Smaller players, however, may join forces to boost scale - Novae, for instance, is rumoured to be considering a bid for rival Lloyd's player, Antares Holdings.
Against that background, analysts expect a round of special dividend payments. "With attractive growth opportunities limited to specific pockets of the market, we expect special dividend announcements to support already attractive normal dividend yields," believes insurance analyst Tom Carstairs of Berenberg. He's expecting special payouts from Beazley, Hiscox, Lancashire (LRE) and - from outside the UK - Swiss Re (SREN).
Motor - a different dynamic
A very different dynamic, however, is at work with the UK's listed motor insurers: Admiral (ADM), esure (ESUR) and Direct Line (DLG). In recent years, this sector has been hit hard with falling premium rates and that pressure shows no signs of abating. Indeed, the AA revealed that the so-called 'shoparound' price for comprehensive motor cover slumped 12.4 per cent year-on-year in 2013's third quarter. This is proving bad news for earnings, although the listed players are still managing to remain profitable at the underwriting level.
Moreover, sentiment hasn't been helped by the Competition Commission's interest in the motor sector. It has been reviewing the motor market since early 2012 and is expected to report shortly. Some analysts think its findings could lead to a ban on the fees charged for arranging replacement vehicles for crash victims; potentially more bad news for insurers' earnings. Even falling whiplash claims, reflecting legislative reforms since April to curtail fraudulent personal injury claims, have yet to deliver much clear upside.
IC VIEW
While dividend yields are fat in this sector, and a benign claims backdrop should boost 2013's earnings, investors need to be wary. Share prices in some of the Lloyd's players have jumped by around a third since early October, making for some demanding valuation multiples. Yet premium rates are softening and it's a matter of luck whether next year's claims experience will also be benign. Sure, holding shares for income makes sense - but real value opportunities are growing scarce. Meanwhile, with premiums rates dropping like a stone at the motor insurers, that sub-sector is best left alone.
| Favourites |
| Lloyd's player, Novae, is our top pick (buy, 486p, 16 May 2013). It boasts a fast-improving return on equity and a reasonable enough prospective yield. The group is also making solid underwriting profits and, while rates are under pressure, they're also falling from high levels. Yet the shares continue to trade at an unsustainable discount to those of its peers. Catlin (CGL) is also attractive. Despite rising strongly since early October, the shares still trade on an undemanding multiple of forecast net tangible assets (NTA) for the sector and there's a prospective yield of over 5 per cent. |
| Outsiders |
| Even though premium rates on RSA's (RSA) personal lines business are still rising modestly, the group is in trouble. Indeed, news in November of financial irregularities at the Irish unit, followed by hefty capital injections and the suspension of three top executives there, have sent the shares tumbling. The fear is that more capital could be needed, which leaves the dividend in doubt. Yet the shares still trade at a punchy 1.7 times end-2013's forecast NTA. We reiterate our sell tip (103.9p, 21 November 2013). |
| COMPARING THE UNDERWRITERS | ||||||
| Company | Market value | Combined ratio† | Share price change since 9 Oct | Price/net tangible assets† | Prospective yield† | Last IC View |
| Amlin | £2.25bn | 85.3% | +14% | 1.54 | 5.8% | Hold, 392p, 19 August 2013 |
| Beazley | £1.41bn | 85.8% | +34% | 1.84 | 6.1% | Hold, 25p, 23 July 2013 |
| Catlin | £2.10bn | 90.1% | +23% | 1.37 | 5.4% | Buy, 482p, 9 August 2013 |
| Hiscox | £2.45bn | 83.8% | +6% | 1.79 | 3.0% | Sell, 677p, 24 October 2013 |
| Lancashire | £1.46bn | 68.7% | +7% | 1.79 | 8.3% | Hold, 812p, 29 July 2013 |
| Novae | £415m | 90.1% | +31% | 1.35 | 3.3% | Buy, 505p, 8 August 2013 |
| RSA Insurance | £3.76bn | 97.8% | -21% | 1.66 | 2.5% | Sell, 82.2p, 13 December 2013 |
| Motor | ||||||
| Admiral | £3.60bn | 92.1% | +11% | na | 7.2% | Sell, 1,268p, 5 September 2013 |
| Direct Line | £3.69bn | 96.0% | +9% | 1.55 | 6.8% | Sell, 233p, 2 August 2013 |
| esure | £1.04bn | 90.2% | +18% | na | 5.1% | Hold, 287.9p, 6 August 2013 |
†Based on Numis Securities' forecasts for end-December 2013 | ||||||
| THE BROKER'S VIEW |
| Lloyd's deserves caution With an absence of big loss-inducing catastrophe events during 2013, the Lloyd's underwriters look set to report impressive full-year figures. But investors shouldn't let those robust returns mask the significant challenges that are beginning to mount. To begin with, property catastrophe reinsurance premium rates - notably in the US - are under strong pressure and that's beginning to spill over into other business lines. Willis Re highlights that US property catastrophe rates were down by 10-25 per cent on a risk-adjusted basis in January renewals. This is partly down to a benign claims backdrop, but it also reflects growing competition after the entrance into the sector of non-traditional capital providers, attracted by the uncorrelated nature of reinsurance returns and the lack of alternative sources of income. Indeed, both the CAT bond market and the collateralised reinsurance market saw significant growth in 2013, with CAT bond issuance set to surpass 2007’s record of $7.2bn. Non-traditional reinsurance sources now provide around 15 per cent of the capital in this segment and it's a proportion that's set to rise. So far, most of the capital is concentrated in US property catastrophe markets, explaining the heaviest fall in premium rates here. So investors should expect premium rates to soften further. What's more, the problem of low investment returns is set to persist given the very limited portfolio diversification, away from bonds and cash, among Lloyd's underwriters. Fading growth opportunities, however, also raise the likelihood of special dividends, probably from such underwriters as Lancashire, Hiscox or Beazley, as management move to return funds that can't be profitably employed. This should bolster the sector's already impressive income prospects. There could be some limited takeover activity, too, as smaller players build scale in the more difficult conditions. Novae has commented that it continues to evaluate a range of strategic options, including acquisitions. Sarah Lewandowski, insurance analyst at Espirito Santo Investment Bank |
