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Insurance's capital glut

A lack of big claims has left most insurers looking overcapitalised: good news for special dividend prospects but bad news for long-term earnings
September 19, 2014

The most benign claims conditions for years helped most insurance companies report impressively profitable combined ratios (which compare claims to premiums) during the recent half-year reporting season. But it's also clear that pricing remains under significant pressure, and that’s hurting sentiment. In fact, shares in all the insurers have fallen since early July, with those of Hiscox (HSX), esure (ESUR) and Admiral (ADM) under especially strong pressure.

Low claims

The first half of 2014 wasn't entirely devoid of losses. Some of the larger events included a snow storm in Japan, which delivered a $2.5bn (£1.5bn) loss, while grim weather in the US hit the sector to the tune of $3.4bn. Overall, reinsurance giant Munich Re (DE: MUV2) reckons that insured losses reached around $17bn globally in the first half.

But that’s fairly insignificant compared to loss events seen in recent years. In 2011, for instance, earthquakes in Japan and New Zealand pushed the global insured loss up as high as $105bn, while Hurricane Kartina alone delivered a loss of around $70bn in 2005. With this year's Atlantic hurricane season only having run half its usual course, storm losses could yet bolster the full-year loss tally. But the storm count so far is both below average and below forecasters' original predictions.

 

Pricing pressures

On the face it it, an absence of big losses seems like a bull point. But extended periods of benign claims - 2013 was well below average, too - is problematic. That's because it leaves underwriters overcapitalised, and tempted to compete for business by cutting premium rates, which puts pressure on longer-term earnings.

Another factor is the influx of new capital into the sector from such sources as hedge funds and pension funds, which is also acting as a catalyst for pricing pressure. In an era of quantitative easing, this reflects investors' search for yield via a focus on less traditional assets. With returns in the insurance market set to remain relatively attractive, insurance analyst Tom Carstairs of Berenberg thinks that new capital "isn't about to leave", either.

This glut of capital has therefore left premium rates, especially for catastrophe-related cover, under mounting pressure over the last few years. "Renewals in July 2014 were just as competitive as in 2013," notes Mr Carstairs. Hiscox's experience at the half-year stage was fairly typical: rates on both its US property catastrophe book and its Japanese earthquake account slumped 15 per cent. This pricing pressure is beginning to affect non-catastrophe business, too. Newly listed insurer Brit (BRIT) reported that rates on its direct speciality business had fallen by 1.5 per cent at the half-year stage.

Neither are conditions set to improve any time soon. "We think there is still pressure on pricing," notes Alex Maloney, chief executive of Lancashire (LRE). "With business more scarce in the second half of the year, we wouldn't be surprised to see some aggressive renewal targets." Indeed, Mr Carstairs notes that global catastrophe rates remain above their pre-Katrina levels, suggesting scope for further price falls. Insurance broker Aon Benfield estimates that a "$100bn or greater insured catastrophe event is required to meaningfully disrupt market pricing for any significant period of time".

Weak investment returns

Unfortunately, insurers can't compensate with investment income. Underwriters tend to avoid risking their capital, and most UK-listed insurers are therefore heavily invested in cash and high-quality bonds. Ultra-low interest rates, as well as a period of rising bond yields, have kept returns weak.

That said, the situation has improved since the wafer-thin returns seen last year. "Investment income declines are flattening out," notes Berenberg. "This is partly as a result of low yields having been with us for some time and partly as a result of stronger balance sheets allowing companies to use an element of 're-risking' to keep investment yields stable." A good example would be Brit: 11 per cent of its book is in higher-yielding assets such as equities. That helped its investment return jump to 2.1 per cent at the half-year stage, from a mere 0.3 per cent a year earlier.

Dividends and deals

These relatively depressed market conditions are likely to leave most underwriters carrying more capital than they can utilise. That could kick-start takeover activity. "A typical reaction to constrained growth is that, if you can’t get it organically, buy it," notes insurance analyst Joanna Parsons of Westhouse Securities. She identifies the sector’s smaller players - Novae and Lancashire - as "obvious targets".

But significant deals in this sector are rare and, as Mr Carstairs points out, valuations are "not low". In most cases, then, excess capital looks likely be returned to shareholders. Barring big losses in the second half - and most underwriters will want to see how the hurricane season finally plays out - investors can therefore look forward to further big special dividends. Mr Carstairs reckons those with a track record of special payouts - Hiscox, Beazley (BEZ) and Lancashire - are highly likely to return capital again. But he also thinks those that have traditionally been less inclined to follow this model, such as Amlin (AML) and Catlin (CGL), may find special payouts “hard to avoid” if their peers are returning capital.

Motor - a turning market?

Pricing among the UK motor insurers has been under strong pressure, too. The latest Tower Watson/Confused.com price index revealed that motor premium rates slumped 15 per cent during the second quarter. Such apparently depressed market conditions have - as with the Lloyd's players - left motor insurers repatriating capital, with both esure and Admiral announcing special dividends at the half-year stage.

But the outlook for pricing may not be so grim. To begin with, the listed players aren't seeing the extreme pressures witnessed in the market more generally. esure reported an 8 per cent fall in rates at the half-year stage, but Admiral's rates were flat and Direct Line's (DLG) slipped just 2 per cent. At the bigger players, management have sounded an unexpectedly positive note, too. Admiral's chief executive Henry Engelhardt reckons there are "some signs that premiums are no longer falling", while esure's boss Stuart Vann thinks the motor market may turn a corner in the first quarter of next year.

Not everyone is so optimistic. Insurance analyst Sami Taipalus of Berenberg notes that the UK motor market hasn't historically seen significant price increases until the market's combined ratio exceeds 115 per cent - signalling heavy losses. Accordingly, he's not expecting "material and sustainable" price increases before 2016. Regulatory threats are on the horizon, too. HM Treasury is known to be concerned about the price increases that usually accompany renewals. It has also flagged concerns about insurers charging more to allow customers to pay premiums by instalments.

IC VIEW:

Lloyd’s players are seeing rates fall fast, but the falls come from still profitable levels. Provided there are no big second half-losses - admittedly, a matter of luck - then the sector should remain robustly profitable during 2014. Add to that special dividend prospects, as well as not overly demanding share price multiples of net tangible assets, and some of the higher-quality Lloyd’s players remain attractive. Motor is harder to call. Dividend prospects look good and the big players aren't seeing the same pricing pressure as the rest of the sector. But until there's firmer evidence that pricing could turn, caution remains wise.

Comparing the insurers
CompanyMarket valueShare priceCombined ratio*Price/net tangible assets*Div yield*Share price change since 4 Jul
London underwriters
Amlin£2.15bn430p90%1.56.4%-10%
Beazley£1.34bn259p90%1.87.5%-1%
Brit£964m245p89%1.314.2%-1%
Catlin£1.79bn501p88%1.16.5%-8%
Hiscox£1.99bn625p86%1.55.6%-15%
Lancashire£1.12bn615p72%1.610.0%-7%
Novae£345m539p90%1.14.4%-3%
Personal lines
Admiral£3.41bn1,243p87%7.88.0%-21%
Direct Line£4.38bn295p96%2.07.9%-3%
esure£976m239p92%4.56.7%-14%
RSA£4.76bn475p90%1.61.9%-1%

*Based on Numis Securities' estimates for end-2104

Favourites

Novae (NVA) is a highly profitable underwriter with substantial scope to boost its return on equity: it plans to establish a more tax-efficient structure once the benefit of some deferred tax assets comes to an end this year. The yield isn't bad either, but the shares trade at a marked discount to the Lloyd’s sector. We stand by our recent buy tip (486p, 16 May 2013).

Outsiders

RSA, which is focused on personal lines, continues to deal with the fall-out from the huge under-reserving problem identified at its Irish unit late last year. That prompted the appointment of former RBS boss Stephen Hester as chief executive and the launch of a turnaround plan comprising non-core disposals and a £775m rights issue. While the plan is delivering, only a modest return to the dividend list is planned near-term. Compared with better-performing Lloyd's players, the shares also trade on a punchy multiple of forecast net tangible assets.