Beazley’s bad news looks baked in

Specialty insurers should be a good investment. Underwriting niche policy lines with limited competition, the market’s principal actors have long benefited from information asymmetry. Unencumbered by the consumer protection regulation that hangs over household and life insurance lines – and selling to corporates keen to minimise risks wherever possible – the capacity to raise rates is also strong. The endurance and adaptability of Lloyd’s of London, historically the most significant exponent of this trade, is testament to all of this: since 2005, Lloyd’s annual return on capital has averaged 11.7 per cent.

Of course, it doesn’t always pan out smoothly, as 2020 proved. Take Beazley (BEZ), one of just a handful of Lloyd’s insurers still trading on the London Stock Exchange (LSE). The Bermuda-headquartered group initially thought Covid-19’s effects would be muted, then acknowledged business insurance claims would hit $170m (£125m). On the back of this (and amid encouraging signs of rate inflation and bullish signals in the reinsurance market), the group managed to raise just under $300m from investors in late May, only to then state in September it was be on the hook for conference-organising policyholders forced to cancel events until 2021.

Its pandemic-linked claims estimate doubled, while reserves for cyber security and casualty lines all kicked up. As a result, the combined ratio – the proportion of claims, costs and expenses to premiums received – is set to come in at around 110 per cent for 2020. To put it bluntly, last year was a bad one for Beazley and the broader specialist insurance sector’s profits, and a reminder of the difficulties of gauging claims exposure during fluid and constantly-changing events.

Darkest before the dawn 

This black-box-like feature notwithstanding, there are solid reasons investors should consider specialty insurers right now, and Beazley in particular.

The sector-wide investment case goes something like this: the huge dent to profits sparked by pandemic-related claims has only accelerated the hardening (or rising) policy rate environment evidenced since 2019 – a trend brought about by several bad years for natural catastrophe claims and lower investment returns from the largely debt-based assets insurers are forced to hold. At the same time, regulatory pressures mean large insurers have withdrawn from many niche lines in favour of bulk policy writing.

Then there is the relative case for owning the sector. While the pandemic has changed consumption patterns and corporate overhead priorities, insurance is not something businesses are about to scrimp on. If uncertainty defines our times, then insurance is arguably the best tool in a risk manager’s arsenal.

Such a backdrop helps explain why specialist insurers managed to raise $9.3bn from equity and debt markets last year. This included incumbents such as Beazley and its listed Lloyd’s peers Lancashire (LRE) and Hiscox (HSX) as well as new entrants such as reinsurer Conduit (CRE), which raised $1.1bn at its December initial public offering in London (see fresh capital chart).

Though the Lloyd's clique was in part forced to ask shareholders to help cover their Covid-19 losses, the fundraisings were sold on signs of higher rates. Though opinion is not unanimous here, few analysts expect this sector-wide refinancing to lead to renewed downward pressure on rates, given the risks of another bout of capital destruction.

When Beazley sold fresh equity at a discounted price of 315p a share in May, the market clearly saw rebound potential in a growth business. This is the best way to view a company whose earnings grew by an average of 6.8 per cent a year over 10 years to 2019, despite strong sales growth being outpaced by the collective impact of rising claims, losses and reserves over the decade.

That track record is also explained by the strong long-term performance of Beazley’s assets, which are almost entirely comprised of government bonds and investment-grade credit (see asset pie chart). Though higher asset prices have helped prop up capital levels, record low bond yields has meant a precipitous drop in the yield of the core portfolio to just 0.5 per cent.

In turn, this has increased the need for Beazley to raise its prices. On this front, it seems to have had little trouble: in the nine months to September 2020, all but one of its seven policy lines saw double-digit increases in rates. This year, the group expects mid-teens percentage growth in gross premiums written, or 10 per cent net of reinsurance used to hedge more volatile lines.

No premium in the rating

Despite this strong outlook, the shares still trade well down on their long-running average price to tangible book value and earnings ratios (see valuation chart), suggesting the market is yet to be convinced by the promises of a turnaround. This contrasts to the recovery in sentiment toward Lancashire, and to a lesser extent Hiscox (see peer comparison chart).

Following last year’s goal-shifting, the loss of trust is understandable. Beazley’s leadership in cybersecurity – one of the largest growth markets in insurance – is also a double-edged sword, even if it currently only makes up about a quarter of existing premiums. Though the group has very strict risk management policies here, the lesson of Covid-19 is that unforeseen systemic risks can be hard to predict, avoid or manage. Higher-value data breach losses – which are typically more likely to be insured – can be substantial. A major cyberattack against the US government, uncovered last month, showed that even industry experts in cyber-security can be caught out.

Beazley declined to comment on whether it expected to face any claims from the incident, the full fallout from which is still unknown. But balanced against this uncertainty is the likelihood that the group would have had to disclose a sudden and material spike in claims to the market. What’s more, reserves for cyber claims had already been lifted prior to the incident, and management implied in November that it has increased its use of reinsurance for this historically highly profitable policy line.

More broadly, capital is being actively managed away from segments likely to be hit by increased litigation or recession – such as healthcare and employers’ liability – in favour of well-priced lines such as marine and director and officers’ liability insurance, which is booming.

And if 2020 taught us one thing about equity markets, it is that investors are prepared to swallow near-term volatility in the pursuit of long-term earnings growth. With this in mind, RBC reckons feverish activity in the specialty insurance M&A market should provide a floor under Beazley’s share price. The attractiveness of sterling-valued companies also remains robust. The recovery from here may be bumpy, but it is not without foundation.