David Flandro, Global Head of Business Intelligence
Companies in the reinsurance sector are trading at or near long term low valuations. This raises the question: Why are “strong buy” recommendations not more common? The answer may lie in the fact that, generally, analysts and investors are concerned about three important obstacles to returns on equity.
First, there is a belief that softening reinsurance pricing will become softer. Lower pricing of varying degrees has been seen in the most recent reinsurance renewals. This creates several areas of downward earnings pressure, both now and in the longer term. For carriers exposed to particularly soft prices top line premium growth could slow or decrease. Worse, if companies are too aggressive in a softening market today, “adverse reserve development” (that great destroyer of reinsurance capital) may soon rear its ugly head. Investors remember the events of the last soft cycle - significant reserve strengthening, particularly on longer-tail lines. This has caused them to be nervous about owning reinsurers’ shares.
If the soft cycle by itself is insufficient to ward off investors, another force may be investment grade bond yields. In many regions these bonds trade at or near forty to fifty year lows. With the heavy focus on underwriting in the reinsurance sector comes the danger of forgetting that well over half of carriers’ earnings are supplied by investment income over the cycle. When fixed income securities yields are low, this crucial income stream diminishes. This scenario has existed in varying degrees since the depths of the financial crisis and shows few signs of abating.
Finally, to the surprise of many, there is now an abundance of capital both in the primary and the reinsurance sectors, at least in simple accounting terms. (It must be remembered that in the reinsurance sector, capital balances are, after all, highly educated guesses.) These large capital positions make book values per share look larger, which in turn deflate price to book ratios. Yet one must ask: If reserve strengthening is anticipated by investors, are price to book ratios really so low?
Figure 1 plots reinsurer valuations as measured by price to book against consensus 2011 estimates for return on equity (ROE). There is a clear correlation between estimates of ROE and valuation, as is normally the case. In the lower-left quartile of the chart is an area of particular interest. Why are these companies’ “forward” ROEs so low? Is it fear of overly aggressive growth followed by reserve strengthening? Is it heavy exposure to low yielding assets? Is it unusually high catastrophe exposure? The answer to this question will also reveal why these companies exhibit particularly low valuations. Another area of the chart that warrants study is the upper-right hand quartile. Why, in a softening market, do these favored few trade at such a premium? Is it their unique underwriting acumen? Is it superior risk protection or careful and well-advised capital allocation?
The dots on this chart will likely move around over the next year as analysts and investors are proved right and wrong as ever. Capital positions will change pursuant to retained earnings growth and to impairments. Many have argued that the key to remaining or arriving in the upper-right hand quartile is returning capital to shareholders. We think this to be overly simplistic.
In Guy Carpenter and Company, LLC’s experience superior capital growth over the long-term is driven by superior capital management and allocation. Guy Carpenter is uniquely positioned to help clients analyze the impact of these factors and deliver thought leadership and innovative solutions to help optimize capital and long term earnings power.