January 10th, 2011

2011 Outlook: The Low Valuation Trap, Part I

Posted at 1:00 AM ET

141x141jan1thumb1Another effect of the sector’s growing capital position has been a marked decline in reinsurers’ valuations. The price to book ratio of the Guy Carpenter Global Reinsurance Composite is near twenty-year lows, or over two standard deviations below the long-term mean, at 0.91x. These low valuations have significant implications for reinsurance company managements with regard to company strategy and capital budgeting. They are also important considerations for financial flexibility and the potential for sector consolidation. Figure 4 plots the price to book ratio of the reinsurance sector from 1990 to the present day. The drop-off in the last decade has
coincided with higher loss activity, falling interest rates, increased capital requirements and lackluster equity global valuations generally.

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Diminished investor sentiment and valuations have been influenced by a conservative forward sector outlook, driven in turn by low investment yields, top line pricing pressure and “new normal” economic growth forecasts. Investment yields are of particular relevance to reinsurers as the majority of carriers’ earnings have historically emanated from net investment income as opposed to underwriting or net realized gains. Yields on “safe” securities (i.e. large Western economies’ and Japan’s government bonds) are at or near thirty-year lows. This means the old model of writing to a 103 percent combined ratio over the cycle with a leverage ratio of net technical reserves to capital of 3 to 3.5x no longer produces returns on equity commensurate with investor expectations, thereby driving valuations lower.

Figure 5 shows government bond yields over thirty years. Viewed in this context, it is remarkable just how low returns on “safe” investments for insurance companies have
become. In addition, Figure 6 shows falling yields on ten-year government securities for the G7 economies superimposed over twenty years of GDP growth trends. Negative economic growth experienced in 2009 continues to affect premium levels and pricing. Together, lackluster premium growth and falling yields have exacerbated the unfavorable valuation situation.

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The fact that yields are low on government securities does not guarantee low investment risk. Although rating agencies and regulatory models tend to influence companies to invest in government securities because of their perceived relative safety, these securities could one day prove less safe than they seem at present. This process may have already begun to happen in the Eurozone, where some sovereign debt securities once considered beyond reproach have drawn increased scrutiny - with certain European countries even requiring special loans from the European Union (EU) and the International Monetary Fund (IMF).

Figure 7 shows five-year credit default swap spreads for sovereign securities. Although disclosure regarding reinsurer exposure to European sovereign securities is relatively sparse at present, Guy Carpenter monitors reinsurance counterparties’ sovereign debt positions (where possible) as well as reinsurer credit default swap spreads on a daily basis.

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Click here to read the Executive Summary of Guy Carpenter’s report: Global Reinsurance Outlook: Points of Inflection; Positioning for Change in a Challenging Market >>

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