While property/casualty insurers may find comfort in reports from various pricing monitors revealing slow but consistent rate jumps over the course of 2012, investors see a different picture, according to a celebrated industry research analyst.
Executive SummaryA double-digit return for the p/c industry overall is not likely in 2013, according to V.J. Dowling.
“Everybody is patting themselves on the back for the fact that they are getting 6 or 7 percent rate increases,” said V.J. Dowling, managing partner for Dowling & Partners Securities, during a session of the Property/Casualty Insurance Joint Industry Forum recently, referring to industry executives’ reactions to indicators of rate movement, such as Towers Watson’s Commercial Lines Insurance Pricing Survey, which recently indicated 6 percent growth in commercial insurance prices in third-quarter 2012.
“If you look at the entire p/c sector—[at] every single publicly traded stock in the United States and in Bermuda, they still sell below book value in the aggregate,” Dowling reported. “Investors are telling you something, which is that they don’t believe the industry is earning its cost of capital,” and also that the situation is likely to persist “in the immediate future,” he said.
(Editor’s Note: Investment dictionaries define the cost of capital as the rate of return that capital could be expected to earn in an alternative investment of equivalent risk.)
Dowling underscored the low level of investor interest by giving some historical perspective on stock market valuations for p/c insurance stocks.
During the 25 years prior to the financial crisis of 2008, p/c stocks in the aggregate sold below book value in only one month—March 2000, which was the month corresponding to the stock market peak of the dot-com boom, he said. “That was the only time in 25 years,” he said, explaining: “We’re old economy. Nobody wanted any part of that” during the new economy tech boom.
Fast forwarding to what’s happened since the financial crisis, “we have had one month in the last four years where the stocks traded above book,” Dowling reported.
“That shouldn’t be a shocker,” he said, adding that 6-7 percent rate increases are insufficient to propel returns to desired levels, even “if you have only a couple of points of [increase in] underlying loss costs.” Factoring in the impact of depressed interest rates “we are barely, if at all, offsetting the impact of lower interest rates by pricing,” he said.
Dowling made the remarks after Matthew Mosher, senior vice president and chief ratings officer for A.M. Best in Oldwick, N.J. predicted “mundane growth” in premiums for 2013, estimating a level of 4 or 4.5 percent overall.
Still Mosher said the rating agency is seeing pricing that is “maintaining or improving” profitability for p/c insurers, forecasting a 102-103 combined ratio for the industry, excluding the impact of events like Superstorm Sandy. Putting the combined ratio projections together with investment returns, he said the overall return-on-equity for the industry is 6 or 7 percent.
“Overall, [it is] an industry that’s kind of moving along, but not setting the world afire in terms of profitability,” Mosher said.
“They are inadequate, Dowling said, referring to the 6-7 percent ROE figures. Not only is the industry not earning its cost of capital, but in addition, “the reported results are overstated,” he said.
“I’d argue that whatever the reported results are, the new business is even worse,” he said, referring to overstatements generated by prior-year reserve redundancies and overstated investment income levels.
“There’s a disconnect between…the new money that you’re getting for the new premiums you’re writing relative to the embedded yield on the portfolio,” he said.
In addition, “we’re still releasing more reserves for a period of benign loss experience than any redundancy, if any, that we’re putting into the new business,” he said.
What’s A Reasonable Return?
During an interview at the conference, Dowling told CarrierManagement.com that a reasonable rate of return in today’s environment would be something in the 9 percent range—roughly 700 basis points above the 10-year Treasury yield. “The industry probably is not close to earning that on the new business,” he said, distinguishing returns for business that is being written today from reported (calendar-year) results.
“In the aggregate, the reported results will only be in the mid-single digits…and that’s after the benefit of old higher interest rates that are embedded in the portfolio and some positive loss reserve development. So we’ve got a long way to go,” he said, when asked about the prospect of getting back to double-digit returns for the industry overall.
“While the federal government took capacity out of the brokerage business by forcing Merrill and others together, [and] it took capacity out of the banking business, it did not take capacity out of the p/c business.”
V.J. Dowling, managing partner for Dowling & Partners Securities
“To earn a 12 percent return in today’s environment, the industry would need a combined ratio on the new business it’s writing between 85 and 88. I don’t think that will ever happen,” Dowling said.
Mosher shared a similar view. “I don’t think you’re talking about double-digit returns at this point in time, given where the yields are,” he said in an interview.
Mosher also noted that return comparisons to other financial services firms may have given a distorted picture in past years—when banks were posting 15-20 percent pre-crisis returns.
“There’s been a realization. Now people look at it and say that wasn’t a real 15-20 percent. So what is the real return?”
Like Dowling, he suggested the mathematics of starting with a risk-free rate and building on top of that to get to a reasonable return for insurers. “People have to look at it in that regard, [asking,’] ‘What is the business I’m in?’ and then, ‘What’s the risk margin that I expect to get over a risk free return,” he said, also citing 700-basis points as a common risk margin talked about for the p/c industry—bringing the total to an 8 or 9 percent ROE.
Government Actions Hurt P/C Insurers
At the Forum session, David Sampson, president and CEO of the Property Casualty Insurers Association of America, alluding to the depressed post-crisis market valuations of p/c insurers, asked Dowling if investors are missing something, given that the industry came through the financial crisis with no casualties tied to the business of p/c insurance.
Still, the industry was severely hurt by the government’s post-crisis actions, Dowling said. “If you look at the industry and why it came through, and why it’s the last man standing, [it is because] it’s an industry that has less leverage as far as invested assets per dollar of equity, and it invests in better quality assets [than] other financial services companies—life insurers, banks, and broker-dealers.”
“Yet if you look at what’s impacted the industry, while the federal government took capacity out of the brokerage business by forcing Merrill and others together, [and] it took capacity out of the banking business, it did not take capacity out of the p/c business.”
“It kept it in there because of TARP,” he said, referring to the U.S. government’s Troubled Assets Relief Program. “In fact, it helped companies that did not get into trouble on the p/c side but…elsewhere—it kept them alive to play another day in a world with too much capacity,” Dowling said.
In addition—and “most importantly”—the Fed is hurting the industry by keeping interest rates low.
“We are an industry that is a saver. On a macro basis, savers have been hurt; borrowers have gained,” he said.
“So while we helped banks, we hurt the p/c industry. Until that changes, the p/c is probably the biggest overall industry that’s been most negatively impacted by government actions—and you see it in the valuations and the [lack of investor] interest in the sector since 2008.”
Everybody is patting themselves on the back for the fact that they are getting 6 or 7 percent rate increases. If you look at the entire p/c sector—[at] every single publicly traded stock in the United States and in Bermuda, they still sell below book value in the aggregate.
V.J. Dowling, managing partner for Dowling & Partners Securities