Reinsurance stocks have suffered of late, but investors who get in now will be making a smart bet, says James Ferguson
It's been a bad year for the insurance business and a great one for commodity plays. Last week, Swiss Reinsurance (RUKN) was replaced in the Stoxx 50 index of Europe's leading 50 shares by the mining giant, Rio Tinto (RIO). Many readers will remember what happened at the peak of the dotcom bubble: a number of overvalued technology stocks got into the major indices at the expense of solid, traditional companies whose shares had fallen out of fashion. But it turned out it was just that fashion. Within a couple of years, some of those dotcom stocks were worth a fraction of what they had been at the peak, but the stocks that had been unceremoniously dropped from the index were at the start of impressive, multi-year rallies. Might the big reinsurers be about to begin similar rallies?
Insuring the insurers
Reinsurers help normal insurance companies lay-off some of their more specific or catastrophic risks in return for a good percentage of the premiums they've collected. Much as you or I will have an excess on our policies so that the insurance only pays out if we have quite a big, significant claim, so our insurance company has reinsurance that pays out only when they suffer an extraordinary hit, like the World Trade Centre terrorist attack, or hurricane Katrina: the reinsurers shoulder these extraordinary burdens.
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Last year was a very bad year for hurricane damage claims, with hurricanes Ivan and Jeanne being only the worst of four major Florida storms that caused $23 billion in insured damages, according to Insurance Services Offices Inc. However, Katrina will hurt the reinsurance market even more, not only because it has been so much worse (some unofficial estimates suggest $50bn-plus of insured losses), but also because insurers will have paid only a single deductible before their reinsurance kicks in, rather than four as last year (if there are four hurricanes, the insurers effectively have to pay an excess' or deductible four times; if there is one big one, they pay one and the reinsurer gets hit with the rest).
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Given that the world's two largest reinsurers, Munich Re (MUV2) and Swiss Reinsurance, have struggled to recover from 2001's terrorist attacks you might think that this is a better time to be selling these stocks rather than buying them. Munich Re made a loss in 2003 and last year's profits still hadn't returned to the levels of five years ago. Swiss Re has fared even worse: it made losses in both 2001 and 2002 and has been unable to get near the sort of profits that it made in the late 1990s.
A cyclical story
Ironically, however, extraordinary claims in the reinsurance market can often mark the start of a period of extended good fortune for the sector. For starters, extraordinary events are just that extraordinary. Runs of relatively quiet good fortune are broken by nasty, big, but largely one-off, disasters. Second, the premiums the reinsurance sector has been accumulating (and investing) in anticipation of a large payout are renegotiated each year, and the longer it's been since a claim, the more the insurance companies press for lower premiums. Reinsurance rates actually fell 1% in January, for example, having risen 4.5% in 2004 and 11% in 2003, in the wake of the World Trade Centre claims.
Now the odds are they'll rise again. Reinsurance rates for next January are being renegotiated this week (the decisions will be finalised in October). Even though we don't know yet how far the New Orleans claims will run, it's unlikely the industry will miss the chance to start raising reinsurance rates immediately.
Insurers of offshore oil platforms and drilling rigs are likely to demand premium increases of more than 50% after the storm, according to The Wall Street Journal, who cited Charles Franks, an underwriter at Lloyds insurer Kiln Plc. However, it's unlikely that premium increases will be restricted to just the Gulf Coast energy and property markets. Global reinsurance premium income totalled $176bn in 2003. With well over $50bn of capital due to leave the reinsurance sector due to Katrina alone, premiums will be hiked with justification across the board. "There's a strong possibility that rates will harden in other areas as people move capital to the opportunities they see," Dane Douetil, CEO of reinsurer Brit Insurance Holdings Plc, tells Bloomberg's Jon Menon. In other words: everyone's insurance will cost more next year because of this'.
The investment case
There's an old Two Ronnies sketch where Ronnie Barker plays an insurance company executive and Ronnie Corbett the little man'. "You don't understand the insurance industry, do you?" booms Ronnie B. "Er, no," replies Ronnie C. "You the insured, pay me, the insurer, an annual sum called a premium," explains Ronnie B. "Yes?" hazards Ronnie C after a pause. "No. That's it," beams Ronnie B. But in reality there's a bit more to it than that. First, of course, reinsurers actually have to pay out occasional, but very large, claims. Also, all insurers match their assets (premiums) to their likely liabilities (claims), but what really matters is how well they manage and invest their surplus assets. Reinsurers, especially, invest heavily in the stockmarket.
This is why the World Trade Centre payouts in 2002 were such an enormous hit to the reinsurance stocks they coincided with the global stockmarket crash. Occasional big payouts are accounted for and stockmarket crashes well, they happen, too. But when a big payout coincides with the trough of a major stockmarket slump, then the industry is hit by a double whammy as it is forced to dispose of its portfolios at a market bottom.
This time the payout will doubtless exceed that for New York. Ground Zero covered an area of 16 acres. The New Orleans city devastation covers 150 square miles. However, not only is New Orleans a one-off, but it will allow premium-income-to-liability ratios to soar and, much more importantly, stockmarkets across the globe have been surging, so for reinsurers to pay up, shareholdings won't this time have to be liquidated at a loss into a buyers' market. Meanwhile, the reinsurance industry can look forward to several years of above-average premium income streams to invest into the markets. This explains why the long-term history of the sector shows it moves approximately in line with major stockmarkets, but with much more volatility. This last point is particularly significant right now because the sector is still not reflecting either the increase in premium rates it has already enjoyed since the World Trade Centre attacks, nor the gains stocks have made since the early 2003 lows.
A closer look at the charts of the two major reinsurance stocks shows just how extreme this lag has become and suggests that the compilers of the Stoxx 50 index may yet come to rue their decision to replace Swiss Re. The blue lines on both charts show the share prices, while the red lines show what the average analyst expects the earnings per share (EPS) to be two years out. This medium-term view takes one-off, extraordinary, claim-related losses out of the picture.
What it shows is that both companies became very oversold by 2003 when they had fallen into the red and their stockmarket gains had gone negative. What is extraordinary, however, is that, since then, with premiums rising, stockmarkets booming, and with plenty of time for sentiment to recover, their share prices have failed to bounce back more towards 2001 levels. The consequence of this is, firstly, that they are both looking incredibly cheap, and secondly, that accelerated premium rises into 2006 and 2007 will only serve to further exacerbate this.
Swiss or Munich?
Although Swiss Re's earnings for this term will have to be revised down to account for Katrina, the outlook through to 2007, with significantly hiked premium rates, should be well above the CHF9 EPS level indicated on the chart. Yet today's share price of CHF83 isn't even discounting an EPS of CHF9, but something closer to CHF6. The p/e ratio is 9 times for 2006, for an earnings yield of nearly 11%, or nearly six times the measly 1.83% yield you can get from Swiss government ten-year bonds. If anything, things appear even more extreme at Munich Re. German government ten-year bond yields are 3.12%, and the Munich Re consensus forward EPS forecasts (before premium hikes) is e10.8. That implies an 11.7% earnings yield (the inverse of the p/e ratio), which is nearly four times the yield from bonds. It was not always this way. In the late 1990s, the earnings yield was approximately 2% and bonds then paid as much as 5%.
Conclusion
Whatever the eventual bill for the New Orleans clean up, the reinsurers will make sure that premiums increase to cover it, and the insurance companies will make sure that they pass these hikes on to us. Major disasters likethis remind the insurance industry how much it needs the reinsurers, and the very size of the catastrophe means the insurers are unlikely to begrudge the reinsurers whatever premium hikes they deem necessary. Moreover, with the world's major reinsurers' stock prices apparently already offering enormous yields compared to government bonds, it can only be a matter of time before investors see the value and the rising premiums as an irresistible lure.For investors, it's like getting to buy a geared bet on the world's stockmarkets and at a whopping discount to boot. Take Warren Buffett. His Berkshire Hathaway Group owns two of America's largest reinsurance companies, GEICO and General Re, outright boosting Berkshire profits. So take a tip from the world's most successful investor: buy some reinsurance stocksfor your portfolio.
James Ferguson is an economist and stockbroker with Pali International
