A silver lining for insurance companies

After several years of calm in the Caribbean, the 2017 hurricane season is expected to prove the most expensive in the insurance industry’s history. The cost of the damage caused by hurricanes Harvey, Irma and Maria remains highly uncertain, but estimates already exceed $200bn – even though many of the losses were either uninsured or covered by the US National Flood Insurance Program.

With $700bn of capital in the US insurance sector, and a further $600bn in the global reinsurance sector, there is no question of a threat to the sector’s solvency, but insurance rates are certain to rise. Insurance companies are required by the regulators to limit their exposure to losses by taking out reinsurance with specialist companies. In turn, reinsurance companies limit their losses with “retro” insurance, which only kicks in when losses on a catastrophe exceed a high, predetermined level. It’s expected that retro rates will rise by about 30%.

Retro insurance was one of the cornerstones of the success of Warren Buffett’s Berkshire Hathaway, but its virtual monopoly has been broken in the past ten years by new market entrants. Prominent among these is the London-listed Catco Reinsurance Opportunities Fund (LSE: CAT), whose share price has dropped by 25% to $1.02 since the summer, a 7.5% discount to net asset value (NAV – the value of its underlying assets).

This price indicates an expectation that Catco’s provisions for claims will be exceeded, but chief executive Mark Belisle thinks the losses will pave the way for future opportunities. Catco has just raised $543m on top of its market value of $400m in a C-share issue. This money will underwrite in the January renewals season but, unlike the existing capital, will not be liable for 2017 losses. The two share classes are likely to be merged at the end of 2020, when all 2017 claims have been settled.

Catco seeks an average return from its investments of 9%-12% over the market rate of interest, net of fees. In practice, returns have varied from +22% in 2014 to an estimated -10% in 2017. Total loss reserves for 2017 amount to 21.5% of NAV, but much of this is absorbed by premium income.

The loss in 2017 was limited, and the returns in recent years were reduced by Catco itself buying reinsurance protection. This limited the maximum net return in 2017 to 16%, but in years when premiums are high and protection expensive it could be nearly 30%, as it was in 2013. Catco underwrites across 50 different “perils”, limiting the risk in each to 10% of NAV. In theory, though, a catastrophe could affect more than one “peril” – for example, a hurricane could hit both the Gulf of Mexico and Florida.

Since Catco intends to return nearly all of its net profits to investors by way of ordinary and special dividends, this is an investment for income, not capital growth. That said, even the normal dividend, targeted at around 6%, is not reliable – investors are unlikely to see any dividend for 2017. Note that the shares are priced in US dollars, meaning currency risk for UK investors.

Although Catco is optimistic, risks remain. The 2018 hurricane season could be even worse, while other natural disasters could make it another year of losses, despite the sharp rise in premiums. Cautious investors should buy the C-shares, but keep something back to invest in a year’s time in the event of further catastrophes. Bolder investors may prefer to take a chance on the 2017 outcome being better than feared by investing in the existing shares.


Activist watch

Shares in Whitbread went up by 7% last Wednesday after activist investor Sachem Head declared a 3.4% stake in the owner of the Premier Inn and Costa Coffee chains. The New York-based fund has not said what it will do with its stake in the FTSE 100 company, but top-20 investor Old Mutual Global Investors has told The Daily Telegraph it believes the new shareholder “will be looking at a break-up”.

The “two most obvious angles” for Sachem Head to pursue are a disposal of Costa and a sale and leaseback of assets, Barclays told the Financial Times. “Whereas the market values Costa at just nine times earnings, recent deal values in the coffee shop sector have been in the high teens,” according to Barclays.

In the news this week…

• The “arrogant and complacent” fund-management industry is taking £35bn a year too much in hidden charges from pension funds, says Chris Sier, the academic appointed by the Financial Conduct Authority to force fund managers to be more transparent. Although the total expense ratios quoted by the industry include management costs and expenses such as auditing, they exclude “a huge number of other costs”, such as trading commissions and foreign-exchange charges.

The total cost of charges to end-investors is about 3% of assets under management per year, but this could be cut to about 2%, Sier told The Times. Although he sees some asset managers – such as Baillie Gifford and BlackRock – as “relatively sympathetic” to this issue, the 25% of fund managers that he expects to reject his proposals “have everything to fear”. The working group is due to report its latest progress before Christmas.

• Since the start of 2017, shares in BlackRock, the world’s largest asset manager, have “hugely outperformed” the wider market, rising by 35% year-to-date, against 18% for the S&P 500, says Miles Johnson in the Financial Times. Shares of other big providers of exchange-traded funds (ETFs) have also beaten the market, including State Street, up 25%. “Before you rush to invest in an ETF, think twice. It may be more profitable to buy an ETF manager instead.”