Are insurance companies a good investment?

The insurance industry is one of the world’s most important, but also misunderstood and underappreciated industries. Most people think of it as an unnecessary cost – they think of the products they see and use, such as home and car insurance. These are important and vital, but they are only really the tip of the iceberg of the insurance industry.

A brief history of the insurance industry

Insurance is all about spreading risk between different parties. The first use of an insurance product can be traced back several thousand years, to around 1750 BC. But it is widely believed that the modern insurance market was born in London in the mid-1600s. John Graunt, an early statistician and demographer, analysed demographics to produce a series of tables that predicted, with an astonishing degree of accuracy, how long a person was likely to live based on their situation in life. These tables enabled fledgling life insurance companies to start pricing risk accurately and helped statisticians devise other methods of measuring risk in other fields. The Great Fire of London in 1666 ushered in the fire-insurance industry. By the end of the century, the insurance industry was blossoming. 

Around the same time, coffee shops started springing up around the city, which became informal gathering places for business owners and investors to swap information and trade. Edward Lloyd, who ran a coffee shop in the city, saw an opportunity to carve out a niche in the market by building an informal gathering place for ship captains, owners and merchants. He provided information on global trade routes and sailings from London to his patrons and, gradually, Lloyd’s coffee shop became known as the place to be for the fledgling marine insurance market. Today, Lloyd’s of London remains a key hub of the global insurance market and the fifth-largest provider of reinsurance in the world.

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The DNA of capitalism

Insurance has been described as “the DNA of global capitalism” and the “oil of the global economy” for the role it plays in reducing and sharing risk. Insurers basically pool risk. To generate a price for a car insurance policy, for example, an insurer will look at all the information on hand about the vehicle, the driver, where the driver lives, the chances of an accident based on the driver’s profile, location and vehicle, and potential cost and severity of any accident, and then offer a price based on the average cost of a claim and the likelihood of a severe claim. If that sounds like it involves a lot of data and many variables, that’s because it does. No company can ever be sure what the cost is going to be, which is why this isn’t an easy business. But it’s also why people need insurance. The cost of an accident could be several hundred pounds or tens of millions. An individual might be able to afford the former, but not the latter. However, for a company that’s underwriting thousands of vehicles, a large loss is manageable – it’s a cost of doing business. For a few hundred pounds a year, insurance removes this risk for one person by pooling the risk with millions of others.

This is known as primary insurance. It’s a contract between the insurance company and the buyer of insurance. Insurance firms will often then sell this risk on to a reinsurance company, which spreads the risk even further. The insurance company will often retain a proportion of the risk, say losses of up to £100 million each year, with any losses over that paid by a reinsurer. The reinsurer may then also choose to use what’s known as retrocession insurance to spread the risk even further. 

This structure is especially common for big risks – such as oil spills or natural catastrophes. These disasters could lead to tens of billions of dollars in losses, and no company wants that exposure, no matter how big it is. In these situations, firms tend to use insurance, reinsurance, retrocession and insurance-linked securities (bonds) to spread the risk far and wide. With the risk shared, no company should, in theory, need to worry about a threat to solvency if losses occur. Oil companies can then drill wells knowing there’s a fail-safe if something goes wrong and homeowners can go about their lives knowing there’s an insurance safety net if a hurricane sweeps away their home. Without insurance as a support, the propensity to take risks would be reduced and economic activity would suffer.

The hardest market of all time

Insurance is a cyclical industry. It is characterised by periods of what’s known as “soft” market conditions, where prices fall, and “hard” ones, where prices are pushed higher. The primary driver of market conditions is the availability of capital. When there’s lots of capital to be had, insurance companies compete vigorously on prices to increase or maintain market share and that usually means pushing down prices or changing the terms of contracts to make agreements more appealing to buyers. Soft markets usually come to an end with a change in the market environment, such as an increase in losses. Companies tend to respond by pushing up prices to cover losses and capital retreats from the market. A hard market then ensues until such time as capital returns to the market, attracted by high returns. The cycle then repeats itself. We’re currently in the midst of one of the hardest insurance markets of all time. Prices have been rising across the board – something most readers will have seen when they come to renew their car or home insurance. 

The Rate on Line (ROL) index compiled by Guy Carpenter, a global risk and reinsurance specialist, measures the change in dollars paid for reinsurance coverage year-on-year. It’s not applicable to the sort of insurance you or I might buy – it covers the global reinsurance and catastrophe insurance markets, the type of policies that are underwritten at Lloyd’s. The index has recorded three years of explosive growth, from 22% in 2022, to 27.5% in 2023 and 5.4% in 2024 (the index measures price growth over the previous 12 months). It looks like further price pressure will come down the pipeline in the years ahead. When Lloyd’s reported its half-year results at the beginning of September, its chief executive, John Neal, noted prices for US reinsurance had risen by 20% and 40% over the past 12 months, with similar growth in Japan. He also warned that prices in Europe had to catch up, having only risen 10% to 12%. 

Climate change and inflation are the two drivers behind higher costs. Neal warned that insurance prices in Europe would have to rise after the continent was hit by a series of natural catastrophes over the summer, from heatwaves to wildfires and storms devastating communities across the region. And it’s not just Europe. Extreme weather is changing the way insurers measure climate risks. Neal said, “The pattern of weather, which is a function of climate change, is changing. I don’t think you can simply rely on past data and say ‘That’s what happened in the past so that’s what will happen in the future’. I think there’s a lot more onus on us to understand what changing weather patterns mean.” 

The cost of rebuilding and repairing damaged property has also jumped significantly since the pandemic. Insurers have had to pass this cost on to customers, and that’s without taking into account the increasing cost of litigation as customers go to court to fight insurers for bigger payouts. Yet despite the increasing cost of disasters and claims, the insurance industry is currently going through one of its most profitable periods in recent memory. But the market has been slow to realise the opportunity here, especially for London-listed names.

Global insurance market players

The global insurance industry is massive, and there are plenty of different companies and angles investors can take to capitalise on this opportunity. While all the household names in the UK, the likes of Aviva, Admiral and Legal & General, have plenty of attractive qualities and are also benefiting from rising prices, consumer-focused insurance businesses can be challenging and often get involved in price wars. Data compiled by Hiscox and brokers at Panmure Liberum clearly illustrates the pressures. Hiscox, the only one of the four large listed London players with a big retail arm, has recorded compound price growth of around 30% in its retail business since 2018. In the core London market (essentially business written at Lloyd’s) and catastrophe reinsurance, prices have risen between 80% and 100%.

With that in mind, I’m going to focus on the global insurance market players, the names that have exposure to the Lloyd’s market and have more flexibility around pricing. There are four main players: Beazley, Conduit Re, Lancashire and Hiscox. A key measure of profitability in the industry is the combined ratio, which measures the value of claims paid out and costs against premiums charged to customers. Anything above 100% indicates the company is paying out more in losses and costs than it receives from insurance premiums and is, as a result, losing money. Anything below 100% signifies underwriting profitability as it means the company is booking more in premiums than it’s paying out in costs. Generally speaking, a combined ratio of 95% or more is quite good for an insurance company. If it is below 90%, the company is doing well and anything below 80% is considered outstanding. 

Beazley’s (LSE: BEZ) first-half results for 2024 reported an undiscounted combined ratio of 81% – four percentage points better than consensus analyst estimates. The stronger-than-expected performance led management to predict a full-year combined ratio in the low 80s. Analysts at investment bank Berenberg called these numbers “truly remarkable”. Assuming there are no major disasters in the rest of the year, Berenberg projects the company’s book value per share could compound at 20% through 2025, which would put the stock on a price-to-book-value ratio of 1.25. That’s “very attractive”. 

Book value tends to be one of the easiest ways to value insurance companies, which have large portfolios of investments to back up underwriting liabilities, often cash and cash-like instruments. Book value gives you the value of these assets as well as any insurance liabilities and potential premiums. It often gives little value to the intrinsic value of the brand and earnings growth. A book value of one to 1.5 for an insurance company is, therefore, incredibly cheap. Panmure Liberum estimates a price-to-book-value ratio of around two, which is more appropriate if the industry can earn and maintain a return on equity of 20% or more.

Beazley, like its peers Hiscox and Lancashire, provides reinsurance through the Lloyd’s market as well as through its own brokers. It also offers insurance directly to clients, insuring assets such as ships, satellites and companies against cyber-attacks. All three companies are benefiting from the global hard market. Lancashire (LSE: LRE) surpassed earnings expectations in the first half of the year by 25.7%. The company reported a combined ratio of 82.2%, while insurance revenues grew 26% year-on-year. Like Beazley, the firm predicts a mid-80s combined ratio for the full year. Lancashire stands out for its cash returns policy. Unlike its peers, which prefer to reinvest capital and grow, Lancashire has a history of returning profits to investors. Berenberg has the firm paying out 50% of earnings as special dividends in 2024, which would translate into a “very hard to beat” total cash yield of 12.3% for the full year. Book value may be one of the best ways to value insurance firms, but a low-teens dividend yield is just as good. The stock is trading at a price-to-tangible-book-value ratio of 1.3. 

Of the three big London-listed Lloyd’s insurers, Hiscox (LSE: HSX) has chalked up the worst performance this year. Despite the hard market in the global primary and reinsurance markets, Hiscox has a large retail insurance book. This has held the company back over the past year because, as noted above, competition in this market tends to be more intensive, making it harder for the likes of Hiscox to define and capitalise on its niche. During the first half of the year, the company reported a combined ratio of 77.3% on an undiscounted basis for the reinsurance and insurance-linked securities book. On the other side of the business, retail, the group’s combined ratio hit 93.8%. It has a long-term target here of 89%-94%. Still, on a group-wide basis, Hiscox reported an undiscounted combined ratio of 90.4%, and it has returned a lot of cash to investors with buybacks and dividends. That all-important return on equity number was 16.5% for the first half, down from 19.9% last year. The stock is trading at a price-to-tangible-book-value ratio of around 1.4.

A different opportunity

Conduit Re (LSE: CRE) offers something different from Lancashire, Hiscox and Beazley: it is a pure-play reinsurance provider and actually started life in 2020, almost at the beginning of the current hard market. It has picked its business carefully over the past four years, capitalising on opportunities when they emerge and avoiding everything that does not meet its strict return criteria. Profit for the first six months of the year came in at $98.1 million, 26.3% better than expectations and giving a return on equity of 19.8% on an annualised basis. Gross premiums written jumped 36.1% year-on-year, with premiums in the speciality segment up 58.6%. With a mid-80s combined ratio, the company has picked its business well and it’s the cheapest of the bunch, trading around book value. There’s also a 5% forward dividend yield on offer. 

All of the insurers look cheap compared with their current earnings potential, and while the market doesn’t seem to have acknowledged this fact, it seems other parties have started to take note. Earlier in the year, shares in Hiscox jumped after rumours started to swirl that Japan’s Sompo Holdings and Italy’s Assicurazioni Generali had been running a rule over the business. If the market continues to overlook the value here, it seems only a matter of time before others start to swoop.

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