The days of plenty are coming for insurers – it’s time to buy

London is home to one of the great unsung heroes of the UK economy. The London insurance market is the clear global leader in commercial insurance. Most of the world’s largest companies buy at least one policy in London and over $110bn of premiums are underwritten there each year, more than twice that of its nearest rival, Bermuda. Insurance is responsible for a quarter of the GDP generated in the City of London and around 50,000 jobs. Most of the business is for clients outside the UK, so it is a huge contributor to the UK balance of payments. 

The market dates back to the formation of Lloyd’s of London in 1688. The 330-plus years of innovation and evolution since then have witnessed several firsts. For example, the world’s very first motor, aviation and satellite risks were all insured at Lloyd’s and more recently, we’ve also seen the first cyber-risk policy underwritten in London. The market is the first port of call for complex risks, such as those surrounding offshore oil platforms and major construction projects. That said, it is probably best known for insuring unusual risks, such as Taylor Swift concerts, David Beckham’s legs and a prize for the capture of the Loch Ness monster. And yet, despite the size and importance of the London insurance market, it is not well known or understood outside of the EC3 postcode. Politicians, journalists and investors alike all tend to overlook it. 

Years of plenty lie ahead for insurers

In the case of investors, this might seem sensible. The insurance industry is notoriously cyclical, with a few years of exceptional profits inevitably followed by long periods of poor returns for shareholders. In this respect the insurance market is like the story of Pharaoh’s dream from the Old Testament book of Genesis. The Pharaoh who ruled Egypt had a series of vivid dreams that were interpreted for him by Joseph. In one such dream, a group of seven fat cows came out of the Nile, followed by another group of seven skinny cows. Joseph explained that this meant there would be seven years of bumper harvests followed by seven years of famine. He told the Pharaoh to build grain stores to hold the surplus food from the bountiful years to help the country through the lean years. 

The insurance cycle usually follows a similar “feast and famine” pattern. Unlike many business sectors, it is not driven in the main by the sorts of wider financial and economic factors that drive the financial markets. Instead, it tends to revolve around major catastrophes such as Hurricane Katrina that produce huge claims for the industry. That said, it is possible to predict the development of the insurance cycle with some confidence if you are familiar with the industry. The good news now is that an opportunity is emerging for shareholders to make bumper returns over the next few years, as the cycle moves decisively in insurers’ favour. 

The trouble with insurance

Insurance has three major problems that make it a difficult hunting ground for investors. Firstly, insurance is viewed as a commodity, so competition largely centres on price rather than product quality. Much as insurers try to differentiate their products and their claims service, the reality is that buyers do not envisage making a claim. For them, insurance is just a product that they must buy to protect their assets, so the average buyers will simply go for the cheapest option. Secondly, the barriers to entry are low. It is possible to raise sufficient capital and establish a new insurance company with regulatory approval and an A- credit rating in a matter of months, especially in a business-friendly territory such as Bermuda. Finally, and most importantly, the cost of sales is unknown and impossible to predict with any degree of confidence. 

When most companies sell a product or service, they have a fairly good idea of how much it costs to make or deliver that product or service. Insurance is different. When an insurance company insures a factory, for example, it has no way of knowing whether or not it will have to pay a claim. Its cost of sales may be close to zero if there is no claim – or extremely high if the factory burns to the ground. To make matters even worse, with liability insurance there can be a long time-lag before claims are made and settled. As an extreme example, claims for diseases resulting from exposure to asbestos are still being made to policies dating from as far back as the 1970s. 

As a result, come the end of the financial year the total premium billed by the insurer is relatively easy to calculate, but the total claims that will be paid are at best an educated guess. Most of the policies written during the year are still running and it may be months or years before they expire. It will be much longer still before the claims are all agreed and settled. For this reason, insurers employ teams of actuaries to model the likely ultimate claims total, so they have a plausible estimate to put into the year-end accounts. The firm will have to keep enough in cash and investments to cover this total, which is known as the “reserves”. 

This is where the fun starts. The management teams of insurance companies have a fair degree of latitude when it comes to picking a number for the total reserves. They should err on the side of caution and put enough aside comfortably to cover a reasonable worst-case scenario. If in future years the actual claims are lower than the reserves held back, then the surplus reserves can be released to boost the profits of the following year. If the claims turn out to be worse than expected, then the reserves will need to be increased to compensate, which might mean the company makes a loss and in extreme cases needs to raise more capital or goes out of business.

When the insurance market is going through profitable times, a good chief executive will make sure that some of the potential profit is held back to boost the insurer’s reserves in the same way that Pharaoh stored extra grain in his silos. However, it does not take many years of attractive returns from the insurance market before more competition arrives. This may take the form of new insurance companies being formed, or existing ones raising extra capital to enable them to increase market share. The only way to expand quickly is to compete aggressively on price. Before long, premiums are falling significantly year after year. This quickly erodes profit margins. 

What happens next is that insurers will tend to raid their reserves to enable them to maintain their profits. To the outside world it looks as though profits are stable. But this in turn attracts yet more competition and reduces pricing still further. Eventually the grain stores (the surplus reserves) run dry and suddenly insurers start making losses. Often at this stage of the cycle the situation is compounded by one or more major disasters, such as a big hurricane that results in a dramatic leap in claims. This results in insurers making large enough losses to affect their capital bases, or even put some out of business. Finally, insurers have to raise prices significantly and the cycle slowly starts to turn again.

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John Chambers worked in the Lloyd’s market for 33 years in underwriting management. He is now a writer and adviser to private equity.