By James S. Stradtner, CFA President, Century Merchant Bankers LLC
"One year ago, in looking at prospects for investing in insurance stocks, I concluded that the outlook was "every bit as exciting as it had been in the past." Results for 1997 have shown that my prognosis was not unrealistically optimistic.
Using our public mutual fund, Century Shares Trust (CST) as a proxy for insurance stock performance in 1997, we found that this sector once again has outperformed the general market. For the 11 months ending November 30, 1997, CST (insurance stocks) gained 38%, while the unmanaged Standard & Poor's 500 stock index increased 31%. The same type of outperformance is evident during longer periods of time such as 10 years and 20 years.
Perhaps the most significant part of this relative performance by insurance stocks is the fact that it may well have been achieved with less stock price volatility and far better valuation comparisons. For instance, CST insurance holdings had a higher return on equity and higher growth of book value plus dividends for the past five years, but these insurance stocks currently sell at a 20% discount to the S&P price x earning ratio and a 37% discount to the price x book value ratio. Faster growth rates and lower valuations certainly make the current conditions favorable, and there is no reason to believe that this will not continue for some years to come.
If insurance stocks are exciting, it is because the insurance industry is exciting. Few consider it to be a growth industry, but it is. Over a 50-year period, insurance industry assets have increased at a rate 13% greater than our nation's Gross Domestic Product. For every 10-year period, premiums, surplus and even the number of companies have grown at a consistently favorable rate.
This growth has been accompanied by change. The two major changes affecting the insurance industry in the 1990s have been the development of the Bermuda insurance market and the resurrection of Lloyd's of London. The former reflects a market that simply did not exist several years ago and that today has evolved into one that writes millions of dollars of premiums, including major catastrophe covers.
Lloyd's has come back from the brink of extinction and is now viewed by many as bigger and better than ever. But the real change at Lloyd's is the shift of market capacity from individual names to corporate entities. This trend will undoubtedly continue into the future, ensuring that corporate capital will ultimately dominate the London market.
Future agents of change will include, but not be limited to, bank distribution of all types of insurance products, multiple marketing approaches that include direct customer solicitation and Internet offerings and globalization of the insurance product by insurance companies operating worldwide. We would be remiss if we did not also mention the growing trend of mutual insurance companies to demutualize.
Since not all companies can grow and/or change, a natural fallout of this is consolidation. The number of mergers in the U.S. insurance industry has increased each year since 1992 and will break records in 1997. The aggregate value of these deals exceeded $35 billion in 1996, and it will be substantially greater in 1997. This does not include the very significant mergers that have occurred this year among non-U.S. insurance companies, including several giant European insurance organizations.
Many factors have contributed to this consolidation trend. It is commonly believed that the "weak" companies give up for lack of management and financial resources and increasing pressure from regulators and rating agencies. While this is technically correct, I prefer to think of it as the strong companies making mergers and acquisitions a key part of their overall corporate growth strategy, especially in an industry suffering from intense price competition brought about by too much capacity. Investors like to own shares in insurance companies that can increase their market share, even by acquisition, without sacrificing profitability.
Simply put, all this adds up to a great opportunity for investing in insurance stocks. Insurance is not a dull and unexciting industry. Instead it is a vibrant, alive and growing industry that is fundamental to all of our business activities. All that intelligent long-term oriented investors need to do is select individual insurance companies with unique characteristics, whether they be large companies or small companies, risk-bearing companies or service companies. Unique, in this sense, means those companies that can grow, change, consolidate and be opportunistic. *
By Myron M. Picoult, Vice President and Senior Insurance Analyst, Wasserstein Perella Securities, Inc.
Industry pricing fundamentals, especially in the commercial lines arena, are abominable. During the 1997 third quarter, we saw a few earning bloopers, mostly from smaller-to-medium sized carriers, but there was a sprinkling of big boys, too. Furthermore, an increasing number of chief executive officers are cautioning investors about their top line and bottom line expectations. With few exceptions, managements tend to err on the optimistic side when discussing the prognosis for their own companies, notwithstanding the operating environment.
Industry punsters are also cautioning investors about the outlook, but have yet to really cut their 1998 earnings estimates. Some are even starting to pop out higher 1999 projections and hold to the belief that their favorite companies will remain virtually unscathed from any carnage.
The industry gurus are again dusting off their crystal balls and prognosticating the future. The difficulty in calling a turn in pricing or the underwriting cycle mirrors efforts to pick the shift in interest rate trends. You're wrong more often than you're right. Nevertheless, we cannot ignore the opportunity to throw in our two cents.
To begin with, no two underwriting cycles or pricing cycles are alike. Trees do not grow to the sky and we do not believe that the bounce off the bottom this time, whenever it occurs, will be as powerful as the 1985-86 recovery! Everybody knows that commercial lines pricing is bad. Our view is that it is far worse than most analysts realize. We sense prices are equal to, or below 1985 levels when one adjusts for changes in terms and conditions. In fact, we do not understand how some companies can be making any money.
Industry fundamentals continue to deteriorate. Cash flows are being squeezed by rampant price cutting in various commercial line segments. What is not being measured as the process unfolds is the impact of changing terms and conditions on prospective losses. Here and there are slight hints of claim notices on the rise. Net investment income growth has been rendered more labored by the sheer size of the investment income base and investment pressures.
Furthermore, we believe many carriers have generated unusually favorable underwriting results at the expense of their balance sheets. It is difficult to believe that any redundancies remain out of the 1986-1988 accident years. Bad loss trends have been remarkably benign, partly due to reined in inflation and partly to chunks of business shifting to alternative market mechanisms, which precludes apples to apples comparisons. Any pick-up in paid loss trends at a time when revenue growth is so labored could put considerable pressure on the earnings. And sharp increases in retention levels add fuel to the fire.
Finally, it is amazing that the industry is again exposing itself to a boom/bust scenario. One would have thought that something was learned from the last debacle. We continue to believe that a reversal of fortunes will be caused by some type of financial catharsis. Exposures to the year 2000 problem, potential tobacco liabilities and/or the unwinding of some inflated expectations on relatively recent acquisitions tied in with the marvels of purchase accounting could start the ball rolling.
The above analysts' comments were compiled by Samuel Schiff of the National Insurance News Service.
©COPYRIGHT: The Rough Notes Magazine, 1998