Why the insurance sector is not all about meerkats and nodding dogs
Nick Martin, Fund Manager of the Polar Capital Global Insurance Fund, looks at the role insurance has provided as the bedrock of some of the world’s most successful companies − a sector often overlooked by investors due to bad experiences.
Individuals often tarnish their thinking when considering investing in the insurance sector, with memories of a bad claims experience, or they question why they even need insurance in the first place because “we are all great drivers”. They overlook the role insurance has provided as the bedrock of some of the world’s most successful companies, such as Warren Buffett’s Berkshire Hathaway.
What many investors often do not appreciate is that, as Dan Glaser, CEO of insurance broker Marsh & McLennan recently noted: “On the upside, insurance enables commerce to thrive. Satellites are launched. Skyscrapers are built. Medicines are invented. On the downside, insurance is a vital buffer enabling lives and livelihoods to be rebuilt following loss”.
While it plays a key role as the oil that greases the wheels of a great deal of global commerce, a key attraction of the P&C (property and casualty) insurance sector is that the driver of the returns of the best companies are their underwriting profits. This profit stream tends to be largely disconnected with what is going on in the broader economy and financial markets, as losses are driven by events such as accidents, fires, natural catastrophes or human negligence. In many instances insurance is a compulsory purchase which is often required by law, which means that the industry exhibits robust demand characteristics. This also means that the P&C sector has historically been defensive in challenging economic times similar to those today. Importantly, P&C insurers have low investment risk given they need balance sheet liquidity to pay claims. In contrast, life insurers have a temptation to stretch for yield in a low interest rate world in order to meet their long-term promises to policyholders.
The best run insurers are compounding machines over time which is best measured by growth in book value per share. However, in order for the magic of compounding to work it is critical to avoid a significant loss. Often it is not what you write but what you do not that protects capital and enables underwriters to benefit from profitable opportunities when market conditions improve. Insurance success is achieved by focusing on companies with good track records of underwriting profits over various cycles, who have demonstrated prudent reserving and who maintain a cautious, liquid investment portfolio. Management ownership, expertise and culture all contribute to creating the conditions to enable companies to underwrite prudently through the cycle. The dispersion of quality, and returns, over time is significant. Insurance is not an industry for passive investing as only the best insurers are likely to deliver good returns.
Bad things happen so investors need diversification. Owning one or two large conglomerate insurers provides one avenue for this, but even then, outsized losses can provide unwanted volatility. We prefer instead to invest in niche underwriters, big fish in small ponds, that remain prudent and stay focused within their circle of competence. This means we flex the portfolio as market conditions change, gaining exposure to lines of business where pricing is favourable relative to the cost of losses and move away from lines of business where returns are inadequate.
In recent years the portfolio has been overwhelmingly focused on primary US commercial risks where returns have been good and the barriers to entry remain high due to the costs of establishing infrastructure such as that required to pay claims. The Fund had reduced exposure to larger risks such as those written at Lloyd’s of London and, more significantly, property catastrophe reinsurance as pricing started to fall due to increased demand from investors seeking the holy grail of high yield and uncorrelated returns. Falling prices were further exacerbated by a benign catastrophe environment prior to 2017. The primary US commercial companies benefited from this cheaper reinsurance coverage which resulted in good returns even during the largest catastrophe loss year ever in 2017.
Today is a particularly interesting time for the sector. We have started to see growing evidence that rates in some of the more challenged lines of business have started to respond to the large losses and catastrophe events of the past few years. In recent months, this trend has become far more apparent as management teams have become more confident on the direction of travel. The specialist E&S (excess and surplus lines) markets such as Lloyd’s of London continue to be the greatest beneficiaries of the tightening of rates in the US primary markets while there has been a material increase in E&S submissions as more risks are deemed “too hairy” for standard market insurers and need to be handled by specialists. At the same time, several large conglomerates who having incurred significant losses in recent years have responded by reducing their line sizes and pulling out of lines such as US D&O (directors and officers), construction or aviation. As Warren Buffett notes adroitly: “It is only when the tide goes out that you discover who has been swimming naked”. This trend has been keenly felt at Lloyd’s of London where the Decile 10 initiative to restore market discipline resulted in unsustainable business plans being rejected. The underwriter exits and job losses that have followed have resulted in the increase in demand for insurance cover occurring against a backdrop of more limited market capacity. As submission levels increase so companies who have kept their powder dry can take advantage.
We focus on investing in companies with strong balance sheets and conservative reserving strategies that balance their portfolios in relation to the underwriting opportunities they face. The best insurers can right size their balance sheets to the underwriting opportunity they see and use excess capital to further protect downside risk in difficult markets by buying back their stock. However, we believe the P&C insurance industry’s growth prospects have never looked better and this should over time be a tailwind to returns. One of the secrets to compounding returns in insurance is sticking within your circle of competence and not seeking growth for growth’s sake. What matters is per-share growth and over any reasonable timeframe investor returns will follow. It is no surprise that Warren Buffett calls compounding “the eighth wonder of the world”.
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