Investor insights

May 22, 2006

Today, it’s not a fun time to be an insurance investor or analyst,” said Ray Joseph, vice president of Los Angeles-based Capital Research Co. Joseph should know; he is an investment analyst with research responsibilities for American large-capitalization insurance companies. Capital Research is a 75-year-old company that, among other things, manages the American mutual funds.

Helping to “forecast the future” for the Insurance Educational Association and Mt. Diablo chapter of the Chartered Property Casualty Under-writers Society recently, Joseph explained his comments. “Insurance is a low-return business relative to other financial services,” he said. “You can never get too comfortable on insurance stocks because the stocks consistently under-perform other financial services. Management teams are improving and may serve as a catalyst for improving valuations, but when good managers meet bad business, the bad business usually wins.”

Another reason Joseph does not believe insurance stocks will fare as well as other investments is that when he has picked winning stocks, there is: 1) usually a rising return on equity bought at cheap valuations, 2) compounding growth in book value at reasonable valuations or 3) a cycle turn in pricing and credit. “None of these conditions exist today,” he said.

Low values

Property and casualty company stocks, in particular, are facing low valuations, Joseph noted. “Low returns and low valuations equals weak stock performance,” he said. In the past 12 years, which he considers “a long period of time,” insurance stocks generally under-performed other financial services because poor structural economics drive low returns. Insurers also are hampered because they don’t know their returns until two to 10 years after they write risk, he said. An excess supply of capital drives down returns. And Sarbanes-Oxley Act regulations have imposed transparency on the industry, but reserve disclosure is still insufficient, he said.

“Rating agencies are reactive, which is forcing insurers to adopt shareholder-unfriendly capital strategies,” Joseph added. “Insurance companies are holding more capital than necessary. Companies are concerned about reinsurance companies and maintaining more of their own surplus to rely less on reinsurance. Will that make a return?”

Property/casualty changes

There were some fundamental changes in the property/casualty market a few years ago. Among of the positive changes, Joseph said, was the consolidation of personal lines insurers to fewer players with more scale. Better information systems and risk management tools have been developed. And the consolidation of insurance brokers to an oligopoly was positive, he said.

“Consolidation and risk management have helped personal auto stocks, especially Progressive and Mercury General,” he said. “A buy and hold strategy worked in personal auto stocks.” Additionally, consolidation in the brokerage business has been helpful so those companies can better serve national and global accounts, he said. That allowed companies to increase leverage over underwriters to get better terms, he explained.

However, Joseph indicated the personal auto cycle is weakening, and the brokerage industry model is in flux with attorney generals questioning contingent commissions. Also, the 2005 hurricanes created too much capital in the market.

“2004 was a perfect year for personal auto stocks with declining frequency and severity of claims, robust price increases and a broadly weak stock market,” he said. “Today, margins are contracting and it’s not a good time to own personal auto [stocks].”

Some negative aspects facing the industry are that rating agencies have become “defecto regulators of capital,” Joseph said, and there is easier access to capital.

With regard to contingent commissions, the largest four brokers said they no longer take contingent commissions, Joseph noted. “Three of the four largest brokers now have margins that are lower than the smaller players in the business. It’s hard to know how the new broker model will develop.” Despite his gloomy outlook, Joseph said he did see some opportunities for new startups in the insurance business that should interest investors. “The question is how much and how big,” he said. “There’s opportunity to build a real business, but if it’s a ‘one and done ‘cycle where you write in January ’06 and then in July ’06 the market goes back to its competitive ways, I’m not sure that’s the best way to put capital to work.”

Joseph was one of several speakers at the 7th Annual Educational Forum, “Forecasting the Future,” presented by the Insurance Educational Association and Mt. Diablo Chapter of CPCU. The program benefited the Child Abuse Prevention Program of the Insurance Industry Charitable Foundation. For more information, visit www.iicf.org or call (925) 280-8009.

Topics Auto Agencies Personal Auto Property Casualty

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