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Insurance

Life Insurance in 2012: Jumping a Big ROE Hurdle

Written February 16th, 2012 by bault

Given the strong start for life insurance stocks in 2012, it is important to re-examine our Short-Term Neutral View on the life insurance subsectors. In this note, we conclude that the Neutral View remains appropriate, owing to a decline in core return on equity, as well as measurable increases in the cost of equity subsequent to the financial crisis

Using US industry statutory data, we examine the components of return on surplus (RoS) both prior to (2003-07) and subsequent to (2010-11) the financial crisis. Average RoS has declined 300 bps, driven by sustained lower interest rates (130 bps) and structurally lower operating leverage (160 bps) as companies sought to raise capital and reduce risk. At least in the short-term, these factors seem difficult to control at the company level

The 300 bps decline in industry RoS is mirrored by a comparable decline in GAAP ROE for mid- to large-cap life insurers. We use a DCF-type model to estimate the change in discount rate pre- and post-crisis that reconciles ROE with average price/book. We conclude that life insurers face 390 bps on average in higher cost of capital post-crisis, owing to the higher asset and liability risk revealed in 2008-09

The combined 690 bp net increase in ROE hurdle needed to support valuation represents a high hurdle for investors looking for investment opportunities in life insurance, in our view. If one holds the view that the apparent increase in life insurer cost of capital is transitory, there may be many more opportunities than we think are available. We think it would be more prudent to focus on those areas where there is a higher probability to improve ROE

At the company level, Life-Investment “value” plays (e.g. LNC, GNW, HIG) seem more challenged to improve ROE near-term, owing to the stress taken during the crisis. In contrast, the lower-risk Life-Other names (AFL, AMP) already have post-crisis ROEs above the pre-crisis level. Neither group seems likely to see near-term decline in risk premium, absent a market event

Some Life Investment names—MET in particular and PFG to a lesser extent—may have a higher probability to increase ROE near-term. Even a recovery of one-half the post-crisis ROE decline (350 bps for MET, 200 bps for PFG) could result in meaningful price/book improvements (on average 100 bps of ROE or cost of capital equates to 0.1 points of price/book)

Our Long-Term Views on the Life Insurance subsectors remain unchanged. We remain Long-Term Negative on Life-Investment, owing to insufficient change in the core asset and liability challenges of variable annuities and their associated guaranties, which are not likely to be full addressed absent another crisis. Conversely, we have a Long-Term Positive View on Life-Other, given its lower risk profile and higher innovative potential, both of which increase of the probability of eventual decline in market risk premium

Quick Thoughts: Why Not Spin Off Hartford’s P&C Business? Because Life Might Be Nearly “Zero”

Written February 8th, 2012 by bault

Insurance is not generally known for heated exchanges publicly aired. Yet this is exactly what we got this morning on Hartford’s (HIG) Q4 earnings conference call. About 55 minutes into the call (and we do recommend listening to the playback if you missed it), a well-known major (largest, actually) shareholder angrily challenged management to take more seriously the idea of spinning off the P&C unit of Hartford in order to realize more value. Specifically, he cited the research of a competitor firm that suggested up to 70% appreciation in the value of the P&C unit in the case of a spin-off. Hartford themselves brought up the idea in a presentation slide, but their determination was that many “challenges” existed that currently rendered the proposal unfeasible. The irate shareholder faulted management for not figuring out ways to overcome the “challenges” to accelerate value creation.

After the drama had passed, we realized that this debate connects to some major research conclusion of ours. Put simply, the reason why Hartford is likely reticent to consider a spin-off is that it implies the Life company may be worth nearly “zero”. In fact, the idea that a breakup will actually unlock value is debatable. Let us first note that we have not done any kind of detailed breakup analysis on HIG. But it is not difficult using public data to perform a quick sensitivity analysis that suggests a simple “sum of the parts” is rather consistent with current depressed insurance valuations. It is not clear why HIG would attract a premium multiple on P&C given current market conditions.

We started with HIG’s year-end financial supplement. HIG has long provided detailed splits of income and balance sheet into Life, P&C, and Corporate segments (which makes breakup analysis more feasible than it might be for some other companies). We took year-end book value per share and allocated the Corporate segment proportionally by book value to Life and P&C. Note that HIG specifically noted that such an allocate was not feasible: Corporate is mostly debt, and HIG noted that Life could likely not support more than 1/3 of the debt to maintain ratings. But we are attempting to estimate implied market value by segment, so it makes sense for us to do the allocation proportionally and show the debt strain on Life. Using yesterday’s closing price of $19.12, this equates to a 40% price/book for the whole company. We first assume this valuation applies to both Life and P&C, but then apply the suggestion that P&C could be worth 70% more standalone. This would assign a suggested price/book ratio of about 70% to P&C, which seems rather conservative but is entirely consistent with the low end of current P&C valuations. Assuming the market has the total value of the company “right”, this would assign a price/book of 23% to Life. This is comparable to a peer like Genworth (GNW), another very troubled life insurer. Finally, if we assume that the Life companies is worth “zero”, it would imply a P&C price/book ratio of 105%, which is not unreasonable and consistent with the current depressed valuations of “quality” P&C companies like TRV or ACE. We lay out all these calculations in the following table.

Sources: Company Reports, Sector & Sovereign Research Analysis

Once again, we stress that we have not done any kind of detailed breakup analysis. It is certainly likely that many different assumptions could be brought to bear. But it does not seem unreasonable to test the idea that, if something like the notion of 70% upside to the P&C unit is already “in the market”, what this must imply for the Life company. There is no reason, in our view, to assign any kind of premium valuation to HIG’s P&C unit, unless you want to argue that all P&C companies are undervalued, which is not the intent of this analysis.

This is important in the context of our overall research. It is our view that the current investor pool is highly skeptical at best, and outright unwilling at worst, to support the legacy assets and liabilities of life insurers, in particular variable annuities (VAs). In such an environment, it simply may not be possible to break up a company like Hartford without lining up runoff capacity to assume the legacy VA book. Hartford brought up this possibility themselves, but likely in the context of no breakup as they would need the P&C balance sheet to support that decision. For a breakup to work, it might be necessary to find investors to take the legacy VA book, and it is not inconceivable that such a buyer would demand nearly all of the capital of the existing Life company. But ironically, once freed of the VA book, the successor Life company might be better able to raise fresh capital! All this is very complicated, and a big step that current management might be unwilling to take. We discussed the topic of “selective runoff” in Nothing To Be Done? Is The Current Valuation Discount for Underwriters Permanent? We thought such actions would take a long time to play out. But this morning’s Hartford soap opera suggests that such considerations may need to be accelerated by managements—or the market will do it for them.

Our current Long-Term Qualitative View on Multiline insurers (i.e. those with roughly equal amounts of life and non-life business) is Negative, precisely because we think the strategy is no longer appropriate given investor preferences for greater company focus. An eventual breakup of a company like Hartford is exactly what we would expect at some future date. But as the above analysis demonstrates, this might not be possible without considerable pain.

CB Q4 Earnings: It Looks Like the Commercial Cycle is Real For Now!

Written January 27th, 2012 by bault

Despite our skepticism, the commercial lines pricing cycle continues apace. Chubb confirmed in its Q4 earnings report that it is seeing pricing similar to Travelers in Commercial Lines, with average pricing up 6% in Q4 and about 3% for the year. Interestingly, they also report the beginnings of price increase in Professional Indemnity, although only +1% in Q4 versus about 1% down for the year.

For comparison, we provide our analysis of renewal versus new business for Chubb’s Commercial Lines:

	Commercial Insurance	Q4	Full Year	Source
	Accident Year Non-Cat Loss Ratio:
1)	2010	55.0%	49.2%	Release
2)	2011	56.2%	50.5%	Release
3)	Real Price Change	-2.1%	-2.7%	(1)/(2)-1.0
4)	Assumed Loss Trend	3%	3%	S&SR assumption
5)	Nominal Price Change	0.8%	0.2%	[1.0+(3)]x[1.0+(4)]-1.0
6)	Renewal Rate Change	6.0%	3.0%	Release
7)	Retention	85%	86%	Release
8)	New Business Rate Change	-28%	-17%	[(5)-(6)x(7)]/[1.0-(7)]

	Sources: Company Reports, Sector & Sovereign Research Analysis

The underlying new business price change in Q4 was about -28%, worse than the -17% for the year. Recall for Travelers that we calculated -14% for Q4 and -22% for the year. But also realize that, with a 56% non-cat loss ratio, Chubb’s average price level in Q4 is about 16% higher than Travelers, with a 65% loss ratio (making no allowances for mix difference).

Chubb is also still releasing reserves, even more strongly than in 2010 (for Commercial, 7 points in 2011 vs. 4 points in 2010). This is all consistent with our view that Chubb emerged from the 2001-03 pricing cycle with one of the best constructed books of business of any US commercial carrier. Given an 11% ROE in 2011 with above-average catastrophes and below-average yields, plus a newly-announced $1.2 billion stock buyback, Chubb does not appear to need much pricing, yet here we are. It is this seeming disconnect from historical behavior that we think bears careful monitoring.

We are doing this calculation of likely new business price changes because we want to remind investors of the quality of this current cycle. In a “classical” pricing cycle, new business would be going up, too, so what we are seeing is not a typical cycle. As best we can tell, what we are seeing is a cycle driven by desire for increased profits. This is very nice, but it’s never happened before. What is normally needed are much higher loss levels, usually that come by surprise. Given that we think more upside surprises are likely on the reserve front, we continue to be cautious, but do now think that sustained pricing is more likely in 2012 than we did previously.

Our working theory at present is that enough time has passed from the financial crisis that insurers are more willing to attempt to get price they likely wanted 3 years ago, but were afraid to push for given the financial condition of their customers. This is tough to prove quantitatively, of course, but trying to find data and metrics to monitor this unusual pricing cycle will be a focus of our research this year.

TRV Q4 Earnings: Stronger Renewal Pricing, and Implied New Business Better, Too!

Written January 24th, 2012 by bault

Travelers reported Q4 operating EPS of $1.48 vs. SNL consensus estimates of $1.54. But as was the case last quarter, the big question is the progress of potential price increases. And this quarter, we see some progress on both renewal and new business pricing. While new business pricing is still down, it appears to be down less than last quarter. This is an important metric to gauge the health of any emerging pricing cycle.

It was a major point of contention last quarter that Travelers was reported increasing renewal pricing, yet its combined ratio deteriorated even excluding catastrophes and reserve development. In Business Insurance, where Travelers reports sufficient data to attempt this analysis, the Q3 non-cat accident year loss ratio (AY LR) was 68.9% vs. 62.3% in Q3 2010. Although Travelers reported renewal premiums increases of 4%, the implied underlying new business price change could have been a decrease of as much as 40%.

This quarter looks much better, and Q3 looks more like a fluke. We have attempted the same analysis, using Travelers supplements and disclosures, for both 2011 Q4 and the full year.

	Business Insurance	Q4	Full Year	Source
	Accident Year Non-Cat Loss Ratio:
1)	2010	64.5%	63.4%	Release
2)	2011	65.3%	66.3%	Release
3)	Real Price Change	-1.2%	-4.4%	(1)/(2)-1.0
4)	Assumed Loss Trend	3%	3%	S&SR assumption
5)	Nominal Price Change	1.7%	-1.5%	[1.0+(3)]x[1.0+(4)]-1.0
6)	Renewal Rate Change	6.0%	3.0%	Release
7)	Retention	79%	82%	Release
8)	New Business Rate Change	-14%	-22%	[(5)-(6)x(7)]/[1.0-(7)]

	Sources: Company Reports, Sector & Sovereign Research Analysis

The headline result for Q4 was 6% average renewal pricing across Business Insurance, with pockets as high as 8% in Commercial Accounts, for example. But unless one is in a raging hard market, it is usually the case that new business will get a decrease on average. That was still the case in Q4, but the results look better than Q3, and trend over the year looks good. We estimate about a 14% new business price decline, averaging to a Q4 total nominal price change (new and renewal) of 1.7%. The was an improvement over the full year, where assuming an average renewal price change of 3%, we get an implied new business price decrease of -22%, and -1.5% total price change. So the average price change across all business in Q4 is 3 points better than the full year 2011. That’s a big improvement.

Keep in mind that this analysis is rough, but hopefully reasonable. The 3% assumed loss trend is a plug. We have no ability to adjust for large losses or other distortions. And the numbers we are pulling off of various Travelers graphs themselves are estimates. Still, the direction of change looks good. Travelers believes they will begin to see underwriting margin improvement in the first half of 2012, and we think this more likely that we would have 12 month ago. Until and unless our forecast for re-emergence of favorable prior year development occurs, the trend looks to be for higher pricing near-term.

P&C Pricing Expectations: Backing Off Reinsurance, Play It Through Specialty

Written January 22nd, 2012 by bault

In preparation for Q4 earnings and the outlook for 2012, we have attempted to organize the available pricing data into an “expectations” analysis. This is difficult given the quality of the various surveys and company commentary, but we do think this can be useful for thinking about stock performance when combined with harder data

The main outcome of this analysis is that we are changing our Short-Term Qualitative View on Reinsurance to Neutral from Positive; the rest of our View remains unchanged. We would play any pricing cycle improvements through P&C Specialty in particular, along with P&C Multiline and P&C Commercial (both Short-Term Positive). P&C Specialty has the potential to benefit from both insurance and reinsurance pricing improvements Read the rest of this entry »

Insurance in 2012: It’s (Still) About the Risk

Written January 3rd, 2012 by bault

Market risk perception was one of the best determinants of insurance stock performance in 2011 (Exhibit 1). The change in market risk premium by insurance subsector during the financial crisis did a better job of forecasting 2011 stock performance than fundamental growth, valuation, or capital management (e.g. buybacks)

We largely expect this behavior to continue short-term into 2012, except that we think the probability of an upside surprise on Reinsurance pricing is increasing. Otherwise, we expect Brokers, P&C Multiline, P&C Specialty, and P&C Commercial to remain the best sources of long ideas

We were not negative enough on the “riskier” subsectors in 2011 (Life Investment, Reinsurance, Multiline, Guaranty), but given the relative multiple compression that has already occurred, we do think underperformance in these “riskier” subsectors eases in 2012, absent a more general market downturn

Unlike longer timeframes, where fundamental growth can trump valuation, changes in valuation (specifically price/book) were the biggest determinant of 2011 performance. While risk perception captured this well, no typical fundamental metric did. For example, the long-run positive correlation of ROE to price/book has no relationship in the short term

Perhaps more notably, share buybacks had no significant short-term impact on performance. There was some slight improvement in performance as buybacks increased, but it was mostly owing to less underperformance

“Deep value” did not work well, either: among stocks trading below book, higher valuations slightly outperformed lower valuations. For stocks trading above book, neither buybacks nor value investing were significant

We have resisted making market assessments of risk perception, but we attempt such an analysis for the first time here. Our conclusion is that the bond market seems to be positioning itself for a negative outcome in equities. We see this in both longer-term corporate spreads, as well as Treasury spreads over inflation, both of which have some predictive correlation to the S&P. We do not claim this is causation, but there is a resemblance to current spreads and past “risk-off” events

If one believes in this bearish market outcome, then our Long-Term Qualitative View would be our guide to how to invest, which is mostly Negative across the board. In fact, a major part of our 2012 research will be in determining when to make the shift from Short to Long-Term, whether fundamental or market-driven

But conversely, if one is betting on a recovery from risk aversion and a return to pre-crisis “normalcy,” insurance may not be the best way to do this. Banks seems to have the most obvious post-crisis re-rating, whereas the apparent re-rating of insurance largely was relative to the market. Thus, banks offer more potential “bang for the buck” in the sense of re-rating potential

This remains true even if one looks at the “riskiest” end of insurance, like Life Investment. While banks were clearly and sharply re-rating downward versus history, life insurers on average are trading at the same relative valuation they were trading in the early 2000s. Thus, one could plausibly conclude that 2004-06 life insurance valuations were an anomaly, and that life insurers would only relative recover in a “risk-on” market

A Portfolio Manager’s Guide to Global Risk Management & Insurance

Written December 7th, 2011 by bault

Our current research has focused on many of the complex cross-currents impacting risk management overall and Insurance specifically. In today’s note, we take a different tack, and look at the industry from the standpoint of a generalist portfolio manager, emphasizing where to look for constructing a “core” portfolio
We conclude that PMs may want to look to the least “hard core” Insurance subsectors: Brokers (e.g. MMC, AON, WSH), Life Other (e.g. AFL, AMP), and P&C Personal (e.g. PGR, ALL). If one is more concerned about owning the best average performance most of the time, and is not focused upon timing the cyclicality of insurance, taking less risk seems to have been the better approach, particularly (but not just) when the financial crisis (2008-?) is taken into account
Other conclusions of this analysis are summarized as follows:

1) Insurance is intrinsically a “longer-term” industry: Insurance is more likely to outperform over the longer-term (we use 3 years in this note) than the shorter-term (6 months in this note). This is true pre- and post-crisis

2) Pre-crisis, a risk “barbell” was effective…: Prior to 2008, investors were most likely to outperform either by taking a great deal of risk (e.g. Life Investment or Reinsurance), or by taking the least possible balance sheet risk (e.g. Brokers or P&C Personal)

3) …But the crisis wiped out all gains from risk-taking…: However, if we add in the performance from 2008 on, all the outperformance from Life Investment and Reinsurance vanishes. We think this is very big deal for Life Investment in particular. Reinsurance has always been a hard sell for many investors, given its specialist nature and opacity. But Life Insurance generally used to be considered a good business, whereas now annuity-focused life insurance (what we call Life Investment) appears thoroughly “broken”

4) …yet left many other subsectors unscathed: Brokers and P&C Personal did worse during the crisis, but not so much that it ruined the long-term track record. In addition, moderately risky subsectors like Life Other (e.g. less annuity exposure) and P&C Specialty (e.g. complex underwriting) produced overall good results

5) Insurance can be a decent indexing source: Because most insurance is tied to overall economic activity, it should not be surprising that insurers market-perform most of the time. But this is not necessarily a problem if it comes with more limited downside. In addition to the 4 subsectors noted in the previous bullet, the large-cap heavy P&C Multiline subsector can be defensive long-term, though is more likely to underperform shorter-term. As a corollary, most insurance subsectors strongly market-performed during the crisis, so they were relatively but not absolutely defensive

6) There are some opportunities for speculation: Subsectors like Guaranty, and especially Services, are less likely to market-perform, and have more symmetric distributions of out- and under-performance, particularly over the shorter-term. These subsectors may be less appropriate for the average PM, which is important to know given that Services, for example, superficially resembles the low capital intensiveness of Brokers, but behaves very differently

7) Value creation matters most: Book value growth mostly offsets multiple contraction over the longer-term, so picking the highest earners, unsurprisingly, is a good strategy. But Life Investment is a major exception here: 20% of its pre-crisis performance was multiple expansion, and this all vanished post-crisis. At present, no other subsector looks particularly at risk for (more) downward re-rating, but in general high multiple expansion should be distrusted over time

The biggest risk we face from this analysis is the possibility that the 2008-2011 “post-crisis” period is only “temporary”, in which case formerly high performance but risky subsectors like Life Investment (e.g. MET, PRU) and Reinsurance (e.g. RNR, PRE) may be the areas that deliver the best performance in any recovery. However, the body of our research does not lead us to this conclusion. We think the changes in risk aversion crystallized by the financial crisis have been a long time in coming (i.e. per our thesis of risk quantumization) and are therefore “permanent.” Even if this is incorrect, calling a recovery in financials seems to us mostly a market and global macro call, where we have no research opinion

More Transatlantic: So Allied World DID Consider Runoff to Get Back in the Game!

Written November 22nd, 2011 by bault

The Transatlantic saga is turning into one of the stranger events in insurance history. Multiple bids, hostile bids, and now…consideration of runoff to make the deal more attractive. This latter item is most interesting to us, as it is the exact topic of our most recent piece. But first, some context.

As things stand now, Transatlantic (TRH) will now become majority-owned by Alleghany (Y), who will likely let the company run more or less independently. However, there was a last-minute attempt by the original suitor, Allied World (AWH), to get back in the game. According to the Insurance Insider (link, although a subscription is required), AWH was planning on teaming up with private equity firm JC Flowers via its insurance runoff firm Enstar (ESGR). The idea was that ESGR would take on some share of TRH’s older reserves, while AWH would get renewal rights. This type of transaction is exactly what we described in our November 11 note.

Now, this deal appears to have been rejected because of the Y offer. We’re not surprised: if we were TRH management, we’d want a straight offer for independence, too. But it’s important to understand why such a structure would even come up, and why we are suggesting this could come up again.

In essence, the insurance market is trying to deal with a situation where capital-intensive entities are currently trading persistently below book value. In a “normal” market where this would be viewed as temporary, investor tend to want management to greatly constrain capital actions, mostly to just buying back stock. But we claim the current environment—which is a market phenomenon, not insurance-specific—is more or less “permanent”, at least as long as the market has a post-crisis mentality. Yet as the TRH soap opera showed, investors still resisted any deal that was below book (and so the Y deal make yet face some hurdles).

If the current market risk premium is so high that capital-intensive financials now trade “permanently” below book, then restricting capital actions to buyback is equivalent to ordering such companies to shrink; i.e. reduce risk. Even if the insurer believes its valuation is temporary and its risk are “manageable,” if a company wants to make a capital decision today, its options are constrained. This is why we hypothesized that runoff of older business would be considered. It is most likely not desired by said managements, or even deemed necessary, but that’s beside the point. The market is forcing consideration of this option because no others seem to be allowed!

We do not think this phenomenon will remain sporadic until and unless a industry capital event occurs…but that’s likely at some point. In particular, while we are not optimistic for a big pricing cycle turn in the near future, we do think something like this will happen by 2014-15. And literally since our first day at Sector & Sovereign, we have been warning that some companies are going to find themselves without easy access to capital, in stark contrast to past pricing turns. The TRH saga gives a small preview of what’s at stake. We suspect people will continue to be skeptical about this. We admit, our thesis seems extreme. But in case it wasn’t clear, this market is extreme. We suspect it will take another crisis, like chronic loss reserve deficiencies (not there yet, of course), to bring this point home. And when that occurs, companies like ACE Limited (ACE), which have drawn the ire of investors for not more aggressively returning capital, may look prescient.

The Transatlantic Saga: As Close to a Private Deal as a Public Company Can Get

Written November 21st, 2011 by bault

In the most recent episode of the Transatlantic Re (TRH) takeover soap opera, it appears that they have reached a deal with Alleghany (Y) to buy the company for $3.4 billion, per various news outlets. Alleghany is an example of what many investors think of as a mini-Berkshire (Markel and White Mountains are anothers): a holding company that may own various insurance-type companies (and other industries), generally running them in a hands-off manner.

As a result, if the deal goes through—and it looks like it is likely to make everyone happy except for hostile suitor Validus—we would argue that this is about as close to a private-like deal that can be done with public companies. One of the main impediments to prior TRH transactions has been how far below book value they were. Indeed, this is a problem for the entire reinsurance industry, as we have discussed obsessively. The TRH/Y deal is still below book: at $60 per share, this is about 86% of last stated book value. But because TRH will be left largely alone, and because Y is known to be a long-term oriented investor, this is about as close as we can get to TRH finding patient capital that is not private. Because the rumored deal involves Y stock, current TRH investors are being asked to take a longer-term stance, which seems to be what is required at present.

The problem we see is that there does not seem to be a lot of capacity to keep doing deals like this. While private money does seem interested in entering reinsurance at some point, they seem more interested in starting with fresh capital, rather than taking on the historical baggage of existing balance sheets. So reinsurers as a class are still at risk of capital constraint if any major events occur (which could be broader than just “catastrophes”). We’d be very cautious in attempting to “read across” this result to other companies. Our most recent piece (http://wp.me/p1W1lB-1ub) about the troubles facing the highly capital-intensive insurance subsectors still seems quite relevant: without more saviors like Y, more drastic balance sheet actions may be required if patience wears thin.

Is It a Pricing Cycle, or a Capital Raising Cycle? Some Initial Thoughts

Written November 17th, 2011 by bault

This post reflects an idea we’ve been mulling over, and now we’ve had some client conversations expressing the same thought. Let us first bring in our existing research to provide context.

The clear consensus of most P&C underwriting managements is that a pricing cycle seems to be forming. There is some debate as to its breadth (i.e. most agree it is property-focused right now), and brokers are more likely to show skepticism than underwriters, but there are now forecasts that pricing could be up as much as 8-10% next year. If true, this would certainly be a big improvement over the past several years.

However, readers of our research know that we are skeptical as to the sustainability of any pricing cycle, as long as balance sheets are a healthy as we think. Reserve adequacy as of year-end 2010 was still very high, and it is unlikely that enough reserve releasing has occurred in 2011 to bring reserves as deficient a level as has been needed in the past produce a big pricing turn. We are not the only ones who think reserves are still quite adequate (e.g. Aon Benfield). Based upon past relationships, it does not seem like we can have enough balance sheet “pain” to turn the cycle until around 2015.

As a result, we have a Short-Term Positive View on most cycle-exposed insurance subsectors (brokers, P&C Commercial, P&C Multiline, P&C Specialty, Reinsurance), but a Long-Term Negative View on these same subsectors (except for Brokers, where our Long-Term View is Neutral). Put simply, we think the momentum on the change in pricing views will work short-term, but we think the risk is great that in 2012, insurers will realize they were too conservative once again, this time on the 2008-10 underwriting years. This realization will likely derail any short-term pricing momentum.

The next step in our research process is to consider what we might be getting wrong. It is a common cliché that “every pricing cycle is different.” In fact, they aren’t all that different, in our view. The exact specifics differ every time, but the basic result is the same: once enough balance sheet destruction occurs, we get a pricing turn. For example, loss reserves became as redundant in the mid-1990s as they did in the mid-2000s. We still have not seen anything as bad as the late 1990s market conduct.

What is different this time is valuations, or more precisely, investor opinions on balance sheets. Valuations have been persistently low since the onset of the financial crisis in 2007-08. We argue that the resulting rerating of all insurance subsectors has been consistent with generally higher risk aversion. So to claim that valuations “have to rise” from here is a market call, in our view, and it is not something where we think we add much value.

The next question is how might companies increase price/book valuations on their own. Our most recent work suggests that ROE increases are unrealistic: it would take over 15 points of additional ROE on average to bring valuations back to pre-crisis levels. Of course, insurance investors know that price/book ratios are likely to rise temporarily to above-normal levels while they are raising price.

This fact raises an intriguing idea. In a “typical” cycle, insurer balance sheets are damaged to varying degrees, which necessitates raising capital. However, they also raise pricing simultaneously, which raises price/book ratios (usually), as investors anticipate higher future ROEs. The causation chain in this case is balance sheet damage à price increases à higher price/book à capital raising à higher ROE (the precise order of the middle 3 items is debatable). The ultimate goal of this activity is balance sheet repair. Now we argue that balance sheets don’t need repair yet. But what if the goal this time is simply to raise more capital? Average valuations in many subsectors are chronically below book value, which is precluding any capital actions except stock buybacks. But if valuations could be temporarily brought above book, could companies could raise non-dilutive capital.

This scenario might seem quite cynical, but this is a cynical moment. Companies have objectively behaved better so far than in past cycles (at least based upon what we can measure), yet they are trading below any historical floors. The reason for this has nothing to do with insurers specifically and everything to do with investor risk aversion generally. We generally reject as insufficient reasons like current ROE, low interest rates, etc. But for insurance companies, the result is the same: their hands are tied with respect to capital actions. So if there is a way get in a capital raise with the goal of hunkering down until overall market valuations rise, this may be worth pursuing. And rather than come out and say this, instead they talk about returns and low investment yields.

Because no cycle has evolved this way before, we are still formulating ways to analyze the problem. But we wanted to get this issue out in market, if for no other reason than to get investors thinking about it. Our initial view that that the combination of current low valuation and the reduced price/book increases from pricing cycles generally makes this gambit unlikely to succeed, and so our current subsector Views seem reasonable. But we bring this up precisely because we could be wrong, and it is worth thinking about. In particular, we have not examined that pricing cycle in the context of risk-adjustment before, so some of the techniques we used in our most recent note on valuations may prove useful. We are very interested in investor commentary while we continue to think about how to measure this issue.

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