Thinking About The Insurance Industry
David J. Merkel is a CFA, FSA. His forthcoming equity asset management shop is tentatively called Aleph Investments. From 2008-2010, he was the Chief Economist and Director of Research of Finacorp Securities.where he researched a wide variety of fixed income and equity securities, and trading strategies. Until 2007, he was a senior investment analyst at Hovde Capital, responsible for analysis and valuation of investment opportunities for the FIP funds, particularly of companies in the insurance industry. From 2003-2007, he was a leading commentator at the investment website RealMoney.com.
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Recently I decided to spend some time analyzing the insurance industry. It’s a different place today than when I became a buy-side analyst nine years ago. Why?
First, for practical purposes, all of the insurers of credit are gone. Yes, we have Assured Guaranty, and MBIA is limping along. Old Republic still exists. Radian and MGIC exist in reduced states. The rest have disappeared. In one sense, this should not have been a surprise, because the mortgage and credit guaranty businesses never had a scientific model for reserving. I’m not even sure it is possible to have that.
Second, the title insurers are diminished. Some, like LandAmerica are gone. Fidelity National seems to be diversifying itself out of insurance, recently buying up a restaurant chain.
Third, health insurers face an uncertain future. Obamacare may disappear, or Obamacare could slowly eliminate insurers. It’s a mess.
But beyond all of that, valuations are depressed across the insurance industry. Part of that may stem from ETFs. Insurers as a whole are smaller than the banks, but not as much smaller as they used to be. Now, if you are a hedge fund, and you want to short banks, you probably have the best liquidity shorting a basket of financials, which shorts insurers as well.
That may be part of the issue. There are other aspects, which I will try to address as I go through subindustries.
Offshore
By “Offshore” I mean P&C reinsurers and secondarily insurers that do business significantly in the US, and who list primarily on US exchanges, but are not based in the US. Most of them are located in Bermuda.
In 2011, many of them were challenged by the high levels of catastrophes globally. But the prices of the reinsurers did not fall because pricing power returned, and investors expect higher future earnings as a result.
Before I go on, I need to explain that what I will use to give a rough analysis of value is a Price-to-Book vs Return on Equity analysis [PB-ROE]. For more details, you can read my article here. The short explanation is that companies in the insurance business (and other financials) are constrained by the amount of equity (net worth) that they have. The ability to earn a return as a percentage of the equity [ROE] drives the market valuation as a fraction of the equity [P/B].
Here is a scatterplot for PB-ROE for the Offshore group:
Click to enlarge:
Companies above the line may be overvalued, and companies below the line may be undervalued. ROE is what is expected by analysts for the next fiscal year, not what has been obtained in the past.
The fit is fairly tight, and indicates mostly logical valuations for this group. The companies that are possibly overvalued are: Arch Capital [ACGL] and Global Indemnity [GBLI]. Possibly undervalued: Everest Re [RE] and Endurance Specialty [ENH].
Now, this simple model can fail if you have an intelligent management team that has a better model. Arch Capital may be that. But with an expected ROE of less than 10%, it is hard to justify their valuation, when the average stock in this group needs an expected 13% ROE to be valued at book.
Why such a high ROE to get book? Earnings quality. Reinsurers have noisy earnings due to catastrophes. You don’t give high valuations to companies that run hot or cold. But the trick here is to see who is accumulating book value the fastest – they tend to be the stars over time.
Life
The life insurance business would be simple, if it indeed were only life insurance. Much of the industry is handed over to annuities, and all manner of asset gathering. Even life insurance can be made more complex through variable and variable universal life, where assets are invested in stocks, and do not receive a rate from the company.
Part of the trouble is that variable products are not simple, but the insurers offer guarantees for a fee. When I see those products, my reaction is usually, “How do they hedge that?!”
Thus I am concerned for insurers that are “equity-sensitive” as I reckon them. Here is the PB-ROE scatterplot:
A very tight fit. The insurers that are undervalued are equity-sensitive ones: Phoenix Companies [PNX], American Equity Investment {AEL] , Lincoln National [LNC], and ING [ING]. Those that are overvalued are FBL Financial [FFG], and CNO Financial [CNO]. CNO has issues from long-term care, a coverage I dislike a great deal. FBL is worth exploring.
One more note: to get book value in Life Insurance, you need an 11.7% ROE on average. That’s high, but I expect that is so because investors are skeptical about the accounting.
Property & Casualty
This graph gives PB-ROE for the entire onshore P&C insurance industry:
It’s a good fit. Again, the casualties of the last year weigh on the property-centric insurers, but for the most part, this is logical.
Potential underperformers include Hallmark Financial Services [HALL], Hilltop Holdings [HTH], Eastern Insurance Holdings [EIHI], Old Republic International [ORI], and Erie Indemnity [ERIE]. Below the line: Hartford Financial Services [HIG], Allstate [ALL], Tower Group [TWGP], and Horace Mann [HMN].
Because of the lower risk in P&C insurers, a firm only needs to earn an ROE of 6.6% to have a book value valuation.
Health
With Obamacare, I don’t know which end is up. It could end up being a giant sop to the health insurers, or it could destroy the health insurers in order to create a government single-payer model, rather than the optimal model for cost reduction, where first parties pay directly, or pay insurers. You want reductions in medical costs, get the government out of healthcare, and that includes the corporate deduction for employee health insurance.
There are many models for profitability here, which makes things complex, but here is the present PB-ROE graph:
It’s a pretty good fit, with the idea that the following companies might be undervalued: Wellpoint [WLP] and CIGNA [CI]. And the following overvalued: Molina Healthcare [MOH] and Wellcare Health Plans [WCG].
I don’t regard myself as an expert on the health insurance sub-industry, so treat this with skepticism. I include it for completeness, because I think the PB-ROE concept has value in insurance. One more note, the PB-ROE model thinks of this as a safe investment subindustry, because to have a book value valuation, you have to have an ROE of 7.8%.
Other Insurers and Insurance-Related Companies
This is a group that is a non-group. It comprises brokers, service providers, title and financial insurers. Here’s the PB-ROE graph:
Pretty tight for a non-group. Perhaps it is because it derives off of a much larger group, some of which has died off, leaving behind profitable entities.
As it is the potential outperformers include Assured Guaranty [AGO], the largest remaining financial guaranty insurer, Fortegra Financial Corporation [FRF] a third party administrator of sorts, and what remains of the title insurance industry, Fidelity National [FNF], First American [FAF], and Stewart Title [STC]. That is one beaten-down group, and, one that would benefit a lot if housing bounced back. There is a lot of potential earnings power there, and it trades for little above book value.
Potential underperformers include AJ Gallagher [AJG] and E-Health [EHTH]. I’ve dealt with AJ Gallagher professionally, and have respect for their management team, but maybe the valuation is stretched there. E-Health is a health insurance broker, and over its existence hasn’t done anything deserving of a premium valuation.
And, for this non-group, it is riskless enough that you only need a 4% ROE to have a book value valuation. This is one beaten-down sector of the market, and one that I do not own any of, but that I will eventually return to, because I have owned I in the past. Should residential real estate finally normalize, many of these companies will fly.
I write this as one that was bearish on housing-related stocks since 2005. There is potential here.
Summary
Insurance is complex, and the accounting is doubly complex, which is a major reason why many stay away from it. But insurers as a group have had reliable and outsized returns over the rememberable past, which should encourage us to do a little kicking of the tires when so much of the industry trades below its net worth and is still earning money with little debt.
In my opinion, this is a recipe for earnings in the future, and why I own a lot of insurers for myself, and for clients.
Full disclosure: long ENH, but I may take other positions for clients in the next month
Source:
David Merkel
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February 24th, 2012 at 8:00 am
How is it that Obamacare, which mandates purchase of health insurers from private health insurance companies, could “slowly eliminate” insurers? I have been an actuary for 35 years, but no insurance expertise is not necessary to conclude that when millions of people who do not purchase your product are suddenly required by law to do so, your business will not be slowly eliminated.
Rate regulation, based on the way regs are being written, is unlikely to be at all onerous, so that shouldn’t be a problem for insurers, either, at least not a more difficult problem than it has been. The coverages mandated are broad in some cases, but there’s nothing in there that can’t be priced profitably.
I hear your argument a lot (I am in the insurance business, after all) but it is usually more political than substantive: if Obama did it, it must be bad.
What’s the basis for your claim?
February 24th, 2012 at 8:17 am
You can always buy Berkshire Hathaway if you want an insurance play that is buffered against a downside risk. I’m not sure why the author states that the health insurance industry is so uncertain. The only way we progress to a government run single payer plan is through an act of Congress (at this point in time extremely unlikely). Even Medicare is tied into the industry through the Part D drug benefit and the Medicare Advantage plans offered by a number of insurance and HMO providers as well as with Medigap policies.
February 24th, 2012 at 9:22 am
Proudhon – Isn’t the choice: pay for insurance, or pay a fine that’s less than the insurance premium? How many employers will decide they’ll be better off just paying the fine. Hence, less money goes to insurers. Obamacare was not a good policy. There should have been a government run single payer plan. In either case, private insurers lose.
February 24th, 2012 at 9:43 am
most regulated insurers at least have limited debt and some reserves –unlike the fake insurers of finance, say RDN ABK AIG and fannie freddie,
but their asset and reserve accounting is awful, there are huge unrealized markdowns still sitting there
because they have no liquidity problems they can sit there for years or decades.
also they have recently been allowed to capitalize future premiums.
while in their case it is only net of reserves,
thats just less of a joke than CDS
where all of their capitalized future premiums are the “price”
your point about the weak ones linked to the equity markets is right,
but its more the total risk markets driving.
these guys, esp the life cos, do not hold a large equity %
i made good money shorting the life cos in later 2008, they will puke on any big trouble
.
February 24th, 2012 at 9:49 am
while i admire buffett overall
he is exposed i think for marking a Berkshire position in a traded equity, is it kraft? at whatever he feels like?
this is an example of insurance accounting.
February 24th, 2012 at 10:02 am
so you can think of the massive massive reserves of the life cos
as a giant pile of manure
that fertilizes the ground of a big fake asset bubble and goes up itself
but stinks in a crash, savvy investors run away
noncyclical my ass..
February 24th, 2012 at 7:17 pm
Unnoticed in 2008 was the LandAmerica Tax Intermediary Real Estate Exchange fraud that cost mom and pop investors over $200 million. They were accepting money until the day before their filing for bankruptcy.
Several suicides and many personal and small business bankruptcies resulted.
Not only did they lose their money, but the contracted real estate that was to be paid for through the “AAA-rated Gold Standard Government-Approved Intermediary” (the company words, not mine) had to be purchased anyway, because it was under contract for sale. The bankruptcy judge in Richmond, VA put the IRS and banks ahead of the small investors, for no valid reason.
This coincided with the Madoff scandal, so it was little noticed.
This is a sordid story waiting to be told. What I related here is not even the tip of the iceberg.
February 25th, 2012 at 8:57 am
Brianinla – there’s some uncertainty about how this will play out. The consensus is that most of the affected employees (those whose employers will choose to pay fines rather than buy insurance) will be low wage workers. Many of these will not have been insured anyway (not all employers currently provide insurance for low-wage workers); many will be eligible for medicaid, and some of those will be lost customers for private insurers. Others will be eligible for subsidized policies under the new law, so they will either stay in, or be added to the private market. I don’t think anyone knows what the net gain or loss to private insurers will be here. I personally think it will be a small net loss more than made up for by individuals who now have no access to care and must buy it, but I could be wrong.
Of course you’re right about the single payer – it would save more money, and provide better and more care. But it’s not going to happen. My preference for implementation of that would be medicare for all – phased in by way of a gradual lowering of the eligibility age.
February 25th, 2012 at 9:27 pm
Proudhon — my rationale is this: it could mess up the private market enough that the solution reached for is a single payer solution. I’ve talked with a decent number of health actuaries on this. The ability to price risk is distinctly limited. Young people pay too much, older folks too little. That’s a formula for antiselection. I think Obamacare was badly designed. I will not achieve its ends, and when the expenses start coming in, they will be far higher than anticipated. That has been the experience of the government in health care in the US. Utilization is underestimated, the further removed people from feeling its costs.
It’s not Obama for me; I don’t like the Republicans either. I believe that the deduction for employer paid health insurance should be eliminated, and we move back to what is predominantly first-payer model, and the same for Medicare. Wind the program down, get the government out of health care.