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Tuesday, November 10, 1998

An Investment Opinion
by Dale Wettlaufer

Tough Year for P&C Insurers

So far, 1998 hasn't been the best year for property & casualty insurers. Looking across the spectrum of companies, here are the year-to-date performances (with dividends reinvested):

Allstate (NYSE: ALL): -5.4%
American Financial Group (NYSE: AFG): -5.1%
American International Group (NYSE: AIG): +22.7%
Chubb (NYSE: CB): -21.1%
Cincinnati Financial (Nasdaq: CINF): -20.1%
Fremont General (NYSE: FMT): -15.4%
Frontier Insurance Group (NYSE: FTR): -18.8%
General Re Corp. (NYSE: GRN): +9.6%
Mercury General (NYSE: MCY): -24.6%
Old Republic International (NYSE: ORI): -18.2%
Progressive Insurance (NYSE: PGR): +20.1%
St. Paul Companies (NYSE: SPC): -15.8%
Safeco Corp. (Nasdaq: SAFC): -8.3%
Travelers Property Casualty Corp. (NYSE: TAP): -29.8%
Zenith National Insurance (NYSE: ZNT): -4.3%

For the year, the S&P Supercomposite Property/Casualty Index is down 4.8%, although it's easy to see that most companies are down much farther than the index would suggest. This is hard to fathom if you believe the old saw about falling interest rates being good for financial services stocks. While decreasing interest rates do contribute to a general rise in the price investors will pay for financial assets, thus lifting the price investors will pay for a dollar's worth of earnings, this doesn't completely offset what happens to pricing in the insurance industry when interest rates drop.

With a general rise in the price of financial assets, the investment portfolios of insurance companies increase in value. Along with that, the amount of insurance coverage the industry can write increases as well, as regulators and executives look at their premium to surplus ratio, which is a company's ratio of net written premiums to what is basically its owners' equity. So if the bond market experiences a year of favorable conditions, a company's balance sheet is going to improve if it is long bonds. The greater the average maturity of its bond portfolio, the greater the positive effect a rising bond market will have on an insurer's balance sheet.

This phenomenon is exactly what economists talk about when they use the term "wealth effect" to describe the spending and saving patterns of individuals during times when the stock market is buoyant. If you're a 50-year-old couple with $1 million in the market in 1995 and you've seen that portfolio grow to $2 million today, you're more likely to feel secure in renting out a house on Lake Geneva for a week next summer. But if the market crashes between now and then and you can get back your deposit, you might do so. With insurers, they feel the wealth effect when their investment portfolios rise by 15% year-over-year and insured losses stay in-line with projections. Put in a couple of years of good investment and underwriting performance, and this wealth effect turns into a desire to gain market share and take on new lines of business.

When lots of companies in the insurance industry feel this wealth effect, premiums (pricing) soften. In a recent Best's Review article on reinsurance for homeowners' multiperil coverage, Insurance Information Institute vice president and economist Robert Hartwig said, "It is questionable whether prices can continue to drop, but I'm not sure anything on its own could harden the market [improve pricing] except perhaps a series of catastrophes or a loss of capital through a prolonged drop in bonds or stock prices." Furthermore, insurers are increasing their underwriting risks to offset the pricing risks.

This happens in a couple of ways. First, an insurer can cede less premiums, meaning it takes out less insurance on the insurance it writes. While it gets to keep more of the premiums its takes in and thus gets to invest those premiums rather than laying off the risk to a reinsurer, that means that a large loss event such as hurricanes, earthquakes, hailstorms, or tornadoes can have a larger effect on the insurer's losses. In addition, there is the temptation to take smaller loss provisions. As in the banking industry, reserves are set aside in advance of the actual losses taking place. By experience, a bank knows that a certain percentage of credit card borrowers, home mortgage holders, and auto borrowers will default on their obligations. At the inception of those loans, the bank sets aside loan loss provisions and has to make adjustments depending upon the actual loss experience that develops.

An insurer models risks and takes loss provisions in advance of the actual occurrence of loss events. If a company wants to improve earnings a little bit, it will set aside a smaller loss provision on its income statement. In the worst case scenario, it could pay out those under-reserved earnings to shareholders or use the capital for bad acquisitions. If it runs into a bad loss, it's toast. In a more benign scenario, it keeps those premiums and invests them. If a big insured loss event comes along, the company will show larger losses than it would have had it taken adequate reserves.

Such pricing environments eventually catch up to the industry, though. Last week Reuters quoted A.M. Best senior vice-president Eric Simpson as saying today's pricing environment is "not close to the bloodletting of the early '80s." In the face of such conditions, the idea is not to abandon the industry as an investor, it's to look for the companies that are handling these conditions most rationally. First, dropping loss provisions to shore up the income statement is something to avoid, unless a company is grossly overreserved and can truly afford to reduce its contingent liabilities. Analysts won't ascribe much, if any, multiple to marginal earnings that are brought about by unwarranted decreases in loss provisions anyway. So the market is supposedly efficient when it comes to that sort of thing, but it's not uncommon to see an insurance company go from stellar results to the doghouse because of poor underwriting standards that eventually come home to roost.

Investors should pay attention to those companies that say they're pulling back from a certain market when management thinks there's too much capital chasing too few insurance risks. Just as in any market, supply and demand in the short run can get out of whack with where supply and demand would optimally be in the long run. The players that write insurance at prices that don't compensate them for the risks they're taking on usually get washed out anyway. In the short term, their irrational actions can hurt the industry overall, but it's the companies with strong balance sheets and prudent risk management that can take advantage of the highly attractive pricing environments that follow large catastrophes such as Hurricane Hugo. In fact, one of the largest inflows of capital into the insurance world took place after that hurricane brought about severe insurance losses and hurt the irrational insurers. In the excellent pricing environment that followed, the fortress-like insurers thrived.

Finally, the best way to take advantage of things is to look at the companies that have developed special underwriting niches, underwriting practices, and strong competitive advantages. For instance, Berkshire Hathaway (NYSE: BRK.A) subsidiary GEICO spends less to produce a policy than its competition because it doesn't use brokers. Its underwriting profitability isn't as good as auto insurer Progressive, but both end up with about the same operating profit margin because GEICO has lower overhead. Then there are companies like Chubb, which has gotten rid of commodity lines to concentrate on business lines where it can differentiate itself. Three of its most interesting business lines are its art collection insurance, underwriting of Broadway shows, and intellectual property insurance for Internet companies. In all, not every insurance company suffers long term just because of poor short-term fundamentals. Almost anytime an industry takes a bit of a beating, there's always a few companies that can handle it and develop strategies to overcome the competition in both the short- and long-term.