With hurricane season upon us, the Fool wants you to be ready for anything. We've got lots of useful advice to help you prepare in case disaster strikes.
Insurance is a cyclical industry characterized by booms and busts. As a result, a lot of money can be made by doing the opposite of what other people do during a panic.
For example, commodities are also cyclical: When commodities prices are high, firms overproduce to capitalize on high prices -- which also means taking on debt. When prices fall, that debt and high cost capacity eat at their profits and basically paralyze them.
Insurance is a similar game, except capacity is measured by surplus (the difference between an insurer's assets and liabilities). A couple of good years can result in irrational pricing and lax underwriting. If a big loss event happens, then the undisciplined insurers are hamstrung by the losses, and the disciplined insurers step in to fill the void and sell insurance at much better prices, thanks to the lack of competition.
The past year was amazing for property and casualty insurers, with automobile, catastrophe, and worker's compensation insurers literally minting money because of low loss ratios. However, in the catastrophe insurance industry, there's been a lot of chatter about a possible $100 billion loss event. In the latest article, I postulated that insurers maintained discipline and that state insurance funds have foolishly been filling the void.
However painful it is to think about a huge disaster in our nation, investors should still have a game plan ready should a huge loss event happen. Here are a couple plans of attack that investors might want to consider if a huge catastrophe loss event occurs.
- Arbitrage the uncertainty discount. A lot of companies got shellacked after Katrina hit. For example, companies like Montpelier Re, Quanta, and PXRE took huge hits after the 2005 hurricane season and seemed to be trading at less than book value. Unfortunately, their initial loss estimates proved inadequate and had to be revised sharply upwards, leaving many sophisticated investors with big losses. It's possible that if a big loss event occurs, insurer shares could trade below book value once again in anticipation of large unfavorable loss developments. However, loss models have been adjusted, rendering sharp readjustments more unlikely. Thus, investors with a strong stomach for investment risk who find themselves able to buy shares of a healthy insurer at a discount to book value might want to scoop up shares of reinsurers with strong long-term track records like RenaissanceRe (NYSE:RNR) or PartnerRe (NYSE:PRE) if their stock prices swoon.
- Buy the babies. When bad things happen, people tend to make sweeping generalizations, known as throwing babies out with bathwater. For example, during the Asian currency crisis, investors painted all emerging markets with the same brush -- even if they were on different hemispheres of the globe. Thus, perfectly rational decisions can result in irrational stock prices. If I'm a portfolio manager who was too heavily invested in catastrophe insurers and a big hurricane hit, I'd naturally look to lighten up on all P&C insurers, even those not as affected by hurricane losses. Thus, if a big loss event happens, I'd pay very close attention to how the stock prices of auto insurer Progressive (NYSE:PGR), diversified and specialty P&C insurers like WR Berkley, Arch Capital Group, ACE, and Axis Capital, and other "all stars" like Markel (NYSE:MKL), White Mountains (NYSE:WTM), and Alleghany (NYSE:Y) respond. Although some of these insurer's stock prices are unlikely to be affected by big hurricane losses, stranger things have happened before. For example, as I noted in another article, life insurer Torchmark's stock dropped in 2000 because the company wasn't an Internet stock. I kid you not. So if the market gives you a big, fat pitch, go ahead and take a swing.
- Sit where the 800 pound gorilla sits. In the reinsurance world, Warren Buffett's Berkshire Hathaway (NYSE:BRK.A) is the 800-pound gorilla, with more capacity (thanks to its bazillions of dollars in book value) and better management (courtesy of Mr. Buffett and Ajit Jain), and a better credit rating than most of its competitors. When premium rates are too low, Berkshire pulls back. When rates harden, as they did after Katrina, Berkshire writes very big policies that no one else in the industry would have the ability to write (especially after a big loss event), and as a result, it gets very good pricing and has a good probability of making a very high return. So if a big one hits and Berkshires stock drops, this would probably be the safest investment you could make.
I previously argued that, apart from those physically affected, state insurance funds (and thus taxpayers) will be the primary financial victims of a big catastrophe. Thus, I would also argue that if those funds take a big hit and lose their capacity to write policies, then unnaturally low prices will harden, resulting in a rising tide for the P&C industry.
Related Foolishness:
- Naked in a Sea of Risk
- Reinsurer Benefits From Mother Nature's Good Mood
- Markel Sees Opportunities in Stock Market
Montpelier Re is a recommendation of both Hidden Gems and Stock Advisor. Berkshire Hathaway is anInside Value recommendation. Try any one of our investing services free for 30 days.
Fool contributor Emil Lee is an analyst and a disciple of value investing. He doesn't own shares in any of the companies mentioned above. Emil appreciates your comments, concerns, and complaints. The Motley Fool has a disclosure policy.
