Tag Archives: calendar year combined ratios

A Tale of Two Insurers

My negativity on the operating prospects for the reinsurance and specialty insurance sector has been articulated many times previously in this blog. Many of the same factors are impacting the broader commercial insurance market. Pricing conditions in the US and globally can be seen in the graph below.

click to enlargeUS and Global Commercial Insurance Pricing

Two insurers, at different ends of the size scale, which I have previously posted on, are AIG (more recently here and here) and Lancashire (more recently here and here). Given that a lot has happened to each since I last posted on them, I thought a quick update on both would give an interesting insight into the current market.

First up is AIG who have been under a lot of pressure from shareholders to unlock value, including a break-up plan for the insurance giant from the opportunistic rascal Carl Icahn. The graph below shows a breakdown of recent operating results (as ever with AIG longer term comparisons are hampered by their ever changing reporting segments). The improvement in the UGC mortgage insurance business has been dwarfed by the poor non-life results which were impacted by a significant reserve strengthening charge.

click to enlargeAIG PreTax Operating Income 2012 to 2015

In January, Peter Hancock (the 5th CEO since Hank Greenberg left in 2005) announced a new strategic plan to the end of 2017, the main points of which are

  • Return at least $25 billion of capital to shareholders through dividends and share buy-backs from operating profits, divestitures and other actions such as monetizing future life profits by $4-5 billion through reinsurance purchases.
  • Enhance transparency by separating into an operating portfolio with a goal of over 10% return on equity and a legacy portfolio that will focus on return of capital. Reorganize into at least nine modular, more self-contained business units to enhance accountability, transparency, and strategic flexibility.
  • Reduce general operating expenses by $1.6 billion, 14 percent of the 2015 expenses.
  • Improve the commercial P&C accident year loss ratio by six points.
  • Pursue an active divestiture program, including initially the 20% IPO of UGC.

The non-life reserve charge in 2015 amounted to $3.6 billion. 60% of the charge came from the (mainly US) casualty business, 16% from financial lines (again mainly in the US) and 15% from the run-off business. After the last material reserve strengthening in 2010, the worrying aspect of the 2015 charge is that approximately two thirds comes from accident years not yet 10 years old (which is relatively immature for long tail casualty business particularly when 42% of the charge is on excess casualty business). The impact of the reserve hikes on the commercial P&C segment can be clearly seen in the graph below.

click to enlargeAIG Commercial P&C Combined Ratio Breakdown 2008 to 2015

Perhaps the most aggressive target, given current market conditions, in the strategic plan is the 6% improvement in the commercial P&C accident year loss ratio by the end of 2017. The plan includes exiting approximately $1 billion of US casualty business, including poorly performing excess casualty business, primary and excess auto liability, health-care and financial lines business. Growth of $0.5 billion is been targeted in multi-national, financial lines, property upper middle market and major accounts which involve specialist engineering capabilities, international casualty and emerging risks such as cyber and M&A insurance. AIG also recently announced a two year reinsurance deal with Swiss Re on their US casualty book (it looks like a 25% quota share). The scale of the task for AIG in meeting this target can be seen in the exhibit below which takes a number of slides from the strategy presentation.

click to enlargeAIG Commercial P&C Metrics

I was struck by a quote from the firm on their turnaround plan – “We will use the data and analytical tools we have invested in to significantly differentiate and determine where we should focus our resources.” I suspect that every significant insurer would claim to have, or at least aspire to have, similar analytical capabilities. Big data and analytical driven underwriting is undoubtedly the future for large insurers with access to large amounts of quality data. Fortune had an interesting recent article on the analytical firm Palantir who are working with some insurers on sharpening their underwriting criteria for the social media age. An analyst in Citi even suggested that Goggle should look at buying AIG as a fintech play. The entry of the big internet firms into the insurance sector seems inevitable in some form or other, although I doubt AIG will be part of any such strategy.

As to the benefits of staying a large composite insurer, AIG cited an analysis commissioned by consultants Oliver Wyman supporting the benefits of diversification between the life and non-life business of AIG. Using the S&P consolidated model as a proxy, Oliver Wyman estimate a $7.5 billion capital benefit to AIG compared to separate life and non-life businesses, as envisaged in Icahn’s plan.

So, can AIG achieve the aggressive operational targets they have set themselves for the P&C business? Current market conditions present a considerable challenge. Combined with their recent results, an end of 2017 target for a 6% improvement is extremely aggressive. Too aggressive for my liking. However, the P&C results should improve somewhat over the short term (particularly if there is no more big reserve charges) and actions such as expense reductions, monetizing future life profits and divestitures will give AIG the fire power to hand out sweeties to shareholders. For those willing to take the punt, the return of a chunk of the $25 billion target in dividends and share buy-backs over the next 2 years for a firm with a current market value of $61 billion, trading at a 0.72 multiple to book value (trading around 0.92 of book less AOCI and DTA), may be too tempting to resist. It does have a certain allure…..

Lancashire, a London market specialty insurer and reinsurer with a mantra of disciplined underwriting, is at the opposite end of the scale spectrum with a niche focus. Long cherished by investors for its shareholder friendly dividend policies, Lancashire has been under pressure of late due to the heavy competition in its niche markets. The energy insurance sector, for example, has been described by the broker Willis as dismal with capacity chasing a smaller premium pool due to the turmoil in the oil market. A number of recent articles (such as here and here) highlight the dangers. Alex Maloney, the firm’s CEO, described the current market as “one of the most difficult trading environments during the last twenty years”. In addition, Lancashire lost its founder, Richard Brindle, in 2014 plus the CEO, the CFO and some senior underwriters of its Lloyds’ Cathedral unit in 2015.

The graph below shows the breakdown of reported historical calendar year combined ratios plus the latest accident year net loss ratio and paid ratio.

click to enlargeLancashire Ratio Breakdown 2008 to 2015

The underwriting discipline that Lancashire professes can be seen in the recent accident year loss ratios and in the 30% drop in gross written premiums (GWP), as per the graph below. The drop is more marked in net written premiums at 35% due to the increase in reinsurance spend to 25% of GWP (from approx 10% in its early years).

click to enlargeLancashire GWP Breakdown 2008 to 2015

The timely and astute increase in reinsurance protection spend can be seen in the decrease in their peak US aggregate exposures. The latest probable maximum loss (PML) estimates for their US peak exposures are approximately $200 million compared to historical levels of $300-350 million. Given the lower net premium base, the PML figures in loss ratio terms have only dropped to 40% from 50-60% historically. Lancashire summed up their reinsurance purchasing strategy as follows:

“Our outwards reinsurance programme provides a breadth and depth of cover which has helped us to strengthen our position and manage volatility. This helps us to continue to underwrite our core portfolio through the challenges posed by the cycle.”

As with AIG, the temptation for shareholders is that Lancashire will continue with their generous dividends, as the exhibit below from their Q4 2015 presentation shows.

click to enlargeLancashire Dividend History 2015

The other attraction of Lancashire is that it may become a take-over target. It currently trades at 1.4 times tangible book level which is rich compared to its US and Bermudian competitors but low compared to its peers in Lloyds’ which trade between 1.58 and 2.0 times tangible book. Lancashire itself included the exhibit below on tangible book values in its Q4 2015 presentation.

click to enlargeInsurance Tangible Book Value Multiple 2012 to 2015

It is noteworthy that there has been little activity on the insurance M&A front since the eye boggling multiples achieved by Amlin and HCC from their diversification hungry Japanese purchasers. Many in the market thought the valuations signaled the top of the M&A frenzy.

Relatively, AIG looks more attractive than Lancashire in terms of the potential for shareholder returns. However, fundamentally I cannot get away from current market conditions. Risk premia is just too low in this sector and no amount of tempting upside through dividends, buy-backs or M&A multiples can get me comfortable with the downside potential that comes with this market. As per the sentiment expressed in previous posts, I am happy with zero investment exposure to the insurance sector right now. I will watch this one play out from the sidelines.

Munich’s Underwriting Cycle

Munich Re had a good set of results last week with a 12.5% return on equity on a profit of €3.3 billion (with the reinsurance business contributing €2.8 billion of the profit). A €1 billion share buyback was also announced contributing to the ongoing shareholder friendly actions by industry players. Munich is targeting €3 billion for 2014 but warned of challenges ahead including “the lingering low-interest-rate environment, increasing competition in reinsurance, and changes in demand from clients in primary insurance”.

Torsten Jeworrek, Munich Re’s Reinsurance CEO, cited tailor-made solutions as a strength for Munich highlighting “multi-year treaties (occasionally incorporating cross-line and cross-regional covers), retroactive reinsurance solutions, transactions for capital relief, comprehensive consultation on capital management, and the insurance of complex liability, credit and large industrial risks”.

Whilst looking through the 2013 report, I noticed historical calendar year combined ratios (COR) for the P&C business (reinsurance & primary) including and excluding catastrophes. I dug up these figures going back to 1991 as per the graph below. A small amount of adjustment was needed, particularly in relation to the 24.3% and 17.1% of deterioration for 2001 and 2002 relating to 9/11 losses (which I included as catastrophes in the CaT ratio for those years). As with a previous post on underwriting cycles, I then “normalised” the COR excluding catastrophes for the changes in interest rates using a crude discount measure based upon the US risk free rate for each calendar year plus 150 bps over 2.5 years. That may be conservative, particularly for the 1990s where equities were a bigger part of European’s asset portfolio. I then added the (undiscounted) CaT ratio to the discounted figures to give an idea of the historical underwriting cycle.

click to enlargeMunich Underwriting Cycle

The “normalised” average discounted COR (excluding CaT) since 1991 is 87% and the average over the past 10 years is 83%. The standard deviation for the series since 1991 is 6% and for the last 10 years 4% indicating a less volatile period in recent years in core ratios excluding catastrophes.

The average CaT ratio since 1991 is 7% versus 9% over the past 10 years. The standard deviation for the CaT ratio since 1991 is 8% and for the last 10 years 9% indicating a more volatile period in recent years in CaT ratios.

Adding the discounted CORs and the (undiscounted) CaT ratios, the average since 1991 and over the past 10 years is 95% and 92% respectively (with standard deviation of 11% and 9% respectively).

As Munich is the largest global reinsurer, the ratios (reinsurance & primary split approx 80%:20%) above represent a reasonable cross section of industry and give an average operating return of 5% to 8% depending upon the time period selected. Assuming a 0.5% risk free return today, that translates into a rough risk adjusted return as per the Sharpe ratio of 0.44 and 0.80 for the period to 1991 and over the past 10 years respectively. Although the analysis is crude and only considers operating results, these figures are not exactly earth-shattering (even if you think the future will be more like the last 10 years rather than the longer term averages!).

Such results perhaps explain the growing trend of hedge funds using reinsurance vehicles as “float” generators. If the return on assets over risk free is increased from the 150 bps assumed to 300 bps in the analysis above, the Sharpe ratios increase to more acceptable 0.73 and 1.13 respectively. And that ignores the tax benefits amongst other items!

As an aside, I again (as per this post) compared the underlying discounted COR (excluding catastrophes) from Munich against a credit index of global corporate defaults (by originating year as a percentage of the 1991 to 2013 average) in the graph below. As a proxy for the economic & business cycles, it illustrates an obvious connection.

click to enlargeMunich Underwriting & Credit Cycle