Tag Archives: Insurance

Trick or treat: AIG Q3 Follow Up

Well, I’d put AIG’s Q3 results firmly in the trick basket. The big surprise for me was the nearly $1 billion income tax benefit item in Q3. I wasn’t expecting that.

Income before tax was distinctly lacklustre. The P&C technical result was only marginally worse whilst P&C investment income added just over $1 billion of incremental income before tax. Life & retirement only added $400 million of incremental delivered income before tax. The hodgepodge of the other segment had a negative impact of over $1 billion of incremental income before tax due to the marginal increases in GCM and DIB lagging interest, corporate & legal expenses. Updated graphs for net income and the other segment for YTD to Q3 are below.

click to enlargeAIG Net Income Breakdown Q3 2013click to enlargeAIG Other Segment Q3 2013

Overall then, I wouldn’t materially change my estimates for a “normal” 2014 (although I may need to reconsider my tax assumptions) and would stick to a book value target of $70 by year end 2014 as being achievable, save any large catastrophes or unexploded bombs. One small treat from the results was the reduction in share count which should continue.

Although the risk/reward is getting more attractive after the price drop to just above $48, I will stay on the side-line as the overall market looks very frothy to me and, as a result, I am currently in risk reduction mode. The uncertainty around the other segment and the lack of clear improvement in the P&C segment may justify the AIG book multiple discount for a while yet.

Does financial innovation always end in reduced risk premia?

Quarterly reports from Willis Re and Aon Benfield highlight the impact on US catastrophe pricing from the new capital flowing into the insurance sector through insurance linked securities (ILS) and collaterised covers. Aon Benfield stated that “clients renewing significant capacity in the ILS market saw their risk adjusted pricing decrease by 25 to 70 percent for peak U.S. hurricane and earthquake exposed transactions” and that “if the financial management of severe catastrophe outcomes can be attained at multiple year terms well inside the cost of equity capital, then at the extreme, primary property growth in active zones could resume for companies previously restricting supply”.

This represents a worrying shift in the sector. Previously, ILS capacity was provided at rates at least equal to and often higher than that offered by the traditional market. The rationale for a higher price made sense as the cover provided was fully collaterized and offered insurers large slices of non-concentrated capacity on higher layers in their reinsurance programmes. The source of the shift is significant new capacity being provided by yield seeking investors lured in by uncorrelated returns. The Economist’s Buttonwood had an article recently entitled “Desperately seeking yield” highlighting that spreads on US investment grade corporate bonds have halved in the past 5 years to about 300bps currently. Buttonwood’s article included Bill Gross’s comment that “corporate credit and high-yield bonds are somewhat exuberantly and irrationally priced”. As a result, money managers are searching for asset classes with higher yields and, by magic, ILS offers a non-correlating asset class with superior yield.  Returns as per those from Eurekahedge on the artemis.bm website in the exhibit below highlight the attraction.

ILS Returns EurekahedgeSuch returns have been achieved on a limited capacity base with rationale CAT risk pricing. The influx of new capital means a larger base, now estimated at $35 billion of capacity up from approximately $5 billion in 2005, which is contributing to the downward risk pricing pressures under way. The impact is particularly been felt in US CAT risks as these are the exposures offering the highest rate on lines (ROL) globally and essential risks for any new ILS fund to own if returns in excess of 500 bps are to be achieved. The short term beneficiaries of the new capacity are firms like Citizens and Allstate who are getting collaterised cover at a reduced risk premium.

The irony in this situation is that these same money managers have in recent years shunned traditional wholesale insurers, including professional CAT focussed firms such as Montpelier Re, which traded at or below tangible book value. The increase in ILS capacity and the resulting reduction of risk premia will have a destabilising impact upon the risk diversification and therefore the risk profile of traditional insurers. Money managers, particularly pension funds, may have to pay for this new higher yielding uncorrelated asset class by taking a hit on their insurance equities down the road!

Financial innovation, yet again, may not result in an increase in the size of the pie, as originally envisaged, but rather mean more people chasing a smaller “mispriced” pie. Sound familiar? When thinking of the vast under-pricing of risk that the theoretical maths driven securitisation innovations led to in the mortgage market, the wise words of the Buffet come to mind – “If you have bad mortgages….they do not become better by repackaging them”. Hopefully the insurance sector will avoid those mistakes!

Historical Price to Tangible Book Value for Reinsurers and Wholesale Insurers

Following on from the previous post, the graph below shows the historical P/TBV ratios for selected reinsurers and wholesale insurers with a portfolio including material books of reinsurance (company names as per previous post). The trend shows the recent uptick in valuations highlighted in the previous post. The graph is also consistent with the Guy Carpenter price to book value graph widely used in industry presentations.

Historical P to TBV Reinsurers & Wholesale Insurers 2001 to 2013Over the past 12 months the sector has broken out of the downward trend across the financial services sector following the financial crisis, most notably in the banking sector as the graph below from TT International illustrates.

TT International Bank Price to Book Ratio

Tangible book value growth across the wholesale insurance sector was approximately 10% from YE2011 to YE2012 and the weighted average operating ROE of 11% in 2012 has been rewarded with higher multiples.

The sector faces a number of significant issues and a return to valuations prior to the financial crisis remains unrealistic. An increase in capacity from non-traditional sources and the increased loss costs from catastrophes are cited in industry outlooks as headwinds although I tend to agree with EIOPA’s recently published risk dashboard in highlighting the impact of macro-economic risks on insurer’s balance sheets as the major headwind.

One issue that deserves further attention in this regard is the impact low interest rates have had on boasting unrealised gains and the resulting impact on the growth in book values. Swiss Re is one of the few companies to explicitly highlight the role of unrealised gains in its annual report, making up approximately 13% of its equity. In a presentation in September 2012, the company had an interesting slide on the impact of unrealised gains on the sector’s capital levels, reproduced below.

Reinsurer Capital & Unrealised Gains

P/TBV is one of my favoured metrics for looking at insurance valuations. But no one metric should be looked at in isolation. The impact of any sudden unwinding of unrealised gains if the macro environment turns nasty is just one of the issues facing the sector which deserves a deeper analysis.