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Whole new ball game in insurance

The insurance industry marches to a slightly different drum to that of other sectors because of the effects of the insurance cycle. While this pattern could justifiably be described as an infuriating and often illogical over-

reaction to the effects of supply and demand, this cycle has recently turned again, due partly to the World Trade Centre loss last September.

The sector is now set to become very popular with investors as it should offer some handsome returns.

The industry is already seeing substantial increases in

premiums and a reduction in sound, experienced insurance companies with strong balance sheets which can meet market demand. My own market focus is global insurance, which is important, as so much of the profitable underwriting will be done in the US. For UK investors with reasonably big and diversified portfolios, it is a global theme worth exploring.

To get to the bottom of why the insurance industry now presents such a good investment opportunity, it is first worth providing a brief explanation of how the insurance cycle works. According to US insurance analyst Dowling and Partners Securities, the cycle is split into four phases – cheating, pain, fear and restoration.

The cheating phase occurs when reported results are better than actual results. This sets in motion the process of weakening company balance sheets. This phase began in 1996 and accelerated in 1997 and 1998. Reserves are raided to boost results. We have seen this in 1997 and 1998 as prior-year releases have been used to bolster corporate performance.

The next phase is pain. This is when the balance sheet no longer permits the company to draw on the fat of prior years and companies begin to announce failure to achieve profit forecasts. Profits are undermined by the need to make special reserves. Investors desert the sector – 1999 equated with these conditions.

The third phase is characterised by fear. This delivers

a short-lived and cathartic shock during which insurance companies are forced to confront the reality of their predicament and bad underwrit-

ing. Some executives lose their jobs and others fear for theirs. Dividends are reduced and cashflow turns negative. Reinsurance dries up. Only one course is open to management – turn away poor unprofitable business, reinforce terms and conditions and, finally, raise premium levels. This point was reached at the end of 1999.

This phase gives way to the restoration phase, which started in early 2000. We believe we are now entering the strongest and most durable insurance upcycle for a generation.

For 10 years prior to 2001, insurance companies had endured unprofitable underwriting returns and supplemented their results with profits derived from their investment portfolios, as inflation and interest rates fell steadily, increasing the capital base or float supporting underwriting.

Strong equity markets were an added bonus, with the result that, for a decade, investment returns covered up poor underwriting. Some insurance companies also chose to reserve inadequately for liabilities on claims to be paid in the future, thereby temporarily assisting the profit and loss account. This imprudence historically has not succeeded in the insurance business and never will.

Against this background, rates continued to rise during 2001 and, equally important, policy terms and conditions imposed by underwriters were being tightened, reducing the level of insurance cover. The classic squeeze of more premium for less risk was firmly in place. The tragedy of September 11, with all its horror and financial implications, accelerated the process that was already underway.

Why should this insurance upcycle be deeper seated than the investment markets give it credit for and will it persist for longer than previous cycles?

First, the supply of insurance cover has been reduced dramatically, initially by companies withdrawing from the market, either voluntarily

like CGNU, which has moved from being a composite insurer to a pure life insurer following the sale of its US prop-

erty casualty operations, and involuntarily, like Independent Insurance.

Second, there is the impact of losses from the World Trade Centre, which are estimated to cost $35bn – the biggest insured loss in the history of the industry. To this total should be added up to $50bn of latent losses accumulated from earlier years of undisciplined underwriting and all too often inadequate reserving for asbestosis and environmental liabilities. In a report in May 2001, AM Best estimated a $57bn shortfall for asbestosis and environmental reserves.

Furthermore, as premium rates rise, so does the regulatory requirement for capital to support the underwriting. If we assume premiums will rise on average by 15 per cent in 2002, this will require a further capital injection of $25bn to support the new levels of underwriting, given that the US property casualty industry writes premiums to an expected $330bn.

The insurance industry needs $110bn of capital to meet liabilities and strengthen balance sheets in order to provide adequate insurance cover going forward. This figure dwarfs the new capital of $16.5bn currently raised. At these historically low interest rate levels, insurance companies can no longer rely on investment profits to paper over unprofitable underwriting. This will also discourage speculative entrants from outside the industry writing business at unprofitable rates and relying on an investment return, as happened in the past.

The capital raised to date is in the hands of insurance people – not naive capital – and all indications to date are that the new capital is price-disciplined. Also, there is a shortage of experienced quality underwriters, which will be a limiting factor on further start-ups.

As Alex Ferguson knows, there is only one David Beckham and he can only play for one club. The same applies

to talented underwriters.

There now exists a worldwide shortage of reinsurance capacity, which has led to a hardening of reinsurance premium rates. As reinsurance rates rise, the primary companies have to raise their rates as well to maintain profitability.

In 35 years in this business, I have not seen such favourable conditions and a market where the fundamentals are so propitious.

Another significant change affecting the buyers of insurance is the implication of underinsurance which the World Trade Centre loss has highlighted. The World Trade Centre was underinsured and this event has focused businesses across the world on the importance of adequate insurance cover.

No chief executive office will knowingly want to expose his balance sheet and thereby shareholders to financial risk beyond his control. The impact has been an unprecedented need for insurance cover, creating greater demand than there is supply. The insurers with the strongest balance sheets are able to cherrypick the best risks, increasing underwriting profitability.

We think this favourable scenario may continue for three or four years. Well managed, underwriting-driven property casualty insurance companies with strong balance sheets are well placed to benefit from this very strong cycle.

The caveat remains to invest in companies with good underwriting skills, a strong balance sheet and the ability to gain profits and rewards for shareholders. We believe the best placed companies come from the US. The large caps we favour are AIG, Marsh Mac and Berkshire Hathaway. Equally well placed are niche underwriting businesses such as Philadelphia Consolidated and WR Berkley.

I cannot put it any better than Hyatt Brown, chief executive officer of US broker Brown & Brown: “We think 2002 will be a damn good year.”


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