Australia | May 24 2012
By Greg Peel
Alphinity is a boutique fund manager established 18 months ago after the four founders left a well known institution together to do their own thing. Prior to leaving, the team had racked up eight years of equity fund management returning an average 2% above the ASX 300 index. Today Alphinity has $1.5bn under management for both retail and high quality institutional clients.
Alphinity's sole focus is on investing in quality undervalued companies undergoing an earnings upgrade cycle. The managers' valuations are deeply rooted in assessments derived from talking at length to those “on the ground” in the various industries which make up the sectors of the Australian stock market. Aphinity's portfolio currently consists of 14 stocks (only one change has been made in 18 months) representing, at present, the sectors related to resources (and resource servicers), the consumer, the US housing market and insurance.
Today's article will deal specifically with the insurance sector.
Someone once suggested “bad luck comes in threes” and someone else once noted “it never rains but it pours”. An insurance company executive would nod knowingly at the latter but as for the former, would probably argue “whaddya mean only threes?” It is the nature of things that for some reason major catastrophes – or “cats” as the cats in the insurance game like to call them – never seem to spread themselves out evenly over time but rather occur in concentrations and then go quiet for long stretches.
It must drive actuarial types nuts.
Take a look at the following graph:
Here we can see a cycle of significantly higher than average cat costs occurring on a rough decade frequency. Very notable is that a bad year is often followed by a particularly quiet year. The latter end of the graph – the five years through 2011 – stands out as a particularly catastrophic period with potentially a final blow-off.
The year 2011 was by this measure the second most costly for insurance companies in four decades. It featured the culmination of a cyclical La Nina period and the less cyclical impact of the larger Christchurch earthquake. Meteorologists are now seeing evidence this La Nina cycle is fading and devastating earthquakes are not a common occurrence.
Alphinity notes Australia's insurance losses accounted for 17% of the global total in 2011 compared to a long-run average of 5% in what was also a stand-out year for losses globally. Alphinity's feedback from insurers, and importantly insurance brokers, is that prices are rising in both personal lines and commercial property.
The insurance cycle is a simple concept. When insurance companies are struck by a run of cats they are forced to run down contingency pools and tap into reinsurance cover. Thereafter, contingency pools need to be topped up again and next year's reinsurance premiums are likely to be higher. Both imply insurance companies have little choice but to increase their own premiums. It is one price rise the general public can mostly understand.
On the assumption the run of cats then subsides, insurance companies are now collecting higher premiums while making fewer payouts. Their net margins thus expand. A period of few catastrophes will then allow insurance companies in a competitive mood to start easing off on premium increases or even cutting premiums. Margins then begin to contract. Along comes another bad cat year or years and bang – margins are crunched.
The performance of insurance companies is also very closely related to global interest rate cycles. This works in two ways. The most obvious is that insurers must invest the funds they collect as premiums in order to cover payouts, such that invested premium income net of payouts is what really provides the day to day margin in “normal” years. Insurers cannot afford to make risky investments lest they find themselves unable to meet payout obligations. Low risk investments such as sovereign and other government-supported bonds thus form the bulk of an insurance company's portfolio. If interest rates on bond investments are in a low cycle, insurers' margins are squeezed, and vice versa.
Interest rate curves are also fundamental to the actuarial alchemy that underpins insurance price setting. Using historical data insurers attempt to predict a level of future payouts and hold contingency pools accordingly. If interest rates are high across the curve the value of future payouts is discounted steeply and thus today's value of an insurance company is enhanced. Vice versa if rates are low. What an insurer really doesn't want is a bad run of cats coinciding with a low interest rate environment.
Have another look at the chart above. Note the most consistent run of high costs on the graph is in the period 2007-11. This happens to be the period in which global central banks began madly cutting rates as first credit markets froze and then collapsed. Subsequent excessive quantitative easing has ensured an historically low interest rate environment.
Alphinity's recent research trip to the US highlighted that a combination of significant catastrophe losses, persistent low interest rates and declining reserve releases and profitability, added to increased capital scrutiny, is finally leading to a turn in reinsurance and commercial property rates in the the major insurance markets globally. Reinsurance and the upper end of the commercial property markets tend to be more global in nature and directly affect the Australian market, leading to rate (premium) rises here. Australia seems to be ahead of other markets, Alphinity notes.
The last positive price cycle for insurers was 2000-04, or ten years ago, albeit margin benefits tend to linger longer than a cycle. While cycles are never consistent and are often driven by major cat events (9/11, Katrina for example), ten years is a rough average and we've just had one of the biggest loss years on record. In other words, suggests Alphinity, “the conditions are right”.
The reality is the long down-cycle experienced from 2004, followed by persistent low interest rates and a rise in cats ahead of last year, meant the premium price cycle had already begun to turn upward before the rolling disasters of 2011 played out. Last year has simply provide greater price rise impetus. With price increases in both personal and commercial lines now coming through in 2012, Alphinity expects an improved cycle for insurance to begin to be reflected in margins and share prices.
It is the trend in underlying margins – that which had begun to turn before 2011 – which best reflects longer term value in insurance company investment, Alphinity points out. However near term share prices are highly influenced by immediate “reported” margins which are impacted heavily by cat levels. With price rises coming through, and if we can look ahead to somewhat steadier investment markets, a more “normal” year of losses ahead would imply “materially” improved insurance margin performance, which should drive share prices.
Australian business is the biggest driver of earnings over time for Insurance Australia Group ((IAG)). Alphinity holds the stock in its portfolio.
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