Olly Russ

European insurance – the ‘boring’ sector making premium returns

Olly Russ

European Insurance

In January 2020, fuelled by an immense rally, US maker of electric cars Tesla exceeded the stock market value of Volkswagen for the first time, reaching around US$100 billion. A few days later, its worth exceeded that of Volkswagen and BMW added together as the share reached US$780. This seemed a relative bargain though, as the very next day Tesla touched US$968. Markets were mesmerised at the sight of a mega-cap stock behaving in the sort of excitable fashion not seen since March 2000. It was a remarkable demonstration of what can be achieved with an exciting story and a glamorous and charismatic CEO – which brings us nicely to the European insurance sector.


European insurance is neither exciting, nor glamorous, nor generally regarded as having more than its fair share of particularly charismatic CEOs. It does have one thing in common with Tesla though: strong stock market returns. In fact, despite its lack of glamour (or maybe because of it) insurance was the best performing sector in the STOXX Europe 600 from the March 2009 lows over the next decade, returning an incredible 570%, eclipsing the market return of 285% and handsomely outperforming their more-followed brethren in the banking sector, which managed only a meagre 136%. We see no reason why this remarkable performance by the insurance sector won’t continue.


The success of Warren Buffet’s Berkshire Hathaway has long been driven by its insurance businesses – starting with the 1967 acquisition of National Indemnity and National Fire & Marine, and now including Geico (cars insurance) and General Re (property and life and health reinsurance). Berkshire Hathaway is of course a giant in the insurance world and is synonymous with US corporate success. Yet less well appreciated is that not only is insurance a stable, long-term business, but also a European specialism. Indeed, General Re itself is dwarfed in non-life reinsurance by Munich Re and Swiss Re, as well as Lloyds of London and Hannover Re (General Re is fifth globally), and one doesn’t have to be Sherlock Holmes to work out where the larger rivals are based.


The different faces of insurance


There are of course various types of insurance company, and Europe can boast market leaders in all of them. Most obvious is the Property and Casualty sector (think car and home insurance). This is also the simplest type of insurance business to understand. Customers pay a premium to insure some physical object for a time-limited term, and insurers get to invest that premium (called the float) in assets which hopefully for the insurer will produce a bigger return. Ideally, the insurance group will have calibrated its costs, risk and pricing correctly so that it ends up paying less in claims and expenses than it receives in premiums in any given time period. When it does so, it generates an underwriting profit. Sometimes however mispricing occurs, or competition in the market is so strong that premiums are driven down to such low levels that the insurer makes an underwriting loss. That is not ideal, but neither is it catastrophic, as long as they can make an investment profit on the premiums they invest in assets such as bonds and equities until they are required to pay claims.


Life insurance companies operate in a similar fashion, but over much longer time horizons, involving the assessment of risks and claims over decades, some of which (as for example asbestos claims) only appear much later on. The scope for mispricing is therefore much greater, and such companies typically build up large reserves in case the assumptions on which they originally wrote the business turn out to be wrong. These large reserves can also be the source of decent payouts for shareholders – as old business lapses without claims, so the capital is freed up to be returned in dividends or special dividends.


In the past, insurance groups writing certain saving policies would include guaranteed annuities, which were relatively modest compared to the prevailing interest rates of the time. However, as interest rates globally have plummeted, such minimum guarantees have become incredibly expensive to maintain and require huge amounts of capital to be set aside against them. As a result, the trend in Europe, as in the UK, is to move to schemes wherein the customer assumes the investment risk and the insurer provides the wrapper and perhaps the management of the policy assets through an asset management subsidiary. This sharply reduces the risks to insurers’ capital requirements going forward.


The third category of insurer is that of the Reinsurance business and, as mentioned above, this is a real European speciality. Operating across categories, the Reinsurance business simply redistributes risks from primary insurance companies to make them more robust. So if, for example, some natural disaster were to overwhelm an individual insurer’s book of underwriting, their losses would be limited by other insurers taking on some of that exposure. There have been some cataclysmic disasters over the last decade or so, but it is to the insurance industry’s credit that it has largely managed these claims without an industry implosion.


Many of Europe’s largest insurers write a diverse set of these various categories of insurance, making them composite insurers, and many of these will be household names in the UK too. These include names such as Allianz, Axa and Zurich, which are global giants.


Unpicking the drivers


One of the problems with the insurance sector as an investment destination – apart from its inherent dullness – is its apparent complexity. Accounting and actuarial assumptions are often opaque, but have a big effect on reported earnings numbers, particularly in Life divisions. Every insurer will claim to be appropriately provisioned against its legacy business, but this carries about the same value as a bank management claiming to have conservative lending standards – no one ever claims anything less, but surprises nonetheless do happen. What then drives the insurance sector?


Safe to say, it is not generally regarded as a high growth sector – the long run growth rate of the insurance sector is probably best estimated as being in line with global GDP. Most things which need to be insured, are already insured, at least in Europe. It is true that there are always new risks to be covered – the risks around cybersecurity for example – but in general the markets are mature and well-covered. It is therefore reliant as an industry on maintaining price discipline.


In former times, insurance was regarded as a cyclical industry – as returns rose, more capital was attracted in, pricing then became more intense, underwriting losses expanded, weaker players went under and so prices eventually reverted back up. Insurers also tended to have more equity market exposure on their investment books, introducing a further element of volatility. These days, insurers are tightly regulated on capital to ensure they do not over-extend themselves and this has severely constrained the risks they are prepared to take in the market. The additional capital rules and regulatory complexity over the last decade also means that new players are few and far between. Of all the fintech start-ups of recent times, alongside challenger banks, relatively few involve a new insurance group – client servicing, deep data, regulatory reporting, claims experience and financial strength all argue against new players.


Defying the low interest rate environment


What has been both a benefit and challenge to the sector over the last decade or so has been the relentless collapse in bond yields. Insurance companies are some of the biggest holders of bonds, and as a result have seen enormous gains on their fixed income portfolios. The drawback is that each year the insurance companies have to reinvest the year’s premiums in bonds which offer lower and lower investment returns – the reinvestment yield. Companies have responded by moving up the maturity curve by buying longer-dated bonds, or moving into corporate credit, or even finding alternative assets such as private equity. Nonetheless, asset/liability matching requires a certain amount of government bonds to be bought, whatever the yield. The absence of compelling investment opportunities is in part what has helped to keep underwriting pricing disciplined – in the past, strong investment returns from stocks and bonds meant that underwriting losses could be sustained until some unexpected market downturn forced management to rethink.


This is what makes the insurance sector sensitive to interest rates, in the sense that they are usually positively correlated to rising rates, making the stunning performance of the sector all the more remarkable against such a difficult (for them) macro backdrop. In fact, insurance was the only sector regarded as being positively correlated to yield to outperform last year, with banks notably having a dire year.


The question is, where do rates go from here? While it is hard to make predictions (especially about the future) it seems not impossible that last year saw the lows in European bond yields. From here on in, rising yields could yet provide a tailwind to earnings. Tightening credit spreads also seem to be beneficial for the sector and this might well prove more crucial for the sector going forward as their investment books reweight from equity to corporate credit.


For those investors looking for value at the moment, insurance is one of the safer options. Its valuations are underpinned by solid cash dividends, while its relative earnings have been upgraded over the last year or so. Despite its decent performance (especially for a value sector), the sector remains a premium yielder and trades at a valuation discount to the overall market.


Admittedly, it is not as exciting as Tesla. But all those expensive new electric cars (which apparently are more accident prone due to the extreme acceleration) are going to need to be insured.


For a comprehensive list of common financial words and terms, see our glossary here.


Key Risks

Past performance is not a guide to future performance. Do remember that the value of an investment and the income generated from them can fall as well as rise and is not guaranteed, therefore, you may not get back the amount originally invested and potentially risk total loss of capital. Investment in Funds managed by the European Income team involves foreign currencies and may be subject to fluctuations in value due to movements in exchange rates. The Fund’s expenses are charged to capital. This has the effect of increasing dividends while constraining capital appreciation. Investment in the Liontrust European Enhanced Income Fund writes out of the money call options to generate additional income. These call options will be “covered”. Unitholders should note that potential capital growth of the Fund would be capped if these call options are exercised against the Fund and the Fund’s capital returns could therefore be lower than the market in periods of rapidly rising share prices.


The information and opinions provided should not be construed as advice for investment in any product or security mentioned, an offer to buy or sell units/shares of Funds mentioned, or a solicitation to purchase securities in any company or investment product. Always research your own investments and (if you are not a professional or a financial adviser) consult suitability with a regulated financial adviser before investing.

Tuesday, February 18, 2020, 11:15 AM