"In our opinion, the primary determinant of industry pricing is the capital level of the insurance carriers, although other factors do play a role. Insurance pricing, like any other market price, is set by supply and demand. As demand for insurance is relatively static, the prime determinant of pricing is the amount of industry capital available to underwrite insurance (supply). Historically, a decrease in industry capital has typically been followed by a substantial spike in pricing within two years, as can be seen in the table below. While industry capital took a hit during the financial crisis, we have yet to see any meaningful increase in pricing. In our view, this is due to the fact that the capital hits were almost entirely on the investment side, and claims experience has been fairly benign over the last couple of years. Additionally, the government stepped in to save failing insurers as the most notable example), which kept these insurers in the market. Finally, the depth of the general economic malaise made it difficult for insurers to justify price increases.
"The combination of heavy stock repurchases by carriers over the last few quarters--and relatively large catastrophe losses so far this year--should work down industry capital levels and lead to better pricing. Indeed, the trend has been increasingly positive, with most carriers characterizing the pricing environment as flattening to marginally up. We believe the stage is set for further improvements in pricing, as low investment yields also should exert some pressure on premium pricing over time, and we believe that carriers are pricing policies below the level necessary to achieve acceptable long-term returns. Headline results have been good over the last year or so, as insurers have been able to report strong profitability numbers due to the benign claims environment and positive reserve developments. However, this dynamic is unsustainable. But we're not confident in calling for a quick and dramatic upward spike. In our opinion, pricing changes in the near term will hinge primarily on the level of catastrophe claims during this year's hurricane season, a factor that is inherently unpredictable. Therefore, while we feel that insurance pricing is at or near trough levels and the upside on this front is much higher than the downside, predicting either the timeline or the scale of any upward movement is beyond the reach of any honest forecaster.
"For investors in insurance carriers, this scenario presents a mixed picture. The long-term benefit of improved pricing would have to be weighed against the potential near-term negative of higher claims losses, and the poor economic pricing on existing policies flowing into reported results. Therefore, we've seen some investors float the idea of the insurance brokers as a safer way to play an improvement in the pricing cycle. This idea holds some merit. The brokers are levered only to the volume of insurance transactions and the pricing level, so anything that improves pricing or volumes is a pure positive from their point of view.
"From a fundamental point of view, we think insurance brokerage is one of the most attractive areas within the insurance industry. Brokers' top lines are relatively stable, they don't face unpredictable claims exposures, and the asset-light nature of the business allows for ample returns on invested capital, or ROIC. That said, the brokers have been laboring under some headwinds over the last few years. Revenue has been crimped by an insurance market characterized by weak transaction volumes and pricing during the recession. Additionally, the float income generated by the business has been reduced due to the low interest rate environment. Over the past few quarters, these pressures have eased somewhat, but industry results have yet to fully normalize. If the pricing cycle were to improve meaningfully, we would expect to see even better results.
"Unfortunately, a long-term investor looking to gain from this situation is about a year too late, in our opinion. We believed valuations on the insurance brokers were very attractive last year, as the market was valuing these companies as if the headwinds the brokers faced during the recession would never dissipate. But while the problems the brokers face have only partially eased, the market now seems to be fully factoring in the cyclical upturn we always expected, and the insurance broker stocks we cover actually look a little overvalued to us.
"An investor dead set on playing this dynamic would be best served by looking at HCC Insurance Holdings and W.R. Berkley, in our opinion. These companies are two of the most selective underwriters in the industry, and have shown a willingness historically to pull back when pricing is not attractive, and to plunge in when prices improve. Both companies have ample capital available to take full advantage of any hardening market, and are the most likely to create value for their shareholders in this scenario. However, while both stocks look mildly undervalued to us, the margin of safety is not sufficient for us to recommend them."