Insurance at a Premium

Nothing is a sure thing. That's why there's insurance: You buy it, "just in case." In the wake of the Sept. 11 disasters -- a tragedy so heinous no one would have imagined it possible -- the concept of "just in case" has radically changed. If anything, its value has greatly appreciated.

That's why there's still time to get into property and casualty insurance stocks. Granted, the group has already moved -- up 21.5% since its arguably oversold low on Sept. 21. But as one analyst said, "If this is anything like history, [these stocks] will move for months and months." Valuations, while not as cheap as they were a year ago, are certainly reasonable, given the outlook. The average price-to-earnings ratio for stocks in this sector is 18, compared with the five-year median of 16 and high of 20. The average price-to-book value is 1.6, compared with the median of 1.8 and high of 2.5 over the past five years.

Insurance Stocks on the Rise S&P 500 Property & Casualty Insurance Index

Source: Dow Jones Interactive

A Little History

Overcapacity in this sector has been problematic for years. Simply put, great returns on investment portfolios, combined with a paucity of big loss-creating disasters, swelled industry balance sheets through the 1990s. So, too many companies with too much capital were all fiercely competing for the same business. Needless to say, pricing was horrible. It got so bad that many companies couldn't make money, resulting in widespread underwriting losses by the end of the decade.

That situation was correcting itself by the end of 2000 as poor results from many insurers started shrinking their capital base. Wall Street noticed this, and property and casualty stocks started to reflect a turn in the underwriting cycle. In fact, before Sept. 11, this group was one of the year's top performers, up more than 20% through July.

The irony is that the Sept. 11 tragedy triggered a more sustainable pricing cycle than anyone predicted. We now seem to have an environment in which the healthiest property and casualty insurers can thrive for some time, and so can the stocks. The only other comparison you can draw is with Hurricane Andrew in 1992, the most significant disaster to confront the industry before Sept. 11. Hurricane Andrew generated estimated losses of $16 billion to $21 billion. The stock market's knee-jerk reaction was to sell off the insurance group. But the stocks quickly recovered and outperformed for the following six months, climbing 50% from their post-event lows, according to Elizabeth Malone, insurance analyst at Advest.

Preliminary loss estimates incurred by the insurance industry from the World Trade Center attack have most recently been tallied at $21 billion, but are likely to rise to $30 billion or more as companies refine their numbers, says Malone. She adds, "Even though there is plenty of capital to meet these claims, the impact of this loss of capital should result in higher prices because companies will have less capital to compete."

While losses from the World Trade Center disaster are much bigger than from Hurricane Andrew, they're also much more broad-based. Rating agencies, including A.M. Best, Moody's and Standard & Poor's, have already downgraded the ratings on a number of insurers, making their access to additional capital more expensive, if not more difficult. "A number of companies will struggle financially, and that will get a lot of attention in the marketplace," says Malone.

Weathering the Storm

But the stronger companies with healthier balance sheets and better access to capital will enter 2002 extremely well-positioned. That outlook was confirmed last week at The Bermuda Angle Conference, an annual investment gathering for insurance companies based there. Most of the companies that presented, including Ace (ACE) and XL Capital (XL), indicated that prices, as well as profits, would likely rise next year. This is virtually assured regardless of the economic environment. Where else in this economy is there pricing power?

I decided to highlight two very disciplined (by that, I mean savvy risk managers), well-positioned and well-capitalized specialty insurers that don't get a lot of attention: HCC Insurance (HCC) and Navigators Group (NAVG).

HCC is a major player in general aviation insurance, a space that for obvious reasons is expected to experience dramatic price increases. HCC is exceptionally well-positioned relative to its competitors because its focus is on certain aviation segments like private corporate jets -- not the catastrophic exposures associated with commercial passenger airlines. Therefore, HCC will benefit from the improved marketplace without the associated risks.

Advest's Malone says she's heard that premium rates have risen tenfold already on the commercial aviation side. While HCC had exposure to the Sept. 11 disaster, it was mainly limited to areas outside aviation, like property and accident and health claims, which are expected to hurt earnings by about 34 cents a share in the third quarter. Thomson Financial/First Call estimates that HCC could earn $1.82 a share in 2002 -- implying a P/E of less than 16 -- in line with peers like Chubb (CB) and St. Paul (SPC).

Navigators Group is the market leader in marine liability and blue-water hull (oceangoing vessels) insurance. Its market cap is just $145 million. Until 2000, when supply and demand balanced out a bit better, marine was one of the worst segments of the insurance market for years. Navigators was one of the few that continued to turn an underwriting profit by refusing to chase unprofitable business. A lot of its competitors, however, sustained heavy losses and have since exited or downsized. Hence, Navigators emerged as a leader in a highly consolidated industry.

The outlook for the marine market could hardly be better. Just think about it. Who would want to underwrite ships -- big sitting ducks -- while we're at war? I heard that war-risk premiums for a well-known cruise ship, for example, went from $600,000 to $8 million! Navigators is positioned very well to benefit from that. It also does a growing part of its business in the offshore energy (rigs) segment, where "we've seen a doubling and tripling of rates," says Stan Galanski, chief operating office and executive vice president at Navigators. Per-share earnings are expected to jump from 45 cents this year to $1.62 in 2002. That's a P/E of just 10.5.

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