Many investors are focusing on bank stocks now that the
has cut short-term rates by a whopping 250 basis points so far this year. But Michael Paisan, a principal with
investment bank in New York, thinks another financial sector looks even more attractive for different reasons.
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That sector is commercial and personal property insurers. According to Paisan, insurers have been increasing their rates across the board recently, leaving them poised for continued growth for years to come. While that's not good news for policyholders, Paisan says, it's definitely good news for investors in these companies.
TSC: Why do you think property and casualty insurance is the best subsector of financial services to invest in?
The Fed rate cuts are all fine, and I do agree that the lower interest rates do help the banks, but it's really a short-term solution, whereas the property/casualty sector really is the only financial services sector that is poised for long-term growth relative to the other groups.
That's predominantly because it is undergoing unique secular fundamental improvement predicated on the rates it charges for its commercial businesses, which have been rising over the past year or so.
Also, in 1999 we began to see a lot of insolvencies. You can only get beaten over the head for so long before you die, and that's what happened to some of these smaller companies. Some capacity was taken out of the industry.
The environment for the banks is certainly not as benign as what we are seeing for the property/casualty insurers right now, particularly if the rates that insurers are charging their commercial customers continue to rise over the next 18 months or two years. Eventually, all of these improving fundamentals will show up.
TSC: Why have these insurers been able to increase their rates?
For 15 years, rates have been going down, and they were significantly underpricing the business for the risk that they were taking. That changed as property and casualty insurers realized their business was in poor shape and they had no choice but to increase rates.
In late 1999 into 2000, the capital markets were not as much in insurers' favor. For the past decade, they built up a lot of excess capital in the industry and have put that excess capital to use. That provided insurers with enough ancillary profits to compete against each other on price to gain more market share.
That began to change in 1999 when the underwriting cash flow for the industry, for the first time ever, turned negative. You can cheat all you want on your earnings, but ultimately, if you are showing negative underwriting cash flow, that is a sign that you are going out of business.
They also were supporting earnings over the past decade by releasing reserves. You can only do that for so long before you have to become disciplined. They finally got to the point where they couldn't deal with it anymore. They discovered that they were really short on reserves.
About a year and a half ago, three or four major companies, the pricing leaders --
-- noticed that underwriting cash flow was negative. It was then that they drew the line in the sand and decided to increase rates.
TSC: Which companies have been able to gain the greatest market share through these rate cuts and are now poised for continued growth?
Obviously, AIG. They have been able to grow fairly steadily, as has
, through acquisitions.
However, I would say that in spite of these rate cuts, very few of these companies were actually successful in increasing their market share, and that's because all of them were undercutting their rates. Nobody was really able to gain an edge.
, one of the most aggressive in cutting prices and one of the few able to gain market share, was bleeding on their income statement two years ago.
TSC: From the perspective of a policyholder, these rate increases aren't good news.
True, but most of the rate increases are for commercial line business, increases generally in the range of 13% to 15%. So for corporate America buying policies, it isn't good news, but I would remind you that for 15 years, the consumer had the power. All these companies are trying to do right now is say, "Enough is enough."
TSC: What about personal lines rates? Are they rising as well?
Ever so slightly. Homeowners and auto insurance line rates are a little bit more competitive, and right now we are seeing modest rate increases in those areas, but they're really just beginning now.
Some of the personal line insurers, like
, that were very aggressive about cutting rates over the past couple of years, have now pulled in the reins a little bit and become more disciplined about increasing their rates, which is good. So, I think eventually we are going to see rates on personal insurance increase as well, in the low to mid single digits, around 4% to 5%.
TSC: Do these rate increases make commercial insurers rather than personal insurers a better bet right now?
I would say that the commercial line insurers are probably a better bet, but you have to remember that they made a big run last year and that was all discounting the fact that rates were going up. So quite frankly, the fact that rates are up means that the earnings are going to grow not this year but next year and the year after that because of the quirky accounting rules in insurance.
The commercial insurance stocks made a big run last year in anticipation of the earnings. So, I would say by and large you need to be a lot more selective than last year. Last year was when the easy money could be made.
On the other hand, I think the personal insurers -- Progressive,
-- are good investments for those who have a little bit longer-time horizon. We are not in the middle of a cycle turn in the personal business, but I think that we will be in the next six to nine months. While they are making very modest rate increases now, the trend is going up.
Personal insurers are going to have to increase rates because of how their loss costs have risen. One of the issues with the personal line has been a huge amount of loss cost inflation, primarily because of medical cost inflation and how expensive it has become today to fix cars. Cars are more complicated today. You get into a fender bender and your entire electrical system can go out. These insurers are going to have to be aggressive on their rates.
TSC: Are there any other insurance stocks that you would recommend?
I would say that long-term value investors should put their money in Allstate and everybody else should put their money in Ace Limited or AIG, in particular, because the theme you want to play right now is the turn in the global commercial lines business. Different markets turn at different times, and generally the rest of the world lags the U.S. by about a year.
Companies with geographic breadth like Ace and AIG will be able to pounce on opportunities when they arrive, and we are beginning to see this already in the
market and in Europe.
TSC: It appears that we might now be headed for a recovery. How do property and casualty stocks generally perform in a recovery?
These stocks do actually quite well because the companies are likely to raise their rates even further, and commercial accounts in particular will pay the higher rates without any problems because everything is improving for them.
On the flip side, in times of recession, the insurance category tends to be more immune and a good defensive play because their products are necessary. You still have to buy auto insurance. If you are
, you still have to buy worker's compensation insurance for your factory workers. Also, since so much of the business is renewal business as opposed to new business, a recession tends to affect the insurance industry less than some other industries.
TSC: How will the rate cuts affect the insurance industry?
In two ways. From an earnings perspective and from a book value perspective. From an earnings perspective, your net investment income tends to go down because the new cash flow is earning lower interest rates. On the other hand, your book value goes up because 75% of the portfolio is invested in fixed income securities and long-term bonds, which benefit from interest rate decreases.