Research in Action: Are insurance stocks on investors’ side?

Carolyn Bigda: From Janus Henderson Investors, this is Research in Action. A podcast series that gives investors a behind-the-scenes look at the research and analysis used to shape our understanding of markets and inform investment decisions.

From devastating wildfires in Maui and Canada, to Hurricane Ian in Florida, to a catastrophic earthquake in Turkey. Property and casualty losses are piling up and impacting the bottom line of insurance companies globally, says Research Analyst Andrew Manguart.

Andrew Manguart: The industry generally became complacent after abnormally low storm activity in 2013 to 2016, which resulted in a multi-year period of underpricing.

Bigda: Inflation has also added to insurers’ costs, as have lawsuits, and regulation, says Research Analyst Ian McDonald.

Ian McDonald: When the industry has to rethink risk, prices go up. And that’s what we’ve been seeing for the last couple of years.

Bigda: This higher-risk, higher-cost environment can be a challenge for the industry or an opportunity to raise premiums and capitalize on new growth opportunities. Investors could also benefit – if they know where to look.

I’m Carolyn Bigda.

Matt Peron: I’m Matt Peron, Director of Research.

Bigda: That’s today on Research in Action.

Andrew, Ian, welcome to the podcast.

McDonald: Thanks for having me.

Manguart: Great to be here.

Bigda: We’ve invited you onto the podcast today because, as many people who are listening probably know all too well, insurance premiums have been rising – and fast. Generally speaking, auto and home premiums are up over 20% this year. And in some places like California and Florida, price increases have been much higher, if people can get coverage at all. Insurance for commercial properties has seen similar price increases.

So, let’s begin by explaining why this is happening. Andrew, do you want to start with the personal lines – home and auto?

Manguart: Sure, so, I’d bifurcate the two stories between home and auto as they’re a little bit different. Maybe just starting with auto, which I’d characterize as being a story of the pandemic. At the onset of the lockdowns people stopped driving. That resulted in a drop-off in the frequency of accidents, and as you would imagine, that’s a positive for auto insurers. So, we saw this period of exceptional profitability, where most insurers were actually rewarding some of the premium back to policyholders.

Fast-forward to the later stages of the pandemic, people are driving again, so accident frequency normalizes. That also happens to coincide with, one, surging inflation – in other words, the cost to repair a car is rising – and two, a noticeable shift in driving behavior, most notably more distracted driving. So, ultimately, that exceptionally positive profitability becomes exceptionally negative. And typically, insurers would respond quickly with pricing, but their ability to push through pricing was inhibited by some key states’ unwillingness to grant the necessary pricing increases. At the same time, the inflation issue was only getting worse. And by the time regulators came around, the insurers found themselves in a huge pricing hole that they are now digging themselves out of, resulting in the very large premium increases that consumers are facing today.

On the home side, the issue goes back to pre-pandemic and is more structural, though there are some parallels. The industry generally became complacent after abnormally low storm activity in 2013 to 2016, which resulted in a multi-year period of underpricing. That came to roost beginning in 2017 through today, when storm activity normalized, exposing the fact that insurance was fundamentally mispriced. That was further exacerbated by two pandemic trends: one, inflation, and two, migration of Americans to coastal catastrophe-prone geographies. I’d also throw in higher reinsurance pricing as well.

So, the pricing hole, which was already a problem, is now an immense problem. And similar to auto, you’ve seen several key states push back on pricing, which in the case of home, has actually driven several large insurers to exit certain markets, namely California and Florida. Elsewhere, you can only push so much pricing at a time. So, I think the industry is looking at persistent pricing increases over the next several years to continue to catch up and dig themselves out of that profitability and pricing hole.

Bigda: It sounds like, on the personal side of things, pricing wasn’t keeping up as costs were rising for these companies. Is that basically the idea?

Manguart: Exactly.

Bigda: Ian, did we see the same thing happen on the commercial side, as well?

McDonald: Yes, it’s been a fascinating few years in commercial insurance, for sure. And maybe just to define a few terms: In industry parlance, a hard market is when prices are going higher, and a soft market is when prices are going lower. And we’ve been in a hard market for some time.

And I kind of like to talk about, there are basically two ways that a hard market happens. And the first one is traditional. And that is prices rise to compensate for either low returns or losses that are lingering in the system. And if you look pre-COVID, we were seeing some cracks in reserves, meaning that losses were coming in higher than originally expected and elevated loss trends due to social inflation. And social inflation is broadly defined as an increase in insurance losses that’s caused by, say, higher jury awards, more liberal treatment of claims by workers’ compensation boards, legislative rises in compensation benefit levels, or even new concepts of tort negligence. So, we’re really seeing attorney involvement in insurance losses leading to higher severity, and prices were moving higher even before COVID came along.

And then the second way a hard market comes along is – and COVID is an example – and this is when there’s a shock to the system. And a prior example, which I think you’ll be familiar with, would be 9/11. The insured losses in 9/11 were larger than any natural or manmade event in history at the time. The losses extended from property, to life, to disability, to workers’ comp lines. It impacted aviation and liability. And these enormous losses were for an unseen peril in which no premium had been collected. And so that provoked an extraordinary shift in insurance underwriting and a rapid increase in prices.

COVID’s along the same lines. It was a massive shock to the system when the world went into lockdown. At one point, it seemed like the insurance industry was actually going to be on the hook for all economic losses, from business interruption policies to even physical damage; where some were arguing that the virus molecules were present on the restaurant table or something of the sort. So, the insurance was going to be holding the bag for everything. And it impacted sectors like cruise lines and hospitals and nursing home policies. It was global. You might have thought you had a diversified book of insurance, some exposure to U.S. wildfires, some exposure to Japan earthquakes. And then all of a sudden, you saw losses in every geography all at once.

So, when the industry has to rethink risk, prices go up. And that’s what we’ve been seeing for the last couple of years.

Bigda: Right, so COVID created this big unknown where people just didn’t know what the end cost would potentially be.

McDonald: Correct. There’s an analogy to almost stock portfolios, where… people talk about correlations going to one when the market goes down. Well, we had a rethinking of risk and it felt like all your risks got hit at once. And so, we have to rethink how much risk we’re actually taking. And that usually brings capacity down and prices up.

Bigda: Okay, so we’ve seen premiums go up, Matt, but what do you think: How much higher can they go from here?

Peron: Well, all of the themes and the different sources of the hard market seem pretty well intact. I personally don’t see that – a lot of those abating anytime soon, although inflation potentially. What do you guys think? Andrew, what do you see?

Manguart: Maybe, again, I’ll start on the auto side. And I think after we saw a reacceleration in the cost to repair in early 2023 – from things like wage inflation at the body shops and elongated times to repair cars – we’ve seen those inflationary pressures start to stabilize more recently. At the same time, the insurers have already pushed through a tremendous amount of pricing. So, while consumers might still be feeling the pain at renewal as those pricing increases are recognized, I’d say, next year, 2025, probably looks closer to normal for auto, barring another spike in inflation.

On the home side, again, I think the hard market, the pricing increases are likely to persist here, just given the hole that the insurers find themselves in from a profitability perspective. We’re probably looking at several years of aggressive pricing increases on the home side.

Bigda: And then what does this mean then for the industry’s growth potential going forward? Now they’re finally catching up. They’re raising the premiums to help offset these rising costs. But how quickly is that going to flow down to the bottom line?

McDonald: I mentioned how a hard market happens. And maybe I’ll talk a little bit about how a hard market ends, and we usually think about, it ends with higher returns. Higher ROEs [return on equity[i]] attract new capital. And then this new capacity kind of saps returns, and we go through another cycle – low returns until people exit and they come back in again, so, a traditional capital cycle.

The good news, as we sit here today, we’re not seeing any new capital formation to date. No new startups in Bermuda looking to write property CAT [catastrophe]. And part of this is because the market has lost its appetite for volatile catastrophe risk. If we rewind a little bit, we actually had a very large and growing CAT bond[ii] market when rates were low. So, this is the idea of issuing a bond that paid a high rate of interest, but the par value[iii] was subject to catastrophe losses. And this seemed like a really good idea when rates were low. You could think about whether risk had little correlation with the rest of your portfolio and the yield was high. These bonds could fit in your portfolio and get you on a better risk-reward trajectory.

The problem is the bonds really didn’t pay off like you thought they wanted. The CAT losses were higher than expected. And today, why would you go through the headache of owning a CAT bond when you can buy a corporate bond at a high single-digit yield?

So, we’ve actually seen quite a bit of capital capacity come out of the industry and we haven’t had any new startups. So, the supply-demand is favorable for the industry at this point.

Peron: All that taken together is another factor that would prolong the cycle?

McDonald: Correct.

Peron: Either through the withdrawal of capital from CAT bonds or reinsurers maintaining pricing. It does seem like the setup here is just kind of interesting.

Bigda: Coming into this, were the insurance companies and their stocks, were they struggling and now it’s turned around, given this supply/demand dynamic or…?

McDonald: It’s a good spot to be in now, but it’s been a little bit of chasing the ball downhill, if that’s the way to think about it – where losses have gone up, pricing has gone up, and then we’ve actually seen losses go up again. And so, the aggregate data for the industry in the third quarter would show reacceleration of prices. We thought we had it, and then you didn’t have it, and here we go around the track one more time raising prices again.

Bigda: We’ve had markets where insurers have pulled out of them completely, like Florida, California, where they’re just saying that the risks are too high. And so what does that then do to the industry?

Manguart: I think in those particular states, it’s a combination of exposure to catastrophes, Florida being a great example with hurricanes. But it’s also a regulator that oftentimes is less favorable to the industry in terms of granting pricing and recognizing things like higher catastrophe levels and higher reinsurance costs in their pricing model. In many instances, particularly on the homeowner’s insurance side, we have seen several large carriers exit markets.

But I think what’s optimistic is that we are seeing some of those regulators start to recognize the issues in their state and start to consider reforms. So, while I think the outlook is bleak in some of these markets, at least over the near term, I’m hopeful that eventually the regulators will take the medicine and push through the reforms that are needed to create healthy markets in those states.

Bigda: And from an investor’s point of view, is that a significant governor on the growth potential for the industry or is it just a minor issue at this point?

Manguart: I would characterize it more as a minor issue overall. Pricing generally is very favorable for the industry, both from correcting underwriting profitability woes but at the same time, growing the revenue base from which you’re deriving those profits. With the hard market likely to persist, at least over the near- to medium-term, it’s a very great environment from a growth perspective for the insurers.

McDonald: And I would note that auto policies are a meaningful and mandatory household spend in the sense that you don’t have to have collision damage on your car, but you have to have liability. And in the sense if you get denied by three insurance carriers, you’ll end up in a state-sponsored pool where you’ll have the insurance. And the states don’t really want to be managing large pools of auto policy. Eventually, they have to come around and reengage with the industry.

I would note one other dynamic, which is kind of fun in auto and homeowner’s, is auto has been defined forever as what they call a lead line in insurance. Meaning that people shop for auto because it’s more expensive, historically, than home. And then at the end of your conversation with your auto agent, you ask for a home policy and then they tag it on there.

What’s happening now is that homeowner’s prices are rising so quickly that homeowner’s is becoming the lead line and autos is going into the backseat. And it’s partly because, as Andrew described, the large CAT losses, the replacement cost of the homes. And there’s also been quite a bit of fraud in states where you can actually, for example, assign your homeowner’s policy to a builder, who then goes knocking on doors and replaces everybody’s roof and charges it off to the homeowner’s company. We’re seeing quite a bit of disruption that’s leading to these rapid price increases, and homeowner’s is becoming a more important line for the industry.

Bigda: Ian, you mentioned bond yields earlier and that’s actually another interesting dynamic to this story, right Matt?

Peron: With the asset side of the ledger, yes. Insurance companies, they take these premiums and they invest them in their general account. And so, obviously, the capital markets are a big influence on their returns. How are they managing navigating through the market?

Manguart: I would characterize higher interest rates as being a material positive for the industry. And I think, at least over the near term, it’s most pronounced at the personal auto, personal home lines players. And that’s because personalized policies are generally no longer than a year, six months in some cases. And as a result, the investment portfolios which are predominantly fixed income or bonds tend to be of shorter duration. As a result, the portfolios turn over more quickly and they’re able to replace their lower-yielding legacy bonds with today’s higher-yielding bonds; so, able to turn over most of their securities portfolio in just a few years in many cases. Which when your book is yielding, say, 2%, is very impactful when reinvestment rates today are north of 5% in some cases.

Bigda: Does that spell relief for policyholders? Will they get a break if the insurance companies could earn more money in the capital markets?

Manguart: There’s certainly some debate around that. Eventually, should these yields hold up, the ROEs at the insurers will ultimately benefit as well. We enter a more competitive market, there is reason to believe that higher interest rates propping up higher levels of profitability allow the companies to accept a lower level of underwriting profitability. But we still have a long way to go to get there.

McDonald: And I agree with Andrew. It depends on the insurance line of business, but if you took an auto insurance company where the losses are realized relatively quickly – so, a short tail line – you might have $3 in premium for every dollar of equity that you hold at the company. So, you can imagine if you had a 4% after-tax yield and three-to-one on premiums-to-equity, you have a 12% after-tax yield before you made any underwriting earnings. And so, the higher yields today are benefiting the companies, for sure.

The U.S. auto market also has a large share of mutual companies. In time, the mutual companies look to rebate the customers. They don’t keep profits. They pay the employees and then look to earn almost a zero return. The higher interest rates will eventually feed back into lower policy costs. The problem with mutuals is they’re losing 20 points of revenue on the underwriting and gaining a little bit on the investment income. So, we’re far away from having the pricing environment to equalize at the moment.

Bigda: What about on a global scale? Are any of these firms looking to grow overseas or outside of the U.S.? And what are the unique challenges there in doing that?

McDonald: For sure, you like a diversified book of business. As I mentioned, how a hard market happens with a shock to the business, you’d love to be diversified and COVID took some of that away from us. And by diversified, I mean by line and by geography.

When you think about the flow of capital or capital mobility, I have in mind this idea of a funnel, so, an upside-down triangle. And then capital comes into the top of the funnel. And it’s easiest to get into the top, and right at the easiest layer would be reinsurance. I’ll exaggerate a little bit, but you can get a few underwriters and a desk in Bermuda, and off you go, you’re writing reinsurance. So, what we usually see is capital entering the insurance industry through reinsurance. We’ll have new companies, CAT bonds, industry loss warrants, lots of ways for the reinsurance industry to recapitalize. And then eventually, that works its way down into standard lines.

If I envisioned that funnel with reinsurance on the top, as I move down, though, we’ll see it gets harder and harder to access standard lines, than small businesses where you need distribution, to specialty lines where there’s limited data and you need a long history and some expertise in order to write that. And then finally, you’re going to end up down in personal lines or personal auto, where you need brand and marketing skill and repair capabilities.

It’s a nice idea to think about, I’d like to diversify by line and geography, but it’s organically harder to do that in practice. It can happen in reinsurance, but it’s a little harder to get into other lines in any reasonable timeline.

Bigda: Speaking of the specific lines, are there any in this current environment that stand out versus others? What would you say right now looks the most attractive?

McDonald: Sure, one interesting feature of this hard market – so, prices rising – is that all lines are not moving together. And that’s different than history where we usually see a high correlation among lines. So, a little something different today. D&O, which is directors and officers – so, insuring public company officers from legal liability – was really hot during COVID years, with the IPOs [initial public offering], and the SPACs [special purpose acquisition company], and new management teams, and new models.

But as you can imagine, that has materially cooled in the last year. Cyber has been slowing meaningfully. Partly this is because it’s really unclear exactly how to write it. What claims are covered? How do you account for the losses? So, cyber has slowed quite meaningfully in the last year or two. And then workers’ compensation is a very highly regulated line, and that has been soft for several years and doesn’t seem to be changing at all near term.

It’s a good environment for stock-picking because we see this dispersion among pricing and firms and lines.

Manguart: One thing I would add to what Ian said, we think a great way to play the hard market is through the insurance brokers, which benefit from premium growth, with the 10% cut that they take, but don’t take on the responsibility of having to worry about the underwriting. And importantly, the relationship between the broker and the client has never been stronger, with more value-add being offered in an environment where companies have to navigate higher pricing and growing complexity of risk as well. We like these companies as high-quality compounders, with wide moats that are defensive in economic downturns, as well.

Peron: Those really fit our investing style in a lot of ways, don’t they?

Manguart: Absolutely.

Bigda: And what areas seem to carry the most risk today?

Manguart: I think one of the big unknowns in the market today is this concept called social inflation, which is brought about by higher levels of litigation. We’re seeing certain specific points of litigation coming forward around asbestos and child molestation that have come back from very old, long-tailed policies that are resulting in very large verdicts. And there’s a significant unknown in terms of how this social inflation dynamic plays out over the course of the next several years. And I think that’s part of the reason that the hard market is being sustained because there is an unknown around some of this.

Peron: Will inflation cause a sort of Goldilocks era here? Because the insurers will benefit first before they pass that through. Will that come through meaningfully?

McDonald: It’s a hard question to answer because, I think as Andrew was speaking to where the risk might hide, insurance is difficult because you have to price a policy today and the cost of goods sold[iv] you find out later on. And I’ll give an extreme example for asbestos, where you wrote something 50 years ago and it’s still bubbling up today. If you priced your policies for a low-inflation world and we end up in a high-inflation world, your back book’s going to be in trouble. And you can reprice today, but you still have to cover the losses that you didn’t cover earlier.

I think the hard part of where the risk lies is in these longer-tailed policies and how you baked in inflation after a really low period of inflation. In a higher period, you might be offside on some of the policies that you had. The longer the duration of the liabilities, the more risk there is to those.

Bigda: I think that’s an interesting point because we’ve transitioned to where inflation’s higher, interest rates are higher, severe weather events are becoming more frequent. There seems to be a lot of changes for the industry. And is that hard to price then for insurance companies going forward?

McDonald: Sure, yes. It’s a little bit of guesswork. And again, pricing policies today, when you find out the cost of goods sold later on – and, of course, management teams seem to underreserve in good times and overreserve in bad times. And so, it exacerbates the industry cycle itself.

And one of the things that we like to think through when investing in insurance securities is when the income statement is looking bad, but the balance sheet is looking better. When you’re increasing reserves, your income statement gets torn apart. And the market typically puts a low P/E [price-to-earnings] ratio on low earnings. But what’s happening when you’re adding to reserves, your balance sheet is strengthening. And we like the part where the balance sheet is strengthening and the multiples are low.

And the opposite would be with good times and you’re releasing reserves and everybody’s happy and they put high multiples on, but the balance sheet is weakening. And so, it’s a little bit of countercyclical investing, just like there’s often countercyclical management.

I made an analogy earlier to the investment industry, but there’s another analogy here in, how do we know who good underwriters are? Because you don’t always know until later on. And just like if you asked, how do we know Janus [Henderson] has investment skill? Well, we look at our track record. And when we look at track records for underwriting prowess, there’s really only a handful of companies that over decades can produce underwriting profits. And so, it’s a relatively small universe of companies that have been profitable, on average, over time. And we pay a lot of attention to those management teams.

Bigda: That’s a nice segue to my last question, which is, if we had to sum it up, what would you say is the most important thing for investors to consider today when they’re looking at the insurance industry? And maybe even more importantly is, what role do these kinds of companies play in a portfolio, in an overall diversified portfolio, for investors?

McDonald: We’ve looked at this a couple of different ways. And one of the ways we look at this, we call it art versus science. And so, the art is underwriting. Are you any good at underwriting? And the only way we can really judge that is having a long track record of underwriting profits.

And the science would be something closer to a short tail line of business, like an auto insurer, where you might have telematics, and brand, and repair facilities, and you have a lot better data and insights into exactly who you’re insuring. And you can imagine this wide dispersion on companies that have a technology advantage.

We prefer science over art, but there’s times when the underwriting cycle is in your favor and we like the art, too. And I think, given where the pricing environment is, we like underwriters here.

And the last piece I’d say, there’s art, there’s science, and then there’s the brokers – the intermediaries, which Andrew mentioned, which can thrive in all different environments. The fun part is if you look at the aggregate industry for P&C [property and casualty] insurance, it’s really, on average over time, is a slow-growth low-ROE business. But if we look at, say, the last 15 years, the top 50 stocks by market cap have basically matched the S&P return over time. But within that, there’s a very wide dispersion. In any given year, there can be a handful of stocks that are up 20% and a handful of stocks that are down 20%. It’s a really interesting feature of insurance where we have slow growth and low ROEs, and yet really wide dispersion, which is a perfect environment for stock-pickers.

Bigda: And what would you say, Andrew?

Manguart: One thing I’d add just specifically to personal lines in terms of searching for differentiation, distribution has just become so key with the players that operate a direct-to-consumer model or have strengthened the independent agent channel continuing to win market share at a very aggressive clip. These channels also support a cost advantage, as they don’t have to support their own agency. And in markets where pricing is on the rise – like we’ve described today across both auto, across home as well – this results in increased consumer shopping activity. Which ultimately drives these consumers into the arms of the direct players that can offer the lowest price because of their cost advantage.

We tend to gravitate to those names, and those companies also tend to have a greater level of growth as well. Whether you’re looking for growth, whether you’re looking for defensive characteristics, there are pockets in the insurance industry to find those.

Bigda: So, shopping around could be good for finding an affordable policy but also, potentially, a good stock for your portfolio. Ian and Andrew, thanks so much for joining us today. We really appreciate your insights.

Next time, we’ll turn our attention to 2024 and speak with the heads of Janus Henderson’s sector research teams for their outlook on the year ahead. We hope you’ll join.

Until then, I’m Carolyn Bigda.

Peron: I’m Matt Peron.

Bigda: You’ve been listening to Research in Action.