Stock Insurers: Setting the Pace

After several years of poor returns and disappointing stock market performance for publicly traded insurance related companies, is it finally time for lift off?

Recent activity on the U.S. exchanges would indicate that the answer could be “yes”. Recent high profile initial public offerings (IPOs) have shown a willingness amongst investors to funnel money back into insurance stocks.

In mid-July, The Phoenix Companies Inc., Willis Group Holdings (the world’s third largest brokerage) and Odyssey Re have all staged successful IPOs, raising above average capital. Their success follows the successful demutualization of several life insurers, including Canada’s Sun Life Financial Services.

Speculation has attributed the interest to the exodus of investors from the high-tech sector and the visible hardening of the U.S. p&c market. In fact, a recent survey of risk managers by Prudential Securities leads analyst Alice Cornish to conclude that U.S. p&c insurance is one of the few sectors with pricing power, and she assigns a “market outperform” rating to the sector.

Optimism south of the border has led Canadian insurer Kingsway to opt for an offering on the New York Stock Exchange, as well as additional shares offered on the Toronto Stock Exchange. The offering of 10 million shares is expected to raise about Cdn$150 million in new capital, says Kingsway president and CEO Bill Star.

Star recently told brokers, “Investors are now more interested in p&c companies again, as they were a few years ago…we see it [the market] opening up this year”.

Renewed interest

Is this renewed interest in U.S. companies sustainable, and will it translate to Canada? Certainly the results of the past few years have not been promising in either country. At the recent Property and Casualty Super Summit in Toronto, Marsh Canada managing director Steve Mallory noted that in terms of stock market performance, the p&c industry is “not healthy”. The poor results on insurers’ balance sheets, weak returns on equity and climbing combined ratios, have not gone unnoticed by investors. “The stock market is looking at us with somewhat a jaundiced eye.” The recent downfall of U.S. insurer Reliance, and Canada’s Queensway Financial Holdings were clearly indications of a seriously troubled marketplace.

Quentin Broad, financial services analyst with CIBC World Markets, says there is no question Canadian p&c insurers have had a rough ride. “Our guys have under-performed.” Kingsway is one notable exception, as are broker networks Hub and Hi-Alta. But more typical performance can be seen in the results of companies like Fairfax and Goran Capital (see charts).

Even Hi-Alta president and CEO Scott Tannas, whose company is among few to hold or increase its share value during the past few years of industry strife, says that insurance is a hard sell with investors. “The insurance industry isn’t a sector investors are dying to get into.”

But Tannas sees the tide turning. One reason is the poor performance of tech stocks, forcing investors to return to more traditional sectors such as insurance. “Stable, value-oriented companies are becoming increasingly in favor with investors.”

“It looks like people in the market are reacting to the stabilization, going back to what they would perceive to be more stable investments,” agrees Kirk James, vice president, secretary and general counsel for Hub International. The attractiveness of insurance stocks is certainly related to the fact that “they are stable relative to others in high tech or more speculative industries”.

Price is right

But the biggest factor contributing to renewed interest in insurance-related stocks, analysts and the industry agree, is the hardening of insurance rates. Investors are watching how insurers tackle their dismal results, which most agree are mainly the result of inadequate pricing. “When you’re at single digit returns on equity, of around 4%-6%, it’s not very attractive to investors,” Broad states. He sees across-the-board rate increases of between 10% and 40%, plus the tightening of policy terms and conditions. This, he predicts, will be the key to a turnaround in insurance stock performance.

“In general, the p&c market is certainly seeing a lot better times now than it has seen, even a couple of years ago,” observes Mike Morden, equity research associate with Scotia Capital. “Really, it’s pricing that’s doing that.”

Combined ratios in the range of 108-110% for primary insurers can not be buffeted by the traditional escape route – insurer investment portfolios. “They [insurers] are not going to see the heady days of the 1990s” when stock market returns could salvage company results, Morden says. “If these companies want to make a profit, they’re going to have to do it the old fashioned way.”

One tale of the ticker that illustrates this point is a comparison of two leading Canadian companies, Fairfax and Kingsway. The pricing environment has taken its toll on Fairfax, chairman and CEO Prem Watsa admits to shareholders in his report on the company’s 2000 results. Return on equity stood at 4.1%, versus 11.4% for the TSE300, and earnings per share increased only 2% for the year to $9.41. “From a net income and return point of view, there is no question that 1999 and 2000 were the worst years we have had in our 15 year history,” Watsa says, noting that the company’s stock price sold below book value for 15 months straight. “For most of 2000, Fairfax was worth more dead than alive and, given our results, it was easy to see why.”

That said, Watsa observes that the company hopes to weather “the longest and toughest down cycle in the history of the property and casualty business”.

Kingsway, conversely, has long touted the virtues of adequate pricing. For 2000, Kinsgway’s ROE was 10.7%, well above North American industry averages of the 5%-6% range. The company’s combined ratio was 101%, versus industry averages in the 108-110% range.

Star notes that importance is being placed on these kind of results, particularly on the combined ratio. “We’ve talked to analysts and fund managers and that’s really something they focus on.” The results are also being watched carefully by investors. “They like to see profit from the insurance business itself [rather than from investment income],” Star observes.

Broad notes that improved pricing will be a needed boost for insurer stocks. And, Tannas explains, the positive effects will spill over into the broker networks. “We see evidence of improved pricing, which will be reflected in our source of revenue, variable commissions.”

Show me the money

How soon will this pricing turn show its effects on stock value? Broad suggests that the effects are already being felt, at least in the U.S. Investors “sniffed the pricing turn”, as evidenced by the performance of large public companies like Allstate and Progressive. “People are playing the expectation. They’re saying, ‘we want to be on the train before it leaves the station’.”

While Broad admits that the Canadian market is lagging behind the U.S. in terms of price correction, he believes “we’re reasonably hot on their heels”. And given that many Canadian companies have significant properties in the U.S., he thinks there will be crossover impact from market returns there. “Most of these companies have got the business in the U.S., so that translation shouldn’t take long.”

Others are more skeptical of the speed at which insurance stocks should expect to climb back. “Valuations reflect results rather than potential,” Tannas observes. He feels insurers will need to prove themselves with results before they will see significant stock price increases. “I’m not sure there will be a lot of money invested in advance of the actual results.”

Morden agrees, on the basis that the p&c industry tends to be more volatile than the life insurance side, and because of its past poor performance, the industry will still have to prove itself to investors. “It will be a ‘show me the money’ sort of process.”

A speedy recovery?

Are investors looking for a “quick hit”, or are they willing to weather t he industry’s cycles? “It’s no secret that most of them are looking for growth equity as opposed to ongoing income in the form of a dividend,” James says. While Hub does pay a dividend, he says the company’s strategy is built around long-term equity growth that should translate into market value. One factor which allows for this, in the case of Hub and many other Canadian companies, is that it is closely held, with very little publicly held stock. Many of the company’s acquisitions have been cash and stock deals, with management making a commitment to hold those shares in escrow for a given period of time. “As those shares are released, you will see volume grow.”

“The better investors are the larger funds that are long-term shareholders,” says Star. Although Kingway’s shares are fairly liquid, he notes that it is held to a great extent by company employees, a trend that should increase with the NYSE offering given that 60% of the company’s staff is south of the border. Nonetheless, he notes, there are a great number of smaller, more agile investors looking for a quick profit, perhaps 5%.

Tannas says that the public offerings Hi-Alta has made have been strategic, beginning with its first rounds in 1996. Liquidity is one reason for going public, he stresses. “There are many sources of capital that require a company’s shares to be public. They want to see liquidity of the investment.” The regulations and accountability that apply to public companies are also a contributing factor making the public offering more attractive than other means of raising capital, he adds.

Land of opportunity

Acquisition strategy is critical to public company success. After all, much of the purpose of stock offerings is to raise capital for acquisition. The question is, how best to spend that capital.

Canadian companies have taken a variety of approaches, such as Hi-Alta’s decision to focus solely on small town brokerages in Western Canada, versus Hub’s expansion across North America. Hi-Alta has sought diversity through its product offerings, trying to provide “one-stop” financial services shopping to its small town clientele, while Hub is seeking both geographic and product diversity.

Hi-Alta’s star appears to be on the rise, having been listed among Canada’s “Profit 100” fastest growing companies in 2000, with five-year revenue growth of 2,724%. And while earnings per share were in the negative in 2000, they have shown signs of turning around early in 2001. Tannas says the company will continue to expand, with plans of growing by one-third, to 50 locations.

Not only has Hub moved into the life market through its nine managing general agencies (MGAs), but it has also made significant inroads into the U.S., recently adding three more U.S. brokerages to its stable. The results have been satisfying, with the company’s total revenue rising to $150 million in 2000 (up from $85 million in 1999) and earnings per share rising 51% year over year, to $ 0.53 in 2000.

James notes that the U.S. is ripe for expansion in the broker market, with new legislation allowing banks to buy brokerages. Brokerage owners have been growing their businesses in anticipation of this new environment, making them ripe for acquisition. Primary insurers have also made the U.S. a major stomping ground, including Kingsway, which has just inked deals to expand its operations into several more states and is looking at opportunities in Hawaii and New York. Star notes that the company’s strategy in terms of acquisition has been to “leave the companies alone, we don’t merge them”.

Kingsway favors companies with strong balance sheets, and looks for acquisitions that complement the company’s lines of business, which are largely in non-standard auto and trucking. The focus is instead on building loyal relationships with brokers through impressive incentive programs and investments in broker technology.

In fact, after several intense years, Star says the recent offering was not part of a new acquisition drive. “That money has already been earmarked,” he notes, and will go to supporting the company’s recent massive growth. While the company did $134 million in business in the first quarter of 2000, this jumped to $216 million in 2001. At this pace, the company could be looking at $860 million in business for the year. And, while Kingsway has concentrated on companies that have solid grounding, Fairfax has picked up struggling operations with the intention of turning operations around, such as U.S. insurers Crum & Forster and TIG. “Many observers believe because we purchased these companies at discounts to book value that they were ‘damaged goods’ or have some unfixable problems. On the other hand, they believe that paying multiples of book value for a company indicates that the company has a solid franchise. Our experience is just the opposite,” observes Watsa.

While the holding company’s overall combined ratio stands at 116.3%, he declares, “we do not plan to make any significant acquisition until our group combined ratio drops to 105% and is clearly headed lower.” And, though he admits he was too optimistic about the prospect of turning the companies quickly given the soft market, he does expect that the turnaround will come. “We have stressed many times over the years…we will accept short term volatility in our earnings for better long term results.”