The Valuation Paradox

Jamie Lyons, Vice President, Guy Carpenter & Company LLC

Geoffrey Lubert, Vice President, Guy Carpenter & Company LLC

Scott Jellous, Vice President, Guy Carpenter & Company LLC

Both the insurance and reinsurance acquisition environment, globally and in Canada, is beginning to show signs of renewed life after a period of relative dormancy. We witnessed the marriage of Paris Re and Partner Re last year, forming a global reinsurance heavyweight with equity of more than US$7.5 billion. Max Re and Harbor Point become Alterra in Spring 2010. Brit Insurance announced a deal with private equity investment firm Apollo Management in the early fall of 2010. And closer to home, in October 2010, RSA Canada announced an acquisition agreement with GCAN Insurance Company, which is expected to form the country’s fourth-largest general insurer with pro forma gross written premiums in 2009 of approximately Cdn$2.2 billion. Recently the Beazley unit of Lloyds Banking Group unit reported it is still interested in acquiring Hardy Underwriting.

So, is this a sign of things to come? Should we brace ourselves for a wave of consolidation? These questions have been the topic of speculation and lunchtime banter for several years now; they have been discussed and written about ad nauseam. We’ll stop short of trying to be another prophetic voice in the crowd.

VALUATIONS AND ‘STRONG BUY’ RECOMMENDATIONS

We can factually say companies in the global reinsurance sector are trading at or near long-term low valuations. (We focus here on the global reinsurance sector because of its influence on the reinsurance landscape in Canada.) So why are “strong buy” recommendations not more common? The answer may lie in the fact that, generally, analysts and investors are concerned about three important obstacles to returns on equity: softening reinsurance pricing, low investment yields and masses of under-used capital.

There is a belief that, barring any major global capital-depleting event, the softening reinsurance pricing trend will continue in Canada and in major markets around the world. Lower pricing of varying degrees has been seen in the most recent reinsurance renewals. This creates several areas of downward earnings pressure, both now and in the longer term. For carriers exposed to particularly soft prices, top line premium growth could slow or decrease. Worse, if companies are too aggressive in a softening market today, “adverse reserve development” (the great destroyer of reinsurance capital) may soon rear its ugly head. Savvy investors remember the events of the last soft cycle, including significant reserve strengthening, particularly on longer-tail lines. This has caused them to be nervous when it comes to owning reinsurers’ shares.

If the soft cycle by itself is insufficient to ward off investors, another force to be considered is investment grade bond yields. In many regions, these bonds trade at or near 40-to 50-year lows. Alongside the heavy focus on underwriting in the reinsurance sector comes the danger of forgetting that well over half of carriers’ earnings are supplied by investment income over the cycle. When fixed income securities yields are low, this crucial income stream diminishes. This scenario has existed in varying degrees since the depths of the financial crisis and shows few signs of abating.

Finally, to the surprise of many after the financial crises, an abundance of capital now exists in both the primary and the reinsurance sectors, at least in simple accounting terms. It must be remembered that in the reinsurance sector, true capital balances can be highly educated guesses. Guy Carpenter estimated the sector was over-capitalized by as much as US$20 billion, or 12%, at the beginning of 2010. Although overcapitalization fell back to around 8% by the end of June, the surplus capital among reinsurers remained the driving factor at the 2010 renewals.

It is worth noting a significant part of the four-percentage-point change is voluntary capital exodus — such as share buy-backs and dividend payments — as opposed to simply underwriting losses. These large capital positions make book values per share look larger, which in turn deflate price-to-book ratios. Yet one must ask: if reserve strengthening is anticipated by investors, are price-to-book ratios really so low?

Plotting Valuations

Figure 1 (please see Page 22) plots reinsurer valuations, as measured by price-to-book, against consensus 2011 estimates for return on equity (ROE).There is a clear correlation between estimates of ROE and valuation, as is normally the case. An area of particular interest appears in the lower left quartile of the chart. Why are these companies’ “forward” ROEs so low? Is it fear of overly aggressive growth followed by reserve strengthening? Is it heavy exposure to low yielding assets? Is it unusually high catastrophe exposure? The answer to these questions may reveal why these companies exhibit particularly low valuations.

The upper right hand quartile of the chart also warrants study. Why, in a softening market, do these favoured few trade at such a premium? Is it their unique underwriting acumen? Is it superior risk protection or careful and well-advised capital allocation?

The dots on this chart will likely move around over the next year as analysts and investors are proved right or wrong. Capital positions will change pursuant to retained earnings growth and impairments. Many argue returning capital to shareholders is key to remaining or arriving in the upper right hand quartile. We think this may be overly simplistic. The real challenge lies in making efficient use of excess capital and, for most companies, executing business moves that add value without navely deploying capacity. The leaders and innovators of our industry, in Canada and globally, will be those who can optimize capital and deliver long-term earnings power.

This brings us back to the topic of acquisitions, consolidation and the future make-up of our industry. We don’t know who will be the next reinsurer or reinsurance buyer to make mergers and acquisitions news, and we don’t know where they might “plot” on the aforementioned chart. We do know the current steady state may not be so steady. As of 2010 Q3, the prevailing conditions suggest a ripe domestic and global environment for corporate activity over the next several years, at least in the absence of a market-changing event.

So what’s the best way to approach this environment? In honour of the start of hockey season, we offer these words from Canadian icon Wayne Gretzky: “A good hockey player plays where the puck is. A great hockey player plays where the puck is going to be.” Perhaps it’s easier just to have a superior capital strategy, stellar risk management and lots of good sound bites to chew on.

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There is a belief that, barring any major global capital-depleting event, the softening reinsurance pricing trend will continue in Canada and in major markets around the world.

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To the surprise of many after the financial crisis, an abundance of capital now exists in both the primary and reinsurance sectors, at least in simple accounting terms. Guy Carpenter estimated the sector was over-capitalized by as much as US$20 billion, or 12%, at the beginning of 2010.