More than four years after the financial crisis began, investors remain nervous about financial stocks. They’re right to be.
Bank balance sheets, in Europe in particular, already contain more holes than your average Swiss cheese. And as the eurozone debt crisis worsens, values of lenders’ bond holdings are taking a further pounding. That suggests that more big losses are in store.
However, not all financial stocks are in the same boat. In their desire to avoid dodgy banks, investors have sidestepped most insurance stocks too. That’s a mistake, as I’ll explain in a moment.
The good news is that it means you now have a good opportunity to snap up some great value shares – just when things are coming right for part of the sector…
Three reasons why investors have sold off insurers
Why have shares in insurers been driven down along with the banking sector? There are three key reasons.
Firstly, investors are worried that insurers’ balance sheets could contain the same sorts of toxic assets as the banks. Insurers need to invest the premiums they receive to ensure they’ve enough cash to cover claims. The market has been concerned that some of these investments may not be up to scratch.
Secondly, there are regulatory issues. Banks must find enough capital to comply with the Basel II and Basel III solvency rules. Insurers have their own version, called Solvency II. There have been fears that insurers might need to raise more capital to meet these rules. That could lead to more equity being issued and lower share prices.
Thirdly, a spate of natural disasters from Japan to New Zealand has made 2011 just about the most expensive year ever for the insurance industry.
For some stocks in the insurance sector, some of these fears might be justified. But there’s one segment whose fall out of favour looks unfair: non-life insurers.
Not all insurers are the same
Non-life insurers provide most insurance needs apart from life cover. These firms won’t insure you against falling under a bus, but they’ll provide cover for damage to the bus itself.
It can be hard to predict when individual claims may be made. So non-life insurers spread their risks by covering a wide range of possible hazards. And contrary to those fears about their balance sheets, non-life firms only invest in low volatility assets. In fact, non-life insurance is actually a much lower-risk business than widely believed.
And that’s where the opportunities for investors start. We’ve been tipping major UK non-life insurer RSA (LSE: RSA), one of the world’s leading players. It writes business in 130 countries and provides a range of insurance products for over 20m customers. And business is going well, despite the poor economic backdrop.
Insurance premiums from customers were 11% higher in the first nine months of 2011 compared with the same period last year. What’s more, the group is making good money, too. RSA’s profit margins in 2011 have reached their highest level for five years.
The balance sheet also looks very sound. Of the group’s total portfolio, 89% is invested in high-quality bonds and cash. Just 1% is in peripheral eurozone sovereign debt. Further, the stock is now trading below its net asset value (NAV) of 109p per share. That’s the cheapest level for six years. On a p/e ratio of just 7.5 and an 8% yield, RSA looks great value.
Things are looking up for Lloyd’s of London insurers
But it’s not the only bargain in the sector. Another group of insurers offer both top value and tasty yields too.
Lloyd’s of London – not to be confused with Lloyds Banking Group – is the world’s leading specialist insurance market, conducting business in more than 200 countries. Lloyd’s underwriters provide cover for “some of the world’s largest, most individual and complicated risks”, as the market’s website puts it. They also supply ‘reinsurance’ cover to other insurers to enable these to ‘lay-off’ part of the liabilities they’ve taken on.
This may sound a bit scary. But Lloyd’s has been operating for over 300 years. Its underwriters are experts at pricing – ie charging the right premium for – the risks they’re assuming. In all that time, Lloyd’s has never failed to pay a valid claim.
And the trading outlook for reinsurers is turning up too. Last year’s catastrophe losses have scared off some providers of cover. That means there’s less supply than before, while demand for reinsurance has stayed firm. That means the remaining providers can charge more for cover.
As a result, catastrophe insurance rates are now climbing again after years of decline. Increases as high as 75% have been seen in Australia and up to 150% in New Zealand, reports the FT.
What’s more, Europe’s woes are actually good news for the industry. As more cover providers drop out, insurance broker Willis Re has just warned that a prolonged eurozone economic crisis “could trigger a significant rise in reinsurance premiums”, according to The Telegraph.
We’ve previously tipped speciality re-insurer Catlin (LSE: CGL). It’s on a forecast p/e ratio for 2012 of just over seven, while the prospective yield is an inflation-busting 7%. Further, it sells on a discount to net asset value of 18% – in other words you’re buying ÂŁ1 worth of assets for 82p. And Catlin has more cash in the bank than its ÂŁ1.4bn market cap. That’s great value.
If you’re interested in taking a wider bet on the sector, fund manager Polar Capital has been crunching the numbers on reinsurance firms in the US and Bermuda (another key reinsurance hub). Both now stand at around their cheapest levels in 25 years.
Even if stock market investors don’t cotton on to this, other industry buyers are likely to snap up the great value on offer. So share prices in the sector should rise anyway.
Clearly, the sector isn’t risk free. Another horrendous year of natural disasters could cause more jitters. But if you’re interested in taking a nicely contrarian bet, Polar runs the only European fund that invests in the global insurance industry. It deals daily at net asset value: for more details call 020 7227 2700 or contact www.polarcapital.co.uk.
Category: Market updates