The Property & Casualty Insurance Pricing Cycle: A Tale of Two Companies

By Austin Hawley, CFA
July 2013

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The commercial property and casualty (P&C) insurance industry is highly cyclical, with substantial capital requirements and uncertain loss costs driving significant swings in pricing and profitability over time. As intrinsic value based investors, we prefer companies with stable profit margins and low capital requirements all else equal. However, the interaction between cyclical industry dynamics and investor emotions can sometimes drive individual company valuations to extremes, providing opportunities for those willing to take a long-term view and dig into company fundamentals. The transition over the past five years to a favorable P&C industry pricing environment has yielded two illustrative cases – one past (Travelers) and one present (AIG) – that highlight our approach to such investment opportunities.

The Travelers Cos, Inc.: Value in Plain Sight (For Those with a Long-Term Investment Horizon)

In late 2008 and early 2009, during the climax of the Financial Crisis, P&C insurance investors were concerned about the potential for permanent losses on investment portfolios and the cumulative effect of four years of negative premium rate adjustments on underwriting margins. Valuations reflected investment uncertainties as well as an extremely pessimistic outlook for long-term returns on equity (ROE). Travelers had a conservative investment portfolio, leading market share among independent agents, and one of the highest normalized ROEs in the industry, yet the company traded between 1.0 and 1.2x operating tangible book value for much of 2008 and 2009. This type of valuation implied an extreme view: a permanent reduction in returns on equity rather than normal cyclical variation.

While we had no specific insight into the timing of an inflection point in P&C pricing, we believed such a change was likely within our five-year investment horizon and a near certainty over longer horizons for companies with return-minded management teams such as Travelers’. Hence we began building a position in Travelers with a view to patiently hold our investment until valuations reflected our view of long-term economics. We had to wait over two years, but beginning in 2011 Travelers helped drive industry premium rates higher, with average rate increases exceeding loss cost inflation by early 2012. Investor expectations rapidly tilted towards higher underwriting margins, and valuation multiples expanded accordingly. Travelers reached our estimate of intrinsic value at the beginning of 2013, and we sold our positions. We continue to see favorable fundamental developments for the P&C industry; however, we no longer believe there is a material disconnect between market valuations and the expected long-term economics of the industry.

American International Group, Inc.: Hidden Value (For Those Willing to Look)

Despite being the largest commercial P&C insurer in the United States, AIG’s valuation has not reflected the increasingly attractive industry fundamentals. This situation can be attributed, at least in part, to AIG’s poor relative results as well as analytical challenges associated with isolating the impact of the P&C segment amongst AIG’s core and non-core operations. We believe the former is a temporary condition that is likely to reverse over the coming years and the latter can be addressed with a little extra time and effort.

As industry pricing improved in 2011, AIG lagged its commercial P&C peers by one to two quarters in implementing price increases that exceeded loss cost inflation, and the company’s operating expenses increased more rapidly than revenue due to investments in technology infrastructure. As a result, AIG’s loss ratios did not improve as quickly as other industry leaders (Travelers, The Chubb Corp.), and elevated expense ratios obscured what improvement there was. However, we believe recent data, and conservative projections of industry pricing, point to a rapid increase in AIG’s ROE over the next several quarters as shown in the chart above. Importantly, this analysis is based solely on our expectations of modest (and decelerating) premium rate increases for the industry and declines in AIG’s elevated level of investment spending. The results shown do not allow for any benefit to AIG from planned re-underwriting of underperforming business lines. Our experience as owners of XL Capital has taught us that the impact of such targeted re-underwriting can have a very positive impact on underwriting margins over a relatively short period of time.

We estimate the implied market value of AIG’s P&C operations has been between 50-75% of operating tangible book value for the last few quarters. To arrive at this estimate, we assume discounted values relative to publicly traded peers for AIG’s other core operations (Life & Retirement, Mortgage Guaranty) and liquidation values for the company’s non-core assets (deferred tax assets, net investments, ILFC). In our view, this is far too low a multiple of tangible book value for a business that is currently earning close to 9% on equity with a visible path towards a 12+% ROE. AIG’s shares appear to be excessively discounted for the risks associated with a turnaround as well as its complex organizational structure. This despite the fact that there is tangible evidence that AIG has closed the pricing gap with P&C peers and expressed a clear intent to reduce non-core assets over time. The path to a simplified corporate structure is not linear, and short-term investors are sure to react negatively to any setback – such as the recent delays to the sale of ILFC – but over the long-term we expect reduced complexity will lead to a heightened investor focus on AIG’s undervalued P&C operations.

The views expressed are those of the research analyst as of July 2013, are subject to change, and may differ from the views of other research analysts, portfolio managers or the firm as a whole. These opinions are not intended to be a forecast of future events, a guarantee of future results, or investment advice.

Originally published July 17, 2013

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