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Two men carry a valuable painting
Two mid-cap insurance companies, Hiscox and Beazley, are textbook examples of insurers which embody the Accordion Principle. Hiscox has a unique product offering ranging from private art to kidnap-and-ransom insurance policies. Photo: Bloomberg

As we approach the final stretch of the year, it is becoming increasingly clear that 2017 will go down as a year when Mother Nature unleashed her wrath with full force. After three (Harvey, Irma, Maria) of the top-10 arguably most destructive hurricanes on record, wildfires on several continents and a seemingly never-ending string of devastating earthquakes, 2017 has been one of the costliest years in history for the insurance industry. Total global insured losses are estimated to exceed $100 billion(1). The sheer magnitude of these anticipated claims becomes clear when you compare that figure with the 10-year industry average of $34 billion of insured losses per year(2).

What are the implications for the insurance companies and their shareholders? As the hurricane season finally starts to wind down, we take stock of the industry outlook, company results and our investment strategy for the insurance sector, with two stock-specific examples.

Long-term gain

First, short-term pain should lead to long-term gain. At industry level, losses will probably wipe out earnings for 2017. However, this is a one-time event only and is not indicative of a secular decline that will erode earnings power for the insurers. Quite the contrary, we predict that the structural outlook will now actually improve for 2018 as major damages will boost demand for insurance products and lead to significantly higher rates across many lines. The extensive global media coverage will further raise awareness and push up the fear factor; a psychological response which often underpins insurance purchasing decisions.

Separating the wheat from the chaff

Second, big losses sort winners from losers at a company level. After five years of abnormally low losses from natural catastrophes, some insurers have gradually lowered their guard and underwritten policies with an insufficient margin of safety. They now have outsized claims on their books. On the other hand, the more disciplined insurers have weathered the storm relatively well. While they are not immune to paying claims, their conservative underwriting principles have helped them better protect the capital base. The loss estimates presented in the third quarter 2017 financial reports strongly hint at which camp each insurer will fall in. While company stock valuations began to converge in the absence of losses, we anticipate that market multiples will once again begin to separate the wheat from the chaff.

Long-term investors rewarded

Third, our investment strategy points to material upside for prudent underwriters. These are the insurers who pull back on volume when rates are unappealing and expand policy writing when pricing is attractive. This combination of adapting volume to profitability is what we call the Accordion Principle – shrink when the opportunities are limited and grow when the prospects are bright. Importantly, this exclusive group of insurers (only a handful qualify in our rigorous framework) is now in the enviable position of having ample capital to deploy just as profitability is set to rise substantially. The market often underestimates the true value of this strategic position because the returns take several years rather than months to materialise. The result may therefore not whet the appetite of short-term speculators, but long-term investors are typically well rewarded by the compounding effect of multiple years of attractive pay-offs.

A rare buying opportunity

At SKAGEN, our contrarian instinct constantly urges us to challenge the behaviour of the crowd. While it is often right to go with consensus, fundamental value investors must also have the insight, mandate and boldness to take – and firmly act on – the opposite view if and when appropriate. At the height of the hurricane season, insurance stocks sold off indiscriminately as short-term investors fled the market for fear of the ensuing losses. While others were running for the exit, the SKAGEN Global team went against the flow, seeing the temporary weakness in stock prices as a rare buying opportunity in two undervalued high-quality insurance franchises, namely Hiscox and Beazley*.

The two mid-cap insurance companies Hiscox and Beazley are textbook examples of insurers which embody the Accordion Principle. Over the years, these skilled underwriters – both of which specialise in the non-commoditised segments of the insurance market – have proven to be dynamic long-term capital allocators with deep industry knowledge and high service levels that have earned their customers' loyalty and trust. It is not a coincidence, for instance, that Hiscox has increased book value per share by a compounded annual growth rate of 14% since 2006. In a similar vein, Beazley has achieved an impressive 90% average combined ratio over the past 10 years while steadily expanding top-line (gross written premium) by 5% per year through profitable niches, thereby driving 10% growth per annum in tangible book value per share since 2006.

Niche market expertise

We see these two specialty insurers continuing to capitalise on structural growth in niche market segments while still trading on relatively undemanding valuations. Outside the catastrophe-exposed business lines, Beazley is a market leader in the emerging cyber insurance market. We expect to see booming demand in this market in coming years in response to the proliferation of sophisticated hacker attacks and stricter regulatory requirements. Hiscox has a unique product offering ranging from private art to kidnap-and-ransom insurance policies that cater to high-net-worth individuals and small and medium-sized enterprises (SMEs). With pricing for natural catastrophe protection likely to improve next year, we predict that both companies will take advantage of the favourable conditions and ramp up volume. Assuming that higher volume translates into higher earnings, this underwriting opportunity functions as a vitamin injection in that the higher earnings can be channelled towards increasing volume in the specialty lines. It is essentially the equivalent of turbo-charging the specialty line divisions which in turn should become increasingly profitable as they gain scale.

2008-2017 Share price for Hiscox and Beazley vs. select natural disasters

All set to surprise the market

Hiscox and Beazley are undervalued according to our investment framework. On 2019 multiples, the market currently values Hiscox at 15.4x P/E or 2.1x P/B and Beazley at 14.1x P/E and 2.2x P/B, only slightly above the valuation for the MSCI AC World index. Taking a step back, what do investors get for these multiples? According to our analysis, Hiscox and Beazley can continue to deliver double-digit growth in book value per share for many years with lower-than-average sensitivity to the overall macro environment. Note that our conservative calculations do not assume any pick-up in interest rates from current levels, so rising interest rates would mean more upside. Investors also benefit from a strong alignment of interests with the tenured management teams through well-designed long-term incentive programs. Moreover, the stocks offer 2% dividend yield with an ordinary dividend per share growing annually at a mid-to-high single digit clip with further optionality of special dividends. Finally, we argue that the exceptional market position of these two extraordinary franchises would make them desirable bolt-on acquisition targets for large insurance conglomerates, an often forgotten feature that provides valuable downside protection. In our view, this rare and attractive combination of benefits to investors should command a significant rather than a small premium to the valuation of the MSCI AC World index.

To conclude, the price tags for Hiscox and Beazley appear cheap compared to most alternatives in today's equity markets. As long as the companies stick to the Accordion Principle, we believe they will surprise the market positively, perhaps materially so, over the next 3-5 years. As large and long-term shareholders of both names, that is music to our ears.

 

* At the time of writing, Hiscox accounts for 3.6% and Beazley 3.1% of the SKAGEN Global portfolio. Based on reported holdings in Bloomberg, the fund is among the top-10 owners of both companies.

References:

(1) PROPERTYCASUALTY360.COM. Heft, J. R. et al. "Catastrophe global re/insurance losses will exceed $100 billion in 2017, Fitch says", 27 September 2017. 

(2) Aon Benfield. "Global Catastrophe Recap: First Half of 2017 (PDF)", July 2017. 

IMPORTANT INFORMATION

Except otherwise stated, the source of all portfolio information is SKAGEN AS as at 23 November 2017. Data has been obtained from sources which we deem reliable but whose accuracy is not guaranteed by SKAGEN.

Statements reflect the writer's viewpoint at a given time, and this viewpoint may be changed without notice. This article should not be perceived as an offer or recommendation to buy or sell financial instruments. SKAGEN AS does not assume responsibility for direct or indirect loss or expenses incurred through use or understanding of this article. Employees of SKAGEN AS may be owners of securities issued by companies that are either referred to in this article or are part of a fund's portfolio.

 

 

Historical returns are no guarantee for future returns. Future returns will depend, inter alia, on market developments, the fund manager's skill, the fund's risk profile and management fees. The return may become negative as a result of negative price developments.