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Insuringtheinsurers

Reinsurershelpnormalinsurancecompanieslay-offsomeoftheirmorespecificorcatastrophicrisksinreturnforagoodpercentageofthepremiumsthey’vecollected。

MuchasyouorIwillhaveanexcessonourpoliciessothattheinsuranceonlypaysoutifwehavequiteabig,significantclaim,soourinsurancecompanyhasreinsurancethatpaysoutonlywhentheysufferanextraordinaryhit,liketheWorldTradeCentreterroristattack,orhurricaneKatrina:thereinsurersshouldertheseextraordinaryburdens。

Lastyearwasaverybadyearforhurricanedamageclaims,withhurricanesIvanandJeannebeingonlytheworstoffourmajorFloridastormsthatcaused$23billionininsureddamages,accordingtoInsuranceServicesOfficesInc。

However,Katrinawillhurtthereinsurancemarketevenmore,notonlybecauseithasbeensomuchworse(someunofficialestimatessuggest$50bn-plusofinsuredlosses),butalsobecauseinsurerswillhavepaidonlyasingledeductiblebeforetheirreinsurancekicksin,ratherthanfouraslastyear(iftherearefourhurricanes,theinsurerseffectivelyhavetopayan‘excess’ordeductiblefourtimes;ifthereisonebigone,theypayoneandthereinsurergetshitwiththerest)。

Giventhattheworld’stwolargestreinsurers,MunichRe(MUV2)andSwissReinsurance,havestruggledtorecoverfrom2001’sterroristattacksyoumightthinkthatthisisabettertimetobesellingthesestocksratherthanbuyingthem。

MunichRemadealossin2003andlastyear’sprofitsstillhadn’treturnedtothelevelsoffiveyearsago。

SwissRehasfaredevenworse:itmadelossesinboth2001and2002andhasbeenunabletogetnearthesortofprofitsthatitmadeinthelate1990s。

Acyclicalstory

Ironically,however,extraordinaryclaimsinthereinsurancemarketcanoftenmarkthestartofaperiodofextendedgoodfortuneforthesector。

Forstarters,extraordinaryeventsarejustthat–extraordinary。

Runsofrelativelyquietgoodfortunearebrokenbynasty,big,butlargelyone-off,disasters。

Second,thepremiumsthereinsurancesectorhasbeenaccumulating(andinvesting)inanticipationofalargepayoutarerenegotiatedeachyear,andthelongerit’sbeensinceaclaim,themoretheinsurancecompaniespressforlowerpremiums。

Reinsuranceratesactuallyfell1%inJanuary,forexample,havingrisen4。

5%in2004and11%in2003,inthewakeoftheWorldTradeCentreclaims。

Nowtheoddsarethey’llriseagain。

ReinsuranceratesfornextJanuaryarebeingrenegotiatedthisweek(thedecisionswillbefinalisedinOctober)。

Eventhoughwedon’tknowyethowfartheNewOrleansclaimswillrun,it’sunlikelytheindustrywillmissthechancetostartraisingreinsuranceratesimmediately。

Insurersofoffshoreoilplatformsanddrillingrigsarelikelytodemandpremiumincreasesofmorethan50%afterthestorm,accordingtoTheWallStreetJournal,whocitedCharlesFranks,anunderwriteratLloydsinsurerKilnPlc。

However,it’sunlikelythatpremiumincreaseswillberestrictedtojusttheGulfCoastenergyandpropertymarkets。

Globalreinsurancepremiumincometotalled$176bnin2003。

Withwellover$50bnofcapitalduetoleavethereinsurancesectorduetoKatrinaalone,premiumswillbehiked–withjustification–acrosstheboard。

“There’sastrongpossibilitythatrateswillhardeninotherareasaspeoplemovecapitaltotheopportunitiestheysee,”DaneDouetil,CEOofreinsurerBritInsuranceHoldingsPlc,tellsBloomberg’sJonMenon。

Inotherwords:‘everyone’sinsurancewillcostmorenextyearbecauseofthis’。

Theinvestmentcase

There’sanoldTwoRonniessketchwhereRonnieBarkerplaysaninsurancecompanyexecutiveandRonnieCorbettthe‘littleman’。

“Youdon’tunderstandtheinsuranceindustry,doyou?

”boomsRonnieB。

“Er,no,”repliesRonnieC。

“Youtheinsured,payme,theinsurer,anannualsumcalledapremium,”explainsRonnieB。

“Yes…?

”hazardsRonnieCafterapause。

“No。

That’sit,”beamsRonnieB。

Butinrealitythere’sabitmoretoitthanthat。

First,ofcourse,reinsurersactuallyhavetopayoutoccasional,butverylarge,claims。

Also,allinsurersmatchtheirassets(premiums)totheirlikelyliabilities(claims),butwhatreallymattersishowwelltheymanageandinvesttheirsurplusassets。

Reinsurers,especially,investheavilyinthestockmarket。

ThisiswhytheWorldTradeCentrepayoutsin2002weresuchanenormoushittothereinsurancestocks–theycoincidedwiththeglobalstockmarketcrash。

Occasionalbigpayoutsareaccountedforandstockmarketcrashes…well,theyhappen,too。

Butwhenabigpayoutcoincideswiththetroughofamajorstockmarketslump,thentheindustryishitbyadoublewhammyasitisforcedtodisposeofitsportfoliosatamarketbottom。

ThistimethepayoutwilldoubtlessexceedthatforNewYork。

GroundZerocoveredanareaof16acres。

TheNewOrleanscitydevastationcovers150squaremiles。

However,notonlyisNewOrleansaone-off,butitwillallowpremium-income-to-liabilityratiostosoarand,muchmoreimportantly,stockmarketsacrosstheglobehavebeensurging,soforreinsurerstopayup,shareholdingswon’tthistimehavetobeliquidatedatalossintoabuyers’market。

Meanwhile,thereinsuranceindustrycanlookforwardtoseveralyearsofabove-averagepremiumincomestreamstoinvestintothemarkets。

Thisexplainswhythelong-termhistoryofthesectorshowsitmovesapproximatelyinlinewithmajorstockmarkets,butwithmuchmorevolatility。

ThislastpointisparticularlysignificantrightnowbecausethesectorisstillnotreflectingeithertheincreaseinpremiumratesithasalreadyenjoyedsincetheWorldTradeCentreattacks,northegainsstockshavemadesincetheearly2003lows。

AcloserlookatthechartsofthetwomajorreinsurancestocksshowsjusthowextremethislaghasbecomeandsuggeststhatthecompilersoftheStoxx50indexmayyetcometoruetheirdecisiontoreplaceSwissRe。

Thebluelinesonbothchartsshowtheshareprices,whiletheredlinesshowwhattheaverageanalystexpectstheearningspershare(EPS)tobetwoyearsout。

Thismedium-termviewtakesone-off,extraordinary,claim-relatedlossesoutofthepicture。

Whatitshowsisthatbothcompaniesbecameveryoversoldby2003whentheyhadfallenintotheredandtheirstockmarketgainshadgonenegative。

Whatisextraordinary,however,isthat,sincethen,withpremiumsrising,stockmarketsbooming,andwithplentyoftimeforsentimenttorecover,theirsharepriceshavefailedtobouncebackmoretowards2001levels。

Theconsequenceofthisis,firstly,thattheyarebothlookingincrediblycheap,andsecondly,thatacceleratedpremiumrisesinto2006and2007willonlyservetofurtherexacerbatethis。

SwissorMunich?

AlthoughSwissRe’searningsforthistermwillhavetobereviseddowntoaccountforKatrina,theoutlookthroughto2007,withsignificantlyhikedpremiumrates,shouldbewellabovetheCHF9EPSlevelindicatedonthechart。

Yettoday’ssharepriceofCHF83isn’tevendiscountinganEPSofCHF9,butsomethingclosertoCHF6。

Thep/eratiois9timesfor2006,foranearningsyieldofnearly11%,ornearlysixtimesthemeasly1。

83%yieldyoucangetfromSwissgovernmentten-yearbonds。

Ifanything,thingsappearevenmoreextremeatMunichRe。

Germangovernmentten-yearbondyieldsare3。

12%,andtheMunichReconsensusforwardEPSforecasts(beforepremiumhikes)ise10。

8。

Thatimpliesan11。

7%earningsyield(theinverseofthep/eratio),whichisnearlyfourtimestheyieldfrombonds。

Itwasnotalwaysthisway。

Inthelate1990s,theearningsyieldwasapproximately2%andbondsthenpaidasmuchas5%。

Conclusion

WhatevertheeventualbillfortheNewOrleanscleanup,thereinsurerswillmakesurethatpremiumsincreasetocoverit,andtheinsurancecompanieswillmakesurethattheypassthesehikesontous。

Majordisasterslikethisremindtheinsuranceindustryhowmuchitneedsthereinsurers,andtheverysizeofthecatastrophemeanstheinsurersareunlikelytobegrudgethereinsurerswhateverpremiumhikestheydeemnecessary。

Moreover,withtheworld’smajorreinsurers’stockpricesapparentlyalreadyofferingenormousyieldscomparedtogovernmentbonds,itcanonlybeamatteroftimebeforeinvestorsseethevalueandtherisingpremiumsasanirresistiblelure。

Forinvestors,it’slikegettingtobuyagearedbetontheworld’sstockmarketsandatawhoppingdiscounttoboot。

TakeWarrenBuffett。

HisBerkshireHathawayGroupownstwoofAmerica’slargestreinsurancecompanies,GEICOandGeneralRe,outright–boostingBerkshireprofits。

Sotakeatipfromtheworld’smostsuccessfulinvestor:buysomereinsurancestocksforyourportfolio。

JamesFergusonisaneconomistandstockbrokerwithPaliInternational

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