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Industry Analysis: Reinsurance
The broader domestic insurance industry is comprised of primary and secondary insurance companies. Primary insurers are the companies that an individual would employ to cover their life, car, house, etc. Secondary insurers, or reinsurers, are employed by primary insurance companies to establish a cap on how much claims exposure they will have in any single catastrophic event. Much like a primary insurance company, the reinsurer is paid a premium, or fee, for their willingness to take on this risk. The reinsurance company invests these premiums with the aim of gaining a solid return. In relatively calm years, secondary insurance companies will be paid premiums for their assumption of risk, and earn a favorable profit from their investments. A portion of these funds is placed in liquid assets, to be used in years when losses mount. The Reinsurance Industry typically insures Property and Casualty (P&C) companies against various natural disasters, such as, hurricanes, floods, wildfires and other events. They may also insure Life and Health (L&H) companies.
Changes With the Wind
This industry is cyclical in nature, loosely following the vagaries of the North Atlantic hurricane season, which can affect a substantial number of policies. The renewal season for many policies, and the writing of new ones, usually occurs near the end of the calendar year. Most catastrophe losses occur during the hurricane season, from June 1st to November 30th. Many reinsurers are expanding globally in an effort to gain market share and diversify risk. Any year with a large amount of losses will typically result in drastically reduced earnings and a decline in share prices. However, high losses in one year can actually benefit future operations. If the Reinsurance Industry experiences several years of calm weather, new entrants emerge, increasing competition and eroding policy pricing. Sometimes, in an effort to protect market share, reinsurers will ease underwriting standards. This is a risky strategy, as lower standards result in under-priced policies, from a risk/reward standpoint. Once a severe hurricane makes landfall, mounting catastrophe claims can deplete earnings very quickly, and in some cases, put smaller inexperienced companies out of business. Such a market shakeout gives way to increased bargaining power and opportunity for expansion for the surviving companies, when they write new policies and renewals. A harsh weather season may depress the stock valuations of favorably positioned companies, presenting an attractive entry point to investors.
Atlantic Multidecadel Oscillation
The majority of risk involved in the reinsurance process is related to natural disasters. First World industrialized nations have the most to lose in a natural disaster. The frequency and severity of natural disasters (e.g., windstorms) are dependant on long-term climate fluctuations. The Atlantic Multidecadel Oscillation (AMO) is a series of longduration changes in the North Atlantic Ocean over a cycle lasting 50-70 years. Successive cool and warm phases last for 20-40 years. Far fewer hurricanes occur during an AMO cooling phase than during a warming one. The last cooling phase ended around 1970, and the most recent warming phase began in 1995, which has resulted in more frequent and destructive hurricanes. Global warming has played a role in increased sea surface temperatures and severe weather, as well. The AMO is a good starting point in gauging the possible severity of an upcoming wind season. Too, Colorado State University gives hurricane forecasts throughout the year. These sources provide investors a barometer of the potential profitability of reinsurers.
Cash is generated through the writing of insurance policies, listed as Premiums on reinsurers financial statements. After adjusting for payouts related to claims, reinsurers are left with what is called Premiums Earned. Premiums Earned takes the place of Sales or Revenues on a typical Value Line page. A key measure of success is the combined ratio. This ratio is the sum of the Loss to Premiums Earned and Expense to Premiums Written percentages. A combined ratio of 100% for a specified period equates to break even. When the ratio is below 100%, it indicates that a profit was earned; anything above that level reveals a loss. This figure can swing widely over the course of a year, moving in unison with weather patterns. Rather than specifying net profit margin, the Value Line page provides the Underwriting Margin as a measure of profitability. It is the difference of 100% and the combined ratio. Also on the Value Line page, investors will find two measures of income per share, Investment Income and Underwriting Income. Investment Income is the dividends, interest and rents on investments, net of related expenses. Underwriting Income is essentially an insurer’s miscellaneous income. (Note: When a reinsurance company is involved in both the P&C and L&H segments, we present P&C results, usually the largest portion of business, on our page.)
The stocks in this industry typically have low relative price/earnings multiples, beta coefficients below 1.00, and high Price Stability ratings. Thus, they offer a fair degree of downside protection, with dividends, to an investment portfolio. Short-term traders can try to play cyclical weather patterns (the hurricane season) to their advantage. Most investors should consider companies with proven operating track records, prudent underwriting policies, the ability to weather difficult times, and success in tapping new business.