Snap up these 'non-life' insurance bargains
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David Stevenson Sep 18, 2009
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News from the insurance sector is rarely thrilling. The latest big story – yet more regulation – seems no exception. But while higher risk 'life' stocks have shrugged it off, soaring in the "dash for trash" market rally, less risky 'non-lifes' have been left well behind. And that's giving investors a good chance to snap up some decent high-yielders on the cheap.
'Non-life' insurance does what it says on the tin: it's insurance for all types of risks bar death. A non-life insurer makes profits when its expenses (the cost of settling claims, plus administrative expenses) are lower than the total premiums it receives. Divide the former by the latter and you get the 'combined ratio'. But even if this ratio is above 100% (ie, the firm is spending more than it gets in premiums) it can still make an overall profit if its net investment income makes up for losses on its underwriting. Investment income is the money the insurer makes on the cash it has accumulated from prior-year premiums, after unsettled claims – which can take years to agree – have been 'provided for' in the accounts.
Meanwhile, the level of risk that insurers can take on is restricted by the amount of capital they have to set aside to satisfy regulators. So companies will often 'lay off' some of their insured risk with a 're-insurer', such as Lloyd's of London. This is particularly common for high-risk catastrophe cover sold to protect clients against hurricanes and the like.
But life for insurers is set to get tougher, says The Independent's Simon Evans. "Where the banks had to grapple with Basel II [which dictated banks' capital levels], insurer gets the snappily titled Solvency II directive." This EU edict is set to go into force in 2012, and in effect means insurers will have to hold more money in reserve than they do now.
That sounds sensible enough, given the financial crisis, but the new rules also contain risks. "UK insurers fear they'll be forced to tap investors for more than £50bn in fresh equity" as a result of the new rules, which they say will also "lead to a dramatic increase in premium rates", says the FT's Paul Davies. Because firms will have to keep more capital on their books, more money – at least at first – will be chasing the same business, so "investment returns will also fall", reckons the Association of British Insurers. Eventually competition will suffer as firms are forced out of the market. "Prices will rise, cover will reduce and innovation will drop."
But it's not all doom and gloom. "We doubt Solvency II will be implemented as currently envisaged," says Marcus Barnard at Oriel Securities. "Even if it is, we doubt the impact will require £50bn" of extra capital. Further, as non-life firms tend to hold liquid, low-risk assets, the directive will impact them less than life companies. And at their latest annual shindig in Monte Carlo, the world's re-insurers were surprisingly upbeat. "Renewal rates (next year) are likely to be flat to small 'down' overall," say Vinit Malhotra and Michael Huttner of JP Morgan. "Re-insurers are profitable, margins are good, and capital is being rebuilt." Hardly Armageddon. Yet fears over capital raising mean many have missed out on the rally, so you can buy decent stocks cheap – as we show below.
The best bet in the sector
If you were actually at London's Brit Oval, to witness England's summer Ashes cricket triumph, you may have missed the significance of the ground's name in all the excitement. Yet not only does re-insurer Brit Insurance (LSE: BRE) sponsor the south London venue, it will also become main sponsor to the England team for four years from 2010. But that's not the main reason we're tipping this stock right now.
We like it because, on a p/e of below ten times current year earnings, which City analysts see dropping to 5.5 times 2010 net profits, it's cheap as chips.
Of course, with "volatility and uncertainty in claims and therefore earnings, individual years can be less relevant" than in other sectors, says Steve Scott on Motley Fool. So "instead of p/e ratios, the market focuses more on net asset value (NAV) and dividend yield, and views insurance companies more like investment trusts".
But Brit scores well here too. At 203p, with a market cap of £640m, it's currently selling on a 14% discount to NAV. The 2009 yield is a chunky 7.5%, forecast to climb to 7.9% next year. Having started 2009 at 220p, the stock has underperformed the FTSE All-Share by 25% year-to-date. Ben Cohen of Collins Stewart has a target price of 230p.
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