Insurance Hard Market

[Viking]

Interesting that Fairfax stock price is down so much YTD; about 10%. Especially when compared to peers, some of which are up significantly (some are up as much as 40% YTD). The relative difference in performance of the stocks is 50% in some cases. What has changed at Fairfax in the past 10 months to warrant such dramatic underperformance (they are the clear outlier)? I can’t think of anything (investment portfolio rebounded from Dec low, underwriting results have been ok, bond portfolio has not seen any big changes). Could it be sentiment? Did a bunch of long term investors decide they had waited long enough and it was time to sell and move on?

 

My guess what is driving most insurance stocks higher is because we are in a hard market (ex workers comp) and prices are moving higher. Fairfax has been taking advantage of the hardening market the past couple of quarters (growing their top line). The hard market may also be in its early innings. There has been lots written about FFH needing to get to a CR of 95 or below to be able to hit its ROE targets. The hard market should help move FFH in that direction over time. The hard market should also be a nice catalyst for Fairfax shares over time.

 

Lots of people would like Fairfax to buy back shares with the stock trading at 0.9xBV. It appears Fairfax is prioritizing growing its business (taking advantage of the hard market). We will get more clarity when they report results in early Nov.

 

Reserving will be a key factor to watch. There is lots of commentary about costs outpacing estimates (for the industry). Fairfax has a pretty good history of reporting reserve releases in its various divisions. Hopefully this continues when they report in Q3. As companies release results we will now start to find out who has been swimming naked (as our friend W. Buffett likes to say).

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A quote from WR Berkley Jr. on their Q3 conference call yesterday (stock is up 40% YTD):

“It is without a doubt a challenging moment for the industry. It is going to be particularly challenging for those that have not been both paying attention and taking action. The combination of low interest rates along with Mother Nature that doesn't seem to want to leave us alone on the cat front, and then really the big nut out there being social inflation, this is a pressurized situation. We think that we will be disproportionately less impacted relative to many of our peers because of the type of business that we operate and our approach to running the business.

 

...We think this shift in the marketplace is not going to be akin to what we saw in 2011. And while no cycle is a mirror image of other cycles, there certainly are some of the fundamentals that are lining up that would suggest that while it may not be like '86, it certainly could be in some ways akin to 2002, 2003. This will undoubtedly create opportunity and benefit for the specialty space and in particular meaningful opportunity for the E&S space, which as you all know is a significant and important part of our business.”

 

https://s22.q4cdn.com/912518152/files/doc_financials/2019/q3/3Q19-Earnings-2019-10-22.pdf

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Another Hard Market Harbinger: U.S. Commercial Lines Prices Up 4% in Q2

https://www.insurancejournal.com/news/national/2019/09/12/539617.htm

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Reinsurers Maintain Upward Pricing Momentum—But Will It Last?

https://www.insurancejournal.com/news/international/2019/10/24/546458.htm

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Brokers expect hard market into 2020 (Canada)

https://www.canadianunderwriter.ca/insurance/brokers-expect-hard-market-into-2020-1004169173/

[Cigarbutt]

The underwriting cycles are all different and it won't be different this time but this last one is shaping up for a rude awakening. In hindsight, 'observers' pinpoint to causes for the turnaround and this time 'social inflation' may be labeled as such but would offer the opinion that it is not such a great variable in the grand scheme of things although it can be a significant contributor in some segments and, recently, social inflation costs have gone up to some degree.

 

If interested, the following may be interesting:

https://www.instituteforlegalreform.com/uploads/sites/1/Tort_costs_paper_FINAL_WEB.pdf

 

Pretty significant but the land of the free hasn't been incompatible with an it's your fault mentality and, in a way, this is nothing new. Once you adjust per capita, for general growth and for inflation, the recent divergence is much less impressive. Much has been said recently in the industry about cost inflation and a car accident where the transfer of energy equivalent to shaking your head while laughing can result in multi-million awards. The Berkley people have recently discussed this topic and have weaved the issue into a larger concern of resentment which makes sense and needs to be watched if larger issues are your thing. In the discussion of recent underwriting results, Mr. Berkley used an analogy which inspired the following table, with assumptions based on historical numbers but yet ending up very subjective. Just see it as a concept.

 

When underwriting results deviate from the initial estimate, which is the essential challenge of the industry, sometimes surprises occur. Which variables are key here?

A-How fast do you adjust reserves and pricing to the new target (there is a large variation in the industry here which is related to the receding tide analogy)

B-How fast do you respond to a rapidly moving target (a variable linked to the initial underwriting decision and related to already built-in contract terms, limits, risk selection etc)

C-How conservatively the reserves are set (for example within the range submitted by internal and outside actuarial valuation)

D-Capital structure and financial flexibility that allow to opportunistically pound the hammer when the hardening occurs

 

On a scale from 0 to 10 (from atrocious to amazing), here's my subjective evaluation based on the historical performance at Fairfax and based on where they stand now:

A-6  B-6  C-9  D-3

 

They have greatly benefitted over time from setting reserves at a very high level and then releasing them but this pattern will be affected by general trends which don't look favorable right now. Also, their capital structure is relatively levered and the float contains a relatively high level of equity (and unconventional) exposure. The present situation with the need to retain capital to grow the underwriting side while the stock price languishes at a discount to book value is a manifestation of that.

 

I agree that the time to find out who has been swimming naked has shortened but it seems that some may be more naked than others.

 

 

[Viking]

On a scale from 0 to 10 (from atrocious to amazing), here's my subjective evaluation based on the historical performance at Fairfax and based on where they stand now:

A-6  B-6  C-9  D-3

 

They have greatly benefitted over time from setting reserves at a very high level and then releasing them but this pattern will be affected by general trends which don't look favorable right now. Also, their capital structure is relatively levered and the float contains a relatively high level of equity (and unconventional) exposure. The present situation with the need to retain capital to grow the underwriting side while the stock price languishes at a discount to book value is a manifestation of that.

 

I agree that the time to find out who has been swimming naked has shortened but it seems that some may be more naked than others.

 

Cigar, thanks for taking the time to share your thoughts and provide a framework of how to look at underwriting (across 4 buckets). I am not an insurance analyst and this helps. Overall, is your assessment that FFH is a little above average when it comes to underwriting (6/10 on average)?

 

You give them a 3/10 on 'D-Capital structure and financial flexibility that allow to opportunistically pound the hammer when the hardening occurs'. Do they not have a fair bit of capital at some of the subs like Odyssey which should let them take advantage of a hardening market? Perhaps they are wanting to continue harvesting more of their equity gains (like ICICI Lombard) to give them a greater ability to write more business should the market continue to harden.

_____________________

Here is what Fairfax had so say on the topic of reserves on their Q2 conference call (Aug 2):

 

Question from Jeffrey Fenwick (Cormark Securities): And just generally, I know Allied was a factor in this, but in terms of reserve development, historically Fairfax -- I know you've taken a conservative approach to underwriting. You've always benefited by, I think, roughly 5 to 8 points a year in terms of favorable development. And that seems to have tapered off for a couple of quarters, not just Allied but Odyssey and maybe the others stand out there. Are we entering a period here where maybe that favorable development starts to taper a bit in aggregate? Or what's your view on that?

 

Answer by Paul Rivett (Fairfax): So I think as an industry, we're starting to see generally maybe redundancies come down a little bit. But within our portfolio of reserves, we continue to be very prudently reserving as we're adding new business. And our reserve redundancies are still going to be relatively strong, and most of those redundancies come out in the third and fourth quarter in any event. So we're feeling good about it. But I think it's a fair question. As an industry, I think it is starting to become a little less redundant, but we still have quite a bit in our portfolio. And everything we're adding, we're being very prudent to make sure that we'll have those redundancies in the future.

[Cigarbutt]

Cigar, thanks for taking the time to share your thoughts and provide a framework of how to look at underwriting (across 4 buckets). I am not an insurance analyst and this helps. Overall, is your assessment that FFH is a little above average when it comes to underwriting (6/10 on average)?

 

You give them a 3/10 on 'D-Capital structure and financial flexibility that allow to opportunistically pound the hammer when the hardening occurs'. Do they not have a fair bit of capital at some of the subs like Odyssey which should let them take advantage of a hardening market? Perhaps they are wanting to continue harvesting more of their equity gains (like ICICI Lombard) to give them a greater ability to write more business should the market continue to harden.

_____________________

Here is what Fairfax had so say on the topic of reserves on their Q2 conference call (Aug 2):

 

Question from Jeffrey Fenwick (Cormark Securities): And just generally, I know Allied was a factor in this, but in terms of reserve development, historically Fairfax -- I know you've taken a conservative approach to underwriting. You've always benefited by, I think, roughly 5 to 8 points a year in terms of favorable development. And that seems to have tapered off for a couple of quarters, not just Allied but Odyssey and maybe the others stand out there. Are we entering a period here where maybe that favorable development starts to taper a bit in aggregate? Or what's your view on that?

 

Answer by Paul Rivett (Fairfax): So I think as an industry, we're starting to see generally maybe redundancies come down a little bit. But within our portfolio of reserves, we continue to be very prudently reserving as we're adding new business. And our reserve redundancies are still going to be relatively strong, and most of those redundancies come out in the third and fourth quarter in any event. So we're feeling good about it. But I think it's a fair question. As an industry, I think it is starting to become a little less redundant, but we still have quite a bit in our portfolio. And everything we're adding, we're being very prudent to make sure that we'll have those redundancies in the future.

Hi Viking,

-----)Aside:

I just finished an article by Mr. Erik Brynjolfsson who reports that Americans spend, on average, 6.3 hours per day on digital media and suggests that this activity (a view I largely disagree with) results in a significant value add which is not captured in official (production and productivity) measurements. I periodically wonder if my inputs add value and appreciate that the last one here may have helped you.

Back to (productive?) work:-----)

 

In the bucket list, D- is not really an underwriting activity but a tool that allows to opportunistically benefit from underwriting leverage (NPW to surplus). D- is typically handled in head office, contrary to the rest which, I would assume, is handled by Mr. Barnard in the Fairfax team. C- includes both a margin of safety which can act as buffer (some use it as a cookie jar to 'manage' earnings) and includes a profit margin (combined ratio objective felt to be necessary to meet specific return on capital hurdles). If you include A-, B- and C-, I would say FFH scores at 7, versus 8 for Travelers and 9 for WRBerkley. The subjective 7 may not sound impressive as such but when put into a longer-term perspective, the improvement of the underwriting culture has been impressive. Do you remember the days of oldco Crum and Forsters? the primary TIG lines? the Ranger business? Ouch!

 

If you look at the last hardening cycles that occurred over the long term, you may want to observe (and analyze) the reserve development cycle. With all cycles, timing is a relative issue, there are cycles within cycles along specific business lines and it is a lagging indicator (who wants to be a laggard?) but I find this aspect of the cycle analysis extremely helpful. I would say an iron law of this specific concept is that a point is always reached when, in the industry at large, it is felt that reserves are still redundant (numbers reported) when, in fact, significant deficiencies have developed but are still unrecognized (the wildness lies in wait). In the Mr. Rivett's quote, solace can be found in the relative aspect of underperformance related to unexpected adverse development which tends to be painful nonetheless.

 

You can look up long-term trends in reserve development but you have to remember that the trend is not static as numbers from previous years are periodically updated every year, sometimes by large and 'unexpected' amounts. A true market hardening is strongly correlated with the realization that reserves that one day you were comfortable with are no longer so, often at a time when the company will realize that its required capital increases at the same time that its surplus decreases. This conundrum is magnified because insurers, during the softening phase, have to balance market share stability versus responsiveness and some (unconsciously?) plan to use cashflow underwriting (write profitable business while adverse development occurs) but this can be tricky. I would submit that this last reserve development cycle has been very unusual in its intensity and duration and, if reversion to the mean is your thing, the industry starting to become a little less redundant could represent an under-statement. The reserve cycle development has definitely been on a downturn (lower redundancies). 2018 revealed a potential slight break in the trend but a material component of the redundancies came from the WC space and the commercial space (which is significant for FFH) likely starts this recognition phase with a larger potential for adverse development.

 

This is all superficial and non specific and look forward to a destruction of the assumptions and analysis and will leave it with a quote which suggests that one does not want to be the dumbest chicken of the bunch, relatively speaking, in the insurance P+C industry:

"The man who has fed the chicken every day throughout its life at last wrings its neck instead, showing that more refined views as to the uniformity of nature would have been useful to the chicken."

- Bertrand Russell, discussing inductive reasoning (1912)

[Cevian]

I just received renewal rates for various insurance coverages out of Lloyds.

 

For 2020-21 period, D&O Insurance Premium up 300%, Commercial Property & Liability Insurance up 50%. No claims history on either. Our brokers told me it's industry wide and no risk appetite at the moment.

 

Anyone else seeing increases?

[scorpioncapital]

If many insurers own government bonds and the Fed promises to hold rates below inflation, the liabilities of these companies certainly don't have this guarantee. I see the risk of your 'run of the mill' insurer that they have escalating liabilities and declining investment income. This is why I see BRk and MKL outperform somewhat, they have far more equity like backup to pay their liabilities. There is also the issue of how fast you can release reserves that become part of your equity base and not depend on your 'credit card'.

[Cigarbutt]

Insurance is a series of cycles influenced by capital markets, underwriting practices and even behavioral aspects.

This hard market is for real and, in many corners and perhaps at large, pricing actions are taking a new direction. It looks like many components of the cycle have correlated to result in one of the most significant soft markets ever. With forward events collaborating, this could become the mother of all hardening.

Some recent 'developments':

-some lines have continued to show poor (to very poor) underwriting results

-price adjustments are also happening in more profitable lines

-many pockets of reserve redundancies have started to reverse

The following is focused on the reinsurance side but is useful to get a sense of where this may go. The second link can lead to the full report using a simple procedure.

https://www.insurancejournal.com/news/international/2020/09/11/582134.htm

https://www.fitchratings.com/research/insurance/global-reinsurance-sector-outlook-remains-negative-for-2021-10-09-2020

[coc]

Insurance is a series of cycles influenced by capital markets, underwriting practices and even behavioral aspects.

This hard market is for real and, in many corners and perhaps at large, pricing actions are taking a new direction. It looks like many components of the cycle have correlated to result in one of the most significant soft markets ever. With forward events collaborating, this could become the mother of all hardening.

Some recent 'developments':

-some lines have continued to show poor (to very poor) underwriting results

-price adjustments are also happening in more profitable lines

-many pockets of reserve redundancies have started to reverse

The following is focused on the reinsurance side but is useful to get a sense of where this may go. The second link can lead to the full report using a simple procedure.

https://www.insurancejournal.com/news/international/2020/09/11/582134.htm

https://www.fitchratings.com/research/insurance/global-reinsurance-sector-outlook-remains-negative-for-2021-10-09-2020

 

Can you explain the procedure?

Thank you.