Reinsurance in the age of AI, part 1

Reinsurance as an industry plays a key role to make society more resilient. As the risk universe increases, we can only hope that its role is going to augment too.

That will require more capital and a different view from investors on the capacity of the industry to deliver consistent, strong results.

Current valuations not far from historical average levels

Since the beginning of the year, among the largest European reinsurers (who, combined, write approximately 50% of worldwide premiums), only Munich Re and Hannover Re have seen their stock value increase. Hannover Re was the only one to outperform its local market, which increased by 13% since the beginning of the year:

A good, albeit rough proxy for how much investors favor a stock in the reinsurance world is the price-to-book ratio (P/B), which expresses the premium or discount at which the Stock trades compared to the Book Value per Share, or BVPS, which is the ratio of equity available to common shareholders divided by the number of outstanding shares. (purists please forgive me as you will probably scream and ask for tangible book values, but that gets too complex to explain and the direction is not too different!)

As a simple example to explain price-to-book ratio, suppose you created a business and decided that it would only have 10 outstanding shares; if today the Equity (or Net Worth) in your business is worth 500, then the Book Value per Share is 500/10 = 50.

If, hypothetically, those 10 shares were publicly traded and valued today at 60 per share, then they would trade at a premium, as 60/50 is greater than 1 (we could also say that they trade at a 20% premium, which is 60/50-1). Likewise, if the ratio between the Stock Price and the BVPS is below 1 then it’s said that the stock trades at a discount.

To simplify, if a stock trades at a premium, it can be interpreted as investors (or the financial markets if you prefer) having positive views about the utilization of the resources of the company. The higher the expectations, the higher the premium.

Going back to our European Reinsurers, as of October 20th, investors' views are quite wide, ranging from a 69% premium to a 28% discount (in terms of price-to-book ratio). Having been in the industry for many years, wearing different hats, I observe that the range of these valuations is a little wider than usual, but overall, not so far from the mean (sadly not much above 1).

In fact, as of today, the 4 European Reinsurers, on an aggregate basis, are trading at around 15% premium, which seems very much in line with the average (you can draw an imaginary line) over the last few years (see below, source AON).

The valuation of a stock is all about expectations and without making it too complicated, expectations usually contain elements of past performance + a forecast of future performance, typically projecting cash-flows for few years out and then assigning a residual value to the “infinite” performance of the business beyond those few years.

Past performance, however, is one of the issues of the industry, which has been lackluster over recent years. I let you draw another imaginary line to see the average return for the industry here, but to my eyes it looks in the 6-8% range (source, AON):

That it’s not too bad, unless you start considering that over recent years, the funding of these businesses has been more expensive than the returns it generated, thus effectively destroying value. You can clearly see it in the below chart from S&P Global Ratings, showing Reinsurers' Cost of Capital (light blue) compared to the Return obtained with such capital (dark blue). Of course, the low-interest rates environment, COVID 19 and natural catastrophes losses have played a significant role, but the fact remains that the industry has underperformed during the last few years.

However, current stock levels are only partially driven by history; for the most significant part they are linked to future expectations.

Tech-driven valuations

In this respect, what is becoming clear, across many industries, not only (re)insurance, is that younger companies often benefit from higher valuations because their main advantage is a digital operating model which does not decrease in efficiency as it grows and thus more scalable than a traditional organisation.

To put things in perspective, some of the newly established Insurance companies (Lemonade, Clover to name a couple), trade today at a premium of 270% and 940% respectively, so that gives an indication of where the money is going these days.

And as the below chart from FT Partners Research shows, in the first half of 2021 alone, more money went into Insurtech than in the full years of 2019 and 2020. North America still taking the lion's share (59%), but Europe also with a substantial position (31%). Most money flowing into P&C (52%) and Health (20%), due I believe to the more scalable nature of the business.

Some of you may rightly point out that Reinsurance is not the same of Insurance.

That’s a fair point, but what I will emphasize in the next article is the underlying nature of the premium commanded by these young companies and how I believe can be brought into the reinsurance world.

That will need to take a step back, re-thinking the value of the firm by its two main ideas: the business model (which is the strategy of the firm in terms of how it promises to create and capture value) and the operating model, which covers the systems, processes and capabilities that enable the delivery of (re)insurance services.