Reinsurance optimism – seeing an opportunity in every difficulty

“If a business does well, the stock eventually follows”

That’s a pretty good maxim from a guy who knows one or two things about picking stocks - Warren Buffett.

Clearly, the sense of doing well in this context is profitability, not necessarily the role that a business brings to society. Otherwise, many reinsurance companies’ stocks would command much higher valuations rather than being depressed with low multiples.

As I have been working in (re)insurance for more than 20 years, I am proud of the role the industry plays at times of natural or man-made losses, to alleviate the suffering of societies.

For those less aware of what (re)insurance does, it provides financial support when disasters struck but is also a key innovator for products which allow mankind to explore further opportunities or cover health risks previously uninsurable (e.g. cancer survivor products).

As an example of its role in these dramatic times, publicly reported COVID-19 pandemic-related estimated losses (awful term given the positive relief it brings), from insurers and reinsurers now stands at just shy of $38 billion - according to data compiled by Zurich-based financial services advisory, PeriStrat LLC, as of 6 April 2021.

Although the pandemic's protection gap (the difference between the amount of insurance that is economically beneficial and the amount of coverage actually purchased) had not previously been recognized, other protection gaps have been raising concerns for some time. As the growing wealth of the rising middle class has outpaced insurance penetration, it has created protection gaps in life, health, cyber, and natural catastrophe insurance.

The latter remains a key and growing element of the (re)insurance industry support to society, as the below chart from Swiss Re demonstrates.

In spite of the above, there will always be some cases providing ammunitions to cynics about the role which (re)insurance brings to society, but the fact remains that it’s an industry which has brought resilience and opportunities to both individuals and companies.

Industry profitability can improve

I have been lucky to work with inspirational people who are truly driven by the need to provide tangible solutions to real problems, be them on the Life & Health side (physical and mental suffering), in relation to assets protection, or the underlying operational and communication aspects related to maximizing the positive impact which (re)insurance brings to the wider society.

Like many in the industry, I am passionate about transformation which creates value, so when Hannover Re recently put out a chart with ROE performance over the last 5 years (see below), it was a sorry picture for the industry as it showed many of the largest reinsurance companies average ROEs hovering in the mid-single digit during the same period.

According to Hannover Re data, the average ROE among these Top 10 players averaged 6.8% over the past 5 years, with 3 years out of 5 marred by weak average results (2017: 5.4%, 2018: 5.1%, 2020: 4.4%).

Is poor performance a lagging indicator of strategy or “bad luck” due to exceptionally adverse events? Are the low returns of 2017, 2019 and 2020 just bad luck or an indication of strategic element(s) gone AWOL?

Perspectives and perceptions matter: in Reinsurance, we tend to “normalise” very adverse results. As an Inter Milan supporter I wish I could feel good about “normalizing” their results of the last 10 years.

They are likely (I am crossing every finger I possibly can) to win the Serie A football league this year, but if that happens it will not be a question of luck, rather of focused strategic planning - and execution.

Strategic considerations among the largest reinsurers

What differentiators are there at play? What distinguish the best and worst performers?

I believe it’s worth looking at this issue both numerically and qualitatively.

Quantitively, there are interesting ways to dissect performance.

I am a fan of the DuPont Decomposition framework to compare operational efficiencies among market participants.

As a reminder, there are three major financial metrics that drive return on equity (ROE): operating efficiency, asset use efficiency, and financial leverage. Operating efficiency is represented by net profit margin or net income divided by total sales or revenue. Asset use efficiency is measured by the asset turnover ratio. Leverage is measured by the equity multiplier, which is equal to average assets divided by average equity.

It can be useful to both investors and management teams to determine what financial activities are contributing the most to the changes in ROE.

An investor can use such analysis to compare the operational efficiency of two similar firms.

Managers can use DuPont analysis to identify strengths or weaknesses that should be addressed from a group optimisation perspective.

From a qualitative standpoint, a winning Strategy should be focused, divergent and (possibly) with a good tagline.

Unfortunately, many industries can suffer from a “me-too” syndrome and drowning in the so-called red ocean, popularized by Kim and Mauborgne.

In Reinsurance, elements which once could be considered strategic differentiators have become hygiene factors.

Additionally, as tech companies’ valuations go through the roofs, technological innovation is often perceived as a silver bullet and thus many companies go through great efforts to shift perceptions (a good example is Mastercard and their purpose to “connect and power a digital economy which benefits everyone”).

In fact, I believe that we should not confuse innovation with value-innovation, which should be a key focus of strategic initiatives: to capture sustainable commercial value, companies should pursue a strategy which aligns their organisations in the pursuit of differentiation and lower costs.

I admire the work which friends and colleagues in the industry put out on a regular basis to update investors and explain the strategic rationales and strengths of their reinsurance companies.

However, as every major player regularly talks of its:

-       Unique Property & Casualty position to profit from a hardening market

-       Life & Health clients partnering

-       Ongoing liabilities' portfolio management

-       Client centricity

-       Capital benefit from diversification

-       Vast geographical presence with economies of scale and scope

-       Innovation focus

-       Solid asset management returns

-       Robust dividend and Capital position

-       Superior AA (in many cases) ratings

-       Active involvement in the wider society

these are all great points which demonstrate the high level of sophistication of an industry with a lot of brainpower. However, from an investor’s viewpoint (and keep in mind that very few of them solely focus on reinsurance), the picture has gotten increasingly blurred and, inevitably, historical performance becomes a key differentiator towards stock valuations. 

Lately, the industry has not been immune from developing purpose-led stories, promoting the role it brings to society both in terms of the products it sells and the active role it can play, for example, on climate change.

I find it refreshing and praiseworthy, particularly when it’s consistent with the culture of the company – as it allows for a deeper connection with key stakeholders.

Peter Drucker famously said that “Culture eats Strategy for breakfast”. Established companies do not have the benefit of younger start-ups, very often created around a core issue or problem experienced by the founder(s).

However, if you are an established company, do you need to choose between Culture and Strategy? prioritize? I have my thoughts and will put them in a new post later on; any strong feelings, please share!

Stock re-pricing through a more focused strategy will contribute to reduce the protection gap

Enhanced efficiencies of financial assumptions (mainly on the P&C, Life or Asset Management – but also costs and capital efficiencies) can bring Underperforming stocks at par with industry levels, unless any of these assumptions can be proven to be a focused strategic differentiator (for example, on the costs side).

On the asset side, based on my experience with investors, particularly those with a long view who are active in the (re)insurance industry, they appreciate the spread we can achieve thanks to the underwriting efforts, less so through fancier asset management strategies or esoteric investments.

If they wish to take more investment risk, such investors can easily (and I would add more proficiently – as it is their core business) do it themselves. Thus, a “safe pair of hands” on the management of (re)insurance assets is often preferred.

I believe that a more sustainable revaluation of Reinsurance stocks can take place if organizations can focus less on coping with the competition, striving to match and beat their advantages - and worry more about value-innovation.

Thus, although the industry has been marred by average results in recent times, I believe that in an expanding risk universe and increased societal awareness, it’s not difficult to be enthusiastic about the future of (re)insurance, providing further value to Society by successfully employing and developing its available capital.

Sir Winston Churchill famously said that "The pessimist sees difficulty in every opportunity. The optimist sees the opportunity in every difficulty". The passion and drive we see in the market make me believe that our industry must be full of optimists.

Thanks for reading, I hope many of you will join me in this conversation.

Keep well,

Antonio Moretti