Property and Casualty Insurance (P&C) February 12, 2014

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1 The Henry Fund Henry B. Tippie School of Management Guang Chris Jin Property and Casualty Insurance (P&C) February 12, 2014 Investment Thesis Drivers of Thesis Given strong sales of new and existing houses, as well as vehicles in US in 2013, big players in housing and auto industry are confident of continuing growth in US unemployment rate has been decreasing from 10% in 2009 to 6.6% by the first month of 2014 and consensus expects the trend to continue. The macroeconomic environment is comfortable to the P&C industry in (Figure 12) Average M&A deal value in the P&C industry increased in 2013 compared with 2012, indicating industrial level improvements in capital efficiency and resources integration. 1,3 Industry Rating Overweight Industry Fundamentals Price Data Current Price (S&P 677) $ wk Range $ year price change 25.86% Key Statistics Market Cap (B) $ Dividend Yield 1.93% Price/Earnings (TTM) 24.7 Price/free cash flow 30.5 Price/Book (mrq) 2.01 Profitability Profit Margin 8.40% Return on Equity (TTM) 7.50% Less catastrophic losses in 2013 than previous years improved reserves in P&C industry companies which in turn will strengthen the industry s investment and marketing activities. Risks to Thesis The sustained likelihood of continuing low interest rate and uncertainty of the ongoing Fed s tapering action together cause possible obstacle for P&C insurers investment operations. The uncertainty of US and foreign insurance regulatory reforms may cause risks to the P&C industry. For example, the Federal Insurance Office s report in 2013 aimed at the use of personal information in insurance pricing P&C LifeInsurance Financial P/E ROE Dividend Yield Profit Margin Source: yahoo finance 12 Month Performance Industry Description The P&C industry is composed of insurance companies that are specialized in providing insurances on houses, automobiles and businesses. Specially, insurers protect insured s personal or business properties against their physical losses and/or legal liability caused by losses to the properties of others. Insurers collect premiums by underwriting and selling insurance policies to customers. The P&C industry plays a significant role in maintaining a sustainable and reliable economy by helping individuals and businesses manage uncertainty and loss, and recover from sever catastrophes quickly. Source: Msn Money Important disclosures appear on the last page of this report.

2 EXECUTIVE SUMMARY Our overall recommendation for the P&C industry is overweight. The consensus optimism in the forecast of the macro-economy indicators including increasing sales of houses and auto vehicles, strengthening consumer confidence level, steady decreasing unemployment rate and upward GDP trend makes us confident of the industry s performance in The industry s growth in both net income and policyholders surplus in 2013 showed that insurers have been enhancing their profitability as well as resilience to losses caused by future catastrophes. According to ISO, a Verisk Analytics company, and the Property Casualty Association of America (PCI), the combined ratio which measures losses and expenses per dollar of premium also showed a significant improvement from 100.7% at the end of September 2012 to 97.9% in the first half of 2013 and further to 95.8% by the end of September ,3 Considering the recovering US economy and the P&C industry s increasing capital efficiency by future mergers and acquisitions, we expect the industry average combined ratio to be kept improving in Low interest rates have been troubling the P&C industry s investment management for the past several years. We expect the year 2014 to see a slight increase in interest rate given the Fed s tapering plan, even though it is still not quite clear how the new Chair of the Board of Governors of the Federal Reserve System Janet Yellen will continue the tapering plan. Regulatory also adds uncertainties to the P&C industry in 2014 at least as much as it did in For insurance, the Terrorism Risk Insurance Program will expire in late 2014 and whether the program will continue existing or not after 2014 is still unclear. The uncertainty towards regulations, with no doubt, need more attention from managements of the P&C insurers. However, these risks are fundamentally controllable and could be well hedged with proper management. INDUSTRY DESCRIPTION Generally, P&C insurers offer instruments (insurance) to insured to protect them from possible hazards that may happen during a pre-set period. The P&C industry is one important sector of the universal insurance industry. Specifically, P&C insurers underwrite contracts offering insurance against various personal, business and property losses caused by accident, illness, as well as legal liability arising from injuries and/or damages to other people and/or property that belongs to them. The P&C insurers are mainly making profits from two sources: premium collection and investment income. On the risk side, unlike Life and Health insurers (L&H), P&C insurers are dealing with greater uncertainty because both the frequency and magnitude of P&C insurance claims are more volatile than L&H claims. Firstly, P&C losses are highly sensitive to catastrophes including hurricanes, earthquakes and terrorism attracts, while L&H insurers typically only have limited losses. Moreover, when catastrophes do happen, the required payment for P&C insurers depends on the insured s actual loss. Though payment is subjected to limits in contract, it can easily run several times out of the premium paid, while payment for L&H insurers is often the face value of the policy. 1, 2 Key insurers in US P&C industry include State Farm, Zurich Ins, Liberty Mutual, Allstate, AIG, etc.(figure 1) Industry Segment In most of the case, P&C insurers are operating business in both commercial lines (company insurance) and personal lines (personal insurance). Commercial lines cover insurance related to business property and liability, such as commercial automobile and workers compensation; personal lines cover insurance associated with personal lives, such as private passenger auto and homeowners Multiple Peril. 2 Page 2

3 Industry Business Model As we discussed, P&C insurers make profits through charging premiums by underwriting policies as well as through investing accumulated funds. A traditional procedure of a P&C company s insurance operation starts with underwriting insurance policies (including determining the acceptability of risks, the coverage terms, and the premium), goes through billing and collecting premiums, and ends up by investigating and settling claims under policies given insured losses happen. Insurers hire actuaries to price various insurance policies based on complex mathematical modeling technics taking into account of probabilities of actual losses. Since the risks associated with different types of insurance policies are not statistically 100% positively correlated, the total level of risk that P&C insurers are managing is to some extent lower than the sum of very individual policy s risk. 2 Another important revenue source of P&C insurers is coming from investment activities. P&C insurers accumulate substantial funds due to the time gap between the receipt of premiums and payment of claims. These funds are normally invested by so called investment divisions in P&C companies to generate investment income. The investment income contributes to earnings and will in turn affects the pricing of insurance policies. 2 In the P&C industry, premiums often constitute a majority part of total revenues compared with investment incomes. In nine-months 2013, US P&C industry generated net investment income and realized capital gains on investment of $40.4 billion, compared with net written premiums of $363.4 billion. 1 RECENT DEVELOPMENTS Improved Financial Results The P&C industry showed big improvements in financial results in 2013 (Figure 2). US P&C insurers achieved highest operating income since 2007 while also kept combined ratios lower than the past five years. Industry net income reached to $43 billion in three quarters 2013 compared with $27.8 billion in Industrial annualized rate of return on average policyholders surplus grew by 3% to 9.5%. Insurers policyholders surplus reached $624.4 billion by the end of September 2013, showing a $37.3 billion increase since The time gap, which creates the so-called float, between the inflow of premiums and outflow of payments consists of two major components. The first is the time interval between the receipt of premium and the occurrence of insured events. Usually this component is relatively small, because the duration of P&C policies is short, e.g. less than a year. This component is reflected in the financial statements in the balance of the unearned premium liability. The other component relates to the gap between the occurrence of insured events and the subsequent payments, and in most cases has long duration. Some insured losses are discovered many years after the event, and often times the claim settlement process extends over several years. In other cases insurance payments are made over extended periods of time. This component of the float is reflected in the financial statements in the balance sheet of the reserve for losses and loss adjustment expenses, which insurers are required to accrue when insured events occur. 2 Page 3 A big part of the favorable financial accomplishment is due to the dramatic decline of insured catastrophic losses in US, though insurers also showed progress in operating efficiency. Since no significant catastrophes happened during the last quarter of 2013, the US P&C industry will no doubt end up with an encouraging annual financial result in Changing Legal and Regulatory Environment P&C insurers will see themselves in a more uncertain regulatory development throughout The Federal Insurance Office (FIO) released a report at the end of 2013

4 discussing possible ways to modernize the current regulatory system. For example, one of the topics is about how to tighten the ways under which insurers are collecting and using customers personal information. Given the initiatives of FIO, however, it is unlikely that any new regulation will come into force in a short period. As the chief advisor of Deloitte s insurance group mentioned in Deloitte s 2014 industry outlook, Most of FIO s recommendations require Congressional action, which is not expected anytime soon, or are a call to the states to make changes, which FIO cannot now compel. The bottom line is that there is likely to be little immediate impact but rather continued uncertainty over a slowly evolving regulatory landscape shaped by how the states and federal government interact. 3 In fact, we believe a slowly rather than dramatically evolving regulatory landscape would benefit the P&C industry as less unhealthy competition will involve in the market and customer expectations can also change in terms of unrealistic loss protection. Declining Catastrophe Losses According to Munich Re, the biggest insurers worldwide, 880 losses events happened in 2013 compared with 830 in both 2012 s insured losses of $65 billion and the ten-year average insured losses of $56 billion (Figure 4). Additionally, in 2012, insured losses were distributed highly unevenly worldwide with 90% of them taking place in US, while the number dropped to 54% in Historically, both overall losses and insured losses have been increasing for the past 30 years, though periodical fluctuations can be observed. The US P&C industry did not have a smooth start this year because of the strong snowstorm which caused great damages to the south part of the country. Even though the exact number of insured losses of this natural catastrophe is still not clear so far, we believe the US P&C insurers will see insured losses to rise mildly in 2014 compared with 2013, while still under the level of INDUSTRY TRENDS AND OPPOUTUNITIES Demographic Changes in the US Despite the increase in number of losses events, insured losses was approximately $31 billion in 2013, lower than The United States is going through demographic changes, which will have significant impact on the P&C industry. Three main changes can be identified: the increased longevity of the aging baby boom generations, population shift toward the coast and increased diversity of US population. These changes can be seen as both risks and opportunities by P&C insurers. For example, it is not unusual to see new retired baby boomers to move to the coast from other parts of America. Such shift will not only raise the value of properties but also force insurers to deal with higher risk of catastrophe losses caused by hurricane. The increased proportion of African-Americans, Hispanics, Asian-Americans and other minorities in the population is bringing new opportunities but also require insurers to learn new preferences and create new products to further Page 4

5 exploit growth in these new but fast growing market segments. With the P&C insurers being aware of ongoing demographic changes and continuing to develop and launch new products, the industry can be expected to increase average profit and insurers surplus by exploring new segments in Compared with the mature P&C insurance market in the developed world (North America, Europe), emerging markets such as Asia and South America are growing much more quickly and showing increasing attractiveness to US P&C insurers (Figure 6). Low Interest Rate Environment Despite US P&C insurers net investment gains rose to $40.4 billion in nine-months 2013 from $38.8 billion in 2012, the low interest rate continues to challenge the industry s profitability in investment. 1 The net yield on invested asset has fallen by 52 basis points from 2008 to 2012 (Figure 5). We estimate the actual yield to show another 15 basis point decline for the entire year of The recent shrink in Fed s QE could slightly pull the interest rate upwards. However, the investment yield will still be facing a downward pressure in 2014 since more and more maturing assets can only be rolled into low-yield categories. One of the biggest drivers of emerging markets is the rapidly growing middle class population. The increasing middle class is strongly support the aggregate consumption of a country including real estate properties and automobiles. By the end of 2020, the combined size of middle class in Asia Pacific and Central and South America will more than double the size of North America and Europe (Figure 7). Many US P&C insurers will see this trend as a new growing opportunity and thus we expect more big insurers are entering into emerging markets by various ways including mergers and acquisition, joint ventures and setting up direct affiliates. Still, this continuing low interest rate environment can also be seen as opportunities by P&C insurers. Insurers are now pressured to re-consider investment and risk management strategies. Industry pioneers can mildly decrease allocations in fixed income assets and increase positions in less correlated instruments such as global equities and commodities to drive long-term investment yield. The Growth of Emerging Markets Page 5

6 Mergers and Acquisitions Aggregate deal values of Mergers and Acquisitions (M&As) in 2013 s P&C industry exceeded the values in 2012 (Figure 8). With excess capital in hand, insurers often see strategic M&As as more effective ways to re-boost organic growth by achieving higher level of economy of scale, expanding to new markets and optimizing capital structures. 3 We expect both the number and values of M&As will increase in the US P&C industry in Two major categories of M&As will be conducted. Leading US insurers seek M&As as ways to penetrate into emerging markets while mid-size and regional ones will actively engage in M&As within North America to increase market shares and capital scales. even to sustain current rates. Given such market characteristics, P&C insurers see profitability improvement in hard market and stagnation or even deterioration in soft market. Typically, indicators of upcoming hard market include large underwriting losses, decrease in policyholder surplus, increase in reinsurance rates, and momentum in premium prices. 4 In a recent survey conducted by Towers Watson Company, twenty-three CFOs from leading North American P&C insurance companies came up with a consensus that the P&C insurance markets are now in the midst of hardening. 5 Given the industry s recovering process after the financial crisis, we also believe the P&C insurance markets will become a little harder in 2014 when insurers are about to keep increasing policy rates. Competition will also be getting fiercer compared with 2013 and focusing on value drivers becomes even more important to insurers. Value Driver Distribution Channels MARKETS AND COMPETITION Market Nature In nature, the P&C industry is cyclical, transitioning between hard and soft markets. Market is hard when the overall underwriting capacity is low, possible due to declining competition or capital deficiency, policy rates are increasing with policy terms becoming more and more restrictive. On the contrary, in a soft market, insurers are operating with ample capacity. Increasing insurance policies make the market more competitive and therefore insurers feel difficult to increase policy rates or In generally, insurers sell products to customers through distribution channels that have been evolving continuously with new trends in customer behavior and technology developments. In the P&C industry, insurers rely heavily on insurance agents channels and direct writing channels. Agents could mean independent agents, brokers and general agents, while direct writing includes internet, captive agents and affinity groups. In fact, with the change of customer behavior, insurers are using internet more and more intensively for various purposes such as marketing, releasing important informations and direct sales. According to AM Best, 71% of P&C personal lines premiums were directly written and 28% were written through agents or brokers, compared with 67% and 30% of commercial lines, respectively. 4 Value Driver Investment Investment of premiums are contributing a key part of profit for P&C insurers. However, since insurers are obligated to pay policyholders claims whenever needed, they must limit their investment portfolios exposure to risky assets such as stocks and foreign currencies. Additionally, insurers also need to keep a relatively high level of liquidity of their portfolios because payments to insured are often needed to be done within a short period. With the two constraints being in place together, P&C Page 6

7 insurers normally allocate funds to a group of low-risk and high-liquidity assets which in most case are fixed income assets (investment-grade corporate bond and Treasury bond), mortgage loans, preferred stocks, cash and other qualified assets (Figure 9). increased with a steady pace from 0.1% at the beginning of 2013 to 4.1% by the end of same year (Figure 10). We expect the real GDP growth rate to end up between 3.25% and 3.75% by the closing of Thus how well an insurer can manage its portfolio, achieving higher yield with a moderate level of risk and liquidity, becomes extremely important to compete in the industry. Value Driver Data Excellence Data management is a key successful factor for P&C insurers. The creation of almost all insurance products, premiums settings and marketing campaigns are based on extensive data analyses. Insurers collect data through several activities. Every time when a policy is sold, a claim is covered or a post-sales survey is conducted, insurers capture valuable data. With continuing analysis of the enormous ever-growing data base, insurers can further promote products to potential new customers, explore new market segments and adjust premiums to maximize profit while minimize risk. Knowing that data excellence is positively related to premium generating ability, industry players are all striving to update technology to build competitive advantages in data management. Interest Rate Given the mild GDP grow rate and consensus expectation that the overall economic situation is still recovering from the financial crisis, interest rate will not see any surprising jump during 2014 (Figure 11). However, since there has been no sign showing the Fed will decrease or abort its ongoing tapering plan, we believe it is safe to expect 2014 to have a slight increase in interest rate. Specifically, we estimate short-term treasury yields to rise to 0.16% over the next six months, while long-term yields (10-year Treasury bond) will grow by 20 basis points to 2.95%. ECONOMIC OUTLOOK Real GDP Growth Rate The US real GDP growth rate has gone through some fluctuations since it climbed up from the negative ground. During the past four quarters, the real GDP growth rate has Page 7

8 Unemployment Rate According to the newly released unemployment rate, the labor market again conveys positive signals of the recovering economy. Unemployment rate has been dropping since it hit its five year s high (10.00) in 2009 and further dropped to 6.6 in January 2014 (Figure 12). As the government is giving dramatic efforts to create more jobs, either from big or multinational companies, or from increasing small- to mid-size businesses, we expect to see the down trend to carry on in the following year with another decline between 0.1 and 0.3. KEYS TO MONITOR We believe 2014 will be a good year for the US P&C industry. It contains growth opportunities for insurers. What we expect to see from US P&C insurers include market penetrations into emerging economies, new segments explorations in domestic market, and increasing synergy and profitability through M&As. Housing Market and Consumer Confidence As one of the important indicators of the P&C industry, the housing market showed three consecutive years of growth since 2011 which to most extent was driven by the decreasing unemployment rate and strengthening consumer confidence (Figure 13 and 14). We expect the housing market to continue the upward trend as the economy is still on the recovery track. We also identify risks coming from natural catastrophes, low interest rates and uncertainty in regulations. However, we would not think these risks have dramatic negative impact on the industry. Instead, certain risks can be transferred to opportunities with proper prediction and management. While we provide a recommendation of overweight in US P&C industry, we will keep monitoring key factors that can have potential influence to the market: Worldwide and US catastrophe losses Economic indicators such as unemployment rate, CPI, and total credit change The Fed s tapering action and interest rate consensus estimation Big M&A deals within the industry Page 8

9 REFERENCES 1. nsf/lookupwebcontent/64ed6a8620d6bb c4a 006B01F 2. Analysis and valuation of insurance companies, CEASA, Columbia Business School 3. Deloitte 2014 Property and Casualty Insurance industry outlook-transforming for growth innovation leading the way 4. Annual Report on the Insurance Industry, Federal Insurance Office, U.S. department of the treasury /10/22/ htm 6. Property and Casualty insurance services: competitive conditions in foreign markets, US international trade commission 7. Insurance 2020: Turning change into opportunity, PWC EY US property-casualty insurance outlook 9. Impact of Demographic changes on the insurance industry, PINNACLE, 2009 CAS spring meeting, Paul A. Vendetti, MAAA 10. Property-Casualty Insurance Basics, American Insurance Association IMPORTANT DISCLAIMER Henry Fund reports are created by student enrolled in the Applied Securities Management (Henry Fund) program at the University of Iowa s Tippie School of Management. These reports are intended to provide potential employers and other interested parties an example of the analytical skills, investment knowledge, and communication abilities of Henry Fund students. Henry Fund analysts are not registered investment advisors, brokers or officially licensed financial professionals. The investment opinion contained in this report does not represent an offer or solicitation to buy or sell any of the aforementioned securities. Unless otherwise noted, facts and figures included in this report are from publicly available sources. This report is not a complete compilation of data, and its accuracy is not guaranteed. From time to time, the University of Iowa, its faculty, staff, students, or the Henry Fund may hold a financial interest in the companies mentioned in this report. Page 9