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ACE And Arch Capital - Can Investors Look To These A-List Insurers?
Hardly anyone seems to have noticed, but 2012 has been a pretty good year for some of the large corporate insurers. True, there have been natural disasters this year and the rate environment isn't great, but many of the top players like ACE (NYSE:ACE), Arch Capital Group (Nasdaq:ACGL) and Renaissance RE (NYSE:RNR) have seen their stocks solidly beat the market this year. Of course, it's not all perfect in P&C and reinsurance - companies like XL Group (NYSE: XL) and PartnerRe (NYSE:PRE) have seen their stocks sell off this year. (For additional reading, see When Things Go Awry, Insurers Get Reinsured.)
The question for investors, though, is whether the recovery in 2011 has taken away the value in top-notch names like ACE and Arch Capital.
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Poor Pricing Problem
One of the problems in the large-scale P&C and reinsurance markets has been poor pricing. Simply put, plenty of insurance companies have been willing to accept relatively poor returns on capital to grab business. That's a problem for the disciplined players, as they must choose between losing business (and seeing lower returns) or chasing mispriced business (and seeing lower returns).
Arch Capital, for instance, has long enjoyed a well-earned reputation for very disciplined underwriting and capital allocation policies. If pricing doesn't meet its standards in one market, it will reduce its activity and reallocate capital to more promising markets. Being well-balanced between primary and reinsurance has served the company well in the past.
Recent comments from insurance executives suggest there has been an overall increase in 2012 in the low-single digits. Arch Capital pointed to some weakness in malpractice and executive assurance rates. ACE commented that international rates have generally been lagging U.S. rates, but that more and more insurers are refusing to go along with lower rates - even though brokers like Willis (NYSE:WSH) and Aon (NYSE:AON) are still keeping up the pressure.
Are the Returns Good Enough?
Arch Capital has posted some of the best returns on equity in the industry over the long haul, due to that disciplined approach in underwriting. To wit, Arch Capital management only deems rates that can support an ROE of 15% as "adequate" ... and rates have been below adequate for some time now. Making matters worse, Arch management doesn't seem to think that rates will be adequate for some time to come.
The situation isn't that much different with ACE. Although ACE doesn't have the record of Arch Capital when it comes to returns, nor quite the same sort of underwriting discipline, this company is hardly reckless.
It's worth wondering how long this can continue. Although there have certainly been some serious disasters in recent memory (including Japan and New Zealand), North American insurers have not only diversified their risk exposures but have also gotten relatively lucky. If a seriously bad hurricane season comes to the U.S., it's worth wondering if there will be another wash-out of those companies that underpriced their risk. It may sound counter-intuitive, but that would actually be a good thing for Arch Capital and ACE - fewer "cowboys" in the market helps their rate structure.
What About Rates?
That low-rate environment that Western central banks have tried so hard to create and perpetuate has also done a number on the investment income for insurance companies. Simply put, it's harder and harder to generate a good return from investment portfolios, at least without going down the ladder in terms of quality.
Can this continue? Not forever. Sooner or later, rates will have to rise again. The trouble, though, is the timing. It certainly does not look like insurance companies will get a boost from better investment returns in the first half of 2012.
The Bottom Line
Unfortunately, while ACE and Arch Capital have plenty of quality, they lack value at present. Arch Capital has to get back close to a mid-teens ROE to really be worth buying today, and the current environment just doesn't support that sort of optimism. Even investors who don't want to build excess return models can look at the price-to-book ratio on the stock. Arch Capital is a quality name that deserves a premium valuation for its above-average returns, but a 20% premium to book is just too much (10% would be more like it).
It's a slightly more encouraging story at ACE. Whereas Arch Capital looks about 5% overpriced on the basis of its likely future ROE, ACE is almost 10% undervalued. The question, though, is whether 10% is enough of a margin of safety to take the plunge. Were this Arch Capital, I'd be tempted to say "yes", as Arch rarely gets very cheap unless something is seriously wrong in the industry. With ACE though, a little more discount would be nice, although it may well be the best value today in the larger P&C market. (For additional reading, check out 5 Must-Have Metrics For Value Investors.)
Use the Investopedia Stock Simulator to trade the stocks mentioned in this stock analysis, risk free!
At the time of writing, Stephen D. Simpson did not own shares in any of the companies mentioned in this article.
Investopedia Markets: Explore the best one-stop source for financial news, quotes and insights.
Poor Pricing Problem
One of the problems in the large-scale P&C and reinsurance markets has been poor pricing. Simply put, plenty of insurance companies have been willing to accept relatively poor returns on capital to grab business. That's a problem for the disciplined players, as they must choose between losing business (and seeing lower returns) or chasing mispriced business (and seeing lower returns).
Arch Capital, for instance, has long enjoyed a well-earned reputation for very disciplined underwriting and capital allocation policies. If pricing doesn't meet its standards in one market, it will reduce its activity and reallocate capital to more promising markets. Being well-balanced between primary and reinsurance has served the company well in the past.
Recent comments from insurance executives suggest there has been an overall increase in 2012 in the low-single digits. Arch Capital pointed to some weakness in malpractice and executive assurance rates. ACE commented that international rates have generally been lagging U.S. rates, but that more and more insurers are refusing to go along with lower rates - even though brokers like Willis (NYSE:WSH) and Aon (NYSE:AON) are still keeping up the pressure.
Are the Returns Good Enough?
Arch Capital has posted some of the best returns on equity in the industry over the long haul, due to that disciplined approach in underwriting. To wit, Arch Capital management only deems rates that can support an ROE of 15% as "adequate" ... and rates have been below adequate for some time now. Making matters worse, Arch management doesn't seem to think that rates will be adequate for some time to come.
The situation isn't that much different with ACE. Although ACE doesn't have the record of Arch Capital when it comes to returns, nor quite the same sort of underwriting discipline, this company is hardly reckless.
What About Rates?
That low-rate environment that Western central banks have tried so hard to create and perpetuate has also done a number on the investment income for insurance companies. Simply put, it's harder and harder to generate a good return from investment portfolios, at least without going down the ladder in terms of quality.
Can this continue? Not forever. Sooner or later, rates will have to rise again. The trouble, though, is the timing. It certainly does not look like insurance companies will get a boost from better investment returns in the first half of 2012.
The Bottom Line
Unfortunately, while ACE and Arch Capital have plenty of quality, they lack value at present. Arch Capital has to get back close to a mid-teens ROE to really be worth buying today, and the current environment just doesn't support that sort of optimism. Even investors who don't want to build excess return models can look at the price-to-book ratio on the stock. Arch Capital is a quality name that deserves a premium valuation for its above-average returns, but a 20% premium to book is just too much (10% would be more like it).
It's a slightly more encouraging story at ACE. Whereas Arch Capital looks about 5% overpriced on the basis of its likely future ROE, ACE is almost 10% undervalued. The question, though, is whether 10% is enough of a margin of safety to take the plunge. Were this Arch Capital, I'd be tempted to say "yes", as Arch rarely gets very cheap unless something is seriously wrong in the industry. With ACE though, a little more discount would be nice, although it may well be the best value today in the larger P&C market. (For additional reading, check out 5 Must-Have Metrics For Value Investors.)
Use the Investopedia Stock Simulator to trade the stocks mentioned in this stock analysis, risk free!
At the time of writing, Stephen D. Simpson did not own shares in any of the companies mentioned in this article.
by
Stephen D. Simpson, CFA
Stephen D. Simpson, CFA, is a freelance financial writer, investor, and consultant. He has worked as an equity analyst for both sell-side and buy-side investment companies in both equities and fixed income. Stephen's consulting work has focused primarily upon the healthcare sector, while he has also written extensively for publication on topics pertaining to investments, security analysis, and healthcare. Simpson operates the Kratisto Investing blog, and can be reached there.
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