While the woes of regional banks have dominated the market narrative recently, Small-Cap Total Return’s investment team has been seeking to use the resulting weakness throughout the broader Financials sector to add to high conviction names in the Property & Casualty Insurance (“P&C”) space. Within this area, we mainly focus on commercial insurance providers, specifically those that offer specialty insurance.
For the last several years, P&C companies have been experiencing the tailwind known in the industry as a “hard market,” which are typically defined by price increases, reductions in terms and conditions (that is, less coverage per dollar of premium written), and capital leaving the industry.
Historically low returns, which have been leading insurers to be more disciplined about capital deployment (and in some cases exiting entire lines of business), as well as the Covid pandemic and inflationary pressures, have led to the current hard market. These conditions may persist for longer than anticipated due to the rising costs of reinsurance, which is insurance for insurance companies. Hard markets have historically portended multi-year periods of attractive economic returns for insurance providers, including improving underwriting margins and returns on equity (“ROE”), as well as growth in tangible book value per share and higher share prices for P&C insurance stocks.
Rising interest rates have further strengthened our conviction. For more than a decade, low rates weighed on P&C insurance companies’ returns (as defined by ROE) because their investment portfolios, which are predominantly comprised of lower-risk, high-quality fixed income investments, saw muted yields. A typical P&C insurer has an investment portfolio three times the size of its equity base. This embedded “investment leverage” leads to disproportionate increases in ROE as interest rates rise. For example, a hypothetical 100 basis point increase in investment yields on an insurer’s investment portfolio can lead to 200-250 basis point improvements in ROE. This is significant given that ROEs often fall in the 10-15% range. Despite recent declines in interest rates—which remain volatile—new money yields on investment portfolios are significantly higher than what is currently on most insurers’ balance sheets.
Despite these attractive fundamentals, these stocks have been hit hard in recent weeks as the failure of Silicon Valley Bank and Signature Bank have sent ripples of fear through the banking industry and into other financial stocks. A wave of selling in Financial ETFs (due to their underlying bank holdings) is also causing indiscriminate selling of P&C insurance stocks. In addition, we believe that portfolios with relatively high exposure to banks have been forced sellers broadly across their portfolios as they look to reduce risk—which is placing additional indiscriminate pressure on P&C stocks. Finally, we think that investors who are drawing parallels with regional bank stocks because P&C insurers have large fixed income portfolios are mistaken.
First, most P&C insurance companies classify their investments as “available for sale,” meaning they are held on the companies’ balance sheets at market value. There are far fewer, if any, “hidden losses” in investment portfolios via unmarked held-to-maturity securities. Second, there cannot be a run on the bank at an insurance provider. The primary liabilities of an insurance company are reserves set aside for future losses. Claims are paid on these losses when they become due. An insured party cannot request money for a claim that does not exist. Third, P&C companies typically match the duration of their assets, that is, their investments, with their liabilities (future claims), which enables them to hold their securities to maturity, so they will not be forced to realize losses in order to create liquidity. In fact, one could argue that the issues at Silicon Valley Bank are a net, albeit modest, positive for our holdings, as “InsureTech” businesses see funding dry up and ultimately fail, thus reducing the number of players (and capital) in the industry.
Our team has been using recent weakness in P&C stocks to add to high conviction names, many of which have been trading at mid-single digit multiples of earnings and at modest premiums to tangible book value per share, creating highly asymmetric risk/reward profiles, particularly given their strong fundamentals. For example, International General Insurance Holdings (IGIC, Financial), one of the Fund’s largest positions, has been trading at a discount to tangible book value per share despite having what we think is the lowest risk investment portfolio of any insurance stock we hold.
We believe one final point is worth emphasizing: the P&C insurance industry has historically shown little sensitivity to broader economic cycles because businesses must purchase insurance irrespective of the strength of the economy or their own businesses. This lack of correlation means that P&C stocks are typically viewed as defensive. We think that this rare combination of defensive attributes coupled with rock solid fundamentals will continue to play out favorably in the years ahead.
Mr. Lewis’s and Mr. Hintz’s thoughts and opinions concerning the stock market are solely their own and, of course, there can be no assurance with regard to future market movements. No assurance can be given that the past performance trends as outlined above will continue in the future. The performance data and trends outlined in this presentation are presented for illustrative purposes only. Historical market trends are not necessarily indicative of future market movements. Past performance is no guarantee of future results.
