While there seems to be growing consternation about the risk to insurers from escalating loss trend pressure, there has been little worry in the stocks to this point. This has been puzzling to me given a) most stocks are trading at peak valuation and b) earnings could easily be heading to trough.
Am I being dramatic? Not really. The market seems to have forgotten just how sensitive P&C EPS is to small changes in the loss ratio. So today I thought I’d put together some illustrations to demonstrate.
Introducing Eastern & Southern Insurance
Our mock company will be a US based excess and surplus insurer with some international operations, primarily at Lloyds. I have named it Eastern & Southern Insurance Company of North America.
Eastern & Southern, E&S for short, was formed by the 1988 merger of Eastern Accident & Fire, known for handling difficult emerging risks for Fortune 500 companies in New York and other major east coast cities, and the Southern Indemnity Company which served growth markets from Florida to Texas and grew with small and mid sized difficult to insure businesses.
E&S struggled in the early 2000s with unexpected 9/11 losses in NY followed by poor limits management in the 2004 and 2005 hurricane seasons hitting the old Southern hard. As a result, they cut back their property exposure to focus more on core casualty strengths and are now 65% casualty and professional lines.
In 2012, they acquired Lloyd’s syndicate 1984 to add international professional lines, marine and energy, and, most critically, binders business in the US to expand their access to smaller accounts west of the Mississippi.
E&S relies largely on wholesale distribution with the exception of their F500 legacy accounts which mostly come through Marsh & Aon. E&S has long been rumored to have interest in buying a regional to add a standard retail presence, but has yet to find a match.
2019 Financials
Now that you know a little bit about E&S, let’s look at some financials. Below is my assumed 2019 full year results. E&S has grown to $5B of premium making them a top 5 player in the E&S market.
| E&S 2019 | B/S | I/S | Notes |
| Net Premium Written | $5B | ||
| Combined Ratio | 93% | 96% AY 3% PPD | |
| Underwriting Income | $350M | ||
| Investments/NII | $15.0B | $375M | 2.5% yield |
| Debt/Interest | $1.7B | $65M | 25% D/C |
| Pre-tax Income | $635M | $25M corporate | |
| Net Income | $508M | 20% tax | |
| Equity/ROE | $5.0B | 10.2% | $50/sh BV |
| Shares/EPS | 100M | $5.08 | $1.50 dividend |
They made a 10% ROE for the year placing them in line with peers. Their stock is trading at 1.7X book or $85. The remaining earnings after dividend and some holding company expenses will be used to buy 4M shares in 2020.
2020 Status Quo Example
Next, let’s look at a likely 2020 EPS forecast for E&S if a typical environment continued with no change in loss trends or pricing expectations.
| E&S 2020 base case | B/S | I/S | Notes |
| Net Premium Written | $5.2B | 4% growth | |
| Combined Ratio | 93% | 96% AY 3% PPD | |
| Underwriting Income | $364M | ||
| Investment/NII | $15.0B | $375M | 2.5% yield |
| Debt/Interest | $1.7B | $65M | 25% D/C |
| Pre-tax Income | $649M | $25M corporate | |
| Net Income | $519M | 20% tax | |
| Equity/ROE | $5.0B | 10.4% | $50/sh BV |
| Shares/EPS | 96M | $5.40 | 6% growth |
EPS grows 6% with 4% from buyback and 2% from business growth. I assume a steady CR which produces 4% more underwriting income. Investment assets remain flat as earnings were paid out in either dividends or stock buyback and the premium growth was offset by increased paid losses. I assume investment yields remain flat.
2020 Elevated Losses Example
But what if claims inflation really is accelerating and companies need to adjust their reserves? What might E&S’s earnings look like in the future?
| E&S 2020 bear case | B/S | I/S | Notes |
| Net Premium Written | $5.2B | 4% growth | |
| Combined Ratio | 100% | 100% AY 0% PPD | |
| Underwriting Income | $0M | ||
| Investment/NII | $15.0B | $375M | 2.5% yield |
| Debt/Interest | $1.7B | $65M | 25% D/C |
| Pre-tax Income | $285M | $25M corporate | |
| Net Income | $228M | 20% tax | |
| Equity/ROE | $5.05B | 4.5% | $50/sh BV |
| Shares/EPS | 100M | $2.28 | -55% growth |
Yes, a 100% CR cuts earnings by more than half. I will discuss if that is a realistic outcome or not below (spoiler: it is!). ROE drops below 5%! Note, repurchase went away because of the lower earnings. It isn’t likely to return soon either as management will feel pressure from rating agencies to hoard some capital in case things get even worse.
Is 100CR a Realistic Outcome?
Remember what I told you about Eastern & Southern. They write a lot of F500 business where they are writing layers in a excess casualty or D&O tower where they are exposed to increasing severity pressures. Maybe they write the disaster cover for if a retailer’s in-house trucking captive blows out the top or the excess above a large hospital group’s med mal captive. Those remote layers have a lot more risk today.
They also have all that small account business concentrated in the southeast, but that has expanded nationally. How do you think they grew in places like Phoenix or Vegas? They had to take what the wholesalers would feed them. They probably are on all the CBD shops in Oregon and the vaping distributors in Ohio. They have every mom and pop retailer struggling in Class C strip malls in St. Louis and Louisville. Oh, and don’t forget the garbage coming through the coverholders at Lloyd’s!
Also, recall they are now ~ 2/3 mid and long tail. They are overweight general liability on both the small and large end. They have a healthy amount of D&O and commercial auto exposure. Those troubled lines could easily be 40% of their premium and over half the reserves.
If picks are too low by ten points on 40% of the book, then the entire AY goes up the 4% I have modeled. Similarly, if reserves are about twice premium and troubled lines make up half the reserves, then it only takes a 3% increase in reserves on challenged lines for reserve releases to disappear. That doesn’t seem unreasonable.
What’s the Downside on the Stock?
If the ROE drops to 5% for two or three years while we wait for pricing to earn in, should the stock really trade above book? Much of the reason it got to 1.7X to begin with was the popularity of P&C as a safe haven defensive sector within financials, not to mention some speculation that E&S would sell out for over 2X BV.
If those perceptions change, trading at book isn’t such a crazy thought. However, there will be a pricing reaction to increased realization of pain. That probably lets you get to 1.25X. That’s still over 25X earnings so it’s a stretch, but given the potential recovery, it’s not a crazy solution. At 1.25X, you’re down more than 25% on the stock though.
What Does This Mean for Real Companies?
OK, so E&S Insurance isn’t real, but admit it, I almost convinced you it was! Surely, it sounds like some companies you may know. Those companies have similar portfolio risks and similar financial leverage to E&S in a downturn.
Yet, I don’t think anyone has put out a note quantifying how bad results can get in a very reasonable outcome. Things can get a lot worse than what I’ve outlined.
I didn’t even consider the possibility that E&S needs to take a $500M reserve charge. Or that after that the rating agencies would threaten to downgrade them if they didn’t raise capital (and that capital would have to be equity given they’re already at 25% D/C). Or that they might need to exit certain lines cutting their future EPS power.
There are a lot more draconian cases I can come up with than a 100 CR scenario. How low will that limbo bar get???