Steve Eisman of The Big Short fame recently stated the stock market was entering a Golden Age for the financial sector, specifically banks. The argument goes, deregulation under Trump and rising interest rates, coupled with rising leverage and higher risk, will be extremely beneficial for banks in the near future.
We don’t disagree with Eisman, but we think it is more likely we are entering a Golden Age for Property & Casualty (P&C) insurance stocks. Whereas deregulation and rising leverage seem to be required steps in Eisman’s thesis for the gilded age for banking stocks to play out, P&C insurance companies can remain at their existing leverage ratios and insurance regulation can remain status quo – the mere rise in interest rates from the zero bound alone has the potential to catapult ROEs in the P&C sector into a gilded era.
As a fund, S&C Messina Capital is happy with the status quo as successful underwriting has been generating healthy ROEs for our portfolio companies, but an increase in interest rates would boost the returns of the portfolio even further; the portfolio would also experience multiple expansion.
With interest rates finally rising from the zero bound, we are entering a Golden Age for P&C insurance companies. As long as rates continue to rise, we shall see the earnings power of P&C carriers continue to rise as well, all else being equal. There is no telling how long this gilded age for P&C insurance carriers will last.
The relationship between an increased ROE & share price performance
Share prices of P&C insurance carriers tend to track their long-term ROEs. For instance, a carrier earning an annual ROE of 10% is likely to see its share price grow 10% per year through various insurance and economic cycles.
Figure 2. Share prices performance follows growth in underlying book value
Why does earnings power increase?
To ask simply, why do rising rates benefit the earnings power of P&C insurance carriers? This is because most of their assets are invested in fixed income assets on a levered basis. See figure 3.
Figure 3. Asset leverage & investment exposure for the U.S. P&C insurance industry
The impact on ROE when interest restore to normalized levelS
With the 10-year Treasury rate hovering around 2%, a return to more normalized levels (4-6%) implies an increase in interest rates of 2-4%, adding 4-8% ROE to a P&C insurance company that has 2:1 fixed income-to-book value (equity) leverage.
In our (S&C Messina Capital’s) case, this would bump our portfolio’s ROE from the 10-15% range to 15-20% range for our portfolio companies. Our performance this year reflects this bump as we are up nearly +30% YTD before fees.
Take for example a carrier who is earning 14% ROE. This 14% can be broken down as follows: with an underwriting profit margin of 10%, the remaining 4% is coming from investment returns. Assume we are levered 2:1. This implies investment returns of 2%. If this 2% approximates the ten-year Treasury, assume that in a rising rate environment, the ten-year note hits 4%. Levered 2:1, this will generate 8% in investment returns for the P&C insurance carrier. Adding 8% to the existing 10% underwriting profit results in a hefty ROE of 18%. There are not many American businesses that can achieve that on a regular basis. Earning 18% ROE annually, we shall see the share price of such said company rise 18% per year as well with a one-off bump due to multiple expansion.
Which P&C insurance companies to buy
Now, some P&C insurance companies are trading at such high multiples, indicating that some or all of these factors have already been priced in. In addition, not all insurance companies have strong enough market positions to maintain profitable underwriting margins. Lastly, management may not have the discipline to maintain healthy underwriting margins and may be tempted to lower premium rates to gain market share, thereby giving back all or most of the ROE windfall gained from higher investment income.
To select companies that will benefit the most from this Golden Age for P&C insurance companies, one must be prudent. We believe the market has priced in some of this rise in earnings power for some companies in our portfolio, but we see further upside as well. Most importantly one has to be in the right companies where underwriting returns will not suffer as investment returns rise. We believe we own those companies.
Our mission is to replicate Berkshire Hathaway & Warren Buffett’s liability & asset management strategy. As a team of professional investors and insurance executives, we’ve been studying the Berkshire model for several years, including analyzing those that have successfully replicated it. We have also studied those that have failed.