In one of the turning points in the franchise's storyline, its protagonists outmaneuver the enemy through several strategic actions, despite being vastly outnumbered.
Unfortunately, the protagonists try to employ the same playbook in the next battle (sound familiar?). The enemy, by now, has learned the harsh lessons and how to avoid them if there is a repeat.
So it avoids the traps and unleashes a wave of lava, which burns down the opponent. This is a pivotal moment in the Tolkien universe as it is the origin of Mount Doom, where the ring will later be created and the only place it can be destroyed.
Of course, we are no Tolkien experts, so please don’t quiz us! But the moral of the story is that with changing times, using the same set of stale responses can result in disastrous outcomes.
Variations of this theme will likely play out in different sub-sectors after Hurricane Ian. Even though it has been two weeks, a wide variety of insured loss estimates abound.
Historically, insurance had an overarching cycle depending on capital or earnings impact from a loss. However, as the industry has matured, one event has less of an effect. The insurance industry now has its own sub-sector mini-cycles.
Hurricane Ian comes at an interesting time for the industry, which is witnessing varied events overlapping. Apart from the usual uptick in catastrophe losses, we are in the midst of an interest rate shift, an uncertain economy, the prospect of a rebound in social inflation and a technical recession.
An interplay of these will create an unequal earnings season. The hurricane season is expected to have a negative impact on Florida homeowners and personal auto carriers, but it remains to be seen if it will swamp the reinsurers along with it.
These reinsurers are in a multi-year rediscovery mode as they continue to balance away from volatile classes (more on this later). These losses, as well as prior losses which haven’t been recouped, will add to future rate pressure.
On the personal auto side, it will be interesting to see if recent markers (Manheim, rate filings, CPI trends) do end up being accurate indicators regarding stabilization.
The overarching interest rate impact on balance sheets will be the background for every company
Taking a step back, there will be one more overarching discussion underpinning every sector discussion: the continued interest rate uptick and its impact on balance sheets. The level of unrealized losses has continued to grow for the industry and in theory generates pressure on insurers’ capital base.
Yes, technically these marks will reverse, and many insurers have hedges, but even an unrealized impact will play into how companies think about capital allocation, and consequently we anticipate a discussion on this on almost every call.
Insurance industry regulators and companies pay close attention to leverage, which is a measure of the amount of business that can be written compared to the pool of capital backing it.
Depending on the tail of losses, insurance companies invest in short- or long-duration instruments. Typically, they attempt to match the duration of assets to liabilities. Longer-tailed duration companies invest in longer duration assets which, although matching the loss payout pattern, exposes them to interest rate risk.
As interest rates have risen, investors can invest them in higher-paying coupons. Instruments issued in prior periods yielding lower coupons have to be revalued downward if sold in the current markets. This leads to unrealized losses which show in the AOCI line for insurance companies.
If unrealized losses continue to grow, it creates pressure on regulators to step in to ascertain capital adequacy and examine if permanent write-downs are needed. Against this backdrop it makes sense to examine the public disclosure on the impact of such a shift and how it would affect the fair value of insurance companies’ assets.
Almost all publicly traded names disclose the impact of 100 basis points on the fair value of their portfolio in their SEC filings. The table below shows the impact on fair value disclosed by the Inside P&C Select carriers. This disclosure shows a somewhat manageable impact.
However, interest rates have risen materially for 2022, up 146 basis points for the first six months, and an additional 85 basis points for the third quarter.
The table below shows AOCI/unrealized losses based on earnings disclosed as of second quarter, and these marks were already running between low single digits to double digits.
Applying the additional 85 basis point mark gives us additional pressure. We also applied the 85 basis points to the available-for-sale piece of the portfolio, which gives the likely unrealized impact for Q3.
This analysis shows the potential for additional pressure on book values by further single to double digits.
Additionally, one should keep three offsetting factors in mind. One is that many companies have different degrees of interest rate hedges, which should lessen the impact of rate movement.
The second point is that insurance companies invest in many other instruments apart from bonds and hence their moves have the potential to offset some of the negative moves overall.
The final and the most important factor to keep in mind is the higher new money yield which generates a higher investment income. In addition, the older instruments coming due can be reinvested at a higher yield.
These could play an offsetting role in how the industry thinks about pricing. The interplay of the broader capital impact should be kept in the background when thinking about the by-segment quarter expectation discussion below.
The major themes apart from the capital conundrum will include the following:
In personal lines, pricing and profitability remain at the forefront
eowners line, the above discussed capital impact from unrealized losses and Hurricane Ian will play a role in how the industry thinks about pricing. Our prior analysis had shown that it takes a while for homeowners insurers to be able to get the approvals and get the requisite pricing in their book.
On the personal auto front, recent indicators have shown varying results, and later in the morning Progressive’s monthly results will wrap up the quarter for them.
On the InsurTech front, a mixed bag will likely emerge with discussions surrounding capital preservation, intersecting with Ian losses and additional rate action. We continue to believe that the best course for wave 1.0 of InsurTechs is to seek partnerships/sales. We spent some time talking to wave 2.0 at the ITC Insurtech Conference and they are already cognizant of the lessons learned by the first wave.
Reinsurance gains another reason to keep the pressure on pricing
Hurricane Ian will add to the pressure on this space at the upcoming January 1 renewals. Yes, as is the case after any large loss, there has been a renewed debate regarding new entrants as well as third party capital/ILS flow. We remain unconvinced of this expectation. We also expect discussion surrounding a pivot away from property-catastrophe and a potential to revisit that thought process.
Commercial lines will reveal shifts in loss cost trends and how the companies are addressing the new interest rate climate
Apart from the impact of unrealized losses and investment income playing a counterbalancing act, we anticipate discussion to focus on pricing momentum vs. loss cost inflation and any change in the trend line from prior quarters.
For brokers, holding the line on organic growth would be a tough act to pull off
We anticipate a continued downward trend in organic revenue due largely to pricing trends, though we still expect positive results, and won’t completely rule out the possibility of another surprise quarter. We also hope to hear about the impact of wage inflation on margins.
Below is a calendar showing earnings for the companies that have announced so far.
Below is a summary of some key EPS numbers including the change in Q3 EPS estimates over the past quarter.
As expected, estimates have almost universally declined during this period, with Ian and other catastrophe loss exposed names witnessing the biggest declines. Looking at the consensus numbers, we can see no-one has escaped the decrease bar a handful of brokers.
The chart below is an alternative view of EPS data, showing revisions for the entire group over time, with the S&P 500’s revisions as a benchmark. While the revisions for the S&P are significantly down (taking a nosedive in August), we can see that the insurers numbers have completely crashed since Ian.
The estimates for 2022 logically follow the same pattern, with 2023 beginning to slightly trend downward. This shift in 2023 is important as a potential indicator of higher than previously anticipated investment income not offsetting the loss cost uptick.
Repeating the same exercise for brokers, we see a very different picture. Their earnings have remained almost completely stable since the spring, unaffected by Ian in October and even unaffected by the drop that affected the S&P in August.
The remainder of the note will look at these segments in more detail.
Personal lines:
Personal lines insurers should start seeing the lagging effects of previous rate hikes along with pivoting market conditions. Personal lines carriers with strong balance sheets should be well positioned for the medium and long term.
Homeowners carriers are taking rate and readying themselves for treaty renewals
Homeowners insurers have seen their loss costs increase due to elevated attritional losses as well as catastrophic events. Increasing prices of building materials have also provided headwinds, but carriers’ inflation guards should have adjusted for the increased exposure. Also, as mentioned in our last note, materials cost inflation may have peaked.
When we analyze homeowners insurance, we must look at the housing market. The housing market, where mortgage rates are currently in the 7.5% region, is seeing a brutal slowdown, which could result in less new policy issuance for carriers.
As earnings unfold, we will be paying attention to any news surrounding changes to underwriting margin, catastrophe exposures, and changes to mix of business (especially geographic changes).
For each carrier’s underwriting margin, any deviation from industry standards may have serious consequences in terms of insurers’ upcoming reinsurance treaty renewals. Reinsurers seem increasingly skittish and may require unfavorable terms of their cedants if they see insurers’ underwriting and exposure management to be poor.
We will also be curious to see discussion surrounding how non-Florida carriers are thinking overall about their Gulf/southeastern exposure in the medium to long term.
Homeowners carriers have been consistently taking rate increases for the past three years. The lagging effects of these increases should be making their way into insurers’ combined ratios as they earn out.
The following chart shows the industry-wide weighted average approved homeowners rate change from October 2019 through September 2022.
We see a trend of monthly increases going from 2%, to the latest available month showing 8%. The regulators in each state may be looking at homeowners more favorably as they didn’t see the Covid profitability spike that auto insurers did.
Personal auto may be over the hump
Auto margins, which were assisted by a dramatic frequency drop during Covid, have seen tougher times since. However, the margins are expected to recover even if they are poor for this upcoming round of earnings.
Progressive is scheduled to report its September results today before the opening bell. Its Hurricane Ian loss estimate will give us an additional insight. This should give us a glimpse into industry results for this quarter, and the plans for the remainder of the year.
We will be looking at shifts in frequency and severity, potentially higher liability claims from an aggressive legal industry, and any actions surrounding carriers’ geographic shifts where regulators are not approving indicated rates.
For Progressive, from its August results (posted on September 15), we are seeing improvement in their year over year combined ratio, going from 105.3% to 93.6% (-11.7 pts).
While there has been near-term weakness and a tough macro backdrop, we expect that these pressures will ease, especially as the cost of used vehicles and parts and repair continue to decline.
As the news team reported last week, the Manheim used vehicle value index is down 13.5% from the January 2022 top, and up only 1.5% year over year.
We are also seeing that the two sharpest increasing components of auto loss costs (body work, parts and equipment) are continuing to roll over – now down about 25% from their January 2022 peak.
In addition, there have been reports that describe the recent demand drop in chips as “breathtaking”, with the Philadelphia Semiconductor Index (SOX) down 43% YTD and analysts slashing estimates on pace with the 2008 financial crisis.
Auto carriers are doing anything they can to achieve rate adequacy against protective regulators. After the auto insurers enjoyed outsized Covid-related profits, filings were few or even negative. However, much has changed as driving habits have returned to pre-covid levels and loss costs have gone up.
The following chart shows the weighted average change of approved rate filings. We see a very insured-friendly rate environment from October 2019 through June 2021. However, the auto insurance industry has since fallen into the clutches of inflation and has scrambled to play catch-up with rising loss costs, as shown in the sharp upward trendline.
Allstate has steadily taken rate since Q2 2022
With these aspects of the auto market as the backdrop, and insurers steadily taking rate for the past year, we believe that personal auto carriers will be better positioned in the medium term.
Reinsurers should continue to feel a wind at their backs
Even prior to Ian, our discussions revealed a desire from market participants to hold the line on pricing into the January 1 renewals. With Ian’s losses, we continue to anticipate a further tightening at the next renewal cycles.
Another focus will be on how several participants have pivoted away from volatile classes in their attempt to build a hybrid book. Perhaps the most intense focus will be on Axis Capital, which earlier this year exited property reinsurance.
The graphs below show the global rate-on-line shift for 2022 was one of the strongest since Hurricane Sandy.
The chart below is an excellent representation of what’s going on with the Florida markets. Even after a near-vertical increase in the slope of pricing, additional momentum is expected at the next mid-year renewals as the industry continues to tighten capacity and seeks to pull back on volatility.
Commercial insurers will discuss any uptick in loss cost trends, a hot topic in Q2
Apart from the usual discussion on interest rates resulting in a negative impact from unrealized losses on balance sheet, growth will once again be under the microscope.
The commercial sector has seen spectacular growth for several years now. While such growth is excellent for the industry, it’s not sustainable long-term, and we previously predicted a flattening/decline in the growth.
All major rate surveys confirm we are seeing a slowdown. The charts below show rate change metrics from CIAB, which shows a Q2 rate growth at 6.1% down from the prior year’s growth of 8.1% - and even those were significantly down from the Q3 2020 peaks of 11%. At the moment, only MarketScout has come out with Q3 numbers, but those are showing the rate increase at 5.3%, which continues this downward theme.
During last quarter’s earnings everyone talked about rate but we saw an interesting bifurcation, with most carriers continuing the standing narrative. A select few (Chubb in particular) changed the discussion and made pointed remarks about changing their underlying loss cost inflation assumption, indicating an awareness of the turning tide.
It will be interesting in the coming weeks to see if and how companies change their stance and what they will have to say on the impact of interest rates on loss cost trends, as the Fed continues to pursue an aggressive rate policy (raising the rate by 75 basis points in September). In conjunction with the rate discussion, we expect to hear about wage inflation as well as broader economic growth.
As far as core business goes, we hope to see a discussion on broader pricing and capacity reallocation between different subsectors. The industry as a whole has still proven resistant to deploying capacity in short-tail vs. long-tail lines. If the markets were to undertake such a transition, there might be more capacity on long-tail lines which would in turn create more opportunity.
Last, we hope to hear some updates on social inflation. While this was the buzzword of the day for quite a time, we saw very little in the way of updates during the calls last quarter. While we have all been expecting a massive influx of Covid-backlogged claims to be pushed through, nothing in the discourse indicates that we have seen any kind of across the board change yet.
From what we have seen, nothing close to the projected numbers have come through yet, so we are still waiting for the other shoe to drop. It remains to be seen if this quarters calls will finally hint at this reversal or if that wave is yet to come.
Brokers surprised with results last quarter, but a cooling economy will bring an end to the super-cycle
Brokers will be an interesting group to watch after they surprised with their earnings last quarter – but they will now need to manage expectations as economic conditions become even more uncertain.
For a little over a year, economic conditions and rapidly increasing rates have allowed for a broker “super-cycle”. We had predicted this would come to an end last quarter as we hit industry-wide headwinds, but we were too early, likely due to better exposure trends and market resilience.
Brokers are the first derivative of the P&C market and can therefore be somewhat insulated from changes or take longer to show them.
Now as we see a period of weaker economic growth and a marked slowdown in pricing growth, we do expect to see this growth taper off as slowing rates lower revenue increases over the next few quarters.
However, that is not to say they won’t post growth. As we pointed out last earnings, the cohort generally had positive results, but the trend was beginning to plateau. With such high numbers, a decreasing trend could remain positive for a while.
The chart below shows brokers’ overall organic revenues over time, and illustrates the trend mentioned above. The growths were generally quite high, with three over 10%, but they are clearly part of a downward trend from the peak mid-2021.
In addition to the above, we expect to see continued discussion on wage inflation and its impact on margins (keep in mind this has both positive and negative effects for brokers).
It appears Truist will again be first to announce, which will set the tone for the group, but we must remember that its business model (skewing heavily toward E&S) is very different from the others and may not be the best early indicator.
In summary, multiple factors will be in play during this earnings season. setting the stage for years to come.
For the Florida homeowners carriers, it will be all about surviving Ian and remaining relevant while broader personal auto will continue to chip away at the loss cost uptick which has remained a tough nut to crack.
For commercial lines, opposing forces will be at play including pressures on balance sheet, partially offset by higher future investment income and a potential uptick in loss cost trends.
Brokers will likely post positive results, though lower than previous quarters.
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