It’s a crisis. We’ve avoided using the word over the past few weeks as financial volatility has picked up. But it is clear that the transmission mechanisms from the biological to the real economy to capital markets have been established, with no easy way out. Financial markets are not functioning, with a flight to cash dislocating markets due to investors dumping anything liquid.
There is an irony in the economic set-up. The last crisis began with highly paid financial workers leaving mid-town office buildings with their possessions in boxes as a financial crisis infected the real economy. This crisis is beginning bottom to top, with main-street businesses ordered shut, many blue-collar and gig workers sent home, and other “real economy” businesses under incredible pressure due to the precipitous decline in revenue resulting from “social distancing” measures.
Much economic commentary has centered on the strength of the economy heading into the crisis providing a potential buffer. We disagree.
The US is almost uniquely ill-prepared among developed countries to deal with such a crisis, with a weak social safety net, high % of hourly workers, limited sick pay benefits, and a lack of access to healthcare for large segments of the population. Almost 30% of Americans could not cover a $400 emergency expense from cash, savings or a credit card, according to the Fed. And the modest growth heading into this current turmoil was being supported by significant fiscal stimulus in the form of a ~$1tn deficit.
Layer on top of this a disconnected and frankly (so far) incompetent policy response and you have the worst combination of panic without precaution, and a grinding halt to the economic system without a clear understanding of the necessary duration.
Financial markets hate uncertainty, and in the absence of clear guidance are clearly pricing in disaster. This is not for nothing. Serious academic papers have predicted deaths of up to 2.2 million Americans without a policy response. On the other hand, social distancing measures will do very real damage to the real economy, in ways that are likely to lead to negative health outcomes for many Americans over time.
What's more, there is no easy way out. The monetary policy “bazooka” has already been fired. While it may ease access to credit over the long haul for some businesses, it also risks infecting the financial system by weakening the earning power of the banks. Though well capitalized at the start of the crisis, this could be challenged quickly as loans begin to sour and companies draw down on their revolvers en masse.
Additionally, looser money is simply not built to deal with the entire economic system grinding to a halt. Right now, it is not a lack of access to credit that is stopping economic activity, it is the coronavirus. Our problems are biological, not financial.
This leaves fiscal policy. We’d argue the US has more headroom than is typically thought. We’d look past the widely cited debt-to-GDP numbers and look to the fact that interest payments as a % of GDP are below levels in the “morning in America” 80s-90s, a period of robust growth. That said, it should be clear now to everyone that increasing the deficit through unfounded tax cuts during a period of long economic growth and a long bull market in order to gin up the economy was economic malpractice. The bill for that policy incompetence is now due, and leaves less fiscal space for a full-frontal assault.
Could we be wrong? For sure. We make no pretenses at being epidemiologists, and even experts in the field have suggested a wide array of potential outcomes driven by factors that are poorly understood (e.g. weather, impact of policy, virus mutations). But the balance of risks does not look good, and there seems no silver bullet without substantial damage, whether to health, the economy or sovereign solvency.
Part 2/3: What does this all mean for P&C?
A while back we argued there was a growing risk of a “worst of all possible worlds” emerging. We outlined a smorgasbord of headwinds including yield pressure, headwinds from market-sensitive items, and loss-cost pressures. We “mark these to market” for the new status quo below.
1. Significant pressure on investment income from lower yields
Interest rates spiked yesterday, and there has been some speculation around the return of the “bond vigilantes” in response to the proposed global fiscal response. However, financial reporting makes clear that treasuries are being dumped for liquidity purposes = a sign of markets not functioning. We’d suggest an “even lower for even longer” environment should be considered the base case. For context, the 10Y treasury has averaged 0.87% over the past two weeks, compared to an average of 2.46% during the Trump administration through to YE2019. Added to this is a growing risk of credit impairments that could significantly damage book value.
2. The reversal of tailwinds from market-sensitive items
As a proxy for risk assets, the S&P 500 is now down 26% YTD. However, for us this is about more than the near-term hits to BV (that will be meaningful, especially for businesses with market exposure on the liability side of the balance sheet through variable annuities and other forms of financial guarantees). This is about a level of normalized earnings that have been inflated by a long bull market and have become baked into normalized earnings (and have offset weak underwriting performances).
3. Adverse loss trends – still an issue, but more complicated
Companies have made a strong case that increased attorney participation is driving severity increases across several lines, notably commercial auto and umbrella, with challenging markets in medmal, D&O and construction to name but a few. This form of “social inflation” is particularly noxious for insurers as, unlike economic-driven inflation, it is not offset by the benefit of higher interest rates due to inflation expectations.
This is now perhaps the area with the biggest potential for wildcards. On the one hand, a cessation of economic activity is likely to benefit loss trends, particularly through frequency. On the other hand, this could lead to pressure on premiums (particularly for those driven by audits like workers’ comp), which may mean pressure on fixed cost leverage/expense ratios. On top of that, there is still the potential for wildcard losses stemming from contingency markets, D&O or creative use of BI coverages (these will be tested at the very least).
Other wildcards include exposure to macro-sensitive risk on the liability side of the balance sheet, most notably through the explosive growth in mortgage insurance and reinsurance across P&C firms.
4. Other factors
We also argued that the mean reversion in personal auto and workers’ comp would act as an offset. However, these lines seem most likely to benefit on a loss-cost basis from a reduction in economic activity, which may complicate this trend.*
However, it is now clear that this anti-Panglossian “worst of all worlds” outcome we outlined just three weeks ago was far, far too optimistic. That worst of all possible worlds has just gotten worse.
Most significantly, we think the entire market dynamic of the past 12 months is going to be thrown into disarray.
The ability of insurers to drive pricing to offset weaker investment income and adverse loss trend is going to run headfirst into the brick wall of financial restrictions of their counterparties. This really is a worst-of-all-worlds scenario.
Ordinarily, the “through the cycle” approach to this is to do your insured a favor, help them through their crisis and take the pricing when you can. In this instance, both parties find themselves in crisis at the same time. Higher insurance costs will act as a very real tax on American consumers and businesses at a time of maximum political pressure for corporations to do their civic duty and provide “relief”.
Part 3/3: Collapse in valuations → “game time”
We hate to be flippant at a time of very real health emergency for the nation. But for many disciplined participants, this type of market is what they have been waiting for. Put simply, it’s “game time”.
Assets across this space are being indiscriminately dumped by a flight to cash. High-quality assets with strong balance sheets are trading at or below book value, like Chubb (0.82x), Travelers (0.80x) and Berkshire Hathaway (0.98x).
On Wednesday night, the average price-to-book multiple of the Inside P&C Select had collapsed to just 0.92x. This compares to 1.34x at the start of the year just over two months ago, and a peak of 1.42x as recently as February 11. The current level is the lowest since the beginning of 2013 and 45% higher than the bottom of the last financial crisis. Note, the IPC Select has an inherent survivorship bias baked in as it does not include weaker firms that have been consolidated. Of course, part of this is explained by pricing in equity exposures and expected credit impairments to M2M “real” book value, yet the reaction appears to be uniform with limited differentiation, suggesting the potential for mispricings and bargains.
Perhaps the starkest way to confirm it is “game time” can be summed up like this. The entire market cap of our “large cap” composite of AIG, Chubb, Travelers, Hartford and CNA is ~$105bn. This is essentially equivalent to the level of cash and short-term liquid assets at Berkshire Hathaway, a long-term buyer of insurance assets.
Juxtaposing estimated ROEs against changes in multiples since the start of the year in the chart below shows that the general downward re-rating (parallel shift down of the regression line) was not accompanied by a flight to carriers with higher expected earnings potential (regression slope slightly steepened complicated by the high variation in Progressive’s P/B before the market slump driven by the volatile monthly earnings results).
Notably, the regression line shifted to the right, meaning higher earnings estimates and pointing to the fact that Wall Street has not started pricing the effect of the potential recession in P&C earnings.
In tomorrow’s PCIB, we’ll break down the movement in ROE and P/B for the companies we follow by sub-segment compared to year end (today’s got a little long). However, first, we offer two final thoughts.
1. Quality business franchises selling at a discount to book value
It is clear that the sell-off has been indiscriminate and driven by a market-wide need for cash. High-quality business franchises, with strong balance sheets, and top-notch management teams are trading at or below book value. We’d also note that, while not dramatic, we expect a crisis to act as a modest catalyst for a “flight to quality”, driven by higher client retentions at both (re)insurers and brokers against an influx of “challengers” (even if there’s no huge influx of new business wins – history suggests this is unlikely e.g. AIG client retention through financial crisis).
In particular, we’d highlight Chubb at 0.9 P/B, and debt-to capital of just ~20%. Recall, earlier this year we speculated the firm had ~$10bn in capital headroom to fund a potential acquisition if the market presented an opportunity. Though this headroom may have been shrunk by the dislocation in capital markets, the valuations of its potential targets have fallen much faster.
On the other hand, we could see some high-quality names become targets too, of long-term-oriented owners like Berkshire Hathaway, which has established a clear foothold in commercial insurance, an ambition to match its dominance in personal lines and reinsurance, and ~$120bn of liquidity ready to go. As noted above, this is almost equivalent to the market cap of our entire “large cap” composite.
We’d also highlight Aon and Willis on sale at 34% off their recent highs. Though now complicated by merger implications, on a standalone basis Aon is trading at the lowest P/E since January 2019. Recall, we outlined our view that though challenging in the near term, the longer-term combined companies have enormous room to drive long-term earnings growth through synergies and should emerge with a stronger competitive positioning, which argues for a higher PE against nearer-term “choppy” earnings.
2. Value
At the other end of the spectrum, there is clearly huge opportunity to create value at distressed assets either through M&A or a change in strategy and capital allocation. Many companies are now well into the “kill zone” where the combination of their low valuations and much more digestible market cap makes them potential targets for private equity, run-off, or liquid competitors.
We note this is not theoretical – Stone Point Capital unveiled a $20mn holding in Axis this week. Even without betting on a control premium, at these levels companies should be considering strategy changes to create value. For sure, capital and liquidity are king in a crisis. But let’s not be too precious about it. This too shall pass, and this is a business where you get your cash upfront and pay the claims later. Our view is there is substantial room for companies to create significant value through accretive share buybacks if they are willing to free up capital by de-risking parts of the business, or can monetize assets at non-distressed levels. The challenge will be to convince CEOs to prioritize returns over growth (and personal power). We would point readers to our comments last week on a need for stronger boards to manage these urgent principle-agent problems.
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