Dan Lukpanov and Gianluca Casapietra
...The firm’s Q4 operating EPS of $4.91 beat the Wall Street consensus of $3.18 by a substantial margin of 54%.
The release included several positive data points including continued rate increases, improvement in exposure, better than expected prior year development, expense ratio improvement, benign catastrophe losses and a partial restart of the share repurchase program following the suspension in Q1:20.
However, perhaps the report’s most notable data point was on the continued underlying loss ratio improvement within the commercial business of over 1.5pt excluding benefits from favorable comp. This could be viewed as continued evidence that rate in excess of loss trend will likely translate into higher margins, something that investors see as an important part of the bull case for the commercial names amid pressured interest rates and spreads.
Management was cautiously optimistic that the margin expansion story should have legs. Travelers’ stock closed +2.5% yesterday versus a flat performance for the S&P 500. Travelers stock is now only 3.9% below its July 2019 high.
Below are our three main takeaways from the Travelers report.
First, the 3.2pt improvement of the underlying loss ratio within BI provides a strong support to ROE despite the net investment income drag.
Travelers reported that over 1.5pt of the improvement was due to earned rate in excess of loss trend, with the remaining ~1.5pt stemming from the favorable comp from the re-estimation of losses in last year’s Q4.
From the perspective of near-record low risk-free yields and spreads, which resulted in dampened investor sentiment in stocks with a limited interest rate hedge, the underlying loss ratio improvement in Travelers’ BI segment is just what the doctor ordered.
There is a strong case for continued margin expansion in the near-term since the industry has been lapping rate-on-rate through 2020 and rates typically reflect in the income statement with some lag. There is continued debate in the investor and insurance community if this cycle could be similar to the rate improvement seen in 2011-2014. At that time, while rates started decelerating heading into 2015, ROEs continued to improve due to the lag effect of earned rate. (see chart below).
Below we highlight data from CLIPS as a proxy for market rates and plotted the ROEs for some of the largest commercial cohorts, which confirms the lag effect. A price to book plot below this chart shows the rerating of the space vs. a 2011 trough.
As highlighted in our preview, estimate revisions for 2021 have largely remained flattish. If Travelers and other larger players confirm this trend, the space could be setting up for estimates and price target revisions. Investors also appear to be less enthused with reinsurers, as well as personal lines names. The reinsurance space is dealing with a “lowered expectations” renewal – particularly around property cat, a major profit driver – while personal auto names will approach inflection in loss costs as and when the economy recovers.
Second, Travelers’ rate disclosures and the strength of the results point to the emerging question of the duration of pricing gains.
Despite the clearly optimistic signs on the margins front, the more important question for commercial names is whether the hardening cycle has legs.
This is likely reflective of the push/pull at renewals as the overall economy continues to deal with Covid. An economic recovery with a faster than previously anticipated vaccine delivery could be a shot in the arm for continued pricing momentum.
The outcome will also be shaped by a number of difficult-to-forecast factors that add a high degree of uncertainty including: a) the development of loss cost trends as Covid unwinds and the courts return to normal; b) the degree of adverse development recognized on accident years 2014-19 by the industry; c) cat loss experience and the degree to which climate change's impact on expected losses becomes baked into pricing models; and d) whether the pendulum starts to swing against carriers on Covid-19 property BI as ex-US jurisdictions show signs of pro-policyholder outcomes.
The market's tendency to exhibit what we have called "micro cycles" with a high degree of differentiation by line of business, geography and type of account also creates scope for staggered outcomes on rate momentum moderating – something underlined by the degree to which workers' comp is out of sync with other lines. Here, the market tends to believe that casualty and professional lines have further to run than property.
Third, auto commentary confirms that frequency benefits remain in play but are diminishing.
Travelers’ Q4 results in personal lines were strong, particularly in its agency auto segment. As discussed in our Q4 preview, auto-exposed names have benefited from Covid’s impact on auto accident frequency, ultimately leading to wider margins. While frequency trends have remained visible from Progressive’s monthly reporting and our auto accident frequency updates, Travelers' results and earnings call show that they have not missed out on the added earnings with its auto combined ratio improving over 12pts YoY to 86.5%.
Management confirmed that the figure reflected favorable frequency levels, and that roughly a third of the underlying improvement (4pts of 12pt total) came from calendar-year adjustments. Taking a step back, our view remains that some carriers will be forced to defend their books as the economy recovers and loss cost trends reverse, while insurers with strong telematics programs such as Progressive’s will be able to react quickly.
While it is generally accepted that accident frequency will remain muted as long as the pandemic remains in play, loss ratios are rising as the “all-in” benefit eases. More specifically, the combination of states easing restrictions in tandem with the hypercompetitive low/negative rate environment acts as a headwind to margins, which reached a high in mid-2020. The upward trend in loss ratios is visible in Travelers’ results, especially considering the significant benefit from its calendar year adjustment – and likewise for its Q3 figure. This would make its true curve/trend more comparable to Progressive’s.
Other items of note
Elsewhere, notable items included a partial resumption of the buyback program, as widely expected, and details on the renewed reinsurance treaties.
The carrier’s main XoL reinsurance was renewed on what the company called “terms in line with the expiring treaty”. It also renewed its underling property aggregate deal – which it totalled last year – but with a number of changes to the structure. The aggregate retention on the $500mn deal rose to $1.9bn from $1.55bn, with the co-participation dropping to 30% from 44%. A franchise deductible of $5mn was also added, and a per-event cap for wildfire of $250mn was added too, alongside the existing cap at that level for wind and earthquake. The company said that it expects the full-year impact of the treaty on its underlying combined ratio be roughly 0.5pts, with only “a minimal impact” on the total combined ratio.
Finally, Travelers provided limited updates on its guidance. Management expects the underlying combined ratio within its bond and specialty segment for 2021 to “slightly improve” from 87% in H2:20. The 2021 net investment income outlook remained unchanged from the guidance shared in Q3 at $420mn to $430mn from fixed income assets quarterly. The firm provided no updates on BI and personal lines margins that it pulled in Q1.
In summary, we believe that Travelers’s strong print has positive read-throughs for Chubb, Hartford and CNA. Investors and industry participants will also be looking for Rob Berkley’s views on the market when WR Berkley reports on January 26.
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