By Matthew G Heimermann & Keith Alexander
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We believe that reinsurance stocks—PartnerRe (PRE: OW) and Everest Re (RE), in particular—offer investors the most direct avenue to follow rising prices within the non-life insurance industry. Unlike the primary insurance market, where fundamentals could be on the cusp of improving, but lack a catalyst to push rates higher, a combination of supply destruction and growing demand should lead to pricing power in property reinsurance. While investment losses have shrunk the industry’s balance sheet, the withdrawal of capital markets participants has further curtailed supply. Meanwhile, demand for protection in peak catastrophe zones now outstrips supply. In addition, investment pressure is leading to increased demand for reinsurance as a substitute for traditional capital. With stocks still trading close to historical trough levels, excepting valuations of the past two months, we believe valuation has room to improve with pricing.
• We estimate global reinsurance capacity is down by more than 10%. Investment pressures, combined with catastrophe losses in 3Q, have led to an approximately 8% reduction in traditional reinsurance capacity. Meanwhile, we estimate that falling leverage, rising borrowing costs, and increased collateral requirements have reduced capital markets capacity by at least 33%.
• Demand growth likely to increase given capital pressures. US non-life surplus (excluding reinsurance) has declined by more than 8% this year below year-end 2006 levels. We expect primary underwriters use reinsurance to bring underwriting and volatility leverage back into balance. In addition, Florida’s state-run reinsurance program could be scaled back, increasing demand for traditional reinsurance by $1.25-$1.75 billion.
• Valuations reflect investment fears, not prospects for pricing power. Based on our analysis of underwriting cycles over the past 18 years, the reinsurance sector (0.83X current book) is trading close to average trough multiples (0.86X), excepting new lows of the past two months. In past cycles, multiples have expanded by an average of 92% to peak. While credit pressures and changes in leverage may limit expansion today, we still see meaningful upside.
• Reinsurance appealing because of low expectations just months ago. With pricing power returning to property reinsurance markets (50% of global reinsurance premiums), we believe the sector offers investors higher rising returns on equity as well as increased earnings visibility. This contrasts with the consensus two months ago, when an abundance of capital, falling demand, and a lack of pricing power made the sector less appealing than primary insurance.
• Capital flexibility crucial in stock selection. We believe that the entire reinsurance market should benefit from higher prices in peak catastrophe zones. However, we believe that companies with on-shore operations in the US and Europe, as well as higher financial strength ratings, will likely benefit most from rising demand and a likely multi-geographical pricing impact.
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We believe that reinsurance stocks—PartnerRe (PRE: OW) and Everest Re (RE), in particular—offer investors the most direct avenue to follow rising prices within the non-life insurance industry. Unlike the primary insurance market, where fundamentals could be on the cusp of improving, but lack a catalyst to push rates higher, a combination of supply destruction and growing demand should lead to pricing power in property reinsurance. While investment losses have shrunk the industry’s balance sheet, the withdrawal of capital markets participants has further curtailed supply. Meanwhile, demand for protection in peak catastrophe zones now outstrips supply. In addition, investment pressure is leading to increased demand for reinsurance as a substitute for traditional capital. With stocks still trading close to historical trough levels, excepting valuations of the past two months, we believe valuation has room to improve with pricing.
• We estimate global reinsurance capacity is down by more than 10%. Investment pressures, combined with catastrophe losses in 3Q, have led to an approximately 8% reduction in traditional reinsurance capacity. Meanwhile, we estimate that falling leverage, rising borrowing costs, and increased collateral requirements have reduced capital markets capacity by at least 33%.
• Demand growth likely to increase given capital pressures. US non-life surplus (excluding reinsurance) has declined by more than 8% this year below year-end 2006 levels. We expect primary underwriters use reinsurance to bring underwriting and volatility leverage back into balance. In addition, Florida’s state-run reinsurance program could be scaled back, increasing demand for traditional reinsurance by $1.25-$1.75 billion.
• Valuations reflect investment fears, not prospects for pricing power. Based on our analysis of underwriting cycles over the past 18 years, the reinsurance sector (0.83X current book) is trading close to average trough multiples (0.86X), excepting new lows of the past two months. In past cycles, multiples have expanded by an average of 92% to peak. While credit pressures and changes in leverage may limit expansion today, we still see meaningful upside.
• Reinsurance appealing because of low expectations just months ago. With pricing power returning to property reinsurance markets (50% of global reinsurance premiums), we believe the sector offers investors higher rising returns on equity as well as increased earnings visibility. This contrasts with the consensus two months ago, when an abundance of capital, falling demand, and a lack of pricing power made the sector less appealing than primary insurance.
• Capital flexibility crucial in stock selection. We believe that the entire reinsurance market should benefit from higher prices in peak catastrophe zones. However, we believe that companies with on-shore operations in the US and Europe, as well as higher financial strength ratings, will likely benefit most from rising demand and a likely multi-geographical pricing impact.
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