The progress of the US hurricane season, which runs for the six months from June to November, is being closely followed by the insurance industry. The forecast this year is for up to 16 named storms, of which four to six could become major hurricanes. Those are reassuring figures compared with 2005, when the season was marked by 28 storms, including seven major hurricanes – most notably the triple whammy of Katrina, Rita and Wilma, which cost around $65bn in insured losses. Some insurers could still be faced with heavy payouts this time, but the premium increases that the industry has forced through in the wake of last year’s turmoil will mean excellent returns for others.
US insurers and hurricanes: higher premiums
Natural catastrophes can strike anywhere in the world, but of late the US has been worst hit. “Climate change seems to be North America-focused,” says James Johns, senior North America property specialist at broking group Marsh. For example, last year’s biggest non-US natural catastrophe – winter storm Erwin in Europe last January – was trivial compared with the US hurricane damage, costing insurers just $2.5bn. Consequently, rates for catastrophe coverage in the US have spiralled in the past year to become much more expensive than elsewhere, as though Mother Nature’s wrath is focused solely on North America. “The market is thinking that way,” says Johns, “and to varying degrees, we all have to take our pain.”
Those suffering include some Fortune 500 companies, including Wal-Mart, who have concluded that they’re better off bearing any losses themselves rather than insuring at these high rates. That trend is a worrying sign for both intermediaries and insurers, since it means less business. But there is a lot else for them to be pleased about – namely the prospect of more attractive returns from higher rates, which has triggered an influx of new capital into the insurance market.
US insurers and hurricanes: the attractions of ‘sidecars’
New investors have been particularly attracted to insurance special-purpose vehicles for catastrophe exposures, more popularly known as ‘sidecars’. Since Katrina, these have raised more than $2.5bn of capital in the insurance and reinsurance centre of Bermuda. Hedge funds and private equity particularly like the returns they offer. But despite this influx, there remains a shortage of capital in the sector. On top of that, early signs suggest that the new investors’ initial expectations of income have been overly optimistic. This means that US pricing is likely to stay high for some time, in order to tempt investors to place their money here, rather than in less-risky ventures.
The aftermath of Katrina may have another, more long-term benefit for the industry. The insurance market has always been prone to cycling between hard (high) and soft (low) rates. Those firms that remain in the market – rather fewer than when Hurricane Andrew’s losses savaged the industry way back in 1992 – are keenly aware that they need to smooth this cycle to provide shareholders with decent returns (and to satisfy the increasingly demanding capital requirements of the credit-ratings agencies). The severity of the latest hurricane damage should give them an excuse not only to hike rates, but also to keep them high. So while hurricane-exposed insurers will always be a risky concern, they look set to offer greater rewards in the future. Below we suggest two ways to profit from this trend.
US insurers and hurricanes: two ways to ride out the tempest
Catastrophe insurers obviously run the risk of another severe round of storms and, with investors nervous about this, they are trading on low ratings. But if this year’s season is milder – as expected – profits should rise sharply, propelling these stocks upwards.
Lloyd’s of London insurer Catlin Group (CGL, 427p) says that it is well placed to benefit in the event of a milder 2006 hurricane season. It has already increased its capacity for writing new business, through a £40m share placing, to respond to market opportunities in the US. In March, Catlin still managed to report pre-tax income of nearly $20m for last year, despite incurred losses of $333m from three hurricanes. On consensus 2006 forecasts, the shares trade on a p/e of just 6.8 and would yield 3.7%, covered 3.9 times.
Concerns over another active hurricane season have dented investor enthusiasm for fellow Lloyd’s insurer Kiln (KIN, 88.3p), which has dropped more than 15% from its November highs. However, the group recently issued forecasts showing sharply improved estimates for its syndicates, even after making provision for fairly severe hurricane losses.
Kiln’s reputation among Lloyd’s Names and their advisers ranks high, despite its relatively small size. It trades on a 2006 forward p/e of 7.3, with a forecast dividend of 4%, covered 3.4 times.
by Graham Buck and Alex Ferguson