The financial meltdown has so far taken its heaviest toll on banks. But other companies in the financial sector have also been hit hard, not least of all insurers. Insurers make money in two ways. There’s underwriting – where they assess the risk of you crashing your car, for example, and charge a premium based on the likelihood of your making a claim. Then they make money by investing the premiums. So while the rest of the insurance industry is being forced to hunker down and cut its losses, this simple and conservative sector in the industry should continue unperturbed.
The financial meltdown has so far taken its heaviest toll on banks. But other companies in the financial sector have also been hit hard, not least of all insurers. Insurers make money in two ways. There’s underwriting – where they assess the risk of you crashing your car, for example, and charge a premium based on the likelihood of your making a claim. Then they make money by investing the premiums. So to thrive in the long run an insurer must ensure that its profits from investing and writing premiums outweigh its running costs and payouts. As Jay Palmer puts it in Barron’s, “an insurance company is only as good as the capital reserves it has built up to pay off claims”.
The trouble is that the investment side of the equation has suffered badly. Many insurers have piled into investments that were among the hardest hit last year. The average life insurer in America, for example, has the equivalent of about 41% of its equity invested in commercial mortgage-backed securities, according to SmartMoney. But many of those securities, backed by hotels and shopping malls, are close to default. Growing losses are eroding insurers’ capital.
But even those with relatively conservative investment portfolios, like America’s largest life insurer MetLife, are not immune, Fitch insurance analyst Douglas Meyer tells The New York Times. Selling products such as annuities that guarantee a certain rate of return is a tricky business to be in when life expectancy keeps growing. MetLife has just reported a 12% drop in quarterly profits, notes Andrew Frye on Bloomberg. The company actually made gains on its investments during the last three months of 2008 – the fall in income was down to the “rising cost of guaranteeing minimum returns on retirement products”.
But not all insurers face the same woes. Ideally, an insurer wants a stable, predictable source of premium income, with good claims visibility, backed up by a conservative investment portfolio. Insurance against medical malpractice in America fits the bill nicely. Unhappy patients will always sue their doctors. So doctors have little choice but to buy malpractice insurance, making it a $10bn-a-year industry in the US. And calculating medical risks is easier than you’d imagine. Statistically, the possibility of a malpractice lawsuit can be easily determined for different specialities – the risk is higher for neurosurgeons and obstetricians, and lower for family practitioners. Annual premiums are adjusted accordingly, and can cost less than $20,000, rising to more than $200,000. It works out at one lawsuit a year for every ten doctors in the US.
Juries have also stopped giving ridiculously high, billion-dollar rewards. “They seem to have realised that this was quite literally destroying the practice of medicine and driving good doctors away,” says Kevin Clinton of malpractice insurer American Physicians Capital. By clamping down on court-house step settlements (where lawyers make last-minute deals with insurers), medical malpractice insurers have been able to curb claims by ‘ambulance-chasing’ lawyers who prey on patients in hospitals. So while the rest of the insurance industry is being forced to hunker down and cut its losses, this simple and conservative sector in the industry should continue unperturbed. We have a look below at the most attractive medical malpractice insurer.
The best bet in the medical malpractice sector
American Physicians Capital (Nasdaq:ACAP) focuses on insuring medical groups and individual doctors rather than hospitals. You won’t find an insurer with a more conservative portfolio, says Jay Palmer in Barron’s. Its $750m investment pot includes only one small equity stake, a $15m holding in a Texas malpractice insurer. Roughly 20% is invested in government-backed Fannie Mae, Freddie Mac and Ginnie Mae debt; 20% is in investment-grade corporate debt; and the rest is in highest-quality municipals (bonds issued by local governments in the US). The firm is also expanding its client base by 5% a year. It could grow faster with acquisitions, but as CEO Kevin Clinton told Barron’s: “If a company expands too quickly out of its footprint, it can be destroyed later.”
Everything comes down to experience and understanding the risks in this field, says Palmer, and this company “has that in spades”. Its move to stop accepting ‘court-house step’ settlements has helped it to cut claims in half from five years ago, as the prospect of going to court puts off claimants. “It’s difficult to find any company more insulated from economic weakness than this one,” says Oppenheimer analyst Michael Nannizzi. That’s perhaps a bit strong, given the troubles in the municipal market. But with its exposure to the defensive medical sector, and being reasonably priced on a forward p/e of 10.4, American Physicians Capital looks as recession-proof as it gets.