Reinsurer valuations too high, even at lower cost of equity: Deutsche Bank

In a report discussing the leading European reinsurance firms, analysts from Deutsche Bank conclude that valuations are too high, having been driven up by a hunt for dependable yield from investors and a market that has tended to avoid the fundamentals.

Reinsurance companies are likely to remain a popular choice among traditional investors, as the market environment has helped them to look attractive even at a time when the industry itself acknowledges it is under the greatest pressure in years.

The European reinsurers that Deutsche Bank’s analysts are assessing have moved as a group as well, which the analysts say ignores the underlying factors that affect each company differently.

“The market has not differentiated between the companies and has tended to ignore fundamentals,” lead analyst Olivia Brindle wrote.

Overall this leads Deutsche Bank to be neutral on the sector but negative on some firms in particular, as their valuations have now risen to levels which “we cannot justify even with reduced costs of equity.”

This is a very interesting statement as it confirms a number of points that we’ve been covering at Artemis.

Primarily that the low-levels of catastrophe losses and rising capital levels have been masking the true performance of the reinsurance sector and that this is ultimately what has been making reinsurance stocks seem so attractive to investors.

But also that, even if reinsurers can become more efficient and reduce their costs, it may not be enough to turn the underlying fundamentals which are eroding some signs of profitability.

Performance between leading reinsurers leaves little to choose between them, according to the analysts, however for some the fact valuations continue to be driven up, when they were considered adequately valued a year ago, suggests that they have reached this level where Deutsche Bank no longer recommends them.

Deutsche Bank continues to recognise the attractiveness of reinsurance company investments from a yield perspective, but notes in particular that it feels Munich Re and Hannover Re are now overvalued.

Conversely, the analysts feel Swiss Re is a little undervalued, reflecting the fact it is the lowest performer of the group of four big European reinsurers, which makes them a little more positive on its stock. SCOR also has upside potential, but its valuation is already considered quite high, so less room for further growth.

The question the analysts pose is that while reinsurers have been tracking upwards as a group, in terms of valuations, will they continue to move in alignment or will a separation occur as fundamentals begin to show through.

We’d add that it will be important to see how these four reinsurers perform when global large losses and catastrophe insured impacts return to normal or above normal levels. That will be a key event, that could show a divergence between these reinsurers in terms of performance.

Losses are also likely to show up any actions by these reinsurers to expand on terms and conditions for their clients. A few consecutive years of average or above average loss experience could make a world of difference to reinsurer performance.

Deutsche Bank don’t see imminent reasons to worry about these reinsurers capital returns, but they do see less scope for upwards movement for the German paid, versus the others. This could be particularly true while the market remains in its currently softened state.

Attitudes to growth remain cautious at these firms, as many of their core business lines come under pressure from competition, new sources of third-party capital, insurance-linked securities (ILS) and cedents buying trends.

This has all led to lower margins on new business underwritten, which will in return slow the capital growth. Again, it may take some more impactful losses to really slow this down as the reinsurance business remains a source of profit, which explains the continued attraction that ILS and institutional investors demonstrate for the sector.

As lower margin business earns through, the analysts say that we will begin to notice pressures on the underlying loss ratios. Here again it will be interesting to watch for any divergence in performance, as this could signal changes in terms and conditions or even a reduction in underwriting discipline, if there had been one.

Attritional loss ratios and underlying combined ratios appear to be trending up for some of these firms, perhaps indicating a shift in business mix, more focus on primary and large commercial property exposed business and generally a greater exposure to attritional weather loss events. Time will show whether this is a blip or a trend that will continue.

As ever expense ratios are becoming increasingly important when the analysts look at reinsurers performance and make their decisions on how to rate their likely futures. With valuations now considered high, even at reduced costs of equity, expense reductions and more efficient underwriting is going to increase in importance. While the market remains large loss free and softened this will only become more important.

And what happens when losses return to more average levels, or above average? These large reinsurers will be pushing for rate increases in order to recoup some of their losses. That is likely to be a very important point in the reinsurance market’s history when it happens.

Will rate increases follow? Will competition increase as more capital flows in? Will there be a divergence, based on rate, as more efficient capital seeks to maximise its cost-of-capital advantage?

Already over-valued even at lower cost-bases, when losses happen and these large reinsurance firms, and more importantly their smaller competitors find capital drained the pressure could actually ramp up rather than be reduced, as some hope.

These large reinsurers remain well positioned to carry on being attractive investments for their shareholders. However there is a need to focus on innovation, cost reduction, diversification and new markets, as well as embracing lower-cost capital.

However, should they fail to make headway and if valuations remain high, while they cannot reduce their cost of capital, it could be a slippery slope in terms of performance. That could result in investors becoming less confident in these companies abilities to successfully navigate the reinsurance market as it evolves.