Sunday, August 21, 2005
Goshawk: a warning on insurance investing
Since I've been gracing the infinite ether that is the internet with this blog, I've repeatedly expressed my opinion that the insurance sector is unfairly under-rated by the market. The shares on offer here are simply too cheap given their prospects and track record. The FTSE 100 trades historically at an average P/E ratio of 15. Most of the insurance sector's constituents trade on P/E ratios between five and six (see Chaucer Holdings and Atrium Insurance) and some cheaper still (SVB).
I can think of two reasons why a discount to the market should be applied to this sector.
Firstly, insurance is a notoriously cyclical sector. The price of premiums insurers can extract from customers don't rise and fall along with inflation unlike, for instance, the price of a loaf of bread. Unlike bread making, there are very few barriers to entry in the insurance business. You don't need a factory, a large workforce or fleet of delivery vehicles to sell insurance, a company already operating just needs a large wodge of capital to reserve against claims and a few advertisements and a company can dramatically increase the amount of insurance business it does. When premiums are rising, this can lead to a glut of capacity competing for business in the market and the inevitable declining premium rates. When premiums are falling, insurers try to step away from the market in fear of underwriting losses and capacity declines again. Thus, after a few years of high premia, a decline would be expected. This cyclical decline will bring reduced profits and in extremis painful losses. The market currently considers insurers to be on the cusp of a cyclical decline and is factoring in expectations of severely reduced profits into valuations.
The second reason insurers are less well-loved than listed companies in other sectors is the fear of suffering from an adverse event, like a major earthquake or severe oil-spillage. This is always a risk in the sector and the market is right to acknowledge it.
To demonstrate this point, consider this announcement made on Friday by Goshawk:
Goshawk has been advised of certain offshore energy catastrophe losses affecting its marine account which will negatively impact the result for the six months ended 30 June 2005. The Company has also incurred losses, to a limited extent, on winter cyclone Erwin and the Suncor plant loss in Canada during the first half of 2005....The marine loss advices received are for hurricane Ivan which occurred in late 2004 and on which the Company had set aside a reserve in excess of loss advices previously received. The total of the loss advices received exceeds the amount reserved.
Goshawk has come a cropper here, the company was exposed to the oncoming hurricane like a teepee in the middle of Cape Canaveral. Goshawk had taken on too much marine insurance business and was hit badly. Furthermore, the company then went on to underestimate the amount they would have to pay out. Not only did this hit the company's profitability but it's reputation too. Can shareholders trust Goshawk not to leave itself this vulnerable in the future? And how good a handle does management have on the business?
Investing in this sector isn't a one-way street, something dangerous can emerge from around a corner at any time. Investors would be well advised to diversify across the sector and avoid companies that have made imprudent underwriting/reserving decisions in the past.
Goshawk has surprised the market previously, suffering losses from specific events at a greater level than its peers. The company suffered some pretty serious burns following the Columbia disaster of 2003.
The Artful Dodger
I can think of two reasons why a discount to the market should be applied to this sector.
Firstly, insurance is a notoriously cyclical sector. The price of premiums insurers can extract from customers don't rise and fall along with inflation unlike, for instance, the price of a loaf of bread. Unlike bread making, there are very few barriers to entry in the insurance business. You don't need a factory, a large workforce or fleet of delivery vehicles to sell insurance, a company already operating just needs a large wodge of capital to reserve against claims and a few advertisements and a company can dramatically increase the amount of insurance business it does. When premiums are rising, this can lead to a glut of capacity competing for business in the market and the inevitable declining premium rates. When premiums are falling, insurers try to step away from the market in fear of underwriting losses and capacity declines again. Thus, after a few years of high premia, a decline would be expected. This cyclical decline will bring reduced profits and in extremis painful losses. The market currently considers insurers to be on the cusp of a cyclical decline and is factoring in expectations of severely reduced profits into valuations.
The second reason insurers are less well-loved than listed companies in other sectors is the fear of suffering from an adverse event, like a major earthquake or severe oil-spillage. This is always a risk in the sector and the market is right to acknowledge it.
To demonstrate this point, consider this announcement made on Friday by Goshawk:
Goshawk has been advised of certain offshore energy catastrophe losses affecting its marine account which will negatively impact the result for the six months ended 30 June 2005. The Company has also incurred losses, to a limited extent, on winter cyclone Erwin and the Suncor plant loss in Canada during the first half of 2005....The marine loss advices received are for hurricane Ivan which occurred in late 2004 and on which the Company had set aside a reserve in excess of loss advices previously received. The total of the loss advices received exceeds the amount reserved.
Goshawk has come a cropper here, the company was exposed to the oncoming hurricane like a teepee in the middle of Cape Canaveral. Goshawk had taken on too much marine insurance business and was hit badly. Furthermore, the company then went on to underestimate the amount they would have to pay out. Not only did this hit the company's profitability but it's reputation too. Can shareholders trust Goshawk not to leave itself this vulnerable in the future? And how good a handle does management have on the business?
Investing in this sector isn't a one-way street, something dangerous can emerge from around a corner at any time. Investors would be well advised to diversify across the sector and avoid companies that have made imprudent underwriting/reserving decisions in the past.
Goshawk has surprised the market previously, suffering losses from specific events at a greater level than its peers. The company suffered some pretty serious burns following the Columbia disaster of 2003.
The Artful Dodger
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