The catastrophe-modeling company AIR Worldwide Corp. has estimated that insurance company losses from the Japanese earthquake and tsunami could reach $35 billion.
That has insurance analysts feeling bullish about insurance stocks: In their view, losses are good because it enables the insurers to ratchet up their premiums.
Personally, I don't see it that way. While I like life-insurance and domestic-insurance companies as investments for ordinary investors, I think the big-ticket insurance market is too opaque, too insider dominated, and much too unlikely to deliver decent returns to its outside shareholders.
In short, here in the aftermath of the deadly Japan disaster, investors need to beware of global insurance stocks.
A Casualty of Insurance Investments
Before proceeding, I should explain a bias here: I had a number of friends who were unfortunate enough to be "names" at Lloyds of London. These people, often quite unsophisticated but generally fairly wealthy (before they invested in Lloyds), were encouraged to put up a minimum of about $100,000 – maybe $250,000 in today's money – to become a "name," which was considereda fairly safe and socially smart thing to do (fortunately I never had that kind of money in those days, or I might have done it).
As a "name," they would participate in the insurance business of a Lloyds "syndicate," receiving the profits but – crucially – bearing unlimited liability for the losses.
Prior to about 1970, the global insurance market was not particularly competitive, Lloyds of London brokers were generally scrupulous in their honesty, syndicate moneys were invested conservatively, and the "names" made a decent return – although probably less than they should have made, given the profitability of the business.
Then came the 1970s.
During that decade, the number of "names" was expanded and the global insurance business became much more competitive and aggressive. Ethical standards declined, syndicate moneys were invested in speculations and the "names" were treated as cannon fodder, to be milked for extra payments if things went wrong.
I have a personal story that ably illustrates the point.
A friend of mine was married to that 19th Century English melodrama villain, a Bad Baronet (baronets were hereditary knights, generally awarded for large donations to James I, or, eventually, to political-party funds).
My friend had inherited quite a considerable fortune, some of which her husband – the Bad Baronet – then invested in Lloyds syndicates, through an assortment of his "contacts." In the 1980s, needless to say, those syndicates all went bad, partly because they had operated at the dodgy end of the U.S. market, where the trial lawyers for a time made insurance fraud against Lloyds a national sport.
Lloyds then presented my friend with a bill for about $10 million, an amount that was far more than she had invested, but one that was her share of the losses on the insurance the syndicate had written.
That wiped her, while the Bad Baronet – who, by then, wanted to turn her in for a newer model – divorced her hurriedly, while she still theoretically had money and couldn't get much of a divorce settlement out of him.
The lessons of this sorry tale are obvious:
- Don't put your money into insurance operations controlled by somebody else.
- And never play cards with a man called Sir Rupert (the Bad Baronet).
A Look Behind the Curtain
The insurance business is intrinsically cyclical. Since the service being offered is hard to differentiate, when the business appears profitable, investors view it as "easy money" and new pools of money flood in.
This money flow is made easier by the fact that such new pools can act as "reinsurers," meaning they can bypass the whole "dealing with the public" facet of the insurance business. They can forgo the expense of agents, advertising, staffing, processing – which makes reinsurance a low-overhead portion of the insurance sector.
That's why disasters such as the Japanese, New Zealand and Chilean earthquakes are seen as positive developments by the insurance industry (provided they are not large enough to send the whole shebang into bankruptcy).
By draining the profitability from marginal reinsurance operations, these catastrophes make it less attractive for new money to enter the business. This, in turn, enables the stronger companies to raise premiums, increasing their profitability. Of course, once this newer, higher profitability is noticed, new money floods in again. But for the short-term, at least, profitability is increased.
For outside investors, this cycle is very difficult to spot, What's more, the losses happen before the profits, which makes the whole enterprise rather more risky than one would like.
There is, however, another factor driving the insurance business, which makes it even more difficult to get right, and that is the investment side of the business. Since premiums are received several years before claims are paid, the actual insurance does not need to make money at all, as companies can make adequate returns through investing the premium surplus. Thus, the "underwriting ratios" (ratio of losses to premiums) of large companies are often above 100%, even while the companies themselves make good profits on the investment side.
The problem here is that, over the past 10 years, investment returns have been lousy. The stock markets really haven't gone anywhere, and bond yields have descended to minuscule levels.
Insurance companies try to make up for this through diversification into such "alternative assets" as hedge funds, private equity funds and commodities.
However, the returns on most alternative assets are very non-transparent, the liquidity is low (so they can't be sold when a big claim occurs) and the fees on funds are high. Also, as American International Group Inc. (NYSE: AIG) spectacularly demonstrated with its credit-default-swap business, some of the bright ideas insurance companies have on the investment side can turn horribly wrong. And when that happens, those bad ideas can transform a once-viable company into a bankrupt shell – and virtually overnight, as we saw with AIG (which we … as the American taxpayers … bailed out to avoid such a fate, but you get the point).
With insurance underwriting depending on a cycle that is difficult for outsiders to predict, and an investment side that either produces very low returns or leads companies to take outlandish risks, I would have to say that the insurance business is pretty unattractive overall.
In fact, I would even say that the insurance business is a lot like the airline business, which – for structural reasons – has produced an overall loss for its investors in the 108 years since the Wright Brothers took off.
Here in the aftermath of the Japan earthquake and tsunami, you're going to hear a lot of bullish sentiment about the insurance business – especially as analysts talk about the prospect of increased premiums.
As we've already explained, that could actually help some of the insurers. But, as we've also seen, that doesn't mean the shareholders will benefit.
So don't be seduced into putting a lot of money into insurance stocks – even if the company you invest in is not run by a Bad Baronet!
But here's the problem: Only 1% of investors know about it.
Fortunately, Money Morning Contributing Editor Martin Hutchinson is among that 1%. The 37 years he spent as an international merchant banker gave him that knowledge, and that insight.
Now you can access that insight.
With Hutchinson's The Merchant Banker Alert advisory service, you can crack this "rich-man's market," discover the identities of those stocks – and reap those massive gains yourself.
Click here for a report that shows you how to get started.]
News and Related Story Links:
- Morning Morning Japan Disaster Coverage:
Japan Disaster Update: Crisis Investing Strategies From Money Morning's Top Experts.
- AIR Worldwide Corp:
Underwriting Expense Ratio Definition.
Definition of Reinsurance.
- The (U.K.) Telegraph:
Lloyds of London "Names" Face Bankruptcy After Court Loss.
- Money Morning News Analysis:
Insurance Companies Likely to Survive – And Even Prosper – Following Japan's Earthquake.
- Money Morning Special Report:
The U.S. Bull Market: At Two Years and Counting, Here's How to Invest