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Financial services: A favourable outlook for insurance

Diversified insurance and property-casualty are particularly attractive in a sector that looks slightly undervalued overall.

Erin Davis 6 July, 2015 | 5:00PM
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While recent price increases have improved profitability in P&C insurance, we don't see a strong reason to assume that pricing will continue to improve. In our view, recent pricing increases have largely been driven by lower interest rates. As lower rates pushed down investment income, higher pricing and underwriting income have been necessary to maintain ROEs. Yields on new issues are still generally lower than yields on maturing securities, and investment income remains pressured. We believe interest rates will continue to have a positive impact on pricing in the very near term, but the effect should fade over time, barring a further decline in rates.

However, we're more optimistic on profitability. Looking at the trends in pricing and profitability, peak levels of profitability have typically lagged peak increases in pricing. In our view, this is due to the time it takes for price increases and improved rate adequacy to filter through insurers' books. We think a momentum factor could also help explain this phenomenon, as momentum in pricing increases would carry pricing past the point justified by fundamental drivers, which would set up the potential for outsize profitability later on. Either way, in the current environment, this trend supports our optimistic view on industry profitability, despite our less optimistic outlook on pricing.

On the investment side, we see surprises as biased to the upside. While interest rates are difficult to predict, with rates near historic lows, we see more upside than downside. Higher interest rates and investment income on the back of recent pricing increases could help propel the industry toward a truly hard state. Also, many insurers have been tactically shortening the duration of their investment portfolio. While this magnifies the current pressure on investment income, it provides greater flexibility to benefit from rising interest rates.

Top Financial Services Sector Picks

Star Rating

Fair Value
Estimate

Economic
Moat

Fair Value
Uncertainty

Consider
Buying
Apollo Global Management

$42

Narrow

 High $25.20
Berkshire Hathaway

$168

Wide

 Medium $117.60
WR Berkley

$58

Narrow

 Medium $40.60
Data as of June 22, 2015. All figures are in U.S. dollars.

 Apollo Global Management (APO)
Apollo is a global alternative asset manager with about US$160 billion in assets under management deployed across private equity, credit and real estate strategies. Notably, it manages assets for Athene, a fixed-annuity provider, which provides Apollo with a US$60 billion-plus source of permanent capital. We believe the market is overly focused on the short-term health of the IPO market and the near-term pace of realizations, and is overlooking the strong growth prospects Apollo has in credit, thanks to regulators forcing banks to sell illiquid and risky assets to the firm at a discount.

 Berkshire Hathaway (BRK.B, BRK.A)
We continue to be impressed by wide-moat Berkshire Hathaway's ability to generate high-single- to double-digit growth in its book value per share, believing it will take some time before the firm finally succumbs to the impediments created by the sheer size and scale of its operations. We also believe that the ultimate departure of Chairman and CEO Warren Buffett and Vice Chairman Charlie Munger will have far less of an impact on the business than many believe it will. In our view, shareholders should be focusing more on excess returns as opposed to outsized returns, as solid operating results, a strong balance sheet and a low cost of capital combine to make the hurdles lower for the next managers of the firm.

 WR Berkley (WRB)
We are optimistic about the direction of profitability in the property and casualty industry. WR Berkley has significant leverage to improved conditions, since its strict underwriting discipline leads to swings in its expense ratio across hard and soft markets. During the last hard market, it averaged a 23% return on equity while earning only an 11% average ROE in the following soft market. With the stock trading at 1.5 times book value excluding goodwill and accumulated other comprehensive income, which is average for commercial P&C insurers, we think the market is underestimating Berkley's ability to improve results.

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Erin Davis

Erin Davis  Erin Davis is an assistant vice president for Morningstar Credit Ratings, LLC. She specializes in European banks.

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