Sector view: Boring old insurance
Our view that developed market valuations remain somewhat extended remains place. However, there is one sector which does not appear overvalued or compromised by legacy liabilities and questions over the future sustainable return on equity. Nor does it appear directly in the line of fire of technology’s advance like retail, or subject to on/off policy switches in China which have contributed to the de-rating of the resources sectors. European insurers appear from a top-down perspective to offer sensible valuations, reasonable returns on equity and high dividend yields in a low interest rate environment.
Exhibit 1: Developed market sector price/book premium to average
Exhibit 1 shows that for developed markets the sectors trading below their long-run average are clearly in the minority. Furthermore, for many of the sectors which appear to offer value there are relatively obvious concerns. For banks, the discount to the historical average price/book is likely to reflect legacy liabilities, residual questions over capital levels and difficulties assessing the sustainable prospective ROE. Similarly in basic industries, the on/off nature of China’s industrial policy in recent years has created a discount for volatility.
Exhibit 2: Insurance sector ROE has retreated but stable close to 10%
In contrast, for European insurers (including the UK) ROE may have fallen since the 1990s but it appears to have stabilised at close to 10%, Exhibit 2. Median sector forecast earnings growth rates of 4-5% are in-line with nominal GDP growth and the sector trades at 1.3x book value, Exhibit 3. While this is close to the lower-end of the historical range we are not expecting a rapid re-rating, due to the decline in growth and ROE. Instead we would suggest that the combination of a sector dividend yield of 4.3% and dividend growth in-line with earnings points to a total return in the upper single digits over the medium-term.
Exhibit 3: Current Price/book consistent with recent sector ROE
Investors may still be concerned about the exposure of European insurers to government bond markets, although we note that the beta of the insurance sector in recent years has fallen below 1, reflecting the more defensive and regulated nature of the industry. There has also been ample time to adjust and hedge portfolios where necessary against sovereign risk in the periphery of Europe. Furthermore, the sector has not suffered from the distressed issuance of shares to rebuild capital on anything like the scale of the banking sector, Exhibit 4. At times over the last decade, proceeds from new bank equity issuance amounted to over 20% of the sector’s market cap. Within the insurance sector, issuance peaked at 5% in 2003 and more recently has been running at a very low percentage of sector capitalisation.
Exhibit 4: Banks v insurance – Equity issuance as percent of sector market cap
It is however somewhat anomalous that we are highlighting, from a top-down strategic perspective, a sector which is expected to deliver equity returns which might only be considered ‘normal’ a few years ago. That yesterday’s normal has become abnormal is a reflection of the current distortions in global asset markets, with bond markets following the hard data indicating softening inflation pressures while equity markets track sentiment and surveys higher.
Therefore while perhaps not representing an opportunity as exciting as that of the mining sector one year ago, investors are however short of alternatives. Absent a flare-up in perceived eurozone risk, from current levels the sector is in our view set to deliver returns over the medium-term significantly ahead of cash. From an investor’s perspective boring can be good.
