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A Dysfunctional Model
PwC has issued a report saying that the shares of nine in 10 listed reinsurers are undervalued. It would hardly have been less surprising had PwC concluded that the Pope is Catholic. PwC said its conclusions point to a lack of confidence in reinsurers' business models, despite their financial strength.
You think? What the markets object to about reinsurance is its inability to earn a reasonable profit on a regular basis. Earnings volatility, the threat that reinsurers remove from their clients, is the bęte noire of the business community.
PwC says that investors view the reinsurers' business model as the villain of the piece. But if that were so, surely reinsurers would be valued nearer to zero than to book value, which is not currently true of any reinsurer. It's one of the great mysteries of investing, like why the euro has any value at all, given that everyone understands (or understood, perhaps, by the time you read this) that the currency is (was) doomed to collapse. Investors hedge their bets, and valuing reinsurers at 90 percent of book value is a hedged bet, if ever there was one. Other industries with dysfunctional business models are not punished equally. The airline business is a good example. Airlines rarely make a profit. When they do, it is almost followed by a whacking great loss in the following year. The airline business model is hopelessly compromised because of competition. The moment an airline charges an economic price for one of its seats, some Johnny-Fly-Lately comes along and undercuts it by cancelling staff pensions or charging for peanuts. The race to the bottom is built into the business model, but investors seem not to care. Perhaps airlines are sexier than insurers. You think? If a company can't earn a decent return, its stock should be marked down. But reinsurance is a special case. Even the best-managed companies must be judged by their ability to earn during the cycle, not during the year. Selling relief from volatility to insurance companies in a highly competitive environment all but guarantees losses when disasters, natural or otherwise, occur. By bringing stability to, and enabling, commerce, reinsurers fulfill a key social function. Investors have little interest in social functionality, even though their lives depend on it. The only practical way out of this conundrum is blocked to many reinsurers. Raising their prices to correctly cover the risks they adopt appears to be impossible in all but the hardest of markets. Investors' responses to hard markets, at least in the past 20 years, has been to rush in and form new companies, thus softening the market. It's a lose--lose for reinsurers. ROGER CROMBIE is a London-based columnist for Risk & Insurance®. October 15, 2011 Copyright 2011© LRP Publications |
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