Improving P&C Insurance Pricing Doesn't Make Us Bullish
Profitability is what really matters, and the forward outlook on this front is balanced.
We've heard chatter among investors and in the media that the insurance pricing cycle is about to break upward, with this view used as a support for a bullish stance on the property-casualty (P&C) insurance industry. While we agree on the outlook for the direction of the pricing cycle, our view is that the industry in aggregate is only mildly undervalued. In order to investigate whether our valuations are too conservative given the outlook on pricing, we analyzed the historical relationship between industry pricing and stock returns. Our conclusion is that pricing is just one factor that drives stock returns, and investors are best served focusing on profitability. Our belief that the industry is not far from fair value is in sync with our balanced view on profitability going forward.
To test whether our valuations are too conservative, we analyzed historical industry returns to see if there is a correlation between pricing increases and P&C insurance stock returns. To do so, we used Morningstar Direct to create an equal-weighted P&C insurance index. Our index is not meant to be comprehensive; we focused on the largest and highest-quality P&C insurance names and those with a long trading history in attempt to best match our industry pricing data. We also limited the index to U.S.-domiciled insurers to match our domestic industry data and excluded those with large non-P&C operations. The fact that our index achieves a 12.4% annualized total return from 1973 to 2010, compared with a 9.8% annualized total return for the S&P 500 during the same time frame does imply a survivorship bias and maybe even a "success" bias, as the largest P&C insurers today are likely the companies that have outperformed the industry over time. However, we don't feel that this skews our regression results, as we would tend to focus on higher-quality names at any point of the cycle. If anything, we take encouragement that this result suggests that high-quality P&C insurers can be good long-term investments.
Brett Horn does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.
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