This article is taken from 'PA Perspective on European Insurance', edition,1, 2008. To download a PDF of this article as published, please click on the link on the right.
Even before the liquidity squeeze hit, European insurers were facing tougher times ahead: growth is slowing, earnings are declining and valuations have fallen. Addressing these challenges will require them to make big strides forward, not small steps.
The headlines are dominated by the liquidity squeeze, whose knock-on effects are rebounding around the financial system. The markets are awash with rumours about companies’ troubles – some well founded, others completely baseless – that are spooking shareholders. Central banks are struggling to restore liquidity and support the prices of asset-backed securities.
And there are calls for more intrusive and international regulations whose costs are much clearer than their benefits.
The insurance sector is at least as susceptible to this general malaise as any other sector. Worryingly, however, our analysis suggests that the tide had turned for European insurers even before the sub-prime market’s difficulties ballooned into a global credit crunch.
Figure 1 (see PDF file) presents trends in return on equity (ROE) and market-to-book ratios (MV/BV) for European insurers since 2002. The ROE story was positive for most of this period, climbing from an average of 4% to more than 18%. This reflects increased premium rates in many markets and impressive investment returns. As for the MV/BV ratio, having increased from 1.25 in 2002 to 1.8 in 2006, it has since fallen back to 1.45.
How can these trends be reconciled? We believe double-digit growth is now seen as a thing of the past; since both interest rates and the required risk premium have increased, the required rate of return has increased, depressing valuations. We also expect ROE to decline, reflecting equity investment losses and the increased margin pressures resulting from heightened price competition in the lower-growth market. This will exert further downward pressure on MV/BV ratios. The upshot: the era of easy returns is over. Insurers are now competing in a much more challenging marketplace, and their valuations are reflecting that fact.
Some have been hit harder than others
But while almost all European insurers are affected by the downward trend in MV/BV ratios, their situations are not identical. In fact, we can identify three distinct groups, as shown in Figure 2 (see PDF file), based on the evolution of their MV/BV ratios between December 2006 and April 2008.
Firms in Group 1, denoted by the red points, have the highest MV/BV ratios (over 2) and these have fallen relatively little. The market clearly believes these firms will be able to sustain higher ROE and growth, possibly because they are well represented in growth markets – as Prudential is, for example.
The ratios for Group 2 firms (shown in grey) have fallen by more than 25% since 2006 (marked by the lower diagonal line). The market is taking a radically pessimistic view with respect to their ROE and growth prospects.
Finally, the experience of Group 3 firms (shown in black) fall between those in the other two groups: they have seen more modest declines in their MV/BV ratios than those in Group 2, but from levels much lower than those achieved by Group 1. These firms thus have the opportunity to graduate to Group 1 – or the prospect of slipping back into Group 3.
Thus the near-universal need to reverse the downward trend in the MV/BV ratio translates into different challenges for different insurers. Those in Group 1 need to ensure they deliver against market expectations, achieving both high ROE and high growth. Those in Group 2 face the stiffest challenge. Reversing the dramatic downward trend in their valuations will almost certainly require them to significantly increase both ROE and growth simultaneously.
Firms in Group 3 are ‘stuck in the middle’. They could opt for relatively modest plans to increase their MV/BV ratios by increasing ROE or growth (or various combinations of the two). But we believe this would be distinctly unwise: it would put them at risk of being supplanted by those Group 2 firms that successfully execute ambitious improvement plans.
Despite the different situations of these firms, and whatever the strategy they select, the underlying message is clear: today’s demanding conditions compel insurers to be ambitious when it comes to bolstering shareholder value. Whether the plan is to increase ROE by cutting costs or to secure better access to growth markets, the imperative is to make significant strides forward, rather than taking small steps.
A multifaceted challenge
Increase growth and improve ROE: easier said than done. Increasing ROE will probably entail substantially reducing costs, since hotly contested, slow-growing markets offer little or no scope for revenue and margin growth. This implies that insurers will have to develop and migrate to lower-cost operating models, rather than just tinkering with their cost bases. Costs will have to be cut, to be sure, but there will also have to be increased efficiency in business processes, including careful outsourcing where appropriate.
Growth will require improvements in persistency, probably in combination with access to new, higher-growth markets. The alternative – winning new business market share from rivals – is unlikely to be possible except at unacceptably low margins. Firms will probably have to increase their footprints in ‘new Europe’ at the minimum requirement, but they may also have to venture into more distant markets such as those of Southeast Asia and India.
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