A Small-Cap Value Analyst’s View on US P&C Insurers
Franklin Small Cap Value Fund Assistant Portfolio Manager and Research Analyst Nick Karzon gives five reasons why we continue to see attractive long-term opportunities for select small-capitalization (small-cap) P&C insurers.
Following relatively strong performance over a trailing five-year period (2015-2019) during which P&C insurance companies in the Russell 2000 Value Index outperformed both the broader index and the financial services sector, the group has been a relative laggard year-to-date.1
In our view, recent underperformance is attributable to lower interest rates as well as multiple risk factors, which have generated elevated loss claim activity across the United States. These factors include the COVID-19 pandemic and related business interruption claims in addition to hurricanes, floods and wildfires.
Here, we outline five reasons why we think the long-term investment opportunities outweigh near-term risks for select small-capitalization (cap) P&C insurers, which remain attractive investments for our strategy.
Reason #1: Alignment in Focus on Risk-Adjusted Returns
The Franklin Small Cap Value Fund’s process is built on investing in businesses that we view as having a track record of success, low leverage and attractive risk-adjusted returns, which we discussed in greater detail in a prior post. Consequently, while we look for potential upside in investments, we also spend considerable time evaluating downside risk.
We have found that P&C insurers typically take a similar approach to capital management with conservative asset allocation strategies, while managing outsized underwriting or liability risk through reinsurance. Our research shows typical asset leverage is only 3-5x tangible equity, which is well below banks or life insurers, and investment portfolios are primarily comprised of investment-grade fixed income securities. On the liability side, insurers mitigate the risk of large losses through reinsurance contracts designed to redistribute exposure to catastrophic loss events.
Reason #2: P&C Insurance Is a Growing Essential Industry
The P&C insurance industry’s function is to protect against risks to property, people and businesses with coverage often mandated—making it an essential industry. As the US economy and population grow, demand for protection also rises.
As the chart below shows, premiums in the US P&C industry have grown at a mid-single-digit pace over the past 20 years.2 While exposure can shrink during a recession as unemployment rises and activity declines (e.g., fewer commercial auto miles driven), the greatest annual reduction in premiums during this period was just 3% in 2009.3 Current pricing trends suggest to us that even with a moderate decrease in exposure in the near term, industry premiums are likely to grow over the medium term.4
Reason #3: Disciplined Approach to Pricing
According to our analysis, the P&C insurance industry focuses on return on equity, and companies have taken a disciplined approach to product pricing. If an insurer’s return outlook is challenged (e.g., rising loss cost trends or lower investment returns), it can raise pricing to return profitability to its targeted level.
In the last few years, we have observed commercial insurers respond with accelerating rate increases to address rising loss severity trends, elevated levels of catastrophe losses, and now lower interest rates. While these factors may manifest themselves in lower near-term earnings, we believe insurers will utilize price increases to offset these potential headwinds over the medium term.