Insuring A Great Return On Your Money

With strong dividends and rising asset values the insurance sector looks like an attractive place to invest.

There's an old saying that there's only two things certain in life; death and taxes. Well they may as well have added insurance because these days, there seems no getting by without it. As a result, in uncertain economic times, it looks like a defensive sector that's well worth further investigation.

Indeed, despite the carnage in the stock markets, the insurance (non life) sector is only 10 per cent off its high of early 2007. Yet it's one which gets little attention from private investors. The reason for this is that, for many, insurance accounts are an enigma. So let's see if I can shed some light on them and hopefully identify candidates worthy of further investigation.

The insurance (non life) sector provides all those types of insurance which are not life cover. So that could be insurance for property, employers' liability, hurricanes and anything else that someone wants to cover for the risk of loss.

Premiums

To take on the risk of loss for customers, insurance companies charge a fee or premium. Usually this is paid in advance for a future period of time. Where the period of insurance is different from the accounting period on which the insurer is reporting, an adjustment is made in the profit and loss for 'unearned premiums' (effectively deferred income).

Insurers are restricted to the amount of risk they can take on by the amount of capital they have. So, like bookies, insurance companies often lay off some of their risk, to other entities called re-insurers. Often you'll see a charge in the profit and loss account for the cost of that.

Claims

The difficulties insurance companies have with claims are that they never quite know how much they are going to be. Claims may come in late or be difficult to quantify until finally resolution. As a result insurance companies make reserves or provisions for future claims. Clearly how prudent or imprudent they are can come back to haunt them. Investors were badly burnt some years ago by Independent Insurance which consistently and intentionally under provided for future claims.

Some insurance companies insure relatively small risks, such as cars, where there are a lot of relatively small claims. Some insure huge but infrequent catastrophic risks, such as hurricanes. The profitability of the later is inevitably likely to be more volatile.

Combined ratio

Insurance companies often quote the combined ratio in their accounts. It's the percentage of premiums which are paid out for claims and administration of claims. Obviously the lower the combined ratio, the more money an insurance company is making out of premiums it receives. Where the ratio is more than 100, the insurance company is losing money on its insurance business.

Investment returns

Even when they lose money on insurance, companies can still sometimes still be profitable. That's because they get paid in advance from customers or because claims can take often years to be settled. That means they end up with lots of cash on their balance sheet. Insurance companies invest this money and make a return from it. Where a large proportion of profits come from this source then insurance companies are acting more like investment trusts. It's important to consider, therefore, what they invest in and how much risk they are taking.

Valuing insurance companies

Clearly there is volatility and uncertainty in claims and therefore earnings which means individual years can be less relevant than in other sectors. Despite this good companies will be consistently profitable with low combined ratios. This indicates that they are good at assessing and managing risk and charging accordingly. Nevertheless, instead of price earnings ratios, the market focuses more on net asset value and dividend yield.

Bearing this in mind, let's look at some prime candidates for investigation

Company Price Discount to NAV Yield Market cap Chaucer 48p 9.4% 8.3% £263m Catlin 330p -6.3% 7.5% £1,183m Beazley 114p - 5.8% 6.1% £608m Brit 206p 12.5% 7.3% £647m

Troubled Chaucer Holdings (LSE: CHU) raised £75 million from the stock market in February after losses of £72 million on its investments. Subsequently a number of senior executives quit after bid talks with rival Brit failed. The company is cutting its dividend to 4 pence with the intention to hold it for the next two years. Probably as a result Chaucer trades at a meaty 9 per cent discount to net assets with a dividend yield of 8.3 per cent.

Catlin Group (LSE: CGL) raised US $289 million from the stock market in March and reported record results for the first half of 2009. It currently trades at a slight premium to net assets but has a good record of rising dividends, which is forecast to continue next year.

Beazley (LSE: BEZ) also raised money from the stock market in April; £150 million, spending some of it on acquiring a US commercial property specialist and the rest to expand its existing businesses. Record profits were achieved in the first half, offset by exchange losses on non-cashflow items. Beazley also trades at a premium to net assets, and although dividends are lower, increases have been strong in recent years and are forecast to continue.

Brit Insurance Holdings (LSE: BRE) also trades at a chunky discount to net assets and offers a 7.3 per cent yield, although dividends have remained static for the last few years. Unlike the others Brit dropped its plans to raise funds, so may not have the capital for future expansion. First half results were largely break even as exchange losses wiped out underlying profits up 24 per cent.

With interest rates at historic lows these shares look good value and industry consolidation cannot be ruled out. However just like they do, it might be worth spreading your risk around.