(Small)investor perspective: (Re)insurance companies and IFSR17/9 - Hannover Re $HANR1.DE $HVRRY
As a first post, the above topic may not initially sound very interesting. However, I found myself delving into it for personal reasons -helping to release some negative energy!- and discovered it to be quite captivating for various reasons, which I will explain later. Aside from that, I’m simply experimenting with this new tool to write and publish openly.
The first notion of investing in (re)insurance companies that I had, came from Peter Lynch, with a simple proxy to invest when you expect interest rates to raise, but still, it was a somewhat obscure/ esoteric sector sector for which I had no insight to construct a structured and genuine investment thesis based on future expectations. I could only rely on retrospective or backward-looking metrics / KPIs (ROE, P/E, book value, combined ratios, payout ratio, dividend yield,..). Furthermore, it fell within the intangible financial sector which did not align with my interest, especially having experimented continuously malpractices and the excruciatingly involvement of banks in the biggest real estate bubble of my country.
Then I found myself working within one of largest reinsurance companies and my mind overwhelmed as I witnessed the industry's inner workings, business model and our strategy. I was particularly captivated by the well-known events, often referred to as major losses within our jargon, such as natural catastrophes and man-made disasters like earthquakes, hurricanes, fires, explosions, and more. These events directly impacted my daily work within the technical department of the facultative unit. From the investor perspective the most striking factor was the immense resilience from which we’re able to absorb those large claims and still show a good technical results, outperforming our peers.
My business idea was evolving, it was no longer about a commodity business, with operational leverage (to generate new business you only need a stamp on a paper! what a dream, another thing is that it is profitable) and in which, among the market leaders with an appropriate rating, the business would come in almost without calling it due to the need for market diversification and in the form of contract renewals, but there were also qualitative aspects, which make the pieces of the puzzle fit together: conservative reserving policy (redundancies!), accumulation caps, diversification by class of business and geography, asset/liability matching, underwriting acumen, low cost provider = better pricing(?), retro strategy.. those are at the heart of the model that helps to provide such a performance. From an investor's perspective, it began to resemble more of a long list of quality checks that assign a certain score rather than a competitive analysis among companies, because if it were the latter, I wouldn't know where to start.
The balance sheet, in a very simplified way, under the previous regime (IAS 39/IFRS4) included equity and technical provisions for insurance liabilities, which encompassed all outstanding claims provisions (what a number!), premium provisions, and other liabilities. The asset side included investments (fixed income, equity, real estate), receivables, the retro part, cash and others. The Profit and Loss was a summary of the net premium - claims + investment income. The accounting logic was obvious, but as an investor, grappling with certain figures, such as technical provisions, was not an easily achievable task, even when interpreting (if you are able to) the run-off triangles in such a vast business, often very long-tailed, where different pricing assumptions were made at the time. Thus, the only thing left was a quality check!
However, the new regime (IFRS17 and IFRS 9 for investments) represents a paradigm shift, looking to the future from the present accounting perspective. It's a new, more complex and significant change to accounting for insurance contracts, which carry many future assumptions. In the balance sheet, the asset side is mainly composed of financial investments adjusted through OCI (those that only consist of interest and principal payments) and those adjusted through P&L + retro. The liabilities side is mainly composed of liabilities from reinsurance contracts which consist of the expected net cash flow, discounted to the present and taking into account the financial risk on the amount and timing (Risk Adjustment), the remainder if it exists is the contractual service margin (CSM), since if a contract is expected to be onerous from the beginning, it will obviously lack a contractual service margin and will declare the expected discounted losses in the P&L; all of this under several measurement models depending on the type of contract. + the rest of the liabilities.
(Munich Re presentation)
What this new accounting really brings is the obligation to break down the portfolios, first starting with the type of business, and then dividing them into onerous, non-onerous and others grouped by terms, thus achieving a level of granularity that did not exist before. But we'll have to wait for the Annual Report.
The P&L is grouped into revenue - expenses + insurance finance result + net investment result. The release of the corresponding CSM for each period will fall into the P&L.
(Munich Re presentation)
What conclusions do I draw as an investor and from the company's perspective?
Firstly, it's gratifying to think that there will now be a higher level of transparency, disaggregation and comparability; but I doubt I can construct a thesis that is not based on the KPIs and ratios mentioned at the beginning. In the end, it seems to me that it's about quality checks and allocating a percentage of the portfolio to this segment.
Risks: the level of complexity of the assumptions made at the beginning of the contract can lead to unrealistic assumptions or creative accounting.
On an aggregate level, it appears to me that on an individual level, it carries risks and more downside for individual companies, as the development of onerous contracts or accumulation of risks that might be visible can be identified through disclosing may impact the results due to the implicit leverage of the business, much more than any positive development.
Much more comparability between porfolios: property US, autoliability US for 2022, etc.. you name it.
I’m intrigued by the potential applications of this new information beyond pure (re)insurance industry analysis.
Disclaimer
I do hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise hold a material investment in the issuer's securities.