The plight of insurance companies in an era of low interest rates has led some to predict the total collapse of the industry. The sector is a bellwether for the stock market, because so much of its profit comes from investment returns. The chart of the PE of European insurers relative to the broader market shows that extreme valuation for the sector is a precursor of major market corrections.
On this logic things are fine, because at two thirds of the average PE, insurance stocks have only just crossed into the normal valuation range following a period in the investment doghouse. This would tie in with our recent message that the prevailing investment trends are uncertainty over the direction of interest rates and gradually rising implied volatility back to normal levels. Relative implied volatility for the insurance sector peaks at index lows.
The woes of the insurance industry are easy to identify, which is why the sector is so popular among investment bloggers, who use it to point to the coming Armageddon in Europe, without having to offer too much analysis. Insurers depend on yield, all the more so as their customers age, so if central banks reduce bond yields to zero or below, insurance companies die.
You do not have to talk to those in the industry for too long to hear them bemoaning the new capital that is driving down returns for everyone. For the insurers, this is dumb capital that lacks the long-term perspective of their industry, but which thanks to light or no regulation has a lower cost of capital than incumbents. This is two different arguments; one about time horizons and another about the shadow financial sector.
Insurance is an industry whose last great innovation was the statistical analysis that brought about mortality tables. This allowed probability as a proxy for predictability and gave rise to a legion of highly specialised mathematicians with skills finely tuned to the needs of the industry. The maths can now be done faster and more effectively by computers, and so any cost advantage that new capital has from efficient operations is a permanent one. Whether you are regulated or not, you no longer need all those actuaries, just as investment banks no longer need so many analysts and lawyers don’t require all those proof reading juniors. Regulation actually serves to slow the loss of white collar jobs, because however onerous it may seem, all regulation favours incumbency.
The longer timeframe argument is more intriguing. Factor analysis shows that the inverse correlation between equity values and bond yields has weakened over several decades, most likely due to lower inflation, which had globalisation as its primary cause. The relationship has actually inverted since 2008, so that bonds and equities rise and fall in sync. Initial observations since 2013 suggest that the traditional correlation is reasserting itself.
This is due to the end of quantitative easing in the US and the political reaction to globalisation across the western world. Rising protectionism and constraints on immigration are the most evident backlash. These measures are designed to push up local wages and hence will be inflationary, and could herald the reversal of a long period of ascendancy of capital over labour.
It should be stressed that the jury is out on this. Most of our blogs reference the standoff between those who believe in the continuation of easy money and those thinking its time has passed, because this is the largest investment argument to be resolved. It is also one that OTAS indicators are ideally placed to track, including our fear gauge and low volatility performance monitor.
If the worm has turned however, and the ineffectiveness of monetary policy at the zero bound combines with political pressure to trigger policies that lead to higher interest rates, then the insurance sector will be back in business. Returns on insurance equities should discount this long before it happens. Those cautious mathematicians who have survived in the sector will have won the argument about the long-term, because underwriting in the industry should be priced using a higher cost-of-capital.