Insurance group Hiscox (OTC:HCXLF) has been a darling stock in the UK financial sector for many years now. Notwithstanding unease over Brexit risks and slowing economic growth in the UK, the stock has continued to pile up new all-time highs one after another, most recently in July when its market capitalization peaked above $7 billion.
Looking ahead, however, things may be about to get much tougher for the London-listed, Bermuda-incorporated insurance provider. In November, Hiscox surprised analysts with the scale of the worsening claims trends in the US casualty business, as payouts to claimants in litigation have risen significantly across a variety of claims.
The insurer warned that the combined ratio – a key measure of underwriting profitability (the lower, the more profitable, since a ratio of more than 100% signifies an underwriting loss) – at its retail business would likely rise above its medium-term target of between 90-95% from 2019 to 2022. It expects the combined ratio for 2019 to be between 97-99%, before steadily falling back to target. The ratio for full year 2018 was 93.6%, indicating a meaningful deterioration in profitability at its retail division over the medium term.
Top-line growth has also slowed considerably from last year’s stellar performance, particularly from its much-envied retail division, although management has said growth at the division for the full year is still on track to meet its previously stated 5-15% target range. Meanwhile, a trio of storms in the US, the Caribbean and Japan forced Hiscox to set aside $165 million for claims, which is more than the insurer’s catastrophe budget for the second half of the year.
Unsurprisingly then, the insurer’s share price has pulled back from recent highs; however, valuations are still at elevated levels, making a review relevant to examine whether the stock has been responding to its fundamentals.
Flexible capital allocation
Hiscox’s flexible underwriting strategy and diversified business model allow the insurer to redeploy capital according to the relative strength of its markets. To date, the group’s track record on capital discipline has been strong. At a time when underwriting profits in the Lloyd’s market were being pressurized by worsening attritional losses and an excess of capital deployed by the industry, Hiscox successfully shifted capital allocation towards better opportunities. Gross premiums written in the London market fell from nearly half of the group’s total a decade ago to currently just over a fifth.
Yet now, market conditions seem to have reversed. Hiscox is once again seeing fundamentals in reinsurance and London markets improving, with pricing momentum expected to remain positive going forward. For the nine months to September, rates are up approximately 9% across the group’s London Market portfolio, with the most significant increases in US public company D&O, cargo, general liability, marine hull and major property.
Elsewhere, there is some hope for the retail market, with gross written premiums in Europe delivering strong double-digit growth, offsetting part of the weakness from the UK and US. CEO Bronek Masojada also noted that growth is accelerating in the US and UK following a slow first half, due to “on-going discipline” in US private company directors and officers’ (D&O) business and the disruption from the introduction of new IT systems in the UK.
However, it will likely take longer for the market to recognize the so-called social inflation which is occurring across multiple US casualty lines. Like others in the industry, Hiscox is seeing substantial increases in jury awards and legal costs, which is increasing the cost to settle claims. And with the abundance of capacity in the industry, competitive pressures will constrain the insurer’s ability to seek higher premiums going forward.
Rates are increasing across some (but not all) casualty lines, although it is not certain when or whether premiums are rising fast enough to offset the underlying claims trends, which is leading to significantly higher reserve provisioning. Rates in the small business insurance market, which accounts for almost a third of Hiscox’s total business, appear to be more sticky, perhaps due to the higher degree of commoditization and more intense competition there.
Hiscox expects margins will take around three years to recover. The combined ratio for the retail division is expected to come between 97-99% in 2019, 96-98% in 2020 and 95-97% in 2021, before returning to its medium-term target of 90-95% in 2022.
But the increased cost of claims may not just be isolated to its retail division. Hiscox’s London Market has also experienced a higher number of large losses, with claims totaling approximately $30 million in the US public company directors and officers’ (D&O), property, marine and energy and space portfolios.
Higher catastrophe losses
In the catastrophe space, Hiscox has reserved $165 million to cover claims resulting from Hurricane Dorian, Typhoon Faxai, and Typhoon Hagibis. In addition, fees and profit commissions are expected to be approximately $25 million lower. The actual net ultimate loss may differ from current estimates, given the complexity of loss assessment, especially for Typhoon Hagibis which saw widespread flooding.
The 2018 catastrophe events, including Typhoon Jebi in Japan and Hurricane Michael in Florida, saw insured loss estimates rise significantly in the aftermath of these events, when it was later discovered that the industry had vastly underestimated property reinstatement costs and business value losses. It’s important to note that flood losses can take longer than windstorm losses to be accurately assessed.
One bright spot for the group this year was in investments. Strong price performances from equity and bond markets helped to lift the return from its investments for the first nine months of 2019 to $186 million (equivalent to 4.0% on an annualized basis), up from $44 million over the same period last year. However, the group warned that although the cut in US interest rates has been positive for mark-to-market returns on the group’s bond portfolios, the underlying rate of income generation is falling. As such, it expects a weaker outlook for 2020.
And despite a more cautious approach to casualty reserving, Hiscox continues to expect to post a small positive reserve development for 2019. For the first half, reserve releases totaled $26 million, down from $154 million for the same period last year. Even so, if lower reserve releases become the norm, dividend growth will become constrained.
Over the past five years, Hiscox has achieved compound dividend growth in constant currency terms of 9.9%. It seems unlikely that that performance can be replicated in the medium term, given that the group paid out some 93% of net income as dividends last year, following dividend growth of 5.2% for 2018.
Though the insurer’s investors have survived downward swings before and came out no worse for wear, I don’t believe this is a trend that can continue forever.
Despite a tougher trading outlook over the next few years, Hiscox’s valuations remain elevated and at a premium to its peers. The group’s price-to-book ratio of 2.28 and forward price-to-earnings ratio of 103.6 (especially high due to near-term earnings pressure) compare rather unfavorably against the US P&C insurance industry’s average P/B ratio of 1.28 and its forward P/E ratio of 13.9.
London-listed insurers with a presence in the Lloyd’s market are more highly rated, with the other two groups, Beazley and Lancashire Holdings, valued at an average P/B ratio of 2.34, with an average forward P/E of 26.9. However, they can probably justify the (slight) valuation gap on their higher returns on equity, which on average over the past decade has been more than four percentage points higher than that for Hiscox. Moreover, they are seeing faster top-line growth, and arguably, better near-term earnings prospects.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.