22 July 2021 (pre-recorded 19 July 2021)
Below is a transcript of the episode, modified for your reading pleasure. Please check the corresponding audio before quoting in print, as it may contain small errors. Please remember we’ve been discussing individual companies to bring investing to life for you. It’s not a recommendation to buy or sell. The fund may or may not still hold these companies at your time of listening. For more information on the people and ideas in the episode, see the links at the bottom of the post.
[INTRODUCTION]
James Yardley (JY): Hello and welcome to the Investing on the go podcast. I’m James Yardley and I’m joined today by Nick Martin, the Elite Rated manager of the Polar Capital Global Insurance fund. Nick, thanks for joining us today.
Nick Martin (NM): Absolute pleasure James, thanks a lot for having me.
[INTERVIEW]
[0:18]
JY: Nick, some people think of insurance as a safe haven, but this obviously wasn’t the case during the global pandemic. So, what was the initial reaction when it hit?
NM: Yeah. So, if you think about insurance and when we’re talking about insurance, it’s important to remember we’re talking about non-life insurance or property casualty rather than life insurance. You know, it’s not a discretionary purchase it’s something that’s often required by law. And you can think about it in a personal capacity, you know, car insurance is required. You know, your mortgage lender requires you to have a home insurance and it’s exactly the same for businesses as well.
So, the demand for insurance tends to be robust almost despite the macro economic conditions you’re kind of faced in. And if you overlay that as well with the fact that, you know, insurers are taking on the risk that you and I and do not want, so they don’t double up that risk with big, exciting things in their investment portfolios, it means that their investment leverage is low. The investment risk is low and therefore overall, there’s a rather disconnected return from non-life insurance compared to the broader financial markets. And in most cases, that means it’s a relative safe haven in sort of choppier waters, but that wasn’t the case last year with the onset of COVID.
And I think a lot of that is that the industry is very used to dealing with natural catastrophes, whether that’s hurricanes or earthquakes, but those things are really defined by a sort of time and geography. So, if a hurricane happens, you can get an idea pretty quickly if the extent of the damage that that’s occurred. Whereas a pandemic is actually something very different because as we’ve all sadly seen, you know, it can last for a long period of time and can travel across borders. And that introduced an element of uncertainty to the industry that we haven’t seen to, fortunately, to a great extent before. But I think it’s important to remember, because pandemics are not constrained by time or geography, it does mean that the underwriting of that pandemic risk is very challenging because, you know, in an extreme an underwriter is taken on some uncapped exposure. And that’s why a lot of policy wordings for many, many years excluded pandemics and communicable diseases, but obviously in the sort of panic the financial markets had, a lot of that got kind of lost in the commentary. And ultimately, you know, we said back in April 2020, this would be an earnings event for the industry sort of taking a normal catastrophe year and making it a rather larger than a normal one. And that’s sort of proved to be the case.
[2:55]
JY: And in January you said the underwriting market was looking the strongest you’d seen it for a very long while, is that still the case? And why is it so strong at the moment?
NM: Yeah, absolutely it is still the case. And, you know, I’ve been investing in the insurance sector now for almost 20 years, and I haven’t seen as strong as underwriting markets as these that we currently have, since I started out back in 2001. And usually when you have a sort of hard pricing environment. So, you know, in other words, premium rates are going up, it’s usually as a result of an industry… a balance sheet stress. You know, that’s often as a result of a major catastrophe, or maybe something’s going on in the financial markets, but this time, you know – and I’ll always worry when I say a variation of these words – it is a little bit different, because there is a number of factors that have caused this underwriting market.
You know, we’ve had a prolonged, no interest rate environment now for many, many years, you know, as I just said, these companies have very conservative investment portfolios because you need liquidity in your balance sheets because pain can happen at any time. So we’re talking about lots of cash sort of two-year bonds and sort of investment returns on those kinds of assets have largely evaporated since the financial crisis. So, you know, you have to make an underwriting profit, because if you don’t, you’re not going to make a satisfactory return for your stakeholders. So that’s led to a lot greater discipline coming into the industry, pricing has had to go up for this, and, you know, we’re talking about an industry where in the aggregate, the returns aren’t that great. So, you know, so a lot of the more marginal average players have had to take disproportionate action on the underwriting side to get the returns to where they needed to be. Therefore, that is actually a very good environment for the best-in-class operators in that.
And we have seen the return of Mother Nature, you know 2013 to 2016 was a relatively benign period. But she came back with a bit of a vengeance in 2017, with a record catastrophe year. And it’s been pretty tough ever since. And that sort of led to a rise in reinsurance costs which are of course an input for you as an insurance company. So again, that led to more pricing coming through. And then finally, of course, we’ve had COVID and I think that’s just generally led to a reappraisal of the price of risk and has actually curtailed the risk appetite of quite a few people within the industry and actually the larger companies, more so than anything. And again, that’s really given some opportunities for the smaller companies where I tend to focus, you know within my insurance strategy we try and keep that sort of natural catastrophe exposure to quite a low amount. And therefore, you know, we’re very hopeful that our companies are set for some good book-value growth over the coming sort of three, four or five-year period.
[5:54]
JY: You recently talked about how the insurance industry is playing a role in tackling climate change, it’s not something which sort of immediately springs to mind, so what did you mean?
NM: Yeah, so I think, you know, insurance companies just generally, just take on the risk that you and I don’t want. And they absorbed that volatility that we as individuals or companies can’t handle, and obviously climate change is a huge source of volatility and it has been, and sadly that’s increasing over time. So, the industry has got a very critical role in helping to manage that associated volatility and also, you know, promote behaviours that help address the climate crisis and also the biodiversity crisis that we’ve had. And I think that when I started out in this business 20-odd years ago, or so, the sort of talk in a natural catastrophe context, was really around hurricanes and earthquakes, but in recent years, there’s been the emergence of sort of secondary perils. Now things like flood, drought, especially wildfire, and it’s indisputable that those are closely linked, you know, to climate change. And then that needs to be sort of dealt with.
We’ve seen some encouraging developments over time and even now preceding sort of everything that’s happening with ESG, we’re kind of broadening the scope from just the climate and incident critical importance of increasing biodiversity as well. And, you know, with those kind of exposures coming in now, we all know, you know, what gets measured gets sort of done. And therefore those increased exposures are going to give, you know, stakeholders, and they’re going to think about their companies and how they’re managing the risks that they’re talking about. And insurance is a very big part of how you manage that risk. So now it should be a very strong tailwind to the sector for many years to come.
[7:46]
JY: Is climate change and the pandemics and all the increasing risk we’re seeing, is that increasing the demand for insurance globally?
NM: Yeah. I think it certainly is increasing the demand for insurance, but you do start to get a bit of a challenge in all of that, because if you have an increased propensity of loss, you know, the insurance companies naturally, they’re going to need more premium to underwrite that particular risk. And at some point in time, you know, you could have a situation where, you know, insurance becomes unaffordable in the more riskier parts of the world. So maybe think of something like California that historically has been very exposed to earthquake risk even now overlay wildfire risk sadly on top of that. And if you have a property there that say is maybe a million dollar rebuild cost and if the risk of that getting burned down now, once every 10 years, you know, your insurance company could charge you a premium if somebody north of a hundred thousand dollars a year, and whose going to maybe pay that?
And so therefore you move into area where, you know, some things become uninsurable, risks get too great and that’s why I think we’re going to see more and more sort of partnerships between, you know, the, you know, the private insurance industry and governments more generally into dealing with some of those big risks. And you can put pandemic within that as well because the insurance industry balance sheet can only take so much of a loss and therefore you do need government backstops beyond this. And we’ve got precedent for that. We’ve had that with terrorism risks post the world trade centre. We have that with flood risks, to some extent in some countries as well.
So we do sort of see that sort of coming in, but we’re also seeing the emergence of what’s being called nature-based solutions. So this is where nature is being a risk prevention partner for the insurance industry to, to some extent and nature-based solutions are all about letting nature restore biodiversity, it’s a bit more beyond sort of traditional conservation, which tends to be.. think of a small nature reserve that has to be managed in order to optimise for a particular species. Now we’re talking about more broader ecosystems within this and they tend to improve wildlife, improve soil health.
And maybe it’s best illustrated by example. So, you know, many of the industry nature-based solutions are focused around coral reefs and mangrove restoration, because it is much better to have coral reefs and mangroves to be a sort of a, you know, a buffer for storm surges post a hurricane than it is to build huge cement walls for example. And we’ve got for example, Chubb’s doing an interesting project in Miami, they’re partnering with the nature conservancy in Florida. Hurricane risk is still the biggest catastrophe peril in the world when it comes to insurance, there’s something like $3 trillion in insured values, kind of there. What mangroves essentially do is it prevents coastal erosion by decreasing the height of waves and therefore reducing that onshore property damage. And of course ,mangroves and things like seagrass as well, and they’re very good carbon sinks and therefore can store a lot of carbon dioxide. So I’d say it’s a win-win for all concerned. So that’s something I expect to see a lot more of in the future.
[11:10]
JY: And in regards to inflation, there’s been a lot of talk about inflation recently, potentially coming back, is the insurance sector a net beneficiary of this, or is it, does it hurt?
NM: Yeah, it certainly is a net beneficiary I would say James, you need to you know almost think again – the non-life insurance sector can be a little bit different from other parts of the financial market and you know, sometimes when you do hear a sort of a rise in inflation, you know, that does sometimes ring alarm bells, for understandable sort of reasons. But I think, you know, in insurance inflation is kind of always there and something like CPI is not necessarily the best measure of inflation in an insurance context. Things like medical cost inflation is probably a bigger driver. And as we’ve seen for many, many years, that’s only gone one way for a very long period of time.
And I think, you know, a key attraction that we have as a sector is that the insurance contracts get repriced annually. So as long as inflation, you know, and it behaves itself in terms of its expectations, the insurance companies can price for that and therefore maintain satisfactory underwriting margins. And where it can kind of go wrong is if you have sort of, you know, rampant unanticipated inflation, and especially in the context, if you underwrite what’s called sort of long tail business, and this is where you’re assuming risk today and your likely lost payments if they happen, are sort of many years in the future. So, think about something like pharmaceutical liability, where you know, you won’t know whether there’s a problem with a drug or something like that, you know, maybe for 15 to 20 years or so. And therefore, if you’ve got your pricing and your inflation expectations wrong in the pricing of that product today, you’ve got 15 or 20 years of compounded error that comes through into that, and you can have yourself a big problem down the line.
So that’s something we try and avoid within the strategy and fortunately for us we tend to focus more on sort of the small to mid-sized specialty underwriters, and a lot of that long tail casualty risk tends to sit in those big large conglomerates that have been around for many years. And that gives sort of the reassurance to the board of directors of that pharmaceutical company, as an example, when they’re taking on that risk, because they need to be sure that those insurance companies are around in 15 to 20 years to pay those potential plans.
[13:46]
JY: You sound very positive on the sector, but it struggled for the past two years or so relatively, at least to global equities. So why has the market not reacted more and is this an opportunity for investors?
NM: Yeah, I think it is, you know, we’ve talked a lot about we’ve had a strong underwriting environment, and obviously margins are in a good place, and we expect them to further improve given what’s happened with the pricing environment in the last couple of years, we could also have the tailwind of increasing investment income if bond yields go up because of rising inflation expectations. And so in that sort of scenario, the earnings power of our companies is rising and you know, you would expect that to be rewarded with a higher multiple, particularly with a backdrop of broadly rising markets. And, you know, there’s a number of sectors if not many sectors of the market that are trading near their historical highs in terms of valuations. That’s certainly not the case in insurance, we’re trading marginally above the thirty-year average, if you look at the US industry price to book valuations.
And at the end of the day, you know, long term returns are highly correlated with [inaudible] book value per share. And I think at the moment, you know, while an insurer can do certainly 10%, I was being conservative on that metric and I think in this environment a little bit more than that. So if you if a share price just follows that book value growth trajectory, you know, all else equal you double your money in seven years. But I think the thing about the industry we’ve always had, you know, is it’s a get rich slow kind of industry, you know, it’s the slow compounding of returns. Don’t make mistakes, don’t lose capital. Push your foot to the floor a little bit when market conditions are there, like the time right now for example, but you know, we do sadly live in a financial market which can be a little bit myopic, you know, there can be a bit of an obsession about next quarter’s earnings. And I think a lot of investors just don’t have the patience to really be there for compounding to work its magic. And therefore, you know, valuations in the insurance tend to stay in a relatively narrow range.
And I think, you know, for me, and as an investor in the sector that suits me fine because over time, you know, over time our performance will closely match the fundamental performance of our companies, that we were not beholden to mood swings of Mr. Market and even right now, you know, Mr. Market is a little bit too gloomy. And given what I’ve said, you know, this being the best underwriting market I’ve seen since 2001, so.
JY: Great, well thank you very much for joining us today Nick.
NM: Absolute pleasure, thanks for having me.
JY: And if you’d like to learn more about the Polar Capital Global Insurance fund, please visit fundcalibre.com and please also remember to subscribe to the Investing on the go podcast.
