Inflation, interest rates and the insurance sector

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Recorded on 12.10.23

Hi, I’m Joss Murphy, research analyst at FundCalibre. Today I’ve been joined by Nick Martin, manager of the Polar Capital Global Insurance fund. How are you, Nick?

[00:12] I’m very well Joss, and thanks so much for, for having me.

Well, great to have you on, great to have you on. Nick, let’s start with the current economic and investment environment. How do interest rates, inflation and, and slow growth impact the sector?

[00:28] Yeah, I think for my sector, so non-live property casualty insurance, one of the attractions has always been, it’s relatively disconnected with what’s going on in the broader macro economy. And our insurance itself is a product that really is a must have over time. So even in more challenging economic times, the demand really stays there. And so when we do have a more grey clouds and stormy clouds gathering in the environment, the demand for the product remains robust. And I think therefore that gives the sector some defensive characteristics which is quite helpful in those more challenging times. With inflation and interest rates, we’re actually a beneficiary of that. So a lot of insurance premium gets priced off of things like company revenues things like company payroll. So as inflation goes through the systems, premiums actually rise commensurately with that. So that’s a boost to the top line of our companies.

And then probably even more significantly with interest rates, our companies take on underwriting risks. So what they don’t like to do is double up that risk of exciting things with their investment portfolios. So they have very liquid balance sheets, lots of cash, two to three year bonds, because you need that liquidity there to pay claims that can happen at any time. Now since the financial crisis, the sort of returns on those kind of assets have been sort of one, 2%, something like that. Today it is more like four or 5%, you know, arguably a little bit more. And that’s really helped transform the earnings power of our companies, from a sort of a low double digit kind of return on capital to one in the mid to high teens. And I think that provides a very exciting investment opportunity for investors who may be thinking a little bit harder about a more tough outlook in the coming months ahead.

No, certainly an interesting and an exciting time for insurance. Nick, looking more globally, we’ve had a summer of wildfires, flash flooding and other catastrophe events as they’re called. Now this part of the insurance sector intrigues me, but before we get onto the subject, I think a quick tutorial would help. Can you briefly explain what a reinsurer and what a primary insurer is?

[02:50] Yeah, absolutely. So the primary insurer would be what we’re all used to dealing with every day. So that’s where we’re buying our home insurance or your car insurance or the corporate equivalent for when businesses buy insurance. So that’s the company you’re buying it directly off of.

But I think it is always important to remember, how insurance works. It’s the premiums of the many pay for the losses of the unfortunate few. So that you really need that to work to, for your insurance business model to be robust. The problem you have with something like catastrophes is that you get a lot of concentration of losses all at the same time. So you as the primary insurer, want to try and manage that risk. And one of the ways to do that is to buy reinsurance and reinsurance comes in various different flavours, and you can use that as a capital tool. So you’re basically renting someone else’s balance sheet as an insurer.

But what we’ve been talking about a little bit here is really to manage that catastrophe risk. So when a bad thing happens, when you have a hurricane or an earthquake or any other kind of event, the reinsurance company’s there to help you as the insurer pick up part of the bill. And I think what we’ve had in more recent times is the reinsurance industry picking up a disproportionate amount of that bill as we’ve had the impact of climate change leading to things like more wildfires, more flooding, more droughts. And that’s really led to a big reset in the reinsurance market in terms of pricing going up there this year, which has left a bigger part of that bill more with the primary insurance companies, which in turn is leading to many of those pricing having to go up.

Because at the end of the day, the insurance cost that you are paying should be reflecting the risk that you are taking. So if there’s more catastrophe events in the world from climate change, or otherwise, you know, we could expect insurance pricing to go up so that the underwriters themselves have a expectation to make a reasonable level of profit over time.

Just set the scene a little more. You said in a recent update that you think this year will end up being the fourth consecutive year that a natural catastrophe losses will top $100 billion and then it’ll be the second highest level of losses since 2011. Who bears the brunt of these losses and and how is that changing?

[05:12] Yeah, I think we have seen over many years now a rising level of catastrophe losses. I mean, one distinction that’s important to make is between the economic losses that happen as a result of those catastrophes and also how much of that is picked up by the insurance companies itself.

As a rough rule of thumb would be when a major event happens the insurance industry collectively, so that’s the primary companies and the reinsurers would pay about 30% of the bill, and therefore 70% is therefore left for others to pay. Whether that be the, you know, that those particular asset owners or governments or whatever, or that risk remains uninsured and the sort of numbers that you’re talking about with $100 billion or so, that’s the level of insured losses that we’ve been seeing in more recent years. I mean, a recent commentator has pointed to maybe $130 billion now is the sort of level of of expected insured catastrophe losses. And that number continues to rise over time.

So I mean, the important message really is the insurance companies are there to bear that volatility and they play a very important role. So when bad things happen – and obviously climate change is the big driver of that – the insurance companies are there to help individuals and to help companies and to help society in general get back to where they were. And having insurance in place means that, you know, money can get to where it’s needed very quickly and, and therefore, you know help economies and society get back on its feet after after these sort of tragic events that we see happening all too frequently, sadly.

And finally, going back to the portfolio, I noticed about half has invested in medium and smaller size companies, which I think is more than usual. Tell us about the opportunities you’re finding here.

[07:09] Yeah, I think in terms of how the portfolio is structured, I mean, the focus has always been to have 30 to 35 companies who typically are more, sort of, more small to mid cap. And, the definitions of what that means can vary. So for us, that’s about sort of 10 to 15, maybe $20 billion market cap. So by no means, you know, very tiny companies, but we’re not really talking about the huge sort of insurance conglomerates that the sort of names that most people would recognise for us, we focus on much more niche companies who are very specialist in what they do.

And I think a big theme that we’ve seen over recent years is that risk is becoming ever more complex. So some of the risks that used to be underwritten by, you know large insurers or mutuals in places like California and Florida, because of climate change and other reasons that, they’ve moved away from their wheelhouse. And where those risks are ending up is more in sort of specialty markets like Lloyds of London and their equivalents around the world. And that is rapidly expanding the opportunity set for our our specialist underwriters. And I don’t see any, any way that that’s going to be changing in the year ahead.

If anything, I think risk is going to become ever more complex and now we are living in an age of risk. We see it everywhere, sadly, you know, whether it’s climate, whether it’s pandemics, whether it’s wars or deglobalisation or whatever it is, risk seems to be rising in the world, and that’s an opportunity for the insurance industry to help society manage that risk. And therefore, the long term characteristics of this industry in terms of growth we think is, is looking much brighter going forward than it necessarily has done in the past. But I think, you know, that all said, the secret to success in this industry is always right sizing your balance sheet relative to your underwriting opportunity. So, you know, industry growth is nice to have, but it’s not necessary for company success. But I think having that tailwind for our companies over the coming years can only be a good thing.

I certainly agree with that. Nick, thank you very much for your time today.

[09:15] Been an absolute pleasure. Thanks very much, Joss.

If you’d like to find out more about the Polar Capital Global Insurance fund, please visit FundCalibre.com