The next few years will present significant opportunities for investment gains in the property and casualty insurance industry coupled with a large and equal amount of failure. As always, the profits reported by insurance companies are only as factual as you want to believe. You need to look beyond operating ratios, leverage and liquidity tests, and loss reserve development to core business practices in order to decide whom you want to financially support.
For example, last week the senior management changed abruptly at a company I was once closely tied to. A decade ago, my agency produced 15% of the underwriting profit for this company, over a seven-year period. We understood and believed in their core philosophies. Things changed and we sold that book of business. We no longer represent them, but it still is hard to see them going through this trauma, which will no doubt impact many of their personnel.
The company I’m referencing has an “A” rating by Best and a “positive” outlook. They recently posted a combined ratio over 100, which isn’t unusual in this environment. However, they also have an expense ratio of nearly 50%, which might be considered atrocious. Also troublesome is the drop in policyholder surplus (net worth) over the last five years.
Since they write a large percentage of bond business an expense ratio of 50% isn’t really all that bad. Western Surety Company is a pure bond market and has an expense ratio of just over 50%. In contrast they’ve combined that with a loss ratio around 20% and have consequently doubled their policyholder’s surplus over the last five years. They’re also “A” rated by Best’s.
Corporations create cultures around their goals. Management fosters those cultures through carrots and sticks. Their actions often have unintended consequences. Those unintended consequences usually come home to roost when the market moves to where we are in the insurance cycle. When loss and expense ratios deteriorate improper actions become apparent.
The above company I once represented had a system of significant bonuses for their employees tied to underwriting results. Although only the most foolish companies instruct their claims departments to knowingly under-reserve losses, I’ve personally experienced corporate cultures that question those with “overactive scruples”. Every reserve contains an element of conjecture and surmise. Companies run afoul when their internal questions put pressure on “adequate” reserving. Companies set their rates for the future based on their prior loss experience. If their prior loss experience is understated due to inadequate reserves, they set rates that will naturally be inadequate for the risk they assume.
I’m not aware of this particular company having any of these specific problems. It’s possible their holding company is merely taking them in a new direction, but I’ve seen many companies experience severe trauma, including the company that gave me my first job, which no longer exists.
The personal lines insurance segment of the property and casualty insurance industry has been experiencing difficulties. Much of this can be blamed on the weather. Over the last fifteen years, the amount of total loss attributed to weather related catastrophes has gone from approximately one percent to six percent.
Many insurance companies state that they don’t know what the “new normal” is. They have set their rates based on their best estimate. The good companies have planned for the worst, setting their rates based on weather stabilizing at something around six percent and are monitoring trends.
During 2013 the property and casualty industry had a very good year with less than one percent in weather-related catastrophe losses. Yet, the personal lines segment of the industry had a combined ratio over 100. Even though a small amount of the loss ratio gain was due to increased bodily injury severity, a combined ratio over 100 threatens disastrous future underwriting results, because even in a good year many companies still posted an underwriting loss.
Many more had “bad” years, despite the good weather, with combined ratios of 105 to 110. Given an investment income of under three percent, in most cases, many companies suffered surplus impairment. I expect that we will eventually discover that they’re the same companies who are waiting to see what the new weather “normal” will be before adequately adjusting their rates.
Getting behind the rate-taking curve can be lethal. If a company missed several years of normal rate taking and has to increase their rates by twenty to thirty percent in one year, they’ll lose premium volume and experience a reduction in policies in force.
Once premium decreases, expense ratios can become adverse without substantial accompanying decreases in underwriting expense. Much of that expense is fixed, or close to fixed making adequate decreases easy to achieve.
Those companies who had a poor underwriting year in 2013 should be reviewed closely before increasing your investment. A better investment would be with those companies who posted profits or near profits during 2013. As stated above, all numbers aren’t created equal, so due diligence is necessary.
Over the next few years it’s obvious if the “cat” levels stay at six percent or above several companies will suffer seemingly irreversible losses. Others will have a substantial opportunity to gain market share at profitable levels.
Some of this might be mitigated by the black box capabilities for rate adjustment, but the market competitive position will restrict the ability to “catch-up” quickly.
Worse yet, many of the companies who are behind on the rate adjustments to adverse catastrophe losses are also those companies who still are trying to understand “predictive modeling”. Under “predictive modeling” it is seemingly as important to underwriting profits to be able to accurately pre-determine length of retention as it is loss costs.
If those companies get their predictive modeling wrong and stumble on setting length of retention they may never recover the loss involved in their initial “teaser” premiums.
Companies that will be successful in the future, in the attention by establishing a “trust” sale, rather than going toe-to-toe on a “commodity” sale. Those companies will succeed by constructing their product to make it easier for the independent agent to be a “trusted counselor” rather than an “order taker”.
- If a personal lines property and casualty company has a combined ratio of 101 or less, that appears valid in all respects, and
- the company is actively engaged in predictive modeling and has been for more than a few months, and
- the company is truly committed to the independent agent and is willing to work to help the independent agent with a “trust” sale,
they appear to be a good place for you to consider an investment.
If the company lacks one or more of the above, I would avoid them.
I’m not a financial advisor. I’m merely an insurance agent who has been watching companies succeed and fail for forty-four years. As always you’re responsible for doing your own due diligence and to take my advice purely as one man’s opinion.
About the Author
Jim Holm is the president of Enhanced Insurance, was National Agent of the Year for Metropolitan in 1993 and Midwest Agent of the Year for Travelers in 2011. He also serves as a founding board member of Surplus Lines Association of Minnesota.
The benefits of automated pension plans
While many people will prefer to speak to fellow human beings when discussing their investments, automation is already part of everyday life. Over the last few years we have seen introduction of robo-advisors, with many pension investment companies placing these new platforms front and centre of their future strategies. So, what are the benefits of automated pension plans and robo-advisors?
No-nonsense information gathering
KYC, or Know Your Client, is an integral part of the investment world. The wider your knowledge base on a particular client the more personalised the service you can offer. Failure to gather the correct information, and use it accordingly, is a breach of investment regulations in many countries. Therefore, the use of robo-advisors allows a no-nonsense and clear approach to information gathering.
These systems use an algorithm to choose the most appropriate investment strategy for your pension fund. The algorithm is based upon issues such as:-
- Your attitude to risk
- Your investment term
- Your current investment goals
It is worth noting the variable “your current investment goals”. Due to the way that the system is set up, you can update your investment goals on a regular basis. This means that your portfolio would be automatically adapted to your new goals.
As pension-fund regulations continue to be tightened, information gathering is becoming even more important. This initial data gathering exercise will also incorporate a degree of guidance and thought provoking comments. For example, this could highlight the risk/return ratio and the suitability for pension fund investment. The concept of the robo-advisors platform is simple; participants have time to think about the consequences of their attitude to risk for example. The majority of platforms use a concept known as modern portfolio theory.
What is modern portfolio theory?
As a sidenote, you will find that many robo-advisor platforms will mention the concept of modern portfolio theory. This is a Nobel Prize winning economic theory based on the use of data points to create a personalised portfolio of investments. Modern portfolio theory presumes that the majority of investors are risk averse. This means that those looking to take additional risk will expect additional rewards. As a consequence, their pension-fund portfolio would need to reflect this.
Using ETFs to create a personalised portfolio
Automated pension investment platforms (also known as robo investing) tend to use Exchange Traded Funds (ETFs) to create personalised investment portfolios. ETFs have been around for many years and they are an integral part of the investment scene. There are numerous benefits to using ETFs such as:-
Focus on a particular market/type of investment
ETFs are basically funds which are structured to mirror the make-up of a particular market, sector or type of investment such as a commodity or index. For example, the S&P/TSX Composite Index is recognised as the benchmark Canadian index. As a consequence, for those pension fund investors looking at a balanced risk/return, an ETF mirroring this index would be ideal for their portfolio. The funds are created by replicating components/weightings of a particular index with some ETFs also using futures and options
Just as indices are rebalanced from time to time, it is important that your pension fund investments undertake the same process. Say for example the robo-advisor system created a personalised portfolio consisting of two index ETFs. If one index was to perform much better than the other, at some point this would need to be reweighted. The strategy behind this is simple; if the balance of your portfolio was tilted towards one particular ETF index then your future performance would also be tilted towards that index. This could lead to increased volatility and impact the balanced approach to investment.
Price visibility and trading
While many people view ETFs and mutual index tracking funds as one and the same, there are a number of differences. The main difference is liquidity, with ETFs constantly traded throughout the day and mutual fund prices set at the end of each trading day. As a consequence, robo-advisors can react to intra-day news flow, while those holding mutual funds will need to wait until the daily price has been set. You’ll often find that transaction costs associated with ETFs can be significantly less than mutual funds.
Risk profile criteria set by human experts
While the majority of the processes associated with automated pension plans have little or no human input, there is significant input with regard to risk profiles. This means that investment experts will allocate particular ETFs, and other exchange traded instruments such as futures, to various risk/reward profiles. When we talk of risk/reward in the context of pension investments, this does not indicate extreme risk – this isn’t advisable for long-term pension investments. Indeed, those pension advisors allocating funds to ETFs offering extreme risk/reward ratios may find themselves answering questions from the regulators.
In the modern era, there is nothing to stop the process of opening a pension fund, right through to management of investments, from being fully automated. Whether we move closer to this alignment in the future remains to be seen. However, in the meantime the vast majority of investors prefer an element of human expert involvement, even if just to oversee any potential discrepancies.
Low-costs improve long-term returns
The cost of any service or product comes down to the components. Traditional active pension fund investment will involve an array of different people with different skill sets. The combined cost of these teams can be significant and is reflected in the fund’s management and ongoing charges. Therefore, the more elements of the system which can be automated the lower the management fees and ongoing charges. When you also consider that many robo-advisors will use ETFs, which simply track various assets or indices, the cost element is yet another competitive edge.
While there is certainly a place for active investment management, using expert investment advisors, very often automated pension plans will complement this alternative approach. Many people now choose to maintain a core element of their pension fund under a robo-advisor platform, as their pension-fund backbone. Allocating an element to a more active investment approach offers the opportunity to enhance returns, although there is an obvious element of risk.
Easy-to-use investment platforms
The subject of pension investment can be complicated at the best of times. Therefore, the introduction of robo-advisor platforms, offering regulatory updates and guidance, has been extremely useful for many people. A growing number of people seem to prefer this plain talking approach to pension fund investment. You could argue that this removes any potential conflict-of-interest, the volatility of human nature making way for cold hard facts. Obviously, there will be advice and guidance available, as and when required, but this would likely come at an additional cost.
It is worth noting that before any robo-advisors platform is released to the market it will undergo stringent testing. This testing will take in both in-person testing and remote user testing which is unmoderated. As a consequence, those creating these platforms can help and assist those testing the systems in person. On the flipside, remote user testing is akin to releasing the platform into the mass market. These users are guided by the instructions and design of the platforms, giving invaluable feedback on any tweaks and changes required.
Removing human emotion
The removal of human emotion from investment decisions can be considered something of a double-edged sword. However, robo-advisors provide a no nonsense approach to pension fund investment. A relatively swift in-depth questionnaire will gather all of the information required, allowing algorithms to calculate the appropriate risk/reward ratio. The use of EFTs takes away day-to-day management of investments, in favour of index tracking funds. Auto rebalancing and opportunities to adjust your risk/reward ratio going forward creates a very flexible environment.
Those looking for a passive investment strategy will be attracted to robo-advisors. Those looking for a more active approach still have plenty of choice in the wider market. Then there are those looking for a mix of the two. In recent years we have seen huge advances in artificial intelligence, which already play a role in wider investment trading strategies. Will this technology become more commonplace in the future?
Robo-advisors have been around, in some shape or form, for some time. In many ways they do the time-consuming legwork that human advisors did in the past. This allows pension advice companies to focus their funding on areas where they can enhance their business. There is a general misconception that robo-advisors have total control over pension fund investments. This is wrong. There are human advisors and investment experts in the background tweaking the system, allocating EFTs to specific risk profiles and constantly enhancing their offering.
While the current raft of robo-advisors make little or no use of artificial intelligence, the ability to learn, this must surely be an aspiration for the future. This is an area of the market which is constantly developing and changing. We already accept artificial intelligence in many areas of our life, so why not the world of investment? Would you trust an advisor who was able to learn from human mistakes?
This is a Sponsored Feature.
The Viral Return On Investment
By Sabine Saadeh Author of Trading Love
It was around August 2018 when a friend of mine approached me with an investment scheme that was remarkably enticing. At first I hesitated because going into business with close friends is never a good idea for me, let alone have your money pooled into an investment fund. The business model was exceptionally thought through and I knew for a fact that it will generate value. Nonetheless, I declined the investment offer. A year later, the fund was generating income long before it had planned to, and I thought I had missed out. The return on investment from that fund in relation to the cost of the investment was outstanding.
A year later, I watched from afar as my friends began to squeeze each other out given their greedy excitement after the success of their fund. As more time went by, I watched them make the biggest mistake of their lives, and that was letting go of the creative element in that fund. Return on investment is the value created by the said investment that is closely tied to economic, financial, psychological and societal factors. However, creativity is their cornerstone.
Come 2020 and Covid-19 reshuffled the classic value mantras. The whole world experienced complete disruption. The path of the virus and the length of time the global economy will remain shuttered is still very much unknown. So what does this mean? This means that investment value will change. The risk of the investment does not have to do anymore with the amount of capital available for resiliency but with the amount of creativity available in the business.
The viral return on investment should change people’s economic narrative. Businesses should focus on liquidity, contingency plans, multiple supply chains and CREATIVITY. After all a business’ local resilience will be highly priced in the value of the investment rather than what the market views as efficient. Taking my friends’ fund as an example, if they had retained their creative element, their business would have proved to be resilient, despite the high debt incurred by the fund to continue operating during lockdown. This high debt increased the risk of their business collapsing and in turn weighed in on their capacity for growth.
After all, an investor is looking for an investment that will preserve his/her purchasing power without undermining their wealth. If I had invested in that fund, I would have lost the capital invested and spent the income generated during the lockdown period. So what was the point of the capital without the talent in that fund? Covid-19 is not the only threat; climate change is even a bigger threat. It is therefore imperative for us to respect and nourish interdependence, and especially in business environments.
We cannot act like the virus anymore, latch on to a person with creativity and sup them dry just because we invested in them. We need the creative more than the creative needs us, it is their talent that is going to generate income for us. Our capital opens the path for the creative to generate income for us. The smart people of the world already set their bets on that, through ESG investment schemes, which is the most sustainable form of investing. ESG which means environmental, social and governance investing; seeks positive return on investment while taking into consideration the long-term impact of the said investment on society, environment and the performance of the business.
The year 2020, is when the world went up in flames and ESG established itself as the mainstream way for investors to make profits. Although the investment preference had already began to change over the last five years, the inflow was still very mediocre in ESG.
It was after the wildfires and the social issues erupting everywhere in the world and the corruption stories of the businesses that are too big to fail, that it became a no brainer that the inflow in ESG would increase massively. Then The DWS Group’s ESG funds according to CNBC began to outpace the S&P 500 this year, and Blackrock highlighted ESG as the most sustainable form of investing.
Businesses that are taking into consideration empathy and creativity while operating are better equipped for future sustainability, even though they are sacrificing return on investment in this present time.
What are we waiting for then? If Covid-19 didn’t help us see clearly that we all intertwined in nature for our future’s sustainability, then what will?
European market responds to second wave of infections
By Rupert Thompson, Chief Investment Officer at Kingswood
Global equities ended last week on a negative note and were down around 4.5% from their all-time high in early September. This morning, European markets have fallen back a further 3%.
The initial catalyst for the correction was a sharp run-up in the mega cap tech names which had left them looking extended and ripe for some profit taking. The FAANGs are now down over 10% from their highs and the froth looks like it has been blown off. While they may well remain volatile, there is no obvious reason for them to be at the forefront of any further sell-off. The fundamentals behind the tech sector remain strong and valuations are once again looking more reasonable.
However, the correction also clearly had its roots in the sheer scale of the rebound from March with global equities up some 50% from their low. This inevitably left markets vulnerable to a set-back, particularly with valuations at twenty-year highs.
The rebound in turn was in good part a result of the massive policy stimulus. The weakness late last week was triggered by disappointment that the US Fed had not extended its QE program. Even so, the Fed is still buying $120bn of bonds a month and remains a major support for equities. Indeed, it made it clear that it has no intention of raising rates for at least another three years.
The Bank of England also decided to leave policy unchanged last week. However, it kept open the possibility of cutting rates into negative territory next year if it should be necessary. An extension of its QE program later this year also remains quite possible.
All the same, the fact of the matter is that central banks have now spent most of their ammunition. Going forward, changes to fiscal policy will be much more important than any tweaks to monetary policy in shaping the economic recovery. And on this front, the news is not particularly encouraging as the markets may now be appreciating.
The US has failed to agree on an extension of the fiscal stimulus measures which expired in July and may now not be able to before the November elections. As for the UK, Rishi Sunak is still resisting calls to extend the furlough scheme beyond October.
Just as important for markets will of course be Covid-related developments. This morning’s declines are a response to the second wave of infections now being seen in the UK and across much of Europe and fears that renewed social distancing measures/localised lockdowns could disrupt the economic recovery.
While the latest wave of infections is clearly a major cause for concern near term, it shouldn’t be forgotten that the longer term outlook regarding Covid is not all bad. Several late stage vaccine trials are now underway and a vaccine could quite possibly become available within a few months. Some countries, most notably China, also seem to have avoided a major secondary spike despite the reopening of their economies.
In short, the outlook remains quite uncertain. We believe it remains prudent at this juncture to maintain a broadly neutral stance on equities until some of these unknowns are cleared up – one way or another.
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