Our 3 Favorite Insurance Stocks

We believe

Given the cost uncertainty and balance sheet leverage inherent to the industry, we believe confidence in management is a critical factor in investing in insurance stocks, compared with other industries, and is just as important as the moatiness of the business. W.R. Berkley is one of the three insurance companies that we believe possess both a narrow moat and Exemplary stewardship, making it one of the highest-quality companies in the space, in our view.

W.R. Berkley has set itself apart from the industry and carved out a narrow moat by focusing on niche insurance areas. In our view, these areas are subject to less competition than traditional insurance, and underwriters with a large amount of knowledge have an information edge, which supports relatively high underwriting income. W.R. Berkley focuses on commercial insurance and prefers to target industry verticals with unique insurance needs, such as biotech and mining. The company also operates in niche lines such as insuring artwork in museums or kidnapping insurance. In our view, W.R. Berkley's competitive advantage shows clearly in its combined ratio results, which are consistently better than industry levels.

We think the company is also notable for its strict underwriting discipline. CEO Bill Berkley has cultivated a decentralized operating structure and a culture that encourages underwriting profitability. Managers of subsidiaries are rewarded for long-term profitability and value creation, while managers at the corporate level allocate capital opportunistically where pricing is the most advantageous.

The company's loss ratio is consistently well below industry averages (which we attribute mainly to its moat) and much more stable across both hard and soft markets (which we attribute mainly to its stewardship). While W.R. Berkley's relatively low exposure to natural catastrophes helps it maintain a more stable loss ratio, its results are smoother than the industry even when we adjust for this factor.

W.R. Berkley Has Most Leverage to Improved Market Conditions Following a fairly long soft market, the property and casualty industry has hardened over the past couple of years and is now producing relatively strong returns. While we would stop short of calling for a truly hard market like the one in 2003-07, we think changes to the current situation are biased to the positive, and we are optimistic about the direction of the industry.

Among the narrow-moat insurers we cover, we believe W.R. Berkley has the most leverage to improved market conditions, since its strict underwriting discipline leads to swings in its expense ratio across hard and soft markets. In order to motivate its employees to focus on underwriting profitability, the company doesn't reduce staff during soft markets, when opportunities are scarcer. As a result, its expenses are more fixed than the typical insurer, and the company leverages and deleverages this fixed expense as it moves through the cycle. The company's expense ratio trended up during the recent soft market, which has weighed on returns.

An additional factor in recent years has been the buildout of a substantial amount of new operations, as management believed the market dislocation after the financial crisis created an opportunity to hire experienced underwriters and develop new lines of business. This can be seen most clearly in the company's expanding international operations, which have roughly tripled over the past six years and now account for 14% of premiums. These new operations carry relatively high expense ratios, because it takes time to fully scale new operations, and the ability to scale has been somewhat hampered by soft market conditions.

The fact that about 30% of premiums are coming from operations started since 2006 has had a materially negative effect on the company's expense ratio, in our view, and provides some scope for the company to improve its expense ratio regardless of industry conditions. We expect the expense ratio to decline significantly as a harder market allows the company to releverage its expenses in established lines and newer operations have an opportunity to fully scale. Any material improvement in the expense ratio would have a significant impact on W.R. Berkley's results. During the last hard market, the company averaged a 23% return on equity while achieving only an 11% average ROE during the following soft market.

While our outlook for the industry has positive implications for W.R. Berkley, we also see company-specific signs that point to greater levels of activity. In our view, trends in domestic insurance are the most critical, since this segment accounts for 74% of premiums. Further, given the high level of new lines in W.R. Berkley's international operations, it is difficult to separate the growth in this segment from an increase in underlying activity and the ramp-up of new operations. Premium growth in domestic insurance has steadily improved in recent years as the pricing environment has become more favorable. In our view, this increased activity implies that management is seeing more attractive opportunities and sets the stage for improved results.

W.R. Berkley Has Some Minor Headwinds Outside Main Segment Management believes pricing in international markets is not quite as favorable as it is domestically. As a result, while growth in the international segment is still strong in an absolute sense, it has been slowing a bit, with earned premiums up 11% in 2014. This could hinder the company's ability to scale its international operations in the near term. Still, given the relative level of the expense ratio in international segment, we think there is significant scope for improvement in the long run.

The reinsurance segment is struggling with a much more difficult environment, as pricing has been falling and industry participants largely agree that it is currently inadequate. As a result, W.R. Berkley has been pulling back, with premiums in the reinsurance segment (12% of premiums) down 7% in 2014 and the decline accelerating to a double-digit level in the back half of the year.

In our view, while lower premiums are not a positive, this further demonstrates the company's discipline, and we are encouraged by the fact that the company posted a modest improvement in the combined ratio in this segment in 2014. We think maintaining profitability is the key variable in generating value for shareholders.

The company also has some minor near-term issues in its investment portfolio that will probably weigh on returns for the next quarter or two. W.R. Berkley has about $150 million in oil-related equity investments. In our view, given Bill Berkley's stated concerns about the possible impact of a quick spike in inflation on the industry, we believe these investments were designed as a bit of a hedge against this possibility. But we estimate that losses on these investments reduced annualized ROE by about 3-4 percentage points over the past two quarters. While these investments are far too small to materially affect the company's financial condition, they will weigh on reported results until the price of oil finds a bottom.

Issues AIG Faced During Crisis Are Largely History While still a large, diversified insurer, AIG is much slimmer than it was in the lead-up to the financial crisis. We are encouraged that P&C operations now make up a larger part of the mix, because we generally view this area more favorably than life insurance. While AIG still generates some revenue from areas outside P&C and life insurance, most of these operations are being wound down.

The credit default swap portfolio that was the company's primary issue during the crisis has been reduced to a point that it no longer represents a material risk. While it was not economical to terminate all of these contracts, the notional amount of the portfolio (which would represent the maximum possible loss) is only about 6% of tangible book value, excluding tax-loss carryforwards. If its credit rating were downgraded by two notches, AIG estimates that it would have to post additional collateral of only $153 million.

AIG does have one outstanding material issue related to its bailout. Precrisis shareholders are suing the government and seeking damages of $40 billion, claiming that the terms of the bailout were overly punitive and out of line with bailouts offered to other institutions at the time. An initial decision on the case is expected in the next few months. While some might consider the claims to be far-fetched, that doesn't mean the case has no legal merit. As part of the bailout, AIG indemnified the government, and the government could seek redress from AIG if damages are awarded. But we think AIG would have some defenses in this eventuality, as the indemnification agreement includes exceptions in the case of fraud or negligence on the part of the government. Investors uncomfortable with this event risk should probably avoid the stock, but we believe the probability of AIG paying a material amount of damages is fairly low, given the string of events necessary to lead to this outcome. Further, given that multiple cases and multiple appeals processes would have to play out before any actual payout, it is likely that a very long time would pass before AIG made any payout even in the worst case.

AIG Still Underperforming, but Management Taking Right Path In our view, underwriting discipline is the key factor in assessing stewardship in the insurance industry. We think AIG's previous focus on growth and its lack of discipline were the fundamental sources of its problems during the financial crisis, and the current management team's concentration on risk-adjusted returns and operational efficiency sets a course in the opposite direction. In his annual letter to shareholders, CEO Peter Hancock highlighted risk selection, IT investments, cost efficiencies, and selling noncore businesses as his top priorities, and we agree that these are the areas with the widest scope for improvement.

AIG has moved away from underpriced business in recent years and simplified its operating structure. Further, management has invested heavily in technology in order to centralize areas such as claims processing and to improve its data analytics, which should open up opportunities to better exploit the firm's size. We think there are a few factors that support the idea that the company can improve returns going forward.

AIG has recorded adverse reserve development every year since 2008, which is especially notable because the industry has generally been recording material favorable development because of muted inflation. Its reserve issues have primarily related to asbestos and environmental policies written before 2005 and reflect the lack of underwriting discipline under previous management teams, in our view. Given the long tails of the affected lines, we hesitate to predict a quick end to this issue, but the impact of these policies will eventually run off. Further, we take comfort from the fact that, ignoring policies written before 2005, the company would have recorded material favorable development over the past few years. This suggests the approach to reserves on more recent business has been adequate, and that the company is on the path to better results on this score. If AIG had recorded no adverse development in 2014, we estimate that its ROE would have been 40 basis points higher. If it had recorded favorable development in line with its peer group average, ROE would have been 140 basis points higher. Clearly, moving past these reserves issues could have a material positive impact on the company's ROE.

The company has been investing in technology to realize some benefits of scale by centralizing areas such as claims processing, and management believes it is at a point where the benefits will start to outweigh the costs of this initiative. Over the next three years, management believes it can reduce general operating expenses by 3%-5% annually, and we estimate that the company would improve ROE by 80-130 basis points if it hits its goals.

We think other factors could support the company's ROE as well. First, the company refinanced a large chunk of high-coupon debt in 2014, and the lower effective interest rate should boost returns slightly. Second, through its life insurance operations, the company would benefit if interest rates increased. Finally, with management now able to focus exclusively on operations, there could be further unidentified efficiencies. The company expects some benefits from integrating its Japanese operations, although it is too early in the process to quantify the impact.

While we believe that AIG can improve its results, long-term expectations should be modest, since we think it would be very difficult for the firm to develop a moat in its current form. AIG does have some areas of strength. It is among the largest commercial P&C underwriters, which means that it should be able to leverage its proprietary database to better price and select risks than smaller peers, and recent investments in technology should allow it to better exploit this potential advantage. AIG also has one of the largest geographic reaches, which gives it an advantage in garnering business from global firms. But AIG participates in essentially every major insurance line, across every distribution channel, and in a number of geographies. As such, we believe that any advantage it might have in any particular area is likely to be diluted elsewhere. Further, we don't believe there are any meaningful synergies from housing P&C and life operations under the same roof (although the combination will be necessary for the foreseeable future in order to fully realize AIG's substantial tax-loss carryforwards). We think AIG's diversification will make it difficult to consistently beat industry returns in the long term.

Aflac One of the Strongest Life Insurance Companies Aflac has differentiated itself from life insurance peers and carved out a narrow moat, in our view. From a product perspective, the company does not sell many commodified life policies. The bulk of its underwriting is tied to supplemental benefits policies for specific diseases or illness, such as cancer. The company currently underwrites around 80% of all cancer policies in Japan. With Aflac taking what was once a side offering for many life insurers and turning it into the firm's core product, it has a cost advantage over competitors, allowing it to price policies cheaper and still produce strong underwriting margins. Aflac was one of the first to offer supplemental insurance in Japan and has developed a fiercely loyal collection of policyholders. Rather than targeting individuals through the expensive agent channel, Aflac sells its products directly to companies as a way to complement the benefit lineup for their employees at no extra cost. This low-cost distribution channel allows Aflac to price its policies at rates similar to or lower than competitors' while still earning a substantial underwriting margin.

Voluntary supplemental benefits help increase client stickiness for the firm. As these benefits often represent a much smaller purchase and are often deducted through policyholders' paychecks, holders are much less likely to shop around for other policies based on price.

Japan's Aging Population Means Product Shift for Aflac Japan's population peaked in 2010 at about 128 million and is expected to decline to less than 100 million by 2050. But a large number of people are reaching retirement age, and the 65-plus population has surpassed 30 million, accounting for about 23% of Japan's population at the end of 2012, the highest level in the world.

The over-65 burden ratio (the percentage of the population aged 65 or older) is expected to reach nearly 40% by 2050, based on projections from the Statistics Bureau of Japan. The impact of this demographic shift on the Japanese economy cannot be understated. Japan spent approximately 9.3% of its GDP, or JPY 39 trillion (approximately $490 billion), on medical expenditures in 2011. Medical expenditures are expected to reach JPY 60 trillion (approximately $560 billion) by 2025. For comparison, the United States still spends the most on medical expenditures (17% of GDP) as of 2011, but Japan is expected to catch up in the next decade, accounting for as much as 14% of GDP.

Japan's universal health system, which covers virtually all of its citizens, is designed to combat the many medical issues related to an aging population. However, with Prime Minister Shinzo Abe's administration looking to divert government spending to infrastructure projects to revive economic growth, medical spending is likely to be a lower priority.

This shift means that medical coverage is likely to be less generous under the universal plan in the coming years. We expect medical spending to make up 18% of the budget in 2018 versus 21% today, as infrastructure spending increases to 12% from 6%.

The reduction in health benefits is a long-term and powerful secular trend that should benefit Aflac, in our view. Aflac's voluntary medical benefit products are designed to help consumers pay for medical expenses that are not reimbursed under the national health insurance system. Currently, out-of-pocket payments represent about 16% of total health-care expenditures.

This ratio is expected to rise to about 30% by 2025, as the gap between government-funded care and consumer out-of-pocket spending widens. The need to bridge this gap should help drive demand for voluntary supplemental benefit policies.

On the other hand, Japan's ultra-easy-money policy has driven consumers to pile into investment trusts and shift away from life insurance products, which have traditionally been used as a safe vehicle for saving and protection. At the same time, Aflac took pricing actions on its life insurance products to compensate for reserve increases, making the products that much less attractive. All of this helps explain the recent decline in life policy sales, which fell 62% year over year in 2014. Given the unfavorable dynamics in the marketplace, we forecast life insurance sales to continue to decline in the near term.

While these demographic and regulatory changes will have a net negative impact on Aflac's top line in the near term, we think the voluntary supplemental benefits business is the core of the company's moat, and the shift is positive from a long-term perspective.

Abenomics Means That Aflac Needs to Change Its Investments, Too As the easy-money policy was intended to achieve, Abenomics, with its bond-purchase program, caused the yen to depreciate against the U.S. dollar by 22% and Japanese government bond yields to drop 57% since 2013. The resulting yen depreciation and yield decline present challenges for Aflac in asset allocation and investment decisions.

With 90% of Aflac's liabilities yen-denominated, the company's investments focus on longer-duration, yen-denominated, fixed-income securities, which include mainly JGBs and other credit investments. However, because the Japanese bond market doesn't have the depth or liquidity of the U.S. and European markets, in late 2012 Aflac started to allocate new money to a hedged U.S. corporate bond program, in which cash flows from U.S. corporate bonds are hedged back to the yen. This program is intended to improve overall new-money yields and gain security-level liquidity, but the results were somewhat mixed, with only marginal gains in new-money yields since the inception of the program.

Aflac Will Change Over the Coming Years but Remain a Strong Business Deregulation in Japan in the early 2000s has led to more direct competition for Aflac. Another issue is Aflac's relationship with Japan Post, through which Aflac currently sells its products. Aflac Japan and Japan Post entered into a new agreement in July 2013, expanding the partnership that was established in 2008. Japan Post began selling a unique Aflac-branded cancer product in the fourth quarter of 2014 in approximately 10,000 locations. It intends to expand the number of post offices that offer Aflac's cancer products to 20,000 by early 2016. Japan Post contributed 30% of new premium sales in 2014, up from 23% in 2013, and we estimate that its contribution to sales will reach 40% by 2016. While this new agreement creates growth opportunities for Aflac, it also increases its reliance on Japan Post. Japan Post has announced a plan to go public in 2015 and could use the increasing leverage it has over Aflac to demand more favorable terms.

While Aflac will evolve in the coming years based on changes in demographics in Japan and a shifting competitive landscape, we think the overall impact will be mixed, and we expect the company to continue to generate sizable excess returns. We think the market is focusing on Aflac's near-term issues and not fully appreciating the long-term demographic trends this narrow-moat life insurer will have working in its favor.