Financial Services: A Favorable Outlook for Insurance

• Markets have created more value in financial services, with the average price/fair value ratio estimate falling to 0.95 across our coverage. We see particular value in diversified insurance (P/FV of 0.91) and property and casualty insurance (P/FV of 0.95).
• We believe investors often make the mistake of focusing on pricing to formulate their outlook for the P&C insurance industry, as historical results suggest that overall profitability levels are the key driver of insurance stock returns. Pricing increases have restored profitability in the P&C insurance market despite lower investment income. Although we are not necessarily optimistic that pricing will continue to increase, we think P&C insurers can modestly improve profitability going forward.
• A gradually rising interest-rate environment would be a net positive for P&C insurers, in our view, given the relatively tight spread between rates and inflation. Overall, we think the current environment is conducive to investing in high-quality names.

While recent price increases have improved profitability in P&C insurance, we don't see a strong reason to assume that pricing will continue to improve. In our view, recent pricing increases have largely been driven by lower interest rates. As lower rates pushed down investment income, higher pricing and underwriting income have been necessary to maintain ROEs. Yields on new issues are still generally lower than yields on maturing securities, and investment income remains pressured. We believe interest rates will continue to have a positive impact on pricing in the very near term, but the effect should fade over time, barring a further decline in rates.

However, we're more optimistic on profitability. Looking at the trends in pricing and profitability, peak levels of profitability have typically lagged peak increases in pricing. In our view, this is due to the time it takes for price increases and improved rate adequacy to filter through insurers' books. We think a momentum factor could also help explain this phenomenon, as momentum in pricing increases would carry pricing past the point justified by fundamental drivers, which would set up the potential for outsize profitability later on. Either way, in the current environment, this trend supports our optimistic view on industry profitability, despite our less optimistic outlook on pricing.

On the investment side, we see surprises as biased to the upside. While interest rates are difficult to predict, with rates near historic lows, we see more upside than downside. Higher interest rates and investment income on the back of recent pricing increases could help propel the industry toward a truly hard state. Also, many insurers have been tactically shortening the duration of their investment portfolio. While this magnifies the current pressure on investment income, it provides greater flexibility to benefit from rising interest rates.

Apollo Global Management

APO

Apollo is a global alternative asset manager with about $160 billion in assets under management deployed across private equity, credit, and real estate strategies. Notably, it manages AUM for Athene, a fixed-annuity provider, which provides Apollo with a $60 billion-plus source of permanent capital. We believe the market is overly focused on the short-term health of the IPO market and the near-term pace of realizations, and is overlooking the strong growth prospects Apollo has in credit, thanks to regulators forcing banks to sell illiquid and risky assets to the firm at a discount.

Berkshire Hathaway

BRK.B, BRK.A

We continue to be impressed by wide-moat Berkshire Hathaway's ability to generate high-single- to double-digit growth in its book value per share, believing it will take some time before the firm finally succumbs to the impediments created by the sheer size and scale of its operations. We also believe that the ultimate departure of Chairman and CEO Warren Buffett and Vice Chairman Charlie Munger will have far less of an impact on the business than many believe it will. In our view, shareholders should be focusing more on excess returns as opposed to outsized returns, as solid operating results, a strong balance sheet, and a low cost of capital combine to make the hurdles lower for the next managers of the firm.

WR Berkley

WRB

We are optimistic about the direction of profitability in the property and casualty industry. WR Berkley has significant leverage to improved conditions, since its strict underwriting discipline leads to swings in its expense ratio across hard and soft markets. During the last hard market, it averaged a 23% return on equity while earning only an 11% average ROE in the following soft market. With the stock trading at 1.5 times book value excluding goodwill and accumulated other comprehensive income, which is average for commercial P&C insurers, we think the market is underestimating Berkley's ability to improve results.

More Quarter-End Insights

• Stock Market Outlook: Pick Your Spots Carefully
• Economic Outlook: Stuck in Neutral as We Cling to Cash
• Credit Markets: Investment Grade Struggles, While High Yield Outperforms
• Basic Materials: China Slowdown Weighs on Commodities (With One Exception)
• Consumer Cyclical: Assessing Disruptions in Restaurant, Retail, and Travel
• Consumer Defensive: Top-Shelf Picks for a Cautious Spending Environment
• Energy: No Rapid Rebound for Oil Prices
• Health Care: A Few Stocks Still Offer Upside
• Industrials: Stronger U.S. Dollar, Weaker Energy Activity Weigh
• Real Estate: Rising Interest Rates Wreak Havoc on REITs
• Tech & Telecom: M&A Heats Up, and the Cloud Changes the Landscape
• Utilities: Starting to Look Attractive After a Woeful 2015 Start