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Analyst predicts London (re)insurers may return capital in 2010

Munich Re's recent decision to reinstitute its share buyback programme to the tune of EUR1bn in "unneeded" capital could act as a catalyst for further returns, according to an analysis of quoted Lloyd's and London Market companies from Oriel Securities.

This analysis - which many may find hard to digest considering the capital scarcity on Lime Street earlier this year - is predicated on the basis that 2009 earnings will be higher than anticipated because of the benign cat year and strengthening investment conditions. This, says Oriel analyst Thomas Dorner, is dampening rates and encouraging (re)insurers to return surplus capital.

Bermuda-headquartered (re)insurer Lancashire was highlighted by Dorner as the most overcapitalised, with a 260 percent capital ratio (equity to net written premium) forecast for the end of 2009, compared to 235 percent in 2007.

Citing the firm's high cat exposure and track record of making substantial capital returns with surplus profits, Lancashire stands out as the most likely Lloyd's insurer surveyed by the analysts to make a material capital return at the end of 2009: "We estimate Lancashire could return up to $350mn (127p per share) and would still have a solid capital ratio of 207 percent and net tangible assets (NTA) per share of 422p."

Overall, strong rallying in investment returns and a benign catastrophe and claims environment should drive "very strong" profits for the Lloyd's insurers at year-end, with Oriel forecasting average return on equity (ROE) of 17 percent. According to the analyst, Lloyd's insurers have increased their capital base by 11 percent in the first half of 2009.

But despite this, the analyst warned that future ROEs could be dragged down by softening pricing and low investment yields in 2010.

"At the moment there is no obvious catalyst to turn the operating momentum positive, which is why we have become more cautious on the outlook," the note said.

And while government intervention and a rebound in markets appears to have mitigated the worst of the financial crisis, Lloyd's insurers' profitability tends to ride the ebb and flow of the underwriting cycle, rather than economic growth. According to Oriel, this dynamic has resulted in underperformance and places the sector at a disadvantage, as investors pile into so-called higher beta sectors such as UK life insurers.

"The Lloyd's insurers have underperformed the risk rally in equity markets since March 2009... should markets continue to be as strong as they have been in Q2 and Q3 of 2009, it seems reasonable to expect that the Lloyd's insurers will continue to underperform," the analysts warned.

A glimpse at the historic performance of Lloyd's vehicles suggests that the sector's weak performance during the equity market recovery is "unsurprising", the analysts said, highlighting similar underperformance when the market recovered after its March 2003 lows.

And due to the effect of gearing in the sector - caused because Lloyd's insurers have twice as many invested assets as they take in premiums - a 1 percent decline in investment returns would impact most companies' combined ratios by 2 percentage points. This 2 percent erosion in combined ratios would in turn reduce 2010 profit before tax by 12 percent on average.

The analysis led Dorner to conclude that the sector is more at risk from historically low interest rates than from a mild deterioration in underwriting margins.

In the long term, the analyst said there is still good value in the sector, since there are several companies trading at discounts to forward NTA. Current valuations - which show that on average the sector trades on 1x 2009 NTA - are 20 percent below their historic average of 1.2x.

But further pressure was forecast in the form of continued capacity from the (re)insurance giants whose future looked so uncertain at the start of the year.

American International Group (AIG), XL and Swiss Re were expected to offer a great opportunity for the Lloyd's insurers, the analysts said. But while Lloyd's has benefited from increased interest in the security of its subscription market, significant global government intervention has propped up the leviathan institutions and allowed them to continue to put pressure on pricing.

"AIG reportedly continues to price aggressively in the market and it will take some time before there is more certainty over AIG's future," the analysts warned. They added that the situation is not sustainable in the long term and that the deteriorating profitability at AIG's general insurance business "will eventually force more sensible pricing".

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