Rising pricing should be seen not as an earnings tailwind, but as a red flag of balance sheet weakness

One commonly held view in this market is that P&C company valuations are largely driven by the pricing cycle, and that positive and accelerating pricing should be considered a universal positive for the group.

We human beings - simple irrational beings that we are - like to reduce complex phenomenon into simple and understandable heuristics. These heuristics tend to be great at managing our anxieties, but fairly useless in predicting the future.

As analyst notes this quarter focus on positive pricing commentary and benign catastrophe losses, I cannot help but feel the bigger picture is being missed.

This pricing fixation is one of those heuristics in finance that comes from a confusion of stocks and flows.

OK, positive pricing tells us something about future cash flows to companies. But it also tells us something potentially more important about stocks – in this case, reserves held against prior accident years.

If companies are raising prices, the first question should be why. The P&C industry structure is highly competitive and highly fragmented with little pricing power. It is a commoditised “cost-plus” business with little-to-no pricing power.

Simply put, until proven otherwise rising pricing power should be seen not as a tailwind to earnings, but as a major red flag for many companies across the space.

I have never quite been able to persuade anyone to adopt my Tolstoy analogy into common lexicon, but my own view is that history has shown that while every soft market may be alike, every hard market is different in its own way.

And in this cycle, one factor muddying the water is the impact of elevated catastrophe losses over the past two years. This has led to an excessive focus from many observers on cat and property pricing.

Indeed, much commentary seems to interpret signs of accelerating pricing outside of property lines as a contagion from catastrophe losses.

For me, this is confusing signal and noise. For sure, property losses have been a major drag on earnings. And there does seem to be some change in risk appetite around wildfire, South East wind, and some larger commercial property exposures.

But the real signal seems to be coming from outside of property, where many markets appear to be becoming increasingly stressed.

If I could simplify this, it would be that the real truism in this market is not that “pricing is good” but that “first comes pain”.

The problem is, for many the experience of 2011-2013 still weighs heavily, where a rational pricing response to weak interest rates and reserve weakness drove stock valuations significantly higher, and even some of those with some reserve holes were able to trade through and repair the balance sheet with some good old fashioned pay-as-you-go reserving.

However, context matters. At the start of that market hardening, the industry was trading at around book value compared to a long-term average of 125 percent.

Today, the average valuation is about 140 percent of book value. You can debate whether the stocks are priced for perfection, but it’s hard to argue that they’re not priced to assume robust balance sheets, continued reserve releases, and accident years that are picked about right. In an industry where pain comes first, it’s hard to see rising pricing as a positive for valuations.

I’m not really in the prediction business anymore. But if I was, I’d say this: Forget industry pricing and forget earnings forecasts. Worry about balance sheet strength, and worry about it now.

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