Wednesday, April 28, 2010

Europe's insurers: No time to relax | The Economist

I continue to struggle with what stocks look attractive in the financial sector.

Financials represent almost 17% of the S&P 500, so it is difficult to avoid the sector in institutional accounts where you are measured versus the broader market indices.

But what to buy? Banks look attractive on a valuation basis. In addition, it now appears that many banks may have over-reserved against possible loan losses, which may lead to an earnings boost later in the year when the "excess" reserves are returned to earnings.

And yet...there are still plenty of areas that could still blow up. Commercial real estate remains a concern. Loan growth has been anemic. The government bailout in 2008-09 may have just masked the loan problems instead of solving them. And who knows what ticking time bombs are in the trillions of derivatives outstanding?

What about the brokers? Last year this group just minted money: illiquid markets lead to huge bid-ask spreads for the remaining brokers, and trading profits were enormous. This year the huge flood of corporate bond issuance should boost earnings as well.

Yet there remains the possible of heavy regulation, as Wall Street continues to demonstrate a tin ear when it comes to politics. It's not just the whole Goldman debacle - I don't know how the hearings will all turn out, but I suspect that any eventual repercussions will hit all of the brokers, and that Goldman will emerge as one of the dominant players once again. Still, it is very possible that Congress does something rash in an effort to please a resentful public, and the brokers get

That leaves the insurance sector: the life companies and the property/casualty companies.

On a valuation basis, the stocks look cheap. Most - with the exception of Berkshire Hathaway - are trading around book value, which historically has been a good place to buy them.

But here again there are issues.

Without going into great detail, one of the biggest issues that all the insurers face is low asset returns. On the life side, insurers have promised high returns to policy and annuity owners - often 5% or higher. However, interest rates on all but the lowest quality borrowers are now below 5%, especially on shorter maturity bonds. The longer interest rates remain low, the more this could potentially be a huge problem.

On the P/C side, low asset returns combined with unattractive pricing levels probably means poor returns. In addition, with too much capacity in the group, maintaining reasonable pricing levels in the midst of fierce competition is a challenge, to put it charitably.

The issues facing the insurance group are not confined to the United States, by the way. European insurers also are facing huge challenges, as the attached article from this week's Economist discusses.

Which leaves me scratching my head.

Europe's insurers: No time to relax | The Economist