Fat Prophets take a profit

There is no question that Swiss Re is (CH:RUKN) all the stronger following last year's acquisition of GE Insurance Solutions. Recent quarterly results from the world's largest re-insurer bear this out. Indeed, financials over the past year show that Swiss Re has been able to make the most of a positive underwriting environment. However, a distinct softening in the medium term outlook for rates is a cause for concern.

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"..a distinct softening in the medium term outlook for rates is a cause for concern. "

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With the claims environment having been somewhat benign over the past two years, historic probabilities suggests that a major shock is likely to occur sooner rather than later. Despite this fact, catastrophe insurers will likely have to accept relatively less to carry these exposures. As such the benefit of having exposure to the sector is being outweighed by the risks in our view. Therefore, and despite the significant merits of Swiss Re's underlying business, management, and performance to date, we believe now is the time to exit our position.

Indeed a look to the charts suggests that other investors are also becoming nervous. Since reaching a five-year high of CHF 119.40 in June, there has been a clear deterioration in the upward trend for Swiss Re. As shown on the daily chart, prices have broken below the 12-month rising trendline over the past month, thus exposing support between CHF 102.1 and CHF 101.1.

We are not in the habit of knee-jerk reactions to short term weakness as long as we remain confident in the longer term picture. However in this case we do not possess such belief.

The past year has seen catastrophe insurers benefit from a double whammy of low claims and high premiums. The latter of course being a direct result of a traumatic experience for the industry in the few years leading up to 2005 with a series of unprecedented man made and natural disasters.

These high premiums created 'supernormal' returns for a period. As any economics textbook will suggest, such a situation often results in new entrants coming to the market to exploit the said gains. And there were clearly gains to be had. The industry's return on equity rose from 11.4 percent in 2005 to 14.6 percent in 2006 on the back of strong underwriting fundamentals.

In the case of the reinsurance industry 'new entrants' arrived in the form of increased capacity, as existing insurers upped their exposures. This has now (quite rapidly) reached a tipping point where 'supply' is catching up to demand and premium rises are now set to reverse.

Indeed, Swiss Re's own sigma study published earlier this month confirms as much.

The company remarks that after a record year of profitability in 2006, downward pressure on premium rates is now a 'salient feature of the market'. The company expects non-life insurance combined ratios to deteriorate as premium growth becomes sluggish.

Likewise the company's Economic Research and Consulting unit advised in June that insurance markets should be bracing for a general softening. The unit noted that the capital strength of the insurance industry is growing due to strong operating profitability, putting pressure on rates and resulting in a slow growth environment going forward.

Meanwhile the unit also noted that the company should prepare for an active hurricane season. And this is half the problem in our view, the mere fact that the hurricanes (along with other disasters) have stayed away over the past 18 months, means that there is an ever increasing likelihood of them occurring as each day passes. Yet this is not reflected in premium forecasts or expectations.

And to reiterate it is looking forward where the problem lies. Looking back there is no question that Swiss Re has been making the most of favourable underwriting conditions.

Net income for the first quarter of this year surged 54 percent to CHF 1.3 billion on the back of a healthy claims environment and disciplined underwriting. Return on equity was 17.1 percent while total premiums grew 23 percent to CHF 8.1 billion, underpinned by new business from GE.

The flagship Property & Casualty division delivered a highly profitable combined operating ratio (claims as a percentage of premiums) of 94.8 percent. However, given the outlook for claims, and the increasing probability of a sizeable catastrophe this will likely continue trending up in our view.

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"..historic probabilities suggests that a major shock is likely to occur sooner rather than later. Despite this fact, catastrophe insurers will likely have to accept relatively less to carry these exposures. "

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A 44 percent rise in net investment income to CHF 2.4 billion for a return of 5.9 percent also boosted profitability.

But we stress once more, we have no qualms with Swiss Re's ability to deliver earnings out-performance in a positive 'trading' environment. We do however believe the dual headwinds of softening premiums and rising large claims risks will make the going difficult.

Long term management may well make an 'over the cycle target' of 10 percent annual earnings per share growth and 13 percent return on equity. However medium term this may be a challenge in our view.

From a trailing valuation perspective we can have no complaint with Swiss Re. The shares trade on a multiple of around 9 times earnings and offer a yield of 4 percent. What we do harbour concerns over is the trend for premiums, and by default, earnings, in tandem with increasing probability of a major loss. Risks are to the downside in our view.

Swiss Re is currently 20 percent above our initial entry level of March 2006 at CHF90. We do however appreciate that some newer Members will also have bought in around CHF94 (August 2006), and CHF107 (March 2007). However, considering the technical potential for near-term weakness in prices, along with a deteriorating outlook for premium levels, we believe that now is a prudent to time to lock in existing profits.

We will be maintaining a close eye on the company and the sector however. We would never wish ill on the world, but the simple fact is the next time to buy into the sector will likely be after the next catastrophe(s) when others are running scared.

In view of that, Fat Prophets recommends selling Swiss Re around CHF 108.

Note: Swiss Re trades on the Swiss Exchange under the code RUKN.