European opportunity

Swiss Re (CH:RUKN) is poised to become the world's largest re-insurer with the acquisition of GE Insurance Solutions. Market sentiment towards Swiss Re suffered recently following weak full year results due to losses from last year's hurricanes. However we believe recent price action has opened up an attractive buying opportunity. In our opinion Swiss Re has the financial and competitive strength to take full advantage of an increasingly robust rate environment.

Swiss Re trades on the Swiss Exchange. We however believe the stock holds exciting potential for UK investors. In our opinion the longer term upward trend for Swiss Re remains intact despite last week's share price weakness. As can be seen on the weekly chart, a large basing pattern has formed over the past three years. Steady gains since the August 2004 low reflect a gradual re-rating of the stock by investors.

It is not uncommon to see share prices pause for consolidation and this is what has occurred since last December. However we believe this will prove temporary with upward momentum ultimately being re-established.

Swiss Re was founded in 1863 in Zurich by the three companies - Helvetia General Insurance, Schweizerische Kreditanstalt (now Credit Suisse) and Basler Handelsbank. Global expansion over the last 140 years now sees Swiss Re operating in over 30 countries. As a re-insurer Swiss Re sells backup cover to other insurance companies, spreading risk so that enormous losses from natural catastrophes can be met.

Shareholders in RUKN have experienced a bumpy ride over the past five years. Earnings at Swiss Re have suffered due to an unusually high number of catastrophes this decade. In the aftermath of losses from the World Trade Centre attacks, the company's share price declined by 70 percent to lows of around CHF 50 in March 2003. Whilst the shares have recovered somewhat since, losses from last year's hurricanes have dealt a further blow to short term sentiment.

Last week Swiss Re reported full year results for 2005. Net income declined 40 percent to CHF 1.5 billion (£658 million) on the back of sizeable natural catastrophe claims. The extent of the decline in profitability came as a surprise to the broader market, which expected net income of around CHF 1.8 million.

In 2005, the re-insurer incurred CHF 3.0 billion (£1.3 billion) in large natural disaster claims, a 150 percent increase on 2004. As a result the combined ratio (claims to premiums) for Swiss Re's entire non-life business was an unprofitable 108.7 percent. Swiss Re's experience was however better than industry averages of 110-115 percent.

The impact of these claims on profitability was mitigated by equalisation reserves (set aside to cushion the impact of exceptionally large losses). As a result the earnings impact was limited to around CHF 1.1 billion.

Operating income at the Property & Casualty business declined 62 percent to CHF 1.0 billion following last year's claims. Premiums earned declined 11 percent to CHF 16.4 billion due to management's decision to cut business, which did not meet minimum pricing requirements. Such a strategy should ensure margins are maintained in the future and will boost the division's earnings profile in our opinion.

Swiss Re is already the world's largest re-insurer of life & health business. Operating income here grew by 26 percent to 1.6 billion, and benefited from positive mortality experience (or policyholders living longer in simple terms). Premiums earned grew 3 percent to CHF 10.5 billion. Strong demand in Asia more than offset declining growth in mature markets.

Swiss Re's Financial Services business acts as an asset and fund manager for both in-house and institutional clients. Operating income at the division grew by 15 percent to CHF 366 million. However the standout performer was the Credit Solutions reinsurance business which delivered an impressive combined ratio of 81.1 percent.

Profitability was also underpinned by a solid investment result of CHF 6.6 billion up 11 percent, and equating to a 5.7 percent return on investment. Swiss Re's excellent investment performance was achieved across all asset classes.

Whilst last year's catastrophes have heavily impacted profitability this year at Swiss Re, we believe the long term earnings outlook is bright. The company reports that premium volumes in January 2006 for non-life renewals were ahead by 1 percent. The combined ratio from these renewals is expected to be below 95 percent..

Management also confirmed (as we have suggested in our other insurance sector recommendations) that underwriting conditions in Europe have been attractive. Property rates in particular are on the rise. Swiss Re expects renewal rates for offshore gulf energy and US hurricane accounts will be highly favourable later this year. Overall, we believe management's focus on underwriting for profit will lend further support to margins.

Swiss Re is highly confident in the direction of future earnings. The Board is proposing a 56 percent increase in the dividend to CHF 2.50 per share. Management remain committed to earnings per share growth of 10 percent per annum over the underwriting cycle.

Swiss Re' financial strength will allow it to take full advantage of favourable underwriting conditions in our opinion. Despite lower premium volumes and increased claims, net cash flows from operating activities this year were still CHF 4.5 billion. Gearing (long term debt/shareholder's equity) is a more than manageable 25 percent.

The acquisition of GE Insurance Solutions (the world's fifth largest reinsurer) should be completed in the coming months and is another positive in our opinion. Size and diversification are crucial for absorbing large insurance risks. Swiss Re is raising up to US$7.5 billion in new capital to finance the deal with GE taking up to US$3.9 billion. Expected cost synergies are in the region of US$300 million.

From a charting perspective, with support located between CHF 88.10 and CHF 87.75, we believe near term downside risks are limited. Longer term upward trend-line support currently underpins the share price in the region of CHF 83. A clear and sustained break above CHF 97.5 will indicate an attempt to re-establish upward momentum. A further break above the CHF 103.40 high would in our view signal a move towards CHF 115.

We regard Swiss Re's valuation as undemanding with a prospective price earnings ratio of just 10 times and prospective dividend yield of 4.5 percent. Additionally, we believe that the European listed company is ideally positioned to take advantage of a robust rate environment. As such, we recommend Swiss Re to all Members as a buy around CHF 90.

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

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

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

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