A Bad Risk - Zacks Industry Rank Analysis

Industry Rank Analysis 5-11-11

There are all sorts of disasters in the world, and they happen all the time. Recently, though, there seem to have been an awful lot of them, from the earthquake and tsunami in Japan to the tornados across the South.

Who pays for the damage caused? In large part it is the Property and Casualty Insurance companies. However, big payouts from disasters are not the only problem the industry faces. Insurance companies collect money upfront in the form of premiums to have the money available to pay out when disaster strikes. They actually make most of their money from the investment of those funds while they wait for disaster to strike.

For the most part insurance companies will park those funds in fixed income securities like bonds. With the yield on 10-year T-notes south of 3.2%, that is not nearly as profitable as it used to be. For most insurance companies, the amount of premiums collected is less than the combined amount of their policy payouts and their overhead expenses (known in the industry as having a combined ratio of over 100%).

However, normally they don’t lose that much on underwriting, but when disasters strike...well, it is disastrous for their combined ratios. The combination of high payouts and low investment yields is a devastating one-two punch for the industry, and the result is showing up in the Zacks rank.

Zacks Industry Classifications

The Zacks industry classifications are very fine, with 256 different industries tracked. It is not particularly noteworthy if a single small industry shows up doing well -- a single firm with good news can propel a one or two firm industry to the top (or bottom) of the charts.

It is interesting when you see a cluster of similar industries at the top of the list. The same holds true for the bottom of the list. The definition of size that matters here is not the total sales or market capitalization but the number of companies in the “industry.”

Where the Pain Is

The Property and Casualty insurance industry is a very large one with 60 firms. Large enough that I don’t have to go looking for other related “industries,” although I would note that the Accident and Health Insurance industry is not looking very healthy either. Of those 60 firms, 15 hold the dreaded Zacks #5 Rank (Strong Sell), and 16 hold a Zacks #4 Rank (Sell). In other words, more than half of the industry is expected to do poorly over the next month or so.

Note that there are almost as many on the number 5 list as on the number 4 list. That is unusual in that there are three times as many “number 4’s” as “number 5’s” in the Zacks Universe as a whole. Only the worst 5% are stuck with the number 5 rank, and the next 15% get a number 4 rank.

In P&C Insurance, 25.0% have number 5 ranks and 26.7% have number 4 ranks. Many of the weakest firms are not household names because they sell insurance to other insurance companies, not directly to individuals or (non-insurance) businesses. That business is known as Reinsurance.

The industry is currently in 247th place out of the 256 industries tracked, an improvement of one spot from last week. Due to the law of large numbers it is unusual to have a very large industry like this at either the top or bottom of the list. The average Zacks rank for P&C insurance firms is 3.68, up from 3.65 last week.

The first table shows the P&C Insurance stocks that hold the enviable number 5 rank (Strong Sell). The second table shows the number 4 rank (Sell) firms. Most of the firms are relatively small cap, but there are several that are well into mid-cap territory and which should be relatively easy to either short or buy put options on.

Just avoiding the smaller-cap names is probably the best strategy. The valuations on many of these firms look very reasonable, particularly if you are willing to look out to 2012 earnings. However, those earnings expectations are falling, and an estimate in motion tends to stay in motion, thus the “true” P/E is likely much higher than the numbers on the table suggest. Many have extremely high (or infinite, shown as N/A) P/E ratios based on this years earnings.

The very high payouts due to the disasters will fall in this year’s earnings. For next year, the implicit expectation is that the level of disasters will be more normal. Frankly I have no idea how many earthquakes and hurricanes will hit next year, and more importantly from the industry’s point of view, where.

Some big disasters can have a very high human toll, but almost no effect on the industry, such as the earthquake in Haiti. Disasters that hit in developed countries such as the US tend to have much lower human costs, but much higher financial costs, which are what matters to the industry.

The falling estimates for next year probably have more to do with the low bond yields. Right now it looks like the business of taking on risk from others is proving to be a bad risk. Down the road, the combination of low yields and big payouts might remove enough capacity to write insurance that premiums start to rise, but you might want to wait a few months (or until the Zacks ranks start to improve significantly) before jumping in.

Number 5 Ranked Firms

Company	Ticker	Market Cap ($ mil)	P/E Using Curr FY Est	P/E Using Next FY Est	% Change Curr FY Est - 4 wk	% Change Next FY Est - 4 wk	Current Price
Xl Group Plc	XL	$7,249	17.97	10.88	-7.79%	-2.53%	$23.45
Everest Re Ltd	RE	$4,873	41.51	7.96	-38.35%	-1.80%	$89.87
Transatlan Hldg	TRH	$3,014	57.9	8.1	3.82%	-0.67%	$48.35
White Mtn Ins	WTM	$2,840	78.65	25.74	-65.71%	-0.72%	$353.92
Aspen Ins Hldgs	AHL	$1,959	120	8.44	-71.85%	-1.38%	$27.75
Endurance Splty	ENH	$1,747	26.51	8.65	-47.70%	-2.66%	$43.97
Harleysville Gp	HGIC	$863	12.35	10.35	-14.91%	-4.05%	$31.87
Argo Group Intl	AGII	$848	N/A	11.14	-238.46%	-7.61%	$30.88
Greenlight Cap	GLRE	$813	14.03	6.49	-25.33%	0.00%	$26.90
Global Indemnty	GBLI	$747	14.92	16.69	0.00%	0.00%	$24.62
Safety Ins Grp	SAFT	$685	15.02	13.73	-10.42%	-0.50%	$45.21
Infinity Ppty	IPCC	$663	13.71	12.04	-13.53%	-1.11%	$53.47
Emc Insurance	EMCI	$266	19.38	11.35	-49.52%	-11.71%	$20.54
Amer Safety Ins	ASI	$196	18.28	9.99	-28.07%	-3.85%	$18.74
Homeowners Chce	HCII	$48	8.64	9.61	0.00%	0.00%	$7.69

Number 4 Ranked Firms

Company	Ticker	Market Cap ($ mil)	P/E Using Curr FY Est	P/E Using Next FY Est	% Change Curr FY Est - 4 wk	% Change Next FY Est - 4 wk	Current Price
Partnerre Ltd	PRE	$5,366	N/A	9.62	-243.48%	-2.44%	$79.44
Arch Cap Gp Ltd	ACGL	$4,494	15.56	12.6	20.09%	0.25%	$101.74
Axis Cap Hldgs	AXS	$4,038	N/A	8.41	-125.69%	-1.15%	$34.39
Markel Corp	MKL	$3,967	27.02	22.2	-7.06%	-0.47%	$408.12
Hcc Ins Hldgs	HCC	$3,656	11.76	10.34	-8.08%	0.00%	$31.82
Renaissancere	RNR	$3,651	61.76	8.34	-36.08%	4.89%	$69.12
Allied World As	AWH	$2,397	13.11	9.85	-12.00%	-1.37%	$63.03
Platinum Undrwt	PTP	$1,369	N/A	8.21	56.84%	0.00%	$36.74
Montpelier Re	MRH	$1,127	N/A	7.61	-118.46%	-1.24%	$18.11
Navigators Grp	NAVG	$775	15.41	14.37	-0.25%	1.38%	$49.23
State Auto Finl	STFC	$639	47.63	13.67	-68.01%	-4.28%	$15.91
Flagstone Reins	FSR	$565	N/A	5.39	21.38%	1.74%	$8.22
Donegal Grp -A	DGICA	$337	15.47	12.52	-5.56%	0.00%	$13.15
Stewart Info Sv	STC	$196	77.1	9.06	-61.07%	-10.98%	$10.28
Hallmark Finl	HALL	$168	24.99	12.81	11.11%	5.41%	$8.33
Investors Title	ITIC	$89	20.74	18.93	-6.47%	-2.37%	$38.99

In evaluating the Zacks Industry Ranks, you want to see two things: a good overall score (low, meaning more Zacks #1 and #2 Ranked stocks than #4 or #5 Ranked stocks) and some improvement the relative position from the prior week. It is also helpful to understand exactly what the Zacks Industry Rank is.

The Zacks Industry Rank is the un-weighted average of the individual Zacks ranks of the firms in that industry. It does not matter if the stock is the 800 lb gorilla that dominates the industry or some very small niche player in the industry -- they have the same influence on the industry rank.

Also, that means that the bigger the industry in terms of number of firms, the less influence any given company has on the industry rank. It also implies that small industries, with just two or three firms, should be the ones found at either the top or the bottom of the list. After all, if there are only two firms in the industry, it is relatively easy to get a Zacks rank of 2.00 (i.e. one with a Zacks Rank of #1 and the other with a #3). Right now, that industry rank would be tied for 6th place among the 255 industries tracked.

The same obviously goes for the bottom of the list as well. If there are 50 firms in the industry, and it ends up at one of the extremes, that means there has to be something pretty significant going on. Thus, I do not always focus on the very highest rated industries, but on the highest rated ones in which there are a large number of firms.

Click here for the Zacks Industry Rank List: http://www.zacks.com/zrank/zrank_inds.php

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