Buying Insurance

Eliot Spitzer has gone on the warpath again, this time against insurance companies, leaving their stocks wounded some critically along the trail. When Spitzer guns for an industry, investors typically get out of the way, and it was no different this time. In the days following the New York attorney general's mid-October announcement of a civil lawsuit against Marsh & McLennan (the firm stands accused

Eliot Spitzer has gone on the warpath again, this time against insurance companies, leaving their stocks wounded — some critically — along the trail.

When Spitzer guns for an industry, investors typically get out of the way, and it was no different this time. In the days following the New York attorney general's mid-October announcement of a civil lawsuit against Marsh & McLennan (the firm stands accused of bid-rigging and accepting contingent commissions), that company's stock lost about half its value. When this article went to press in late November it was still off 41 percent from the day before Spitzer's announcement.

Other firms named in the suit — American International Group, Ace Ltd., Hartford Financial Services Group and Munich-American Risk Partners — also sank on the news. The S&P Insurance Index, which includes AIG and Hartford but not Marsh, slid 13 percent in the seven trading days following the announcement.

It's a pretty dire situation, but if the other industries that have endured the wrath of Spitzer are any indication, now could be a prime opportunity to acquire insurance company stocks.

Déjà Blue

Last September Spitzer went after the mutual fund industry for improper trading, sticking it for nearly $2.8 billion in settlements. That action sent investors in the tainted funds running for the exits, but the $7.4 trillion industry rebounded in 2004. Investors pumped $244 billion in new net cash flow to long-term funds in 2004, up from $71 billion in 2003 for the 12 months ending in May, according to a recent study by the Investment Company Institute.

At investment banks, the story was the same. Spitzer's charges resulted in 11 banks coughing up $1.4 billion in settlements over conflict-of-interest issues, and the shares of the involved companies dipped, but not for long. A year after the banks reached an April 2003 agreement with Spitzer, Merrill Lynch shares were up 37 percent and Bear Stearns shares had grown 21 percent.

Some on Wall Street are now betting that insurers' stocks, currently mired in headlines and uncertainty, will enjoy a similar recovery.

J. Paul Newsome, senior research analyst for A.G. Edwards in St. Louis, suggested in a report that the insurance industry fines would likely mirror those in the investment banking industry.

“Ultimately the fines will be one-time in nature and immaterial to the book value of these giant companies,” he wrote. Bargain hunters did some hunting and pecking in the insurance sector in late October, apparently betting that the investigations would not result in enough damage to merit a selloff. However, given the possibility that Spitzer's investigation could expand, investors still are treading cautiously, as evidenced by the continued languishing of the firms' stock prices.

“The bounce brought insurance stocks from silly lows to something that's still fairly inexpensive,” Newsome says, adding that stocks have room to climb from early-November levels.

Insurance Picks
Several insurance firms are still trading at a discount.
Company Ticker Recent price % change since day before investigation announced (Oct. 13) 52-week high 52-week low Forward p/e Cash, (period ending Sept. 30) Total debt to assets
Marsh & McLennan MMC $27.53 Down 40.3% $46.69 (01/05/04) $22.75 (10/20/04) 9.5 $577 million 0.28
American International Group AIG $62.65 Down 6.5% $77.36 (04/13/04) $54.28 (10/22/04) 13.9 $2.07 billion 0.12
Willis Group Holdings WSH $37.01 Down 0.3% $38.80 (03/01/04) $30.06 (10/15/04) 13.5 $270 million 0.04
Sources: Reuters, Morningstar

Pacemaker Holdings

Caveat emptor: Insurance stocks are not currently for the faint of heart or risk averse, but for those who are up to sifting through the detritus for potential winners, Wall Street's ready with its two cents.

Analysts say one stock that could come out on top is Willis Group Holdings, the third-largest insurance broker. According to Morningstar, Willis holds 7 percent of the worldwide market, compared with 31 percent for Marsh & McLennan and 23 percent for Aon. Clients seeking to distance themselves from scandal-plagued companies could seek refuge in Willis.

“If clients want to leave Marsh or Aon, Willis could really benefit from stealing market share from both of them,” says Justin Fuller, a stock analyst at Morningstar. “For the last three years it has rapidly been gaining market share…they're a terrific growth story, and this presents them with a great opportunity.” He estimates that for each 1 percent increase in market share, Willis could add $220 million in annual revenue.

Not only could Willis lure competitors' clients, it could also poach their staff — inheriting new clients in the process. Fuller put Willis' fair-value price at $35 a share, but is considering revising that upwards by as much as $5 a share after seeing the company's third-quarter earnings report, which showed 8 percent increase in reported revenues year over year to $490 million.

Alain Karaoglan, an analyst for Deutsche Bank in New York, says problems in the industry are not widespread and that investors weren't being entirely rational during the October selloff.

“This is not going to be pervasive — in a competitive industry, bid-rigging can only be done on an isolated basis in specialized lines of business where you have a handful of companies able to provide coverage,” he says. “Ultimately, it's all going to be settled through legal costs; the companies aren't going bankrupt.”

Selloffs were so acute that he actually upgraded one of the companies implicated by Spitzer and kept his buy rating on another.

“AIG's market cap declined by $33 billion in seven days. Do we think it's overdone? Absolutely,” he says. “It was so much overdone that we upgraded AIG to a buy rating.”

Karaoglan maintained his buy rating on Marsh & McLennan. He owns neither AIG nor Marsh.

Other analysts are bullish on AIG as well. Newsome has an $85 price target on the stock, which was trading in the low 60s when this article went to press in late November. Even if fines rival the $1.5 billion levied on investment banks, that'll hardly make a dent in the coffers of the largest insurer: In the third quarter, AIG had operating earnings in the neighborhood of $2.7 billion.

Morningstar analyst Dreyfus Neenan thinks AIG shares are worth about $80 each. He figures that even if AIG is fined or sued for $10 billion — a much higher estimate than what the company will ever likely have to fork over — his fair-value price would drop by only $5 a share, to $75.

Whatever the long-term implications of Spitzer's latest crusade, one thing is certain: Short term, it could be a bumpy road for insurance stocks.

“For someone who has a 12-month horizon, these stocks are extremely attractive,” says Karaoglan. “For someone with a one-day horizon…I don't know.”

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