Is the auto insurance sector stabilizing?

The auto insurance industry experienced a challenging post-pandemic era. Many insurers have struggled to keep pace with elevated used-car prices, worsening frequency and severity of accidents, and higher costs tied to medical claims and litigation related to accidents. The Travelers Companies' shares have fallen 5.72% this year, and Allstate Insurance shares dropped 16.06% year to date.

It's well known that Warren Buffett has a soft spot for auto insurer Geico, as he invested in the company at $2 a share back in 1976. After the pandemic, Geico became a pressure point, and Warren Buffett took a painful hit on Berkshire Hathaway Inc.'s underwriting businesses as inflation continues to weigh on the company's operating units.

What's the future for the auto insurance industry? Is the market stabilizing? JP Morgan recently released a Q2 preview for Personal Auto Insurance industry. It forecasts a temporary pressure in the margin but an improvement from the second half of 2023, due to the rising insurance fees and declined car prices amid easing parts inflation.

Personal auto insurance lines have a shorter liability tail and less volatile underwriting results (specifically in auto) than commercial lines or reinsurance. Consequently, personal lines underwriters tend to generate more stable underwriting margins over time.

Furthermore, even though insurance is a highly commoditized and price-competitive market, leading carriers in personal lines are better able to differentiate themselves on brand, customer interface/digital capabilities, distribution, service, and underwriting acumen than commercial re/insurers. These factors, in turn, should allow top-tier personal lines insurers to earn outsized returns compared with commercial lines or reinsurance carriers.

JP Morgan predicts personal auto margins to stay below long-term levels over the next year, but improve from the second half of 2023.

There were headwinds since late 2021. Low miles driven reduced frequency and lifted margins in personal auto through 2020 and early 2021, but frequency eventually reverted close to pre-pandemic levels by mid-2021. Meanwhile, severity spiked above long-term levels because of higher parts/labor costs as well as a spike in used car prices. Liability costs also increased from an active plaintiffs' bar and more severe accidents caused by higher speeds and more aggressive driving behavior. The good news is Y/Y change in US miles driven started to slow down.

In response to higher claim costs, insurers have been raising prices and pulling back from states where regulators have been slow or unwilling to approve rate hikes. Despite price hikes, margins have not recovered as expected thus far, and ongoing high inflation (high parts and used car prices; labor shortages at body/repair shops) could prove current projections too optimistic. On a positive note, the pricing environment has improved. Most states had been granting permission for price hikes since early 2022, and, as expected, some of the outliers, such as California, started approving increases in late 2022 (CA is roughly 12% of U.S. personal auto insurance premiums.)

Meanwhile, used car prices, a major contributor to higher claims costs, have dropped from mid-2022 highs, although they remain well above pre-pandemic levels. JP Morgan expects a further drop in used car values as new car inventories increase with easing chip shortages through the year. These factors, along with our expectation of further price hikes, should help revive margins.

New money yields increased in 2Q23 and present an ongoing tailwind to investment income. In 2Q23, the yield on the 3-year Treasury bond rose 74 bps and that on the 5-year Treasury increased 58 bps. New money rates are well above yields on maturing investments, which bodes well for investment income.

On the other hand, income on alternative investments (mainly private equity allocations) was still relatively weak in 2Q23 and consistent with levels in 1Q 23 despite the healthy equity market in 1Q23 (+7%)

Analysts' views on stocks vary by segment. Longer term, brokerage business seems to be a more attractive business model, more defensive than underwriters in a weaker economy. Brokerage is a structurally superior business to insurance underwriting given its capital-light financial profile, lack of exposure to actuarial or credit risks, and strong cash flow generation.

Reinsurance stocks have outperformed this year, buoyed by the hard pricing environment, but long-term fundamental outlook is cautious given structural challenges in the market. Reinsurance buyers are fairly sophisticated. Pricing tends to be the main driver behind reinsurers winning or losing business. In addition, capital can enter the reinsurance market considerably faster than the primary markets, which have higher barriers to entry and require more investment in distribution, service, and brand.

Personal auto margins are likely to be weak in the near term, but personal lines are better than commercial lines or reinsurance in the long run. Personal auto margins are likely to rise since the second half of 2023 given the benefit of price hikes and lower used car values, as stated before.

There are only a handful of insurers that operate across the vast majority of lines across all major geographic regions, a key competitive advantage for these firms and one that has enabled them to maintain pricing power. Insurers have maintained their relevance to insureds in areas of the market where viable alternatives are sparse. In parts of this kind of market (e.g., smaller-sized accounts, more homogenous commercial lines coverage, personal lines, etc.), large insurers have either built mass-market oriented platforms or acquired potential disruptors. Efficiencies arising from scale, has enabled large companies to expand margins even during periods of weak economic conditions.

Insurers' balance sheets are healthy now, but an uptick in credit defaults or downgrades would restrain capital flexibility. Healthy capital and liquidity levels, adequate overall reserves, and the lack of surrender/withdrawal risk in liabilities make insurers less vulnerable than other financials (banks, asset managers) in the current macro environment.

Though there was uptick in losses in CRE, overall portfolio losses are manageable. However, a spike in defaults (which reduce capital) or downgrades (which increase required capital) in corporate bonds presents a risk for the Personal Auto Insurance sector, but less so than for life insurers or banks.

Within JP Morgan's company coverage, ALL and PGR are the most susceptible to a potential uptick in investment downgrades or defaults. They have higher allocations to alternatives and equities. Also, excluding TRV and ALL, all major underwriters have high allocations to structured securities, with HIG, KNSL, and PLMR being the most exposed.