You're in Good Hands with Insurance ETFs

Insurance ETFs are not for the faint hearted, but with high risk can come high returns

Morningstar ETF Analysts 14 April, 2010 | 12:33AM
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Recently, famed investor Warren Buffett increased Berkshire Hathaway's holdings of European reinsurance giant Munich Re to more than €1 billion, becoming the single largest shareholder in the firm with a 5% stake. And Munich Re is not the only European insurer that Mr. Buffett has had on his radar over the last couple of years. Berkshire also holds a 3% slice of Swiss Re, in addition to reinsuring a large share of the firm's US life business. The attention Mr. Buffett has lavished on the European insurance sector becomes more interesting when you consider that insurance has been the backbone of Berkshire Hathaway's success over the years. While we don't recommend blindly mimicking the investment choices of billionaires, as they often have different goals than the average investor, they can serve as a good starting point for further analysis.

The past few years have not been kind to the insurance industry, as a combination of severe weather events, massive investment losses and pricing competition has impaired the sector's profitability. Of the 19 STOXX super sectors, the only ones to post poorer annualised returns from 2007 to 2010 than the insurance sector (which fell at an annualised rate of 20% during the period) were Banks, Financial Services and Real Estate. However, there are indications that the market may begin to improve in the next 12 months. The rate of price decreases has been declining and, judging by historical results, a bottoming in prices followed by rapid rate increases could be on the cards. In fact, executives at many of the major insurers are optimistic that capacity depletion in the industry will lead to a resumption of rational pricing by early 2011. Because the amount of insurance a company can write is limited by its capital, when capital levels in the industry decrease due to large losses, supply is restricted and the reduced competition for business leads to increasing rates. In a cyclical market like insurance, years of a 'soft' market (insurance terminology for a weak rate environment) will eventually be followed by a 'hard' market, which can be a catalyst for superior returns for the sector.

So if you’re interested in following Mr. Buffett’s lead but don’t want to take on the stock-specific risks of buying shares solely in Munich Re and Swiss Re, how might you proceed? We suggest that a low-cost way to capitalise on potential margin expansion in the insurance industry is to purchase an ETF tracking an insurance sector index.

Morningstar's equity analysts currently cover 10 European insurers, including Warren Buffett's aforementioned investments. We can use our equity analysts' fair value estimates for these stocks to estimate the fundamental value of the index and its corresponding ETFs.

Choosing an Index
There are four indices that cover the European insurance sector and are tracked by ETFs: the MSCI Europe/Insurance LCL Index, the STOXX Insurance Total Return Index, the STOXX Euro Insurance Total Return Index (only includes companies based in the EMU) and the STOXX Optimised Insurance Index (which excludes illiquid and difficult to borrow stocks from the STOXX Insurance Index).

The two most similar indices are the STOXX and MSCI with an 87% overlap between their components, while the MSCI and STOXX Euro indices only have 58% overlap. While an investor's unique preferences will play a large role in determining their pick among these indices, in most cases the greater assets under management and diversification of the STOXX indices (regular or optimised) will make them a better choice than the MSCI or STOXX Euro indices as they are all--at present--comparable from the perspective of valuation and total expense ratio (TER).

Choosing a Fund
Let's next try to pick the best ETF tracking this index. While investors limited to the London Stock Exchange have no alternative to the db x-trackers STOXX Insurance ETF, there are several options available on the continent. The primary factors we use to sort through our options are the TER and assets under management (AUM), which we'll use as a rough proxy for liquidity.

On the Deutsche Borse, our favourite option is ComStage's ETF (also available on the Swiss Exchange), with the lowest TER available of 0.25% and a respectable €40 million in AUM. While iShares' offering has more than €90 million in AUM, its TER is more than twice that of the ComStage ETF owing in part to the higher costs involved with running a physical replication ETF versus a swap-based fund. Another good option that combines good liquidity with low costs is the Lyxor STOXX Insurance ETF available on EuroNext Paris. This fund has more than €100 million in AUM and a TER of 0.30%. (You will find this data and more in this table.)

While investors will naturally prefer lower expense ratios and higher levels of liquidity, there are some additional considerations that may lead you to select an alternative to the cheapest, most liquid funds around. For instance, some ETFs distribute dividend payments (distributing funds) to shareholders, while others (capitalising funds) will reinvest them in their underlying portfolio. Your preference between these two factors will depend largely on your unique tax considerations. For instance, if you are subject to high tax rates on dividends and plan on holding a fund in a taxable account, you might prefer the ComStage ETF, which capitalises dividends, as opposed to the Lyxor fund, which distributes them to unitholders.

While there are some signs--including reasonable valuations and potential catalysts, which could lead to a hard insurance market--that buying into the industry now may be a wise investment, it will likely largely depend on economic fundamentals in Europe. The stock market performance of insurance companies tends to trend with broader economic sentiment, but with far more volatility. This is a high risk, high return investment idea that's not for the faint of heart, and should only be limited to a small portion of the equity allocation in your portfolio.

Financial professionals can find out more about the case for passive investing at our next ETF Conference Call, where you will also have the opportunity to ask our ETF analysts questions. Sign up for the next free, interactive call, to be held April 28, by clicking here.

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

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Morningstar ETF Analysts  research hundreds of ETFs available to European investors. The Morningstar Rating for ETFs is based on a risk-adjusted performance measure.