Life insurers are not as overpriced as many investors believe, said JP Morgan Cazenove in a note on Friday, but an expected shifting pricing backdrop in 2018 saw it upgrade Lancashire but downgrading Admiral and Hastings.
Cazenove expects a different pricing outlook for both motor and commercial/specialty insurance lines. In motor, anticipation of a reversal of last year's changes to the 'Ogden rate' -- the discount on personal injury claim payouts -- and potential reforms to rules on whiplash claims are likely to weigh on pricing, analysts said.
"We believe a temporary decline in pricing is possible, which in itself may not be negative for margins (it is in response to an expected benefit), but is not helpful for sentiment in our view. "
Meanwhile in the commercial/specialty lines, an improved outlook is perceived following the heavy natural catastrophe activity in 2017, which is seen as a potential positive for Lloyd's companies and RSA Insurance.
As a result, the analysts' preferred stocks comprise those that offer "attractive valuations with strong defensive characteristics", such as Direct Line and RSA, or "outstanding long-term growth potential", such as Beazley and Hiscox. All four of which were kept on 'overweight' ratings.
Admiral was downgraded to 'underweight' from 'neutral' partly on valuation but also on the more cautious view on the motor pricing cycle, with the company expected to find it difficult to improve its industry-leading margins and a likelihood of some erosion in a more competitive motor market.
Hastings is also downgraded but only to 'neutral', from 'overweight', as the Cazenove team believes it is better positioned in a rising pricing backdrop.
Lancashire is upgraded to 'neutral' given the improving outlook seen for reinsurance and retrocession pricing.
While outperformance of broader European markets for five out of the past six years, has led to a perception, that the insurance sector is now expensive, Caz calculated that the sector's outperformance of the market has in fact been driven by its superior earnings momentum and so the sector's PE discount remains in line with the 10-year average.
"Looking ahead, not only do we see a positive outlook, but we also believe there is a case for this discount to close, due to: 1) improving sources and uses of earnings and 2) increasingly strong balance sheets."
The analysts' London-listed top picks in the sector are Aviva and Direct Line.