The mere rise in interest rates in the last couple of years doesn’t have the potential to significantly catapult Property & Casualty (P&C) insurers’ investment income. However, the improving economic health that convinced the Fed to raise rates will likely contribute a lot to their business growth. That’s because, increasing disposable income and improving consumer sentiment will lead to more car and home purchase, which means more policy-writing.

Moreover, some major adjustments to their business in order to offset the damage caused by the prolonged low interest rate environment have been helping P&C insurers to improve their bottom lines.

The industry’s growth potential attracted investors to bet on its stocks more than others since the Fed’s resumption of rate hike in Dec 2015. This is clearly evident from the Zacks classified P&C Insurance Industry’s 23.6% gain versus 11.1% growth of the S&P 500.

Why P&C Insurance Stocks Have Plenty of Upside Left

While the industry outperformed the broader market over the last one year, there is still a value-oriented path ahead. Looking at the industry’s price-to-book ratio, which is the best multiple for valuing P&C insurers because of their unpredictable financial results, investors might still want to pay more.

The industry currently has a trailing 12 month P/B ratio of 1.49. This level compares unfavorably to some extent with what the industry has seen in the last five years. The ratio is higher than the average level of 1.36 and almost near its high of 1.50 over this period.

However, it actually compares pretty favorably with the market at large, as the current P/B for the S&P 500 is at 3.32, the median level is 2.98 and the low level is 2.87.

Overall, while the valuation from a P/B perspective looks slightly stretched when compared with its own range in the time period, a significant discount to the broader market’s position calls for plenty of upside in the quarters ahead.

Modest InterestRate Hike Not Much of a Concern

P&C insurers are less sensitive to interest rates than life insurers. That’s because the large financial portfolios managed by these carriers are designed to be fairly conservative. Meaning, they keep the required fund in hand to cover claims that they typically face faster than life insurers. Due to this, they depend significantly on short-term Treasury bills.

For P&C insurers, the interest rate sensitivity has both positive and negative directions. Whether the upside offsets the downside is yet to be seen, as there hasn’t been any measurable progress on the rate hike front so far.

A rising rate environment would boost P&C insurers’ investment income that has been declining in an extended low-rate environment. However, the key downside is a significant amount of bonds in P&C insurers’ portfolio losing value if rates are hiked steadily (which is unlikely, though).

P&C insurers’ extreme sensitivity to asset inflation will aggravate the situation. In other words, the value of the properties insured by carriers will appreciate with an improving real estate market, increasing their potential liabilities from claims. This may outpace the rising yields on bonds they added to their portfolios for covering the claims. In fact, the bonds in their portfolios will lose value with rising interest rates. And this could ultimately result in capital volatility.         

Addressing this concern would require P&C insurers taking more risk to meet the rising liabilities from claims. And this would eventually increase their costs.

Continued Buyer's Market Poses a Threat

Looking beyond the implications of the slow and modest interest rate hike, it is market softening that characterizes the P&C insurance industry. In order to retain renewals and secure new business, carriers are aggressively reducing rates and making the market advantageous for buyers.

The softening was evident right through 2015 and has continued so far. Pricing primarily remains soft in the areas of commercial property, workers' compensation, general liability and business interruption. On the other hand, the commercial auto line has been witnessing an increase in rates.

By its very nature, a soft market causes lower underwriting profitability for carriers, as they prioritize market share gain over making more from premiums to exist in the market.

With the increasing appetite of carriers, their willingness to negotiate on terms and conditions, and enhanced capital strength, the market is likely to remain highly competitive in the quarter ahead.

However, greater demand for insurance, particularly following the emergence new insurable risks including cyber threat and endemic disease, will keep the business of P&C insurers afloat.

Fundamental Strength to Keep Growth Momentum Alive

In addition to the continuation of a soft market environment, slowing reinsurance renewals across most lines due to less significant catastrophe in recent years should curb P&C insurers’ bottom-line growth.

However, ample underwriting capacity, a strong liquidity profile and evolving coverage opportunity should help these carriers stand tall.

Concerns related to weak capital levels are now things of the past, as the industry’s capital position has been building up on the back of improved earnings and policyholders' surpluses. The industry has also been witnessing continued inflow of alternative capital (which is one of the reasons for market softening). High capital levels are actually positioning the industry to perform well.

Further, better preparation to withstand catastrophe losses should translate into higher underwriting profits and a lower combined ratio in the upcoming quarters. Conservative investment strategies should also work in favor.

As P&C insurers hold about two-thirds of the invested assets in the form of bonds, their capacity is highly sensitive to changes in credit market conditions. With the credit market showing resilience and almost no possibility of a sudden spike in interest rates, insurers are likely to incur lesser realized and unrealized capital losses in the quarters ahead.   
    
Though competition is cropping up both within the primary lines of the P&C space and with reinsurers’ expansion, proactive transformational measures, including adoption of technology solutions, will give a competitive advantage.

Also, for more enthusiasm in renewals and to meet evolving demands of policyholders, insurers are in the process of product reframing and innovation. This should help them expand their customer base for products that will offer higher margins.
   
The emerging risks related to cyber threats are also giving P&C insurers scope to capitalize on. This segment, though relatively small in size, has been witnessing continued growth in premium and policy count.  

How to Play the Industry

As there are plenty of reasons to be optimistic about U.S. P&C insurers’ growth prospects, buying some stocks from the space based on a favorable Zacks Rank would be a prudent decision now.

Here are a couple of top-ranked P&C insurance stocks you may want to consider:

Mercury General Corporation (MCY Quick QuoteMCY - Free Report) : This Zacks Rank #1 (Strong Buy) stock gained about 31.2% over the last one year compared with about 10.7% gain for the S&P 500. The stock’s earnings estimates for the current fiscal year were revised 14.9% upward over the last 90 days.

State National Companies, Inc. : A 10.5% upward revision in earnings estimates for the current fiscal year over the last 60 days lead to a Zacks Rank #1 for this stock. The price of this stock surged over 41% over the last one year.

However, the likely continuation of the buyer’s market will typically hold insurers back from flourishing in the near term. In fact, stiff competition and reducing premium rates may pose significant challenges to bottom-line growth for some carriers. As such, staying away from stocks with an unfavorable Zacks Rank should be the right strategy.

We strongly suggest staying away from or getting rid of the following bottom-ranked stocks:

Markel Corporation (MKL Quick QuoteMKL - Free Report) : This Zacks Rank #5 (Strong Sell) stock gained only 4.4% over the last one year. The stock’s earnings estimates for the current fiscal year were revised 20.8% downward over the last 90 days.   

RLI Corp. (RLI Quick QuoteRLI - Free Report) : An 8.7% downward revision in earnings estimates for the current fiscal year over the last 60 days precipitated a Zacks Rank #5 for this stock. The price of this stock gained only 5.4% over the last one year.

Check out our latest U.S. Insurance Industry Outlook for more on the current state of affairs in the overall insurance market.

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