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It’s well known to investors that insurers are among the major beneficiaries of a rising interest rate environment because of their dependence on bonds to invest the chunks of cash they typically hold to meet their commitments to policyholders. But the gradual improvement in the rate environment after almost a decade surprisingly failed to attract investors’ attention to insurance stocks.

While the Fed’s latest rate hike -- along with the forecast of two more this year -- should have ideally led to a strong rally in insurance stocks, the performance the SPDR S&P Insurance ETF (KIE - Free Report) paints a different picture. This representative ETF of insurance stocks lost 3.3% since the Fed’s latest rate hike on Mar 15 versus the S&P 500’s decline of 1.8%. Moreover, the Zacks classified Insurance Industry saw a 4.8% decline over this period.

Perhaps investors are waiting to see what sort of aggressive actions the central bank takes down the road. On the other hand, the market had priced in this modest increase in interest rates even before the Fed took the recent actions. And it’s quite predictable that there will be only a little impact of this monetary policy tightening on the Treasury yield curve that insurers depend on for their investment income.

Did Low Rates Hurt Insurance Stocks at All?

The low-rate era could not stop the industry from drawing investors’ attention, as evident from the SPDR S&P Insurance ETF’s 104.3% gain and the Zacks classified Insurance Industry’s surge of 77.4% in the past five years versus 70.2% growth of the S&P 500. What made this outperformance possible?
     
Many insurers have changed their asset allocation strategies in an effort to minimize the impact of low rates on their business. Moving beyond their traditional holdings, they have been investing in racier asset classes for increased returns.

In fact, this has now reduced their ability to reap the benefits of rising rates. Of course, pricing changes and the eventual improvement in yields on high-quality bonds based on rising rates will let them earn more, but their revenue model is now stable enough to counter a low rate environment.

Do Insurance Stocks Still Have Some Upside Left?
 
While the industry outperformed the broader market over the last five years, there is still a value-oriented path ahead. Looking at the industry’s price-to-book ratio, which is the best multiple for valuing insurers because of their unpredictable financial results, investors might still want to pay more.
 
The Zacks classified Insurance Industry currently has a trailing 12 month P/B ratio of 2.49. This compares unfavorably with the average level of 2.13 seen by the industry in the last five years. In fact, the current number is near the high of 2.57 witnessed by the industry 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 3.52 and the median level is 3.08.

Overall, while the valuation from a P/B perspective looks stretched when compared with its own range in the time period, its lower-than-market positioning calls for some more upside in the quarters ahead.

But the group’s Zacks Industry Rank indicates that any upside is hard to come. Per Zacks classification, the industry is sub-divided into five industries at the expanded (aka "X") level: P&C, Multiline, Accident & Health, Life and Brokers.

The Zacks Industry Rank is #49 (top 19% of the 250 plus Zacks classified industries) for Life, #61 (top 24%) for Multiline, #167 (bottom 35%) for P&C, #185 (bottom 28%) for Accident & Health and #236 (bottom 8%) for Brokers. Our back-testing shows that the top 50% of the Zacks ranked industries outperforms the bottom 50% by a factor of more than 2 to 1.
    
The Rate-Hike Benefit Varies Across Industry Segments

Being structurally tied to interest rates, the monetary policy tightening will bring some benefits for the industry sooner or later. But the extent of benefits will vary across industry segments. Moreover, the relationship of profit with the interest rate is not direct.

Property & Casualty (P&C) insurance, which is not too sensitive to the interest rate environment, holds a significant amount of bonds, which would fall in value with interest rates rising steadily (which is very unlikely, though). This will lead to capital volatility in the industry.

However, a rising rate environment would keep alleviating the pressure on P&C insurers’ investment income, and thus their earnings. Moreover, a higher rate environment would make the pricing environment more competitive, further supporting carriers to grow.

Life insurers depend heavily on investment income, so they will benefit more from a rising rate environment. There will be relief from operating pressures resulting from tight credit spreads that the low-rate environment has exerted for so long. However, the benefit is expected to be modest as life insurers have significantly reduced their interest-sensitive product lines in the low-rate era.

No matter how the changing interest rate environment impacts insurers, normal catastrophe losses and continued influx of capital are expected to keep most lines of P&C insurance favorable for buyers. On the other hand, containment of underwriting expenses and a modest increase in premiums are shoring up the prospects of life insurers.
 
With glaring dissimilarity in business dynamics, it makes better sense to look at the prospects of these two key segments of the U.S. insurance space separately (read our subsequent posts for a detailed insight).

Factors to Influence the Industry’s Performance

Domestic economic progress and a likely boost in infrastructure spending under Trump’s administration make the backdrop stronger for the country’s insurers. After all, an improving job market and consumer sentiment, along with a resurgent housing market, will lead to more car and home purchase, which means more insurable exposure.

Moreover, a strengthening U.S. dollar will not have much impact on the industry, as it drives the majority of revenues from the domestic economy.

Evolving insurable risks (such as cyber threats, endemic diseases, etc.) should increase demand for coverage. In fact, this increase in demand from economically recuperating American households should eventually place insurers in a favorable pricing cycle.

Recovery in underwriting and a lower combined ratio for P&C insurers are expected to continue if the trend of modest catastrophe losses prevails.

A strong liquidity profile by virtue of continued capital inflow into the industry, ample capacity, conservative product design and evolving coverage will not only limit any downside but will also keep the industry’s growth trend alive.

However, a rising rate environment may result is momentum loss primarily for the housing market, leading to lower insurable exposure in this segment.

Further, increasing dependence on automation will gradually reduce the number of insurable workers across industries.

Bottom Line

Looking at the broader trends, the industry is unlikely to see significant growth until the Fed takes aggressive steps in raising interest rates. Moreover, the emergence of new issues might dampen insurers’ business. However, learning from past experience, insurers are capable enough of remaining profitable through structural modification and expense savings.

It may not be easy for insurers to please investors. While there are enough drivers for margin expansion, the inability to increase premium rates will keep on curbing profitability.

How to Play Insurance Stocks

As you can see, the interest rate environment may not significantly benefit insurers any time soon and there are other challenges too. However, taking advantage of the recent gloom, one may pick a few insurance stocks that are well positioned to capitalize on the industry’s positive trends.

Here are a few top-ranked insurance stocks you may want to consider:

Health Insurance Innovations, Inc. (HIIQ - Free Report) : This Zacks Rank #1 (Strong Buy) stock gained over 170% in the last six months compared with about 8.9% gain for the S&P 500. Its Zacks Consensus Estimate for the current year revised 31.8% upward over the last 60 days.

Erie Indemnity Company (ERIE - Free Report) : This Zacks Rank #1 stock gained roughly 21% over the last six months. It has seen the Zacks Consensus Estimate for the current year earnings revising 6.1% upward over the last 60 days.    

Legal & General Group Plc : The average annual earnings growth rate for this Zacks Rank #1 stock was 15.6% over the last 3-5 years. The price of this stock surged over 25% in the last six months.   

Argo Group International Holdings, Ltd. (AGII - Free Report) : This Zacks Rank #1 stock gained nearly 16% over the last six months. Its Zacks Consensus Estimate for the current year revised 5% upward over the last 60 days.

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