The Fed’s latest minutes reflect disagreement among its officials over how quickly to raise rates, but it appears that the streak will continue, at least until inflation reaches the 2% target. This makes the backdrop favorable for insurers because of their dependence on rate-sensitive instruments to invest the chunks of cash they typically hold to meet their commitments to policyholders. In fact, insurers are known to be one of the beneficiaries of a rising-rate environment.
However, U.S. insurers don’t appear to have attracted special attention of investors amid this gradually improving interest rate environment. This is clearly evident from the 7.6% gain of the SPDR S&P Insurance ETF (KIE), which fairly represents the insurance industry, versus the S&P 500’s rally of 8.5% since the beginning of the year. In fact, the Zacks Insurance Industry has performed on par with the S&P 500 over this period.
The reason behind this restrained reaction could be fading optimism of investors over the key interest rate reaching a level that actually benefits insurers. Investors are perhaps expecting only a little impact of this monetary policy tightening on the Treasury yield curve that insurers depend on for their investment income. On the other hand, the market had priced in this modest increase in interest rates even before the Fed started off.
Was Low-Rate Environment a Blockage at All?
The performance of insurance stocks over the past five years doesn’t show any unusual weakness that the low-rate could have caused. In fact, the industry performed better than the broader market during this period, indicating its ability to easily dodge the rate-induced hindrances. The SPDR S&P Insurance ETF gained 119.3% and the Zacks Insurance Industry rallied 87.7% in the past five years versus 75.4% growth of the S&P 500.
What made this outperformance possible?
In the low-rate era, many insurers changed their asset allocation strategies to minimize the impact of low rates on their business. Moving beyond their traditional holdings, they invested 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.
Valuation and Zacks Rank Indicate Further Upside
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 Insurance Industry currently has a trailing 12 month P/B ratio of 2.48. This compares unfavorably with the average level of 2.21 seen by the industry in the last five years.
However, it actually compares pretty favorably with the market at large, as the current P/B for the S&P 500 is at 3.54 and the median level is 3.17.
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.
Moreover, the group’s Zacks Industry Rank indicates further upside for most of the segments. Per the Zacks classification, the industry is sub-divided into five industries at the expanded (aka "X") level: Property & Casualty Insurance, Multiline Insurance, Accident & Health Insurance, Life Insurance and Insurance Brokers.
The Zacks Industry Rank is #18 (top 7% of the 250 plus Zacks industries) for Accident & Health, #21 (top 8%) for Life, #109 (top 43%) for Multiline, #203 (bottom 21%) for Property & Casualty and #235 (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.
Benefit from Rising Rates Varies Across Segments
Being structurally tied to interest rates, the monetary policy tightening has started benefiting the industry. But the extent of benefits varies across industry segments. A lot depends on how interest rates change going forward.
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, the 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 the rising rate environment. There will be relief from operating pressures resulting from tight credit spreads that the low-rate environment exerted for long. However, the benefit is expected to be modest as life insurers had significantly reduced their interest-sensitive product lines in the low-rate era.
No matter how the changing interest rate environment impacts insurers, continued influx of capital is 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 Beyond Interest Rates
Domestic economic progress 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 buying, which means more insurable exposure.
Moreover, any fluctuation in the 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, higher demand from economically recuperating American households should eventually place insurers in a favorable pricing cycle.
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, P&C insurers may no longer benefit from a recovery in underwriting and low combined ratio, as natural catastrophes are increasingly on the rise. In fact, the first half of 2017 witnessed the highest catastrophe losses since 2011.
Further, increasing dependence on automation will gradually reduce the number of insurable workers across industries.
Looking at the broader trends, the industry is unlikely to benefit significantly from raising interest rates, but that may not stop it from growing. While emergence of new issues might dampen growth to some extent, insurers are capable enough of remaining profitable through underlying strength and business modification.
However, it may not be easy for insurers to allure 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
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 has gained nearly 84% year to date versus the S&P 500’s 8.5% rally. Its Zacks Consensus Estimate for the current year has been revised 6.8% upward over the past 30 days. You can see the complete list of today’s Zacks #1 Rank stocks here.
Kemper Corporation (KMPR - Free Report) : This Zacks Rank #1 stock has gained roughly 10% since the beginning of the year. It has seen the Zacks Consensus Estimate for the current year earnings revising 31.4% upward over the past 30 days.
CNO Financial Group, Inc. (CNO - Free Report) : The Zacks Consensus Estimate for this stock has been revised 4.6% upward over the past 30 days. This Zacks Rank #2 (Buy) stock has gained nearly 15% since the beginning of the year.
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