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U.S. Insurance Stock Outlook - April 2018

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The Federal Reserve’s rate hike in March 2018 marks the sixth increase since December 2015, reflecting stability in the U.S. economy. The Fed’s promise to increase rates further in 2018 and beyond, improving economic scenario and tax rate overhaul make the backdrop favorable for insurers.

Insurers are all set for improved profitability after suffering in 2017 due to hiccups like catastrophic losses (cat losses). Last year was the costliest for insurers in terms of cat losses.

An improving rate environment continues to benefit insurers as they depend 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.

Moreover, while the expected continuation of a benign credit environment will likely support the operating performance of life insurers, a strong capital base is anticipated to help Property & Casualty (P&C) insurers combat catastrophe loss.

Interestingly, mergers and acquisitions are grabbing attention of late. This space is one of the most important trends to look out for in 2018. The last couple of years has set the stage for insurers to take an aggressive and positive approach toward the deal-making environment in 2018, mainly driven by an evolving industry and M&A environment.

Despite trials, the industry still managed to complete 350 mergers and acquisitions in 2017 per a report by the London-based law firm, Clyde & Co. Even though the above-mentioned deal volume was considerably lower than the previous year’s tally, the same is estimated to rise in 2018.

However, improvement in interest rates not creating much impact on the insurance industry. This is clearly evident from the 12.02% gain of the SPDR S&P Insurance ETF (KIE - Free Report) , which fairly represents the insurance industry in comparison to the S&P 500’s rally of 12.08% in a year. In fact, the Zacks Insurance Industry has marginally underperformed the S&P 500 index over this period.

The reason behind this restrained reaction could be attributed to fading optimism of investors over the key interest rate, reaching a level that actually benefits insurers. Investors are perhaps expecting only a little impact from this monetary policy tightening on the Treasury yield curve that insurers depend on for their investment income.

Moreover, as a number of industry participants, particularly life insurers, had reduced their exposure to underperforming interest-sensitive businesses in a prolonged low-rate environment, investors expect only a modest impact of higher rates on their financials.

In fact, concerns over unfavorable underwriting results, severity trends, market softening and regulatory uncertainty over the past few years have overshadowed the optimism surrounding monetary policy tightening.

Was the Low-Rate Environment Too Big an Issue?

The performance of insurance stocks over the past five years doesn’t show any noticeable weakness that the low-rate could have caused. In fact, the industry managed to dodge the rate-induced hindrances. The SPDR S&P Insurance ETF has skyrocketed 91.8% and the Zacks Insurance Industry has soared 67.2% in the past five years.

How have insurers managed to perform so well?

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.

Industry Looks Undervalued

While the industry underperformed the broader market over the last five years, there is 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, comparing favorably with the market at large, as the current P/B for the S&P 500 is at 3.74 and the median level is 2.54.

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

Zacks Rank

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 #45 (top 18% of the 250 plus Zacks industries) for Life and #65 (top 25%) for Brokers. However, the rest three - #249 for Accident & Health, #235 for Property & Casualty, #180 for Multiline fall in the bottom half of the Zacks Industry Rank.

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.
    
Rising Rates to Benefit the Industry Partially

Being structurally tied to interest rates, 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 insurance holds a significant amount of bonds, which would fall in value with interest rates rising steadily going forward (which is likely). This will lead to capital volatility in the industry.

Nonetheless, the rising rate environment would keep easing 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 has 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 — expect personal lines that might experience higher premium rates due to the recent catastrophe losses. On the other hand, containment of underwriting expenses and a modest increase in premiums are shoring up the prospects of life insurers.
 
With a 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 Rising Rates to Determine Fate of Insurers

Domestic economic progress makes the backdrop stronger for the country’s insurers. After all, a strong job market and boosted consumer sentiment along with a moderately growing homeownership rate will lead to more personal property buying, which means more insurable exposure.

Federal Reserve expects the unemployment rate at 3.8% for 2018, 3.6% for both 2019 and 2020 and 4.5% over the long term. Also, the Central Bank forecast GDP to grow at 2.7% in 2018 and 2.4% in 2019. GDP for 2020 is now projected at 2% and 1.8% in the long run.

However, inflation is expected to remain below the targeted 2% throughout the year, though it is likely to meet the target next year and exceed the same thereafter. While inflation is estimated at 1.9% in 2018, the same will move up to 2% in 2019 and 2.1% in 2020. All these together come as good news, clearly signaling toward economic improvement gaining traction.

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 the economically recuperating American households should eventually place insurers in a favorable pricing cycle. A heightened number of data breaches has already set the stage for more increasing demand for cyber insurance.

Premium rates for auto insurance, which have risen over the last couple of years due to increasing accident frequency and severity trends, will reduce to some extent with the growing adoption of accident avoidance technologies.

Due to benign cat environment, reinsurance rate has also remained flat over some time. Given last year’s unprecedented hurricane activity, market hardening is expected and reinsurance rates are also likely to rise higher.

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

Bottom Line

Looking at the broader trends, though the industry will benefit from raising interest rates, but it is not the only factor. While growth may be dampened to some extent if new issues crop up, 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 despite the damage caused by successive hurricanes, the inability to increase premium rates will keep 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:

National General Holdings Corp. (NGHC - Free Report) : This Zacks Rank #1 (Strong Buy) stock has surged 23.9% year to date. The stock has seen the Zacks Consensus Estimate for the current year being revised 5.7% upward over the last 60 days. You can see the complete list of today’s Zacks #1 Rank stocks here.

Kinsale Capital Group, Inc. (KNSL - Free Report) : This Zacks Rank #2 (Buy) stock has gained 14.9% since the beginning of the year. It has seen the Zacks Consensus Estimate for current-year earnings being revised 2.5% upward over the last 60 days.

Aegon N.V. (AEG - Free Report) : The consensus mark for this stock has been raised 5.1% over the last 60 days. This Zacks #1 Ranked player stock has gained nearly 14.3% since the start of the year.

Health Insurance Innovations, Inc. (HIIQ - Free Report) : This stock with a Zacks Rank of 2 has jumped roughly 13.8% since the commencement of the year. It has seen the Zacks Consensus Estimate for earnings in the ongoing year being moved 21% north over the last 60 days.

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