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U.S. Insurance Stock Outlook - January 2016

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Being one of the very few industries to thrive in a rising interest rate environment, the U.S. insurance industry is cheering loudly for the interest rate hike by the Fed and the possibility of a slow but continued upturn. But the business dynamics of insurers are not that simple, and the relationship of profit with the interest rate is not direct either.

In particular, Property & Casualty (P&C) insurance, which is not very 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 likely). 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 the carriers to grow.

Life insurers, however, 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 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 prolonged low-rate environment.     
 
No matter how the changing interest rate environment impacts insurers, mild catastrophe losses and continued influx of capital are expected to keep most lines of P&C insurance favorable for buyers. Yet evolving threats such as cyber-attacks and a persistently soft market pose challenges for the carriers.

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).

Let’s take a quick look at the overall insurance market:   
          
While continued economic uncertainty across the globe is not leaving the U.S. totally unscathed, the latest interest rate hike, propelled by convincing domestic economic progress, makes the backdrop stronger for the country’s insurers. Further, with the economy expected to see a continuation of rate hike, insurers look well positioned for growth.

Moreover, 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 growth trend alive.

One of the segments enjoying a steady influx of capital is cyber insurance. This space has emerged as a winner with the fastest growth logged in the industry over the last few quarters.      

Also, the ongoing reserve development will continue to support insurers’ financials. Increasing demand from the economically recuperating American households should eventually place insurers in a favorable pricing cycle, too.
 
Further, recovery in underwriting and a lower combined ratio for P&C insurers are expected to continue if the trend of modest catastrophe losses prevails. Then again, lower catastrophe losses indicate lower premium rates as well.

Moreover, heightened competition might curb insurers’ profitability in the quarters ahead. But the rapid influx of alternative capital will keep the prices down and expedite M&A activities.

Regulation Not Yet Effective  
 
Apparently, a safe and sleepy business nature keeps U.S. insurers out of federal regulations, which could have marred business expansion. But the industry has yet to be strongly braced by the advantages of operating under state-run regulations. Instead, decentralized regulation and consumer protection make the industry susceptible to insolvency.
 
Now, the changing nature of business -- more like banks in terms of liabilities -- perhaps calls for a federal oversight. Though the necessity for a regulatory revamp has been strongly felt after banks witnessed success, this will delve another blow to the insurance industry.
 
A provision of the 2010 Dodd-Frank Act requires setting minimum capital and leverage standards on insurance companies as well, but these have yet to be implemented by U.S. lawmakers, who are considering the distinct business fundamentals differing from banks. But the industry, which accounts for 7% of GDP in terms of insurance premiums paid each year, has scant chance of being relieved of Federal Reserve control.
 
Zacks Industry Rank

Within the Zacks Industry classification, insurers are broadly grouped in the Finance sector (one of the 16 Zacks sectors) and are further sub-divided into five industries at the expanded (aka "X") level: P&C, Multiline, Accident & Health, Life and Brokers. The level of sensitivity and exposure to different stages of the economic cycle vary for each industry.

We rank 265 X industries in the 16 Zacks sectors based on the earnings outlook and fundamental strength of the constituent companies in each industry.

We put our X industries into two groups: the top half (industries with the best average Zacks Rank) and the bottom half (the industries with the worst average Zacks Rank). Over the last 10 years, using a one week rebalance, the top half beat the bottom half by a factor of more than 2 to 1. (To learn more visit: About Zacks Industry Rank.)

The Zacks Industry Rank is #91 for P&C, #98 for Accident & Health, #145 for Multiline, #180 for Life and #185 for Brokers.

Earnings Trends

The earnings and revenue beat ratios (percentage of companies coming out with positive surprises) of the S&P companies in the Insurance industry, which is a medium level (or M-level) component of the broader Finance sector, for the third quarter of 2015 were the same at 52.4%. The industry witnessed a 15.2% year-over-year decline in earnings despite 2.5% growth in revenues.

For the broader Finance sector, earnings and revenue beat ratios were 54.8% and 46.4%, respectively. The sector witnessed 0.5% earnings growth on 0.3% growth in revenues.
 
The sector is expected to witness a 4.5% year-over-year decline in revenues in Q4, but earnings are projected to grow 6.8%.
 
For a detailed look at the earnings trend for this sector and others, please read our latest Earnings Trends report.
 
Bottom Line
 
Looking at the broader trends, the overall health of the industry appears to be improving despite the emergence of new issues. And learning from past experience, insurers are resorting to expense-saving measures to tread water.

If insurers manage to overcome the short-term resistance that may be holding back premium rate increases, they should ultimately witness margin expansion. Also, in the absence of federal regulation, insurers can take on new challenges with the ample capital that they now have.

How to Play the Insurance Sector
 
As you can see, apart from the recent interest rate hike, there are plenty of other reasons to be optimistic about the industry’s prospects. So it would be prudent to pick a few insurance stocks that might perform well in the near term.
 
We highly recommend stocks with a Zacks Rank #1 (Strong Buy) such as Aspen Insurance Holdings Ltd. (AHL) and Hallmark Financial Services Inc. (HALL - Free Report) .
 
However, we suggest staying away from or getting rid of Zacks Rank #5 (Strong Sell) stocks such as American International Group, Inc. (AIG - Free Report) , White Mountains Insurance Group, Ltd. , Genworth Financial, Inc. (GNW - Free Report) and Erie Indemnity Company (ERIE - Free Report) .   

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