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U.S. Insurance Stock Outlook - August 2016

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The long-awaited benefits of a rising rate environment that the insurance industry were highly hopeful of after the Federal Reserve’s first rate hike (in Dec 2015) in almost a decade, are unlikely to be felt any time soon, as any further liftoff is probably off the table for the rest of 2016. Though domestic economic factors – including growth, labor market conditions and consumer price inflation – are favorable for the Fed’s next rate hike move, it will perhaps wait to see stability on the global front.

If concerns over global economic growth weren’t enough, the Brexit storm gave the already-dovish Fed more reasons for staying away from the next rate hike.

The insurance industry is one of the very few to thrive in a rising interest rate environment as its investment strategies are liability-driven. But a prolonged low rate environment could not stop the industry from drawing investors’ attention, as evident from the SPDR S&P Insurance ETF’s 124% gain in the past five years versus 94% gain of the S&P 500. What made this possible?

Many insurers have changed their asset allocation strategies in an effort to minimize the impact of the prolonged low rate environment on their business. Moving beyond their traditional holdings, they are 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 based on rising rates will let them earn more, but their revenue model is now stable enough to counter a low rate environment.

A rising rate environment will surely brace insurers’ business sooner or later. 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 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, 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 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 this low-rate era.
No matter how the changing interest rate environment impacts insurers, normal catastrophe losses ($11 billion insured losses in the in the first half of 2016 versus $8 billion a year ago) 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 carriers.

On the other hand, containment of underwriting expenses and a modest increase in premiums are shoring up the prospects of life insurers. But the prolonged low rate environment has been intensifying their struggle to generate adequate returns to meet their commitment to policyholders.

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).

Overall Insurance Market at a Glance   
While continued economic uncertainty across the globe is not leaving the U.S. totally unscathed, domestic economic progress makes the backdrop stronger for the country’s insurers. Insurers might not see significant improvement in their rate-sensitive business in the near term, but growing demand for coverage with improving labor market conditions and evolving insurable risks (such as cyber threat, endemic disease, etc.) should keep them afloat. In fact, increasing demand from economically recuperating American households should eventually place insurers in a favorable pricing cycle, too.   

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. Also, the ongoing reserve development should continue to support insurers’ financials.

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.

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

Will Regulation Hinder Insurers’ Growth Prospects?  
Apparently, a safe and sleepy business nature keeps U.S. insurers out of federal regulations, which could have marred business expansion. But the industry is 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 federal oversight. Though the necessity for a regulatory revamp has been strongly felt after banks witnessed success, this would deliver another blow to the insurance industry.
A provision of the 2010 Dodd-Frank Act requires setting minimum capital and leverage standards on insurance companies, but these have yet to be implemented by U.S. lawmakers, who are considering distinct business fundamentals different from banks. But the industry, which is increasingly contributing to GDP, has scant chance of being relieved of Federal Reserve control for very long.
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 #60 for Life, #180 for Accident & Health, #218 for P&C, #224 for both Brokers and Multiline.

Earnings Trends

All S&P 500 companies in the broader Finance sector, of which the Insurance industry is a medium level (or M-level) component, have reported second-quarter 2016 results. The earnings beat ratio (percentage of companies coming up with positive surprises) is 66.7%, while the revenue beat ratio is 54.4%.

The sector has witnessed an earnings decline of 5.2% year over year compared with a 6.9% decline in the prior quarter. Revenues have declined 0.2% compared with an increase of 2.1% in the prior quarter.

For the third quarter, the sector is expected to witness year-over-year earnings growth of 4.9% and revenue growth of 2.3%.

For a detailed look at the earnings trend for this sector and others, please read the latest Earnings Trends report.
Bottom Line

Looking at the broader trends, the growth prospects of the industry appears bright even if the low rate environment continues. The emergence of new issues might not significantly dampen insurers’ business either. Particularly, learning from past experience, insurers are resorting to expense-saving measures to tread water.

It may not be very difficult for insurers to overcome short-term resistance. While the inability to increase premium rates will keep on curbing profitability, there are enough drivers for margin expansion in the medium term.  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 Industry
As you can see, though the interest rate environment may not significantly benefit insurers any time soon, there are plenty of reasons to be optimistic about the industry’s prospects. So it would be prudent to pick a few insurance stocks that might outperform the markets in the near term.
We highly recommend stocks with a Zacks Rank #1 (Strong Buy) such as Health Insurance Innovations, Inc. (HIIQ - Free Report) , Allied World Assurance Company Holdings, AG AWH and Argo Group International Holdings, Ltd. AGII.
However, we suggest staying away from or getting rid of Zacks Rank #5 (Strong Sell) stocks such as Hartford Financial Services Group Inc. (HIG - Free Report) , Cigna Corp. (CI - Free Report) and MetLife, Inc. (MET - Free Report) .   

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