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The Federal Reserve’s action last month of modestly raising interest rates, just like it did a year ago after almost a decade, came as a relief to the insurance industry. The prolonged low-rate environment and falling yields on alternative assets have been making it difficult for insurers to generate a decent investment income.
The Fed’s latest action, along with the forecast of three hikes in 2017, should have ideally led to a strong rally in insurance stocks. However, investors don’t appear too excited, considering last year's rate-hike predictions versus what actually happened.
Only a little optimism is evident from the SPDR S&P Insurance ETF’s 0.6% gain since the Fed’s latest rate hike decision versus the S&P 500’s decline of 0.8%. This gain is actually insignificant given the fact that the industry is one of the very few to thrive in a rising interest rate environment as its investment strategies are liability driven.
The fact is that the market had already priced in this sluggish increase in interest rates even before the Fed’s announcement. And it’s quite predictable that there will be little to no impact of this monetary policy tightening on the Treasury yield curve that insurers depend on for their investment income.
Have Low Rates Really Affected Insurance Stocks?
The low-rate era could not stop the industry from drawing investors’ attention, as evident from the SPDR S&P Insurance ETF’s 92% gain and the Zacks classified Insurance Industry’s surge of 82.6% in the past five years versus 73.1% 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.
Why 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 industry currently has a trailing 12 month P/B ratio of 2.3. This level compares unfavorably to some extent with what the industry saw in the last five years. The ratio is higher than the average level of 2.03 and almost near its high of 2.33 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 3.36 and the median level is 2.98.
Overall, while the valuation from a P/B perspective looks slightly 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.
The Rate-Hike Benefit is Not Unvarying
A rising rate environment will surely brace the industry 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 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).
Overall Insurance Market Backdrop Shows Promise
Domestic economic progress makes the backdrop stronger for the country’s insurers. After all, an improving job market and consumer sentiment will lead to more car and home purchase, which means more policy-writing. Moreover, evolving insurable risks (such as cyber threat, endemic disease, 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.
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. Though catastrophes and lower favorable loss reserve development kept P&C insurers under pressure in the first half of 2016, the long-term trend has been favorable. Recovery in underwriting and a lower combined ratio for P&C insurers are expected to continue if the trend of modest catastrophe losses prevails.
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 more than twice as much.
The Zacks Industry Rank is #57 (top 22%) for Accident & Health, #74 (top 28%) for Life, #135 (bottom 49%) for P&C, #176 (bottom 34%) for Multiline and #222 (bottom 16%) for Brokers.
Bottom Line
Looking at the broader trends, the growth prospects of the industry appears bright even if interest rates don’t rise faster. 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 please investors. 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 Insurance Stocks
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.
Here are a few top-ranked insurance stocks you may want to consider:
AXIS Capital Holdings Ltd. (AXS - Free Report) : This Zacks Rank #1 (Strong Buy) stock gained about 16.8% over the last one year compared with about 10.7% gain for the S&P 500. The stock surpassed earnings estimates in the trailing four quarters, with an average beat of 30.2%.
The Hartford Financial Services Group, Inc. (HIG - Free Report) : This Zacks Rank #2 (Buy) stock gained roughly 11.6% over the last one year. The company is expected to see earnings growth of 9.5% over the next five years versus the industry’s expected growth of 8.7%.
Amerisafe, Inc. (AMSF - Free Report) : An upward revision in earnings estimates for the current fiscal year over the last 60 days lead to a Zacks Rank #2 for this stock. The price of this stock surged over 25% in the last year.
Loews Corp. (L - Free Report) : This Zacks Rank #2 stock gained nearly 24% over the last year. Earnings estimates for the current fiscal year were revised 4.7% upward over the last 60 days.
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U.S. Insurance Stock Outlook - January 2017
The Federal Reserve’s action last month of modestly raising interest rates, just like it did a year ago after almost a decade, came as a relief to the insurance industry. The prolonged low-rate environment and falling yields on alternative assets have been making it difficult for insurers to generate a decent investment income.
The Fed’s latest action, along with the forecast of three hikes in 2017, should have ideally led to a strong rally in insurance stocks. However, investors don’t appear too excited, considering last year's rate-hike predictions versus what actually happened.
Only a little optimism is evident from the SPDR S&P Insurance ETF’s 0.6% gain since the Fed’s latest rate hike decision versus the S&P 500’s decline of 0.8%. This gain is actually insignificant given the fact that the industry is one of the very few to thrive in a rising interest rate environment as its investment strategies are liability driven.
The fact is that the market had already priced in this sluggish increase in interest rates even before the Fed’s announcement. And it’s quite predictable that there will be little to no impact of this monetary policy tightening on the Treasury yield curve that insurers depend on for their investment income.
Have Low Rates Really Affected Insurance Stocks?
The low-rate era could not stop the industry from drawing investors’ attention, as evident from the SPDR S&P Insurance ETF’s 92% gain and the Zacks classified Insurance Industry’s surge of 82.6% in the past five years versus 73.1% 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.
Why 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 industry currently has a trailing 12 month P/B ratio of 2.3. This level compares unfavorably to some extent with what the industry saw in the last five years. The ratio is higher than the average level of 2.03 and almost near its high of 2.33 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 3.36 and the median level is 2.98.
Overall, while the valuation from a P/B perspective looks slightly 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.
The Rate-Hike Benefit is Not Unvarying
A rising rate environment will surely brace the industry 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 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).
Overall Insurance Market Backdrop Shows Promise
Domestic economic progress makes the backdrop stronger for the country’s insurers. After all, an improving job market and consumer sentiment will lead to more car and home purchase, which means more policy-writing. Moreover, evolving insurable risks (such as cyber threat, endemic disease, 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.
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. Though catastrophes and lower favorable loss reserve development kept P&C insurers under pressure in the first half of 2016, the long-term trend has been favorable. Recovery in underwriting and a lower combined ratio for P&C insurers are expected to continue if the trend of modest catastrophe losses prevails.
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 more than twice as much.
The Zacks Industry Rank is #57 (top 22%) for Accident & Health, #74 (top 28%) for Life, #135 (bottom 49%) for P&C, #176 (bottom 34%) for Multiline and #222 (bottom 16%) for Brokers.
Bottom Line
Looking at the broader trends, the growth prospects of the industry appears bright even if interest rates don’t rise faster. 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 please investors. 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 Insurance Stocks
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.
Here are a few top-ranked insurance stocks you may want to consider:
AXIS Capital Holdings Ltd. (AXS - Free Report) : This Zacks Rank #1 (Strong Buy) stock gained about 16.8% over the last one year compared with about 10.7% gain for the S&P 500. The stock surpassed earnings estimates in the trailing four quarters, with an average beat of 30.2%.
The Hartford Financial Services Group, Inc. (HIG - Free Report) : This Zacks Rank #2 (Buy) stock gained roughly 11.6% over the last one year. The company is expected to see earnings growth of 9.5% over the next five years versus the industry’s expected growth of 8.7%.
Amerisafe, Inc. (AMSF - Free Report) : An upward revision in earnings estimates for the current fiscal year over the last 60 days lead to a Zacks Rank #2 for this stock. The price of this stock surged over 25% in the last year.
Loews Corp. (L - Free Report) : This Zacks Rank #2 stock gained nearly 24% over the last year. Earnings estimates for the current fiscal year were revised 4.7% upward over the last 60 days.