Insurance Industry Stock Outlook: January 2014

The U.S. insurance industry continues to gain traction on earnings growth and risk management across the board, thanks to better premium rates after prolonged softness since the height of the financial crisis. Further, favorable reserve development and modest catastrophe losses helped insurers show potency in 2013.

The sector is set to reach a favorable pricing cycle with assured improvement in pricing power as demand from economically recuperating American households rise. But a dearth of positive catalysts is holding back growth. Among the fundamental challenges, weak underwriting gains and low investment yields stand out.

Though modest catastrophe losses helped the industry to witness significant recovery in underwriting and lower combined ratio in 2013, underwriting performance is expected to remain subdued in 2014. This, along with heightened market competition, will drag earnings improvement.

Insurers continue to prepare themselves better to buttress drastic losses from catastrophes, but increasing probability of such incidents continues to raise concerns. Some analysts expect catastrophic losses to double every 10 years and the pace of capacity buildup by the insurers to be insufficient to withstand the resulting insured losses.

However, the overall health of the industry improved to a great extent in the recent past riding on improved macroeconomic trends, after enduring pricing pressures and reduced insured exposure since the latest recession. Moreover, learning from past experiences, insurers are now resorting to expense saving measures for bottom-line growth.

Rising premium rates should ultimately translate into margin expansion and mitigate the negative impact of the still low interest rate environment on insurers’ investment income. Also, insurers now have ample capital to take on new challenges. Further, increasing awareness on the risk of catastrophe, favorable reserve development and efforts to strengthen underwriting discipline should support the industry.

That said, though the market condition isn’t soft anymore, reasonable hardening is not expected at least in the near term. Moreover, stress on balance sheet, lack of real employment growth and legislative challenges are threatening insurers’ ability to rebound to the historical growth rate.

Also, limited organic growth opportunities and more capital for regulatory requirement will push the industry toward consolidation. Insurers are seeking structural economies of scale through mergers and acquisitions to enhance market share. While this will help insurers stay afloat, inter-segment competition will alleviate. So increasing profitability after complying with regulatory requirements would be quite a tall order.

Zacks Industry Rank

Within the Zacks Industry classification, insurers are broadly grouped in the Finance sector (one of 16 Zacks sectors) and are further sub-divided into five industries at the expanded level: Insurance - Property & Casualty, Insurance – Multiline, Insurance - Accident & Health, Insurance – Life and Insurance - Brokers. The level of sensitivity and exposure to different stages of the economic cycle vary for each industry.
 
We rank all the 260-plus industries in the 16 Zacks sectors based on the earnings outlook and fundamental strength of the constituent companies in each industry.
As a guideline, the outlook for industries with Zacks Industry Rank #88 and lower is 'Positive,' between #89 and #176 is 'Neutral' and #177 and higher is 'Negative.'

The Zacks Industry Rank for Insurance - Property & Casualty is #29, Insurance - Multiline is #35, Insurance - Accident & Health is #114, Insurance - Life is #164 and Insurance - Brokers is #171. Looking at the Zacks Industry Rank of the five insurance industries, it can be safely said that the near-term outlook for the group is ‘Neutral.’

Earnings Trend of the Sector

The broader Finance sector, of which the insurance industry is part, is about to report fourth-quarter results. The consensus earnings expectations for the quarter show an improvement.

Earnings growth for the quarter is expected to increase to 20.3% from 10.5% in the third quarter. Overall, the sector is expected to register full-year earnings growth of 10.6%.

However, revenues are expected to decline 5.1% in the fourth quarter compared to a fall of 15.7% in the third quarter. While both earnings and revenues indicate improvement, margin is expected to deteriorate to 3.26% from 4.14% in the third quarter.

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

Life Insurers Should See Modest Growth

Reduction in underwriting expenses and a modest increase in premiums have been helping life insurers increase net income in the last few quarters. But downward pressure on investment yields due to higher hedging costs, lower income from the variable annuity business and more burdensome capital requirements will continue to mar profitability.

Moreover, life insurers have struggled with low interest rates for years now as they primarily invest in long-term interest earnings assets which were not able to generate sufficient returns to match up their future commitments related to the policies sold to various individuals.

Until the interest rate environment shows improvement, life insurers will have to continue to seek alternative asset classes to optimize return from investments. The addition of any risky asset class in their investment portfolios with hopes of better yield may result in further losses.

However, the rise in the U.S. Treasury yields since the middle of 2013 is expected to change the fate of life insurers. As the long-term bond yields have finally started rising, cash flows of life insurers will be invested at higher yields, leading to higher returns and increased profit margins.

The industry’s statutory capital level improved significantly in 2013, with the help of steady retained earnings and effective capital management. A beefed up capital market should keep the industry’s liquidity profile strong in the upcoming quarters and help industry participants confront challenges.

Balance sheet fundamentals are expected to improve to some extent on better operating performance in recovered financial markets. However, the overall growth of the industry will heavily depend on the interest rate scenario.

The underlying trends in a recovering economy indicate modest improvement in the sector over the medium term with respect to credit profile and financial prospects. However, higher-than-average asset losses, primarily resulting from real estate exposure, will be a major concern.

On the other hand, Americans, primarily the young, have significantly reduced expenditures on life insurance products, and are instead choosing alternative investments that promise better returns. But continued economic recovery and higher disposable income will help life insurers broaden their customer base. Also, the carriers are transforming their products and businesses to make them attractive and profitable for customers.

Currently, the life insurers with favorable Zacks Ranks worth considering include Lincoln National Corporation (LNC), Protective Life Corporation (PL - Analyst Report) and Reinsurance Group of America Inc. (RGA) with a Zacks Rank #2 (Buy).

P&C Insurers on Growth Trajectory

Market hardening has been the key to improvement for property-casualty insurers in the recent quarters. After struggling with falling prices for years, the industry seems to have finally reached better premium rates.
 
However, the carriers are still feeling the pressure on their investment portfolios due to the overall interest rate environment which is still low. Concerns related to weak capital levels are now things of the past though, as the industry’s capital position has been building up on the back of improved earnings.

Along with continually improving pricing power, stronger preparation to withstand catastrophe-related losses should help insurers perform better in the upcoming quarters despite the pressure on investment income.

As property-casualty insurers hold about two-thirds of the invested assets in the form of bonds, their capacity is highly sensitive to changes in credit market conditions. With credit and equity markets turning around and long-term bond yields on the rise, insurers are likely to incur lesser realized and unrealized capital losses on their portfolio in the quarters ahead.  
    
Moreover, insurance volume is expected to expand going forward on speedier economic recovery. With improved employment in the private sector and recovery in the housing markets, a number of carriers have already started seeing growth in insurance sales.

The recent quarters have been witnessing a rebound in claims-paying capacity (as measured by policyholders’ surpluses), which reflects the industry’s resilience. Conservative investment strategies and capital restructuring efforts will continue to help property-casualty insurers improve their financial footing in the upcoming quarters.

The overall industry should be able to perform better over 2014 with increased support from both external and fundamental factors.

Proactive steps on transformational measures, including adoption of technology solutions, will give a competitive advantage. Also, in order to meet evolving consumer demands, insurers must innovate.

Currently, PartnerRe Ltd. (PRE), Allied World Assurance Company Holdings (AWH) and Hilltop Holdings Inc. (HTH) -- all with a Zacks Rank #1 (Strong Buy) -- are worth a look in the property-casualty space.

OPPORTUNITIES

The industry has been undertaking several structural changes that will make underwriting and pricing schemes even more attractive to consumers. Also, improving fundamentals on the back of favorable macroeconomic trends make the stocks of a number of industry participants appear attractive.

We remain positive on RLI Corp. (RLI), Greenlight Capital Re, Ltd. (GLRE), Aspen Insurance Holdings Ltd. (AHL), Maiden Holdings, Ltd. (MHLD), CNO Financial Group, Inc. (CNO) and Prudential plc (PUK) with a Zacks Rank #1.

Other insurers that we like with a Zacks Rank #2 include ProAssurance Corporation (PRA), The Chubb Corporation (CB), American International Group, Inc. (AIG), Cigna Corp. (CI), Prudential Financial, Inc. (PRU), Amerisafe, Inc. (AMSF) and Reinsurance Group of America Inc. (RGA).

WEAKNESSES

We expect continued pressure on investment yield and lower income from the variable annuity business to restrict the earnings growth rate of life insurers at least in the near term. Also, pressure underwriting will hurt the earnings of many property-casualty insurers. Moreover, the overall industry is vulnerable to the ever-increasing threat of natural disasters.

We would suggest staying away from the Zacks Rank #5 (Strong Sell) stocks such as Catlin Group Ltd. (CLNGF), Tower Group International, Ltd. (TWGP - Analyst Report), Ageas SA/NV (AGESY) and Fortegra Financial Corporation (FRF - Snapshot Report).

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