U.S. Insurance Stock Outlook - December 2017

The Federal Reserve’s latest rate interest rate increase and prospects of further hikes in 2018, with an improving economic outlook supported by the impending tax legislation, make the backdrop favorable for insurers. This is because insurers 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 support the operating performance of life insurers, a strong capital base will help Property & Casualty (P&C) insurers combat losses from hurricanes — Harvey, Irma and Maria — and the wildfires in California.

However, the gradual improvement in interest rates so far have not drawn the attention of investors toward insurance stocks. This is clearly evident from the 10.7% gain of the SPDR S&P Insurance ETF (NYSE:KIE), which fairly represents the insurance industry versus the S&P 500’s rally of 20.3% since the beginning of the year. In fact, the Zacks Insurance Industry has marginally underperformed the S&P 500 over this period.

The reason behind this restrained reaction could be fading optimism of investors over the key interest rate reaching a level that actually benefits insurers. Investors are perhaps expecting only a little impact of 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 performed better than the broader market during this period, indicating its ability to easily dodge the rate-induced hindrances. The SPDR S&P Insurance ETF gained 108.7% and the Zacks Insurance Industry rallied 87.1% in the past five years versus 89.2% growth of the S&P 500.

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 and Zacks Rank Indicates Outperformance

While the industry performed almost in line with 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 2.65. This compares unfavorably with the average level of 2.25 seen by the industry in the last five years.

However, it compares pretty favorably with the market at large, as the current P/B for the S&P 500 is at 3.8 and the median level is 3.2.

Overall, while the valuation from a P/B perspective looks 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.

Moreover, the group’s Zacks Industry Rank indicates outperformance for all segments. 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 #12 (top 5% of the 250 plus Zacks industries) for Accident & Health, #56 (top 22%) for Life, #109 (top 43%) for Property & Casualty, #115 (top 45%) for both Brokers and Multiline. 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, which is not too sensitive to the interest rate environment, 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.

However, 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.

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.

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.

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, the industry is unlikely to benefit significantly from raising interest rates, but that may not stop it from growing. 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 on 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:

Kemper Corp. (KMPR): This Zacks Rank #1 (Strong Buy) stock has gained more than 55% year to date versus the S&P 500’s 20.2% rally. Its Zacks Consensus Estimate for the current year has been revised 31.8% upward over the last 60 days. You can see the complete list of today’s Zacks #1 Rank stocks here.

MGIC Investment Corp. (MTG): This Zacks Rank #2 (Buy) stock has gained 50% since the beginning of the year. It has seen the Zacks Consensus Estimate for the current year earnings revising 3.4% upward over the last 60 days.

The Hanover Insurance Group (THG): The Zacks Consensus Estimate for this stock has been revised 12.6% upward over the last 60 days. This Zacks Rank #1 stock has gained nearly 18% since the beginning of the year.

Torchmark Corp. (TMK): This Zacks Rank #2 stock has gained roughly 23% since the beginning of the year. It has seen the Zacks Consensus Estimate for the current year earnings revising 1.1% upward over the last 60 days.

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