by Zach Scheidt, Investment U Research
Friday, July 5, 2013
Shares of property and casualty insurance stocks have been under pressure for the last few weeks. The industry is in the early stages of what could be a significant decline, following an extended period of strength.
Similar to the risks we have discussed for the utilities sector as well as homebuilder stocks, the recent weakness in P&C insurance stocks is a direct result of the Fed’s recent comments on its bond purchasing program.
As the Fed reduces its $85 billion monthly purchases of Treasurys and mortgage-backed securities, interest rates will naturally rise. As this happens, much of the conservative capital that has been forced into “safe” areas of the equities market will move back into higher-yielding fixed-income securities. We’re already seeing the effects of this as high-yield, low-risk stocks begin trading down.
The insurance sector is actually even more vulnerable than other “safe” sectors that are currently under pressure. Not only are stocks in this group affected by the capital rotation back into fixed-income products, but the shift in interest rates has a dramatic effect on the underlying business of these companies.
Acute Sensitivity to Interest Rates
The insurance industry is extremely sensitive to changes in interest rates. To understand why, let’s take a quick look at how the companies generate income.
To begin with, insurance companies charge their customers “premiums” (typically monthly payments) in exchange for protection. Essentially, the insurance companies are accepting a future liability and are getting paid for that liability by accepting premium payments today.
There are two ways insurance companies actually turn a profit…
The first source of profit is the difference between the amount of premium the company charges customers, and the ultimate liabilities the company is required to pay. So for property & casualty insurers, the premiums are typically the monthly or yearly payments from customers, and the liabilities are paid out when claims are filed.
If an insurer is skilled in the actuarial process of analyzing how big its long-term liabilities will be, it can typically realize a small gain between the amount of cash collected and the distributions that are required. Remember, the insurance business is very competitive, so it is important for these businesses to charge customers a low price in order to keep their customers happy and continue receiving premium payments.
The second source of profit is the return on the company’s book of investments. Insurance companies typically sit on large levels of cash or marketable securities. This makes sense because they need to have capital available to pay to their customers when claims are filed. But of course they want to realize a return on all of this capital that is being held for the purpose of eventually paying claims.
The insurance industry is highly regulated, and the companies are required to invest the majority of their capital in stable, low-risk investments. These investment portfolios typically have a high allocation to Treasury bonds, mortgage-backed securities and dividend-paying equities. This is the exact group of investments that is being hit hardest by the Fed’s recent comments.
As interest rates rise and the underlying prices for Treasuries and other “safe” investments decline, insurance companies are seeing the value of their investment portfolios drop. Traders are already beginning to sell insurance stocks as the domino effect of higher rates works its way into different areas of the economy.
Don’t Look for a Change in Earnings
Because of the way the accounting rules work for insurance companies, we are unlikely to see the effects of higher interest rates actually show up as a decline in earnings. So if you’re looking at an insurance stock and you see that the company is trading at a very cheap price/earnings valuation, you could easily overlook the actual decline in the company’s investment book.
When insurance companies buy fixed-income investments (Treasury bonds, mortgage securities, corporate bonds etc.), they typically assume they will hold the security until maturity. Since fixed-income products mature at a very specific price and pay regular coupon payments, the accounting rules allow the company to simply overlook a change in the market value of these securities.
To the insurance company, it doesn’t really matter what the day-to-day value of the investment book is unless it must sell a position before maturity in order to pay claims (or to raise cash in anticipation of future payments).
So on a quarterly basis, you won’t see a major change in earnings resulting from an increase in rates. But if an insurance company is forced to sell some of its investments at a lower market price, you may see a write-down in the investment portfolio.
This type of write-down would likely come from out of the blue. And the insurance company would probably try to hide any write-down in the footnotes of a quarterly report, while still showing “pro-forma” or operating earnings as being stable.
Still, a write-down like this would have a significant effect on the underlying value of the insurance stock. This risk of write-downs is a significant risk for insurers and is a big part of why we are seeing weakness in the group.
Some Insurers More Vulnerable Than Others
When looking at the broad insurance sector, it is clear that some companies have more risk to higher interest rates than others. Life insurance companies typically have liabilities that are much longer-term than P&C companies. Longer-term liabilities allow life insurers to better wait out the rise in interest rates without having to take write-downs in the interim.
Insurance companies that offer investment products (such as annuities and structured investment products) may also be partially insulated against interest rate shifts. This is because as interest rates increase, the annuities and investment products that these companies sell become more marketable (leading to higher income from investment customers).
For now, P&C insurance companies have the most risk because shorter-term liabilities could cause them to face write-downs as portfolio values drop.
Given the combination of declining portfolio values for insurance companies and the rotation of capital out of “safe” stocks and back into Treasury securities and other bonds, I would avoid any new investments in insurance companies right now.
Many of these stocks feature relatively cheap valuations and dividend yields that are somewhat attractive. But the danger of write-downs will likely push these stocks lower over the next few months.
If you currently own shares of P&C insurers, you may want to consider selling the stocks now, and then possibly re-entering the stocks later in the year when prices are lower and the market is fully pricing in the risks.Trouble Ahead for Insurance Stocks,