Only several industries are in position to benefit from a steady uptick in rates of interest and rising equity prices. Life insurance agencies, that offer financial products aimed towards providing for retirement and protecting income, is going to be one on the biggest winners in this particular environment.
While there are a variety of different forms of life insurance, the essential idea is straightforward: The insured pays periodic premiums to your insurer to acquire a guaranteed payout upon death or, now and again, disability.
On lack of of the transaction, the insurer employs myriad factors including age, health history, tobacco use and international go assess the danger and endurance of a particular individual. Based on that estimate along with the amount of insurance requested, actuaries calculate a monthly premium to the policy. Insurers begin using these same statistics to predict, by incorporating degree of accuracy on the large sample size, their claims within a particular period.
The insurer makes money by investing the premiums it collects in low-risk portfolios which include large allocations to high-quality government bonds and corporate debt-security classes that traditionally exhibit less volatility than stocks. In total, the US a life insurance policy industry has allocated about three-quarters of the company's $3.51 trillion in invested assets to bonds simply 2.2 percent to equities.
Our favorite life insurer, Metlife ( MET ), manages a portfolio around $500 billion, 71 percent that is purchased fixed-income securities. In contrast, the firm holds only $3.23 billion in equity investments.
When bonds within these investment portfolios mature, the life span insurers roll the proceeds into new fixed-income securities. In recent years, these reinvestments have forced insurers to receive lower yields and weaker returns in accordance with periods when rates have been higher.
To have a sense on the headwind that this Fed's extraordinarily accommodative policies created for that insurance industry, read this graph comparing the median pretax yield reported with the major insurers for investment portfolios towards the yield within the 10-Year US Treasury note and BBB-rated US corporate bonds.
(Click to enlarge)
Source: Bloomberg
With the yields on both corporate debt plus the 10-year Treasury well below the median yield on insurers' portfolios within the last few few years, a's investment income has declined as those higher-rate bonds rollover.
Against this backdrop, it's really no surprise that shares of life insurers lagged the broader market right from the start of 2010 for the end of 2012; over now, the Bloomberg North American Life Insurance Index delivered a full return of 28.2 percent, compared towards the 36.2 percent gain posted through the S&P 500.
But the tide is turning. As the Fed normalizes its monetary policy and rates tick up, the coupons positioned on government and corporate bonds should recover to levels which might be on par with life insurers' median portfolio yields. These incremental improvements show that life insurers will face a progressively lower yield haircut.
The recent uptick in rates in the wake in the Fed's initial announcement of promises to phase out quantitative easing has helped to catalyze a 45 percent rally from the Bloomberg North American Life Insurance Index to date in 2013. That's over double the return posted with the S&P 500.
Despite this dramatic outperformance, life insurers are still from the early innings of these recovery story; rising rates will remain a tailwind for your group for a minimum of the next 2 to 3 years.
In a gathering call to go over Metlife's second-quarter results, CEO Steven Kandarian had this to say about the improving monthly interest environment:
To assist you to think about the impact of rates and earnings, I refer you for the low mortgage rates stress scenario inside our 2012 10-K. We said that this continuation on the late 2012 rate of interest environment within the U.S., through year end 2014, would reduce our operating earnings by $45 million in 2013, and $150 million in 2014 in accordance with plan.
In late 2012 the 10-year treasury yield was 1.69%. Our plan assumed rates would steadily increase and reach to 2.38 percent by year-end 2013, plus they remain at this level through 2014. In addition, credit spreads were tighter in late 2012 than assumed in your plan. Today, the 10-year treasury yield is concerning 2.6 percent, or slightly above our planned assumption, and credit spreads have widened, which puts them roughly in-line with his plan.
With the incidence environment only a little more favorable than our plan, do not assume investment margins will expand as a result with the recent increase in interest levels. To be sure, higher rates of interest are a positive development, though the benefits for MetLife are reduced probability of margin compression in balance sheet charges.
Not only will the uptick in interest levels from the ultra-low levels that prevailed after 2012 save the organization about $45 million in lost operating earnings this current year and $150 million next season, but current rates and the outlook for next season also suggest how the emerging bull sell for insurers has legs.
At the starting of 2013, Metlife's baseline business strategy plan assumed that this yield on 10-year Treasury notes would increase to 2.38 percent by year-end and stop at that level throughout the end of forecast has proved being conservative: 10-year Treasury securities yield almost 2.9 percent and forward market expectations involve this rate to best three.5 % in 12 months-a huge tailwind.
Variable Annuities as well as a Rising Stock Market
At first blush, rising equity prices would seem to be a neutral for life insurance coverage companies; however, the bull industry for stocks bodes well for your variable annuity business.
Variable annuities really are a type of insurance and investment product. The individual getting the annuity pays a restricted amount on the insurance company on a monthly basis during the accumulation phase. This money is dedicated to a separate account in which the customer consider a menu of investment options. The advantage of an variable annuity is that it provides the investor the opportunity to earn returning leveraged to that from the broader currency markets or some other index as opposed to accepting the paltry yields provided by bonds along with other fixed-income products.
Because these funds are purchased separate accounts controlled because of the individual, they don't really show up as part with the life insurer's investment portfolio. U.S. life insurance coverage companies have about $2.17 trillion valuation on assets in separate accounts, while Metlife has almost $250 billion over these accounts.
Life insurers historically have marketed variable annuities with assorted guarantees. For example, the corporation might promise the investor some minimum return regardless from the performance in the stocks purchased within her or his separate account. Other annuities allow policyholders to withdraw cash balances inside separate account early with certain prepayment penalties.
Rising share prices profit the annuity business into two ways. Not only are definitely the fees insurers charge of these products situated in part on account values, though the uptick available prices also reduce their liability to produce good on minimum-return clauses.
Moreover, insurers usually face an improvement in withdrawals in the event the economy and stock exchange weaken; financial hardship forces customers to withdraw capital using their company nest egg to generate ends meet.
Insurers make use of a combination of futures, options and also other instruments to hedge the risk how the broader market will work poorly as well as alleviate the hit from making good for the guaranteed minimum payments connected with outstanding variable annuities. The Milliman Hedge Cost Index measures the price that life insurers face to hedge their variable annuity business lines' experience of guaranteed minimum withdrawal benefits (GMWB).
(Click to enlarge)
Source: Bloomberg
Life insurers' hedging costs soared over the 2008-09 financial doom and gloom, however the stock market hitting new highs has fueled a welcome decline during these expenses, letting them ramp up sales of annuities without taking on all the risk.
Many life insurers got burned on their own variable annuity lines over the financial crisis, prompting the scale back the advantages and guarantees related to these products while hiking fees.
Metlife has moved aggressively to cut back risk in this particular business line, cutting the roll-up rate (the minimum return on paid premiums) on its variable annuities to 4 % from five percent and reducing the return on withdrawals.
Although these moves have eaten into Metlife along with other insurers' sales of variable annuities, these changes have reduced raise the risk embedded within these portfolios considerably. Metlife's forecast demands sales of these items to approach $11 billion in 2010, down from $28.4 billion this year.
The SIFI Risk
Life insurers' earnings outlook has brightened significantly considering that the end of 2012, but Metlife along with the industry's other heavyweights still face their great number of challenges.
The biggest cloud hanging on the group: The likelihood that Metlife and Prudential Financial ( PRU ) is going to be classified as systemically important finance institutions (SIFI), subjecting them towards the same standards for capital adequacy as banks. These rules require banking companies to weigh their assets by risk and keep sufficient core capital (primarily reserves and equity capital) to face up to any potential blow-ups.
The complex financial regulations inevitably entail myriad unintended consequences. Under the Basel III capital regime and also the Dodd-Frank Wall Street Reform and Consumer Protection Act , variable annuities along with other assets stuck Metlife and Prudential Financial's separate accounts could well be subject towards the same rules as assets held on living insurers' own balance sheets.
Because these separate accounts contain equities and also other assets that have a higher risk weighting under Basel III, insurers could be required to keep more capital accessible. Moreover, a rising stock exchange increases their value from the life insurers' separate accounts as well as their risk-weighted assets, effectively penalizing them to get a development that decreases the likelihood they'll have to generate good on minimum income guarantees. Insurers also receive no credit with the hedges they tackle to protect against a lengthy decline in equity markets.
Federal Reserve Chairman Ben Bernanke along with policymakers have questioned the logic of applying capital standards tailored for bank holding companies to insurers. Even Senator Susan Collins of Maine - a Republican who authored the amendment that effectively exposed large insurance companies for the Basel III capital regime-has indicated that Congress hadn't meant for insurers for being regulated with this manner
Bills that could amend Dodd-Frank and regulate insurers having a different group of standards have bipartisan support, however the looming fight on the debt ceiling and continuing resolutions to advance the government could delay their passage. The announcement of the separate regulatory framework for Metlife and Prudential Financial would represent a significant upside catalyst for that stocks.
Buying Life Insurers for the Cheap
The two most typical valuation ratios for a lifetime insurers are price to book and price to book excluding accumulated other comprehensive income (AOCI). For insurers, AOCI primarily is made up of unrealized gains and losses for their portfolios of stocks, bonds and also other investments. For example, an insurer's AOCI would increase when bonds rally and yields decline, inflating its book value.
By both metrics, shares of Metlife trade at valuations which are well below pre-crisis levels.
(Click to enlarge)
Source: Bloomberg
As rates of interest gradually tick higher, we expect shares of Metlife to undergo a substantial re-rating; a valuation of just one.three times book value excluding AOCI would imply an expense of $62.00 per share, in comparison with less than $50.00 on the current quote.
And prospective investors shouldn't disregard the potential for Metlife another capital to shareholders by growing its dividend and repurchasing shares. The company began paying a quarterly dividend this current year and hiked its payout by almost fifty percent, to $1.10 per share. With management projecting free income to increase to between 35 and 45 percent of operating earnings, Metlife contains the scope to increase its dividend considerably in future. The proposed amendment to Dodd-Frank would also regain additional capital for Metlife to pursue shareholder-friendly initiatives.
With rising rates of interest driving earnings growth plus a management team focused on returning capital to shareholders, Metlife looks attractive at lower than $53.00 per share. If you want to discover some of our other favorite stocks, Roger Conrad and I will host a complimentary webinar on Oct. 15, 2013, to debate our favorite stocks and investment themes for 2014.
While there are a variety of different forms of life insurance, the essential idea is straightforward: The insured pays periodic premiums to your insurer to acquire a guaranteed payout upon death or, now and again, disability.
On lack of of the transaction, the insurer employs myriad factors including age, health history, tobacco use and international go assess the danger and endurance of a particular individual. Based on that estimate along with the amount of insurance requested, actuaries calculate a monthly premium to the policy. Insurers begin using these same statistics to predict, by incorporating degree of accuracy on the large sample size, their claims within a particular period.
The insurer makes money by investing the premiums it collects in low-risk portfolios which include large allocations to high-quality government bonds and corporate debt-security classes that traditionally exhibit less volatility than stocks. In total, the US a life insurance policy industry has allocated about three-quarters of the company's $3.51 trillion in invested assets to bonds simply 2.2 percent to equities.
Our favorite life insurer, Metlife ( MET ), manages a portfolio around $500 billion, 71 percent that is purchased fixed-income securities. In contrast, the firm holds only $3.23 billion in equity investments.
When bonds within these investment portfolios mature, the life span insurers roll the proceeds into new fixed-income securities. In recent years, these reinvestments have forced insurers to receive lower yields and weaker returns in accordance with periods when rates have been higher.
To have a sense on the headwind that this Fed's extraordinarily accommodative policies created for that insurance industry, read this graph comparing the median pretax yield reported with the major insurers for investment portfolios towards the yield within the 10-Year US Treasury note and BBB-rated US corporate bonds.
(Click to enlarge)
Source: Bloomberg
With the yields on both corporate debt plus the 10-year Treasury well below the median yield on insurers' portfolios within the last few few years, a's investment income has declined as those higher-rate bonds rollover.
Against this backdrop, it's really no surprise that shares of life insurers lagged the broader market right from the start of 2010 for the end of 2012; over now, the Bloomberg North American Life Insurance Index delivered a full return of 28.2 percent, compared towards the 36.2 percent gain posted through the S&P 500.
But the tide is turning. As the Fed normalizes its monetary policy and rates tick up, the coupons positioned on government and corporate bonds should recover to levels which might be on par with life insurers' median portfolio yields. These incremental improvements show that life insurers will face a progressively lower yield haircut.
The recent uptick in rates in the wake in the Fed's initial announcement of promises to phase out quantitative easing has helped to catalyze a 45 percent rally from the Bloomberg North American Life Insurance Index to date in 2013. That's over double the return posted with the S&P 500.
Despite this dramatic outperformance, life insurers are still from the early innings of these recovery story; rising rates will remain a tailwind for your group for a minimum of the next 2 to 3 years.
In a gathering call to go over Metlife's second-quarter results, CEO Steven Kandarian had this to say about the improving monthly interest environment:
To assist you to think about the impact of rates and earnings, I refer you for the low mortgage rates stress scenario inside our 2012 10-K. We said that this continuation on the late 2012 rate of interest environment within the U.S., through year end 2014, would reduce our operating earnings by $45 million in 2013, and $150 million in 2014 in accordance with plan.
In late 2012 the 10-year treasury yield was 1.69%. Our plan assumed rates would steadily increase and reach to 2.38 percent by year-end 2013, plus they remain at this level through 2014. In addition, credit spreads were tighter in late 2012 than assumed in your plan. Today, the 10-year treasury yield is concerning 2.6 percent, or slightly above our planned assumption, and credit spreads have widened, which puts them roughly in-line with his plan.
With the incidence environment only a little more favorable than our plan, do not assume investment margins will expand as a result with the recent increase in interest levels. To be sure, higher rates of interest are a positive development, though the benefits for MetLife are reduced probability of margin compression in balance sheet charges.
Not only will the uptick in interest levels from the ultra-low levels that prevailed after 2012 save the organization about $45 million in lost operating earnings this current year and $150 million next season, but current rates and the outlook for next season also suggest how the emerging bull sell for insurers has legs.
At the starting of 2013, Metlife's baseline business strategy plan assumed that this yield on 10-year Treasury notes would increase to 2.38 percent by year-end and stop at that level throughout the end of forecast has proved being conservative: 10-year Treasury securities yield almost 2.9 percent and forward market expectations involve this rate to best three.5 % in 12 months-a huge tailwind.
Variable Annuities as well as a Rising Stock Market
At first blush, rising equity prices would seem to be a neutral for life insurance coverage companies; however, the bull industry for stocks bodes well for your variable annuity business.
Variable annuities really are a type of insurance and investment product. The individual getting the annuity pays a restricted amount on the insurance company on a monthly basis during the accumulation phase. This money is dedicated to a separate account in which the customer consider a menu of investment options. The advantage of an variable annuity is that it provides the investor the opportunity to earn returning leveraged to that from the broader currency markets or some other index as opposed to accepting the paltry yields provided by bonds along with other fixed-income products.
Because these funds are purchased separate accounts controlled because of the individual, they don't really show up as part with the life insurer's investment portfolio. U.S. life insurance coverage companies have about $2.17 trillion valuation on assets in separate accounts, while Metlife has almost $250 billion over these accounts.
Life insurers historically have marketed variable annuities with assorted guarantees. For example, the corporation might promise the investor some minimum return regardless from the performance in the stocks purchased within her or his separate account. Other annuities allow policyholders to withdraw cash balances inside separate account early with certain prepayment penalties.
Rising share prices profit the annuity business into two ways. Not only are definitely the fees insurers charge of these products situated in part on account values, though the uptick available prices also reduce their liability to produce good on minimum-return clauses.
Moreover, insurers usually face an improvement in withdrawals in the event the economy and stock exchange weaken; financial hardship forces customers to withdraw capital using their company nest egg to generate ends meet.
Insurers make use of a combination of futures, options and also other instruments to hedge the risk how the broader market will work poorly as well as alleviate the hit from making good for the guaranteed minimum payments connected with outstanding variable annuities. The Milliman Hedge Cost Index measures the price that life insurers face to hedge their variable annuity business lines' experience of guaranteed minimum withdrawal benefits (GMWB).
(Click to enlarge)
Source: Bloomberg
Life insurers' hedging costs soared over the 2008-09 financial doom and gloom, however the stock market hitting new highs has fueled a welcome decline during these expenses, letting them ramp up sales of annuities without taking on all the risk.
Many life insurers got burned on their own variable annuity lines over the financial crisis, prompting the scale back the advantages and guarantees related to these products while hiking fees.
Metlife has moved aggressively to cut back risk in this particular business line, cutting the roll-up rate (the minimum return on paid premiums) on its variable annuities to 4 % from five percent and reducing the return on withdrawals.
Although these moves have eaten into Metlife along with other insurers' sales of variable annuities, these changes have reduced raise the risk embedded within these portfolios considerably. Metlife's forecast demands sales of these items to approach $11 billion in 2010, down from $28.4 billion this year.
The SIFI Risk
Life insurers' earnings outlook has brightened significantly considering that the end of 2012, but Metlife along with the industry's other heavyweights still face their great number of challenges.
The biggest cloud hanging on the group: The likelihood that Metlife and Prudential Financial ( PRU ) is going to be classified as systemically important finance institutions (SIFI), subjecting them towards the same standards for capital adequacy as banks. These rules require banking companies to weigh their assets by risk and keep sufficient core capital (primarily reserves and equity capital) to face up to any potential blow-ups.
The complex financial regulations inevitably entail myriad unintended consequences. Under the Basel III capital regime and also the Dodd-Frank Wall Street Reform and Consumer Protection Act , variable annuities along with other assets stuck Metlife and Prudential Financial's separate accounts could well be subject towards the same rules as assets held on living insurers' own balance sheets.
Because these separate accounts contain equities and also other assets that have a higher risk weighting under Basel III, insurers could be required to keep more capital accessible. Moreover, a rising stock exchange increases their value from the life insurers' separate accounts as well as their risk-weighted assets, effectively penalizing them to get a development that decreases the likelihood they'll have to generate good on minimum income guarantees. Insurers also receive no credit with the hedges they tackle to protect against a lengthy decline in equity markets.
Federal Reserve Chairman Ben Bernanke along with policymakers have questioned the logic of applying capital standards tailored for bank holding companies to insurers. Even Senator Susan Collins of Maine - a Republican who authored the amendment that effectively exposed large insurance companies for the Basel III capital regime-has indicated that Congress hadn't meant for insurers for being regulated with this manner
Bills that could amend Dodd-Frank and regulate insurers having a different group of standards have bipartisan support, however the looming fight on the debt ceiling and continuing resolutions to advance the government could delay their passage. The announcement of the separate regulatory framework for Metlife and Prudential Financial would represent a significant upside catalyst for that stocks.
Buying Life Insurers for the Cheap
The two most typical valuation ratios for a lifetime insurers are price to book and price to book excluding accumulated other comprehensive income (AOCI). For insurers, AOCI primarily is made up of unrealized gains and losses for their portfolios of stocks, bonds and also other investments. For example, an insurer's AOCI would increase when bonds rally and yields decline, inflating its book value.
By both metrics, shares of Metlife trade at valuations which are well below pre-crisis levels.
(Click to enlarge)
Source: Bloomberg
As rates of interest gradually tick higher, we expect shares of Metlife to undergo a substantial re-rating; a valuation of just one.three times book value excluding AOCI would imply an expense of $62.00 per share, in comparison with less than $50.00 on the current quote.
And prospective investors shouldn't disregard the potential for Metlife another capital to shareholders by growing its dividend and repurchasing shares. The company began paying a quarterly dividend this current year and hiked its payout by almost fifty percent, to $1.10 per share. With management projecting free income to increase to between 35 and 45 percent of operating earnings, Metlife contains the scope to increase its dividend considerably in future. The proposed amendment to Dodd-Frank would also regain additional capital for Metlife to pursue shareholder-friendly initiatives.
With rising rates of interest driving earnings growth plus a management team focused on returning capital to shareholders, Metlife looks attractive at lower than $53.00 per share. If you want to discover some of our other favorite stocks, Roger Conrad and I will host a complimentary webinar on Oct. 15, 2013, to debate our favorite stocks and investment themes for 2014.