Understanding the Interest Rate Sensitivity of Insurance Companies

Are insurance company stocks interest-rate sensitive? To some, this may appear to be a rhetorical question. But it truly depends on the type of insurance company and the products you underwrite and sell. Because life insurers write a lot of spread business in which they earn money from the difference between the total return on their assets and the rate they credit to their policyholders, life insurance stocks tend to correlate highly with interest rate movements. One simple way to track this spread is to look at the 10-year treasury note (or the 10-year treasury note compared to the two-year treasury bill).

In 2019, despite the 100-basis-point drop in the 10-year bond, the S&P Life and Health Insurance index held its own with the overall S&P 500 and rose about 25% for the year. What happened?

Not All Insurers Are Created Equal

If you are an automobile or homeowners’ insurer, the yield on the 10-year treasury note or your investment return is less important than your underwriting margin. This is also known as the combined ratio (CR), defined as the sum of the loss ratio (claims/earned premiums) and expense ratio (total expenses/earned premiums).

If your CR is a lot more than 100%, you are likely losing money in almost any interest rate environment, excluding the high-interest-rate period of the late 1970s and early 1980s. If your CR is around 90%, as is the case for most property and casualty (P&C) insurers today, you are generating a nice positive return for your investors.

The key question for P&C company analysis is whether their reserves are redundant or deficient. The five-year historical page of the statutory statement is a good starting point to attempt to answer this question. However, any insurance geek will tell you to turn to Schedule P and “square those triangles” or use some actuarial projection to determine reserve adequacy (see tables below).

However, life insurers are the ones that sell true interest-rate-sensitive policies. These companies’ investment leverage (investments/shareholders’ equity or investments/statutory surplus) is usually 8-14 times (x) and their net investment income can represent more than 100% of their operating income. The 10-year bond is typically used as a proxy for life insurers’ investments despite the fact that most life insurers invest primarily in corporate bonds, mortgage-backed securities, commercial mortgage loans, and real estate.

Small changes in the benchmark 10-year treasury note can lead to large changes in the prices of life insurers’ stocks. This happens because investors tend to extrapolate the small move in the note to future note movements. Thus, a 25-basis-point move in the 10-year bond has led to 5% downdrafts in life insurers’ stocks. This large price swing becomes exacerbated when the 10-year is lower because this is when the life insurers’ crediting rates are close to (or at) their minimum guarantees. This means that they can’t cut their crediting rate at all, causing the spread between the earned rate and the crediting rate to collapse.

What Happened in 2019?

In 2019, interest rates dropped precipitously. The 10-year treasury note collapsed from 2.7% at the beginning of 2019 to just 1.9% at year end. If they were prescient and knew this was going to happen, many macro investors in life insurers would have gone short (betting that the individual component stocks and the overall life insurance index would drop). Yet in 2019 the S&P Life and Health Insurance increased by 25%.

How did this happen? In 2019, the equity market return more than offset the collapse in the yield of treasuries and other fixed-income securities. That is, because of the sensitivity of life insurers’ shareholders’ equity and liabilities to the overall equity market, in 2019 the stock market return won out over interest rates.

Therefore, despite the very high risk to life insurers and annuity underwriters of low-interest rates, the average stock in the index performed quite well in 2019.

When Will Investment Returns/Yields Matter Again?

Valuations tell a different story. A representative sample of U.S. life insurers was valued at a pedestrian 7.7x 2020 consensus earnings and 0.85x next year’s book value in late December 2019. This compares to 17.8x and 1.4x for a sample of U.S. P&C insurers. Apparently, investment returns and yields matter for valuations, just not for insurers’ stock prices.

When this will change for stock prices will depend on an insurer’s portfolio. Details on the risk and yields in the portfolio, as my fellow insurance geeks know, is in the regulatory statement that insurers file with their state insurance departments. These statutory statements include some interesting morsels (for those of us who enjoy reading footnotes and CUSIP-level detail of the bonds held by an insurer).

As you can see below, if you are interested in an insurer’s bond cost, fair value, book value, and any unrealized gains or losses, Part 1 of Schedule D is your hunting ground. If you want to see the CUSIP-level details of any bond, you’ll also find all the details including terms and conditions of the note.

Many insurers like to do competitive analysis and check the total return that their peers are generating on their whole portfolio. If you are industrious, you can calculate it from the individual pages for Schedule A (real estate), B (mortgage loans), D (bonds and stocks), E (cash and special deposits), and DB (derivative instruments including synthetic assets).

Of course, an analyst can also use the five-year historical page’s investment data to get the total investment return (with or without unrealized gains and losses) and the invested asset base (without derivatives) to get a pretty good approximation of the net investment yield.

Conclusion

2020 should prove to be an interesting year for interest rate sensitive insurers. It’s important to understand the product distribution of the insurer, even within the life insurance subsector. Some life insurers are much more sensitive than others to interest rate movements, which we’ll discuss in a future post. For now, at least, remember to watch at least two variables: equity markets and interest rates.