Only a handful of industries stand to benefit directly from a steady uptick in interest rates and rising equity prices. Life insurance companies, which offer financial products aimed at providing for retirement and protecting income, will be one of the biggest winners in this environment.
While there are a number of different types of life insurance, the basic idea is simple: The insured pays periodic premiums to the insurer in exchange for a guaranteed payout upon death or, in some cases, disability.
On the other side of the transaction, the insurer employs myriad factors such as age, health history, tobacco use and international travel to assess the risk and life expectancy of a particular individual. Based on that estimate and the amount of insurance requested, actuaries calculate a monthly premium for the policy. Insurers use these same statistics to predict, with some degree of accuracy over a large sample size, their claims during a particular period.
The insurance company makes money by investing the premiums it collects in low-risk portfolios that include large allocations to high-quality government bonds and corporate debt-security classes that traditionally exhibit less volatility than stocks. In total, the US life insurance industry has allocated about three-quarters of its $3.51 trillion in invested assets to bonds and only 2.2 percent to equities.
Our favorite life insurer, Metlife (MET), manages a portfolio of about $500 billion, 71 percent of which is invested in fixed-income securities. In contrast, the firm holds only $3.23 billion in equity investments.
When bonds in these investment portfolios mature, the life insurers roll the proceeds into new fixed-income securities. In recent years, these reinvestments have forced insurers to accept lower yields and weaker returns relative to periods when interest rates have been higher.
To get a sense of the headwind that the Fed's extraordinarily accommodative policies created for the insurance industry, check out this graph comparing the median pretax yield reported by the major insurers for their investment portfolios to the yield on the 10-Year US Treasury note and BBB-rated US corporate bonds.
With the yields on both corporate debt and the 10-year Treasury well below the median yield on insurers' portfolios over the past few years, the industry's investment income has declined as those higher-rate bonds roll over.
Against this backdrop, it's no surprise that shares of life insurers lagged the broader market from the beginning of 2010 to the end of 2012; over this period, the Bloomberg North American Life Insurance Index delivered a total return of 28.2 percent, compared to the 36.2 percent gain posted by the S&P 500.
But the tide is turning. As the Fed normalizes its monetary policy and interest rates tick up, the coupons available on government and corporate bonds should recover to levels that are on par with life insurers' median portfolio yields. These incremental improvements mean that life insurers will face a progressively lower yield haircut.
The recent uptick in interest rates in the wake of the Fed's initial announcement of plans to phase out quantitative easing has helped to catalyze a 45 percent rally in the Bloomberg North American Life Insurance Index thus far in 2013. That's more than double the return posted by the S&P 500.
Despite this dramatic outperformance, life insurers are still in the early innings of their recovery story; rising interest rates will remain a tailwind for the group for at least the next two to three years.
In a conference call to discuss Metlife's second-quarter results, CEO Steven Kandarian had the following to say about the improving interest rate environment:
To help you think about the impact of interest rates and earnings, I refer you to the low interest rates stress scenario in our 2012 10-K. We said that the continuation of the late 2012 interest rate environment in the U.S., through year end 2014, would reduce our operating earnings by $45 million in 2013, and $150 million in 2014 relative to 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, and they remain at this level through 2014. In addition, credit spreads were tighter in late 2012 than assumed in our plan. Today, the 10-year treasury yield is approximately 2.6 percent, or slightly above our planned assumption, and credit spreads have widened, which puts them roughly in-line with our plan.
With the rate environment only slightly more favorable than our plan, we do not assume investment margins will expand as a result of the recent increase in interest rates. To be sure, higher interest rates are a positive development, but the benefits for MetLife are reduced risk of margin compression in balance sheet charges.
Not only will the uptick in interest rates from the ultra-low levels that prevailed at the end of 2012 save the company about $45 million in lost operating earnings this year and $150 million next year, but current interest rates and the outlook for next year also suggest that the emerging bull market for insurers has legs.
At the beginning of 2013, Metlife's baseline business plan assumed that the yield on 10-year Treasury notes would increase to 2.38 percent by year-end and remain at that level through the end of 2014.This forecast has proved to be conservative: 10-year Treasury securities yield almost 2.9 percent and forward market expectations call for this rate to top 3.5 percent in 12 months-a huge tailwind.
Variable Annuities and a Rising Stock Market
At first blush, rising equity prices would appear to be a neutral for life insurance companies; however, the bull market for stocks bodes well for the variable annuity business.
Variable annuities are a type of insurance and investment product. The individual buying the annuity pays a fixed amount to the insurance company each month during the accumulation phase. This money is invested in a separate account where the customer can choose from a menu of investment options. The advantage of a variable annuity is that it offers the investor a chance to earn a return leveraged to that of the broader stock market or some other index rather than accepting the paltry yields available from bonds and other fixed-income products.
Because these funds are invested in separate accounts controlled by the individual, they don't show up as part of the life insurer's investment portfolio. U.S. life insurance companies have about $2.17 trillion worth of assets in separate accounts, while Metlife has almost $250 billion in these accounts.
Life insurers historically have marketed variable annuities with various guarantees. For example, the company might promise the investor a certain minimum return regardless of the performance of the stocks purchased within his or her separate account. Other annuities allow policyholders to withdraw cash balances in the separate account early with certain prepayment penalties.
Rising share prices benefit the annuity business in two ways. Not only are the fees insurers charge for these products based in part on account values, but the uptick in stock prices also reduce their liability to make good on minimum-return clauses.
Moreover, insurers usually face an increase in withdrawals when the economy and stock market weaken; financial hardship forces customers to withdraw capital from their nest egg to make ends meet.
Insurers use a combination of futures, options and other instruments to hedge the risk that the broader market will perform poorly and to alleviate the hit from making good on the guaranteed minimum payments associated with outstanding variable annuities. The Milliman Hedge Cost Index measures the expenses that life insurers face to hedge their variable annuity business lines' exposure to guaranteed minimum withdrawal benefits (GMWB).
Life insurers' hedging costs soared during the 2008-09 financial crisis, but the stock market hitting new highs has fueled a welcome decline in these expenses, allowing them to ramp up sales of annuities without taking on as much risk.
Many life insurers got burned on their variable annuity lines during the financial crisis, prompting the industry scale back the benefits and guarantees associated with these products while hiking fees.
Metlife has moved aggressively to reduce risk in this business line, cutting the roll-up rate (the minimum return on paid premiums) on its variable annuities to 4 percent from 5 percent and lowering the return on withdrawals.
Although these moves have eaten into Metlife and other insurers' sales of variable annuities, these changes have reduced the risk embedded in these portfolios considerably. Metlife's forecast calls for sales of these products to approach $11 billion this year, down from $28.4 billion in 2011.
The SIFI Risk
Life insurers' earnings outlook has brightened significantly since the end of 2012, but Metlife and the industry's other heavyweights still face their fair share of challenges.
The biggest cloud hanging over the group: The likelihood that Metlife and Prudential Financial (PRU) will be classified as systemically important financial institutions (SIFI), subjecting them to the same standards for capital adequacy as banks. These rules require financial institutions to weigh their assets by risk and maintain sufficient core capital (primarily reserves and equity capital) to withstand any potential blow-ups.
The complex financial regulations inevitably entail myriad unintended consequences. Under the Basel III capital regime and the Dodd-Frank Wall Street Reform and Consumer Protection Act, variable annuities and other assets held in Metlife and Prudential Financial's separate accounts would be subject to the same rules as assets held on the life insurers' own balance sheets.
Because these separate accounts contain equities and other assets that carry a higher risk weighting under Basel III, insurers would be required to keep more capital on hand. Moreover, a rising stock market increases both the value of the life insurers' separate accounts and their risk-weighted assets, effectively penalizing them for a development that reduces the likelihood they'll have to make good on minimum income guarantees. Insurers also receive no credit for the hedges they take on to protect against an extended decline in equity markets.
Federal Reserve Chairman Ben Bernanke and other 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 to the Basel III capital regime-has indicated that Congress hadn't intended for insurers to be regulated in this manner.
Bills that would amend Dodd-Frank and regulate insurers using a different set of standards have bipartisan support, but the looming fight over the debt ceiling and continuing resolutions to fund the government could delay their passage. The announcement of a separate regulatory framework for Metlife and Prudential Financial would act as a significant upside catalyst for the stocks.
Buying Life Insurers on the Cheap
The two most common valuation ratios for life insurers are price to book and price to book excluding accumulated other comprehensive income (AOCI). For insurers, AOCI primarily consists of unrealized gains and losses on their portfolios of stocks, bonds and 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 that are well below pre-crisis levels.
As interest rates gradually tick higher, we expect shares of Metlife to undergo a significant re-rating; a valuation of 1.3 times book value excluding AOCI would imply a price of $62.00 per share, compared to less than $50.00 at the current quote.
And prospective investors shouldn't overlook the potential for Metlife to return capital to shareholders by growing its dividend and repurchasing shares. The company began paying a quarterly dividend this year and hiked its payout by almost 50 percent, to $1.10 per share. With management projecting free cash flow to increase to between 35 and 45 percent of operating earnings, Metlife has the scope to raise its dividend considerably in coming years. The proposed amendment to Dodd-Frank would also free up additional capital for Metlife to pursue shareholder-friendly initiatives.
With rising interest rates driving earnings growth and a management team committed to returning capital to shareholders, Metlife looks attractive at less than $53.00 per share. If you want to learn about some of our other favorite stocks, Roger Conrad and I will host a free webinar on Oct. 15, 2013, to discuss our favorite stocks and investment themes for 2014.