Operation Twist Will Have Mixed Effects On Insurance Companies

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 |  Includes: CB, MET, MFC, PRU, TRV
by: Tom Armistead

Insurance companies tanked along with the market on yesterday's FOMC announcement, driven by concerns that the intended reduction in long-term US Treasury rates would affect investment income. The overall effects will be more complex, and may be helpful as well as harmful.

Future Income vs. Fair Value

Well-run insurance companies match the duration of their investments with the expected timing of claim payments. As such, they expect to hold a large portion of their investment portfolios to maturity, and market fluctuations are not relevant to this process. Mark-to-market advocates should note that when interest rates decline, the fair value of an insurance company's bond portfolio will increase. The Fed action will present insurance companies with unrealized capital gains.

Investment vs. Underwriting Income

When expected rates of return are high, insurance companies may be willing to incur underwriting losses in order to secure investment income on the float. When returns are low, the companies will be more likely to price and select their business so as to earn an underwriting profit.

Travelers (NYSE:TRV) and Chubb (NYSE:CB) are both conservative companies that have recorded combined ratios, ex cat, of about 95% on a regular basis for most of the past ten years. They have avoided reaching for yield on their investments, and were rock solid going through the financial crisis.

They will have an advantage under the new conditions. They already know how to underwrite to a profit, and with unrealized capital gains on the books they can continue to take a long-term view. Their competition may be forced to raise rates, in order to earn an underwriting profit, and may be handicapped by unrealized losses on shaky investments in RMBS or CMBS.

Interest Rate Sensitivity

Insurance companies include a disclosure of interest rate sensitivity on their 10-K's, and the following from Prudential (NYSE:PRU) is a good example (click table to enlarge):

Click to enlarge

A 100-basis-point upward parallel shift in interest rates would result in a 13.6 billion decrease in fair value. A downward shift would cause an increase along the same order of magnitude, $28 per share.

A parallel shift across all durations would be unlikely, and the Fed operations are intended to increase short-term yields and decrease long-term.

Hedging

Because these risks are substantial, they have the attention of management. MetLife (NYSE:MET) has been hedging since 2004. Here's an excerpt from its 2Q 2011 earnings conference call:

Of course, what won't change to MetLife is our commitment to financial strength and risk management. For example, faced with the threat of low interest rates pressuring earnings, we have not sit by idly. As we told you at our last Investor Day conference, we began purchasing hedges against low interest rates in 2004. I'm not sure how many in the industry can say they have hedged their interest rate risk as successfully as we have, which we think is a good example of the forward thinking we do here at MetLife. Even if the 10-year Treasury drops below 2.5% and stays there for several years, we have in place significant protection.

Hedging may not always be successful. However, interest rate risk is relatively straightforward, so hedging results should not be too uncertain. The 10-year Treasury is well below 2.5%, and may stay there for a while.

Regulatory Considerations

ManuLife (NYSE:MFC), based in Canada, is especially vulnerable, as Boyd Erman discussed in this article. Briefly, the combination of Canadian GAAP and insurance regulations, both of which are very mark-to-market, places the company at risk of requiring more capital, which would need to be raised in a very poor market, leading to shareholder dilution.

Product Design

The following from PRU's Q2 2011 earnings conference call shows that products can be designed to be profitable in the face of low prevailing interest rates:

Nigel Dally: You mentioned this in passing, but I wanted to come back to the issue of the impact of low interest rates to your Annuity business. With the new annuity product, you talked previously about it being priced for a high teens ROE. Can you discuss how sensitive that ROE is to changes in rates? And if rates remain at around a 2.5% level, any need to make further recalibrations to your product design?


Charles Lowrey:
Nigel, this is Charlie. I think we anticipated a low interest rate environment when we made the changes, and we did that on a prospective basis earlier this year. So as of now, we don't anticipate making further changes. I think the product is designed for a low interest rate environment, and we're pleased with the returns we're getting.


Nigel Dally
: So would the new business return still be in the teens given what current rates are?


Charles Lowrey
: Yes. That's a fair comment.

US Treasuries as a Percentage of Portfolio

Consulting the 10-K, PRU as an example lists US Government as 3% of fixed-maturity securities in its Financial Services Business. Corporate securities are 46%, and foreign governments are 32%. Both PRU and MET are international companies with large amounts of business in Japan, which has been a low interest rate environment for some time. Similarly, TRV lists US government and agency fixed maturities as 3% of its portfolio.

Presumably movements triggered by the Fed will also be mirrored in state and local fixed maturity rates, and will also affect corporate rates, but the ability of the Fed to manipulate rates across the entire spectrum is suspect. Just shifting maturities on a publicly announced schedule seems unlikely to change the economics of the entire fixed-income market.

Financial Complexity

Doing a word search in a life insurers's 10-K, "derivative" will get more than 100 matches, as will "hedge." Corresponding searches for P&C insurers are nowhere near as rewarding; for CB derivatives gets 13 matches, most of them related to the discontinued Chubb Financial Services business, which was placed in run-off in 2003.

The point is that the analysis of large life insurers is rendered difficult by the scope of derivatives employed in managing risk. Efforts to come up with a meaningful estimate of the effects of Operation Twist may not be fruitful. It's more useful to develop a sense of management's competence and integrity.

Investment Implications

Operation Twist will affect insurance companies in different ways, depending on the lines of business written and the degree to which management has anticipated and hedged the interest rate risk, or dealt with it through product design. Treasuries are only part of the portfolio for these companies, and not always a large one.

I've been very enthusiastic about insurance companies, based on attractive fundamental valuatons, either on P/B or forward P/E. That hasn't worked out well during the meltdown inspired by the economic slowdown, the debt ceiling debate, and the Greek debt crisis.

I continue to regard CB and TRV as undervalued, and good defensive investments, with beta at 0.5 and 0.6. MET and PRU are likewise undervalued, but with beta checking in at 1.9 and 2.4 respectively, they might be scary for investors who don't care for volatility. I've made good money on MFC in the past, but would stay away under current conditions.

Disclosure: I am long MET, PRU, CB, TRV.