Insurers Offer An Interesting Counter-Cyclical Hedge Against Rising Interest Rates

Includes: AIZ, BRK.A, BRK.B, CB, LNC
by: Tim Worstall


Insurers, and the longer term the better, offer a useful hedge against rising interest rates.

At some point the Federal Reserve is going to raise rates strongly again.

The increased earnings from the float will benefit such as AIZ, CB and LNC.

This is not to make a recommendation about a particular stock. Rather, it's to explain a little quirk about how the world of insurance works and thus to point to the manner in which insurers, and the longer term their risks the better, offer an interesting hedge against the Federal Reserve's sometime, sometime before never at least, raising of interest rates.

Clearly, we know that at some point the Fed is going to be raising interest rates and not just in the very occasional 0.25% chunk. At some point some semblance of economic normality will return and money will return to its proper price. When that happens there's not all that much out there which will act as a hedge. Bonds will obviously fall in value as rates rise. Rising rates will also mean the likelihood of QE being unwound, which will be negative for both bonds and equities. So, we'd rather like to have something we could use as a counter to this, some sector or industry where rising rates will mean higher profits. And insurance is just such a sector.

To explain this we need to understand the economics of the sector. The WSJ has this piece:

The main culprit: the Federal Reserve's seven-year-old campaign to boost the economy. Life insurers earn much of their profit by investing customers' premiums in bonds until claims come due. They have typically favored high-quality, long-term corporate bonds to meet regulatory requirements to back their obligations with safe investments. As the Fed began driving down rates in 2008 to rescue the economy from a global meltdown, the yield on corporate bonds has tumbled.

Not too difficult to see that rising rates would put that process into reverse. But in more detail.

We generally expect, in a competitive market, that an insurance company will make an underwriting loss. In fact, one of the things we look at to see whether an insurance market is uncompetitive is whether the participants are making an underwriting profit. So, given that Geico normally does (part of Berkshire Hathaway (NYSE:BRK.B)) make an underwriting profit we tend to think that U.S. auto insurance is not a fully competitive market. The blame is normally placed on the manner in which it is split up state by state. The rather smaller, but larger as a single market, auto insurance market of my native U.K. normally has the insurers making underwriting losses thus leading us to think that that market is more competitive.

The insight is that there are two revenue streams for an insurer. The first is the premiums that come in, and that obviously in time becomes premiums minus claims paid out. But the premiums come in some time before the claims are paid out. The money can thus be used to invest in something for some period of time. This is the carry, or perhaps the float (depends which version of English you want to use). As there are those two income streams, and the level of premiums is going to be one of the great competitive areas to gain business, we expect the premiums to get bid down to an underwriting loss, the profits of the whole operation coming from the investment returns of the float.

The longer the insurance period the more this is true. Auto insurance tends to balance year by year on premiums and claims: so there's 6 months (on average) of float to invest. Something like earthquake reinsurance might have 30 or 40 year balances: thus the investment return is a very much larger portion of the profit.

This is not the only business line that works this way: John Corzine's MF Global, a futures broking firm, had very similar economics. The actual broking made nothing if not a small loss. But holding investor margins and deposits allowed investment for the benefit of the firm. The problem there was as yields fell in general they went hunting yield by taking risk and that risk taking blew up.

So, we've got the basic economics: what makes an insurer profitable is the ability to gain yield on safe (because all will recall MF Global) assets into which to put the float. That ability is severely damaged by QE and low interest rates. Thus, as they unwind, as and when they unwind, we should see insurers doing very much better. And the longer their line of business, the longer they get to keep that carry, then the better they will be doing. Property insurance perhaps better than auto, reinsurance better than insurance itself.

As up at the top there this isn't to advise on particular stocks, rather to alert to the sector. But companies that should benefit from this would include Assurant (NYSE:AIZ), Chubb (NYSE:CB) and Lincoln National (NYSE:LNC).

Oddly, I would think it won't apply so much to Berkshire Hathaway (NYSE:BRK.A) itself, as the basic secret of that company is that Buffett has been using the float all these decades to buy operating companies. It's exactly his skill at stock and subsidiary picking that has made his model so successful, and made the company as a whole rather less dependent than other insurers on the general conditions for investing that float.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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