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posted on 17 May 2017

As The Fed Tapers, Insurance Stocks Will Be Winners

by Ben Shepherd, Investing Daily

Investing Daily Article of the Week

After heroic efforts to revive an ailing economy, the Federal Reserve is finally taking it off supportive care. While the central bank hasn’t been actively growing its $4.5 trillion balance sheet it accumulated during the financial crisis, it has been reinvesting the proceeds from maturing bonds into more bonds to help keep interest rates down.

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Now the Fed is saying it’s finally time to stop providing even that level of support. One corner of the market that will benefit is financials, especially insurance companies.

Thankfully, the Fed’s tightening hasn’t caused a 2013-style taper tantrum, when the Fed signaled that it was ending its asset purchases and caused a massive upheaval in the stock and bond markets. That said, there’s still likely to be volatility, as the Fed tightens and investors enter unknown territory.

This process will mark the culmination of a massive, global experiment in unconventional monetary policy, the likes of which had never been tried before.

The Fed’s unwinding of its balance sheet will be mirrored overseas as the European Central Bank starts running off its own assets. The upshot: interest rates will rise here and abroad.

The reason central banks have accumulated so many assets was to help push rates down without setting an explicitly negative interest rate. As that process unfolds, yields will rise across the bond market, making riskier assets such as junk bonds and stocks less attractive.

Insurance companies, though, are poised to benefit. Insurers make a lot of their money from good underwriting, which basically entails selling policies to people who aren’t likely to use them. Every premium dollar collected and not paid out is profit. Those premiums don’t flow straight to the bottom line as soon as they’re collected. Instead, reserves must be held, known as the float, in case claims have to be paid, but that money doesn’t just sit idly on the balance sheet.

While the insurance industry has generally been profitable since the financial crisis, those profits have been squeezed. Insurers have to make low-risk, liquid investments in case that money has to be paid out, which means their portfolios are typically heavy on bonds. As a result, low yields have effectively capped how much an insurer can expect to earn on the float.

While the Fed is expected to make at least two more quarter-point rate increases this year, it could hold off making additional hikes thanks to “natural" rate increases as its bond portfolio runs off. As a result, insurers will see higher returns on their float, regardless of whether the Fed makes official policy hikes or not.

That means we should witness solid dividend increases from the insurance industry over the next few years, barring any financial catastrophes. Take advantage of the coming volatility by picking up blue chip insurers, such as Chubb (NYSE: CH) or Old Republic International (NYSE: ORI), which are poised to see profits rise along with interest rates.

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