There has been an enormous amount of time invested by analysts and economists the world over attempting to pinpoint when US interest rates will rise. What is clear is that rates will eventually rise, but rather than trying to pinpoint the exact moment, possibly a more rewarding endeavour would be to position your portfolios with businesses that will, at worst, be resilient to rate rises and at best, benefit from them. One industry that is well placed is insurance.
As holders of large, bond focused investment portfolios, insurance companies benefit from rising interest rates due to the potential for higher investment returns. This means that reinvestment occurs into higher yielding securities, and the income generation of floating rate securities also increases, which can be significant given the size of some insurance company’s investment portfolios.
However, rising rates can a double-edged sword, as higher rates decrease the value of outstanding bonds that have been issued at lower rates, particularly so for long dated bonds. The insurers that are best placed are those that have positioned their investment assets at the short end of the maturity curve, as these securities have the least price sensitivity to rising interest rates.
The second benefit of rising rates arises due to a reduction in an insurer’s liabilities. Insurers report a present value estimate of the amount of claims that have to be paid out in the future as a liability on their balance sheets. If interest rates rise, the liability is lower in present value terms due to an increase in the discount rate. Insurers with long dated liabilities, arising from long tail insurance lines (such as doctor malpractice insurance) receive the largest liability reduction, and hence the greatest expansion in equity per share.
An insurer with its investment portfolio positioned towards short dated bonds, while having a large exposure to long tail insurance lines, is the best placed to experience increasing investment returns and rising book values when interest rates rise.
Two international insurers we like (that are covered by our valuation tool, StocksInValue) are:
Berkshire Hathaway (BRKa.N)
The cash engine of Berkshire is the insurance division, spread over reinsurance, automotive and traditional property/casualty lines.
In 2014, insurance contributed 75% of revenue and the consistently profitable underwriting has allowed the investment portfolio to expand considerably over time. In 2014, Berkshire held over $217B of insurance investments, including over $85m of interest rate securities. While not cheap today, Berkshire is well placed for the future; the guy in charge seems to know a thing or two about investing.
American Insurance Group (AIG.N)
AIG’s insurance book has evolved considerably over the past 5 years. Today the business is evenly split across commercial and consumer lines, with the two largest lines of property casualty and personal insurance contributing 44% and 22% of revenue respectively. Less than 2% today remains in the mortgage guarantee insurance that lead to AIG’s undoing in 2008. At the December balance date, AIG ’s investment portfolio exceeded $355B, of which $280B is held in fixed income investments. AIG remains at a 27% discount to book value.