Insurance Stocks in a Tight Spot

 | Mar 07, 2012 | 4:00 PM EST  | Comments
  • Comment
  • Print Print
  • Print
Stock quotes in this article:

brk.a

,

all

,

aet

Last August, I wrote a column headlined "Insurance Sector Can't Survive a Flat Yield Curve." Given Warren Buffett's acknowledgment in the recent Berkshire Hathaway (BRK.A) annual report that the company's float will likely stagnate from here, this is a good time to review this business again.

The float that Buffett was referring to is the value of the pool of funds the company generates in the form of insurance premiums. These premiums are for the funding of liabilities at some future date. In between collecting the premium and paying it back out, the company gets to use the money for its own benefit. It can buy stocks, bonds and even other companies.

In the process, Buffett has transitioned his company from an insurance conglomerate that funded -- using insurance premiums -- its expansion and diversification into an industrial conglomerate that is now responsible for paying the liability obligations attached to those premiums. So comparing Berkshire with other insurance companies is not really an apples-to-apples deal. However, the issue facing Berkshire's insurance operations, stagnating float, is something that affects the entire sector.

Before going further, I want to do a quick review of what has happened in the sector since we discussed it last August. Insurance companies invest their float, or large portions of it, in investment-grade bonds of countries and very large companies. This was the genesis of the column from last August.

In general, that means that insurance operations are more profitable the higher long-term yields are and the wider the spread is between them and short-term yields. If long-end yields fall or the spread between the short-end yields and long-end yields shrinks, the company's investment return also shrinks. If the spread stays flat for a long period of time, many years, the mounting liabilities not being offset by investment returns could render a company or the entire industry insolvent.

Although Buffett was focusing on the property-and-casualty portions of Berkshire's float, the process is much the same for the life and health segments too.

When I wrote that column last August, the 10-year yield was at 2.64%; today it is 1.97%. Declining U.S. sovereign bond yields and a shrinking spread between the fed funds rate and the 10-year Treasury yield indicates that profit margins of insurance companies' float returns are under pressure.

And yet insurance company stocks are above where they were last August. In that column, I used Berkshire, Aetna (AET) and Allstate (ALL) as examples to follow in that column.

Berkshire is up 6%, Aetna is up 16%, and Allstate is up 12%. This is a diverse group, and that's why I chose these names. Berkshire's operations are dominated by property and casualty. Allstate is large in both property and casualty and life, and Aetna is a health insurance company. Their principal operations, however, are all the same: Income must exceed outgo, or else the company is insolvent. Income consists of premiums and on returns on these premiums. Outgo is payment on the liabilities incurred by issuing premium-generating policies.

Premium increases require an expanding base of potential insurance buyers. Otherwise, the industry is left to compete for existing buyers, and that drives down premiums. Increasing clients requires both a generally growing human population and more importantly a growing demographic within the population of people who both need and can pay for insurance.

The aging baby boomers are beyond the peak demographic age for purchasing life and health insurance. The population behind them, now at their peak years for purchasing insurance, is 40% the size of the boomer population. This is helping to drive down insurance premiums.

If insurance premiums are not enough to cover liabilities and overhead, then insurance companies must rely on investment returns -- the return on their float -- to do so.

Coming back to the beginning, if the yield curve is flat, those returns are not possible. This is the situation the insurance industry is in today. It is caught between the proverbial rock and a hard place, as both premiums and returns on premiums are under pressure and look to be for many years.   

At the same time, however, the stocks are rising along with the general market. A rising tide lifts all boats. But I would be very cautious about the sector. For some reason, investors in the insurance industry have not fully understood the ramifications of Buffett's observation of a flat float at Berkshire.

It is even possible that the stocks will continue higher. Last Saturday, Barron's published an article suggesting that Berkshire's stock would rise by 45%. Maybe it will. My advice remains to avoid it and the rest of the insurance sector.

Columnist Conversations

I've read recently quite a few comments about how Chinese stocks are cheap and investors should jump in. ...
Just some resistance to be aware of. Not saying it will cap the market, just that it is there for a decision....
Shares of Amazon (AMZN) are trading down below the 50% retracement level of their 2014 range in the after-hour...
Conclusion LNKD has a strong upward trend in revenue, has maintained very high gross margin % even as revenues...

BEST IDEAS

REAL MONEY'S BEST IDEAS

Columnist Tweets

BROKERAGE PARTNERS

Except as otherwise indicated, quotes are delayed. Quotes delayed at least 20 minutes for all exchanges. Market Data provided by Interactive Data. Company fundamental data provided by Morningstar. Earnings and ratings provided by Zacks. Mutual fund data provided by Valueline. ETF data provided by Lipper. Powered and implemented by Interactive Data Managed Solutions.


TheStreet Ratings updates stock ratings daily. However, if no rating change occurs, the data on this page does not update. The data does update after 90 days if no rating change occurs within that time period.

IDC calculates the Market Cap for the basic symbol to include common shares only. Year-to-date mutual fund returns are calculated on a monthly basis by Value Line and posted mid-month.