The Insurance Contagion

 | Oct 20, 2011 | 4:00 PM EDT
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I've recently written about the effects of the flattening sovereign yield curve on the insurance industry and the implications of simultaneous flat sovereign yield curves in the U.S., Germany and Japan on currencies, global trade and economic activity. So, let's look next at the cascading trajectory this implies for the U.S. economy.

The insurance industry is divided between discretionary and mandatory products. Discretionary insurance is for life and health, while mandatory insurance is for property and casualty, mostly auto and homeowners insurance.

Although a flat yield curve affects both areas, they play out differently. I've written about the overall effect before: flattening curves reduce insurance companies' ability to earn income on their assets. To make up for this loss, one of the principal compensating factors is to increase premiums. This affects policyholders financially, obviously.

Putting aside economic activity, demographics and other issues, if individuals experience increased premiums for both mandatory and discretionary insurance costs, the immediate response will be to decrease discretionary policies, namely health and life insurance. They can quickly decrease these costs in three ways: increase the deductible, decrease policy coverage or decrease policy usage.

This means that people will shift to self-insuring for preventive and maintenance health care and use their insurance coverage for catastrophic purposes, such as hospitalization.

As a result, the health-insurance sector will experience a decrease in returns and expenses. Over time, it will also experience a decrease in volatility as it adjusts to this new model, which is really a reversion to what was dominant in the U.S. from the end of World War II until the early 1970s, when the deregulation era began in earnest in the U.S.

However, the net effect will be less capital moving through the insurance and healthcare sectors more slowly, because people will use less of both insurance and health care, and that will reduce the profitability of both industries. There will be less profit in developing new drugs, new methods of medical practice and care for the sick and elderly. Hospitals, medical facilities and research laboratories will experience reductions in revenue and earnings, which will cause salaries for medical practitioners to decrease. This will happen with or without a nationalized or quasi-nationalized health care system.

The financial reality is that the pain of a flat yield curve for the insurance industry will cascade into the health care industry: pharmaceuticals, biotechnology companies, long-term-care facilities, medical-appliance firms, laboratories and many others will be negatively affected.

There are two takeaways for investors to remember: The requisite financial condition (the flat yield curve) bringing about this systemic change in the insurance and health care industries has already begun and, more importantly, it's the opposite of what the financial industry has conditioned investors to expect. (The current and continuing meme is that aging baby boomers will demand, and pay, whatever is necessary to extend their longevity, quality of life and comfort in their final days.)

For investors, there is a silver lining. Companies involved in home health care and preventive health care should benefit from this shift. In that space, look at Lincare Holdings (LNCR), Chemed Corp. (CHE) and Amedisys (AMED). In the preventive healthcare space, consider Life Time Fitness (LTM).

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