Rising interest rates are the biggest story of 2022.
As you are no doubt aware, the Federal Reserve raised rates to fight inflation… which is stuck at its highest level in 40 years.
Higher interest rates create difficulties for investors. They reduce the value of investments – stocks, bonds and just about everything else. This is why we have seen declines in all major asset classes since the start of this year.
However, there is one industry that really benefits from rising interest rates: insurance.
As I will explain, the higher the rates, the greater the growth of the insurance companies. History shows that these stocks can be great performers in a rising rate environment.
Today we’re going to take a look at the last two periods of rising interest rates…and how a few insurers performed during those periods. Plus, I’ll share my favorite “one-click” way to buy a bunch of insurance stocks because they enjoy higher interest rates.
Rising rates are great for insurers
In general, rising interest rates are bad for investors. As rates rise…safer assets like short-term bonds and certificates of deposit (CDs) are starting to offer decent yields, allowing money to be taken out of riskier investments.
For example, six-month Treasury bills are currently yielding over 2.6%. That may not seem like much…but it’s a huge improvement from a year ago, when those bills were bringing in less than 0.1%.
In short, investors can safely generate a 2.6% return while taking no risk right now. This puts pressure on stock and bond prices… but it also creates an attractive situation for insurance companies…
You see, insurance companies are constantly raking in money as their customers pay their insurance premiums.
Insurers take this steady cash flow and invest it, usually in bonds. And when rates rise, that means cash can be invested in bonds with higher coupon rates… leading to bigger profits on the bottom line.
This makes intuitive sense. Most insurance companies don’t make a lot of money on their core insurance business. After factoring in the costs of running the insurance business, most insurers keep less than 10% of their premiums as profit. You can check the profitability of a company’s core underwriting business by looking at its “combined ratio”, which adds up all claims losses (plus business expenses) and divides them by the premiums earned by the company. Only the best insurance companies can push this ratio below 90% (meaning they keep more than 10% of the premiums).
In contrast, insurance companies keep all the money they earn by investing the money.
And the higher interest rates rise… the higher the yields on the bonds they buy.
This is why the current environment is creating a significant tailwind for insurance companies. They’re going to make a lot more money now that interest rates aren’t stuck near 0%.
And keep in mind that insurance needs remain in demand all year round, so there is a constant need for insurance companies to keep investing new capital. More cash in company coffers versus policy liabilities (what they owe) improves their financial strength and allows them to return capital to shareholders through dividends and stock buybacks.
Simply put, now is a great time to buy insurance stocks.
History shows these stocks outperform when rates rise
Rising rates are not a unique situation. History shows many periods of rate hikes that lasted for months… and even years.
To put it simply, let’s focus on the last two periods of sustained rate hikes: May 2004-August 2006 and November 2015-April 2019.
Below I’ve included a 20-year chart of the effective federal funds rate – the only rate the Fed adjusts when it wants to raise (or lower) interest rates. The red boxes indicate the two hiking cycles we will be focusing on…
With these two periods in mind, let’s check out how insurance stocks have held up historically…
As I mentioned above, insurance companies benefit from rising rates because they make more money on the bonds they buy. Two prime examples are WR Berkley Corporation (WRB), which provides commercial insurance and reinsurance…and Arch Capital Group (ACGL), a specialty insurer and reinsurer.
Below you can see how WRB stock fared from May 2004 to August 2006, when the Fed raised rates from 1% to 5.25%. If you had bought WRB at the start of the cycle (May 2004), you would have almost doubled your money as the stock soared 96%. Check it out:
Now let’s check out the most recent ride cycle. From November 2015 to April 2019, interest rates rose from 0.12% to 2.42%. If you owned WRB during this time, you would have returned 64%:
Clearly, WR Berkley was a good stock to hold over the past two periods of rising interest rates. But we need more evidence.
Let’s look at the other insurance stock I mentioned: Arch Capital.
During the 2004-2006 hiking cycle, the ACGL trended steadily upward, gaining 52%:
And when rates rose from 2015 to 2019, ACGL generated a solid 30% gain. (Note how well the stock performed during the first half of this period, when interest rates started to climb.)
As you can see below, WRB is up 40% over the past year. Institutional investors started buying the stock in droves at the end of 2021 as the Fed hinted it would start raising rates. Note the green vertical bars in the graph. They represent Big Money buy signals. Looked:
Likewise, ACGL is starting a new uptrend. The stock is up 18% over the past year… impressive considering the S&P 500 is down more than 10% over the same period.
You should also notice the nine Big Money buy signals since last December. They are an important sign that ACGL is poised to deliver strong returns during the current rate hike cycle.
Both WR Berkley and Arch Capital are solid players in a rising rate environment. However, there is a better way to play this situation…
A “one-click” way to hold 50+ insurance stocks
The easiest way to gain broad exposure to insurance stocks is through the SPDR S&P Insurance ETF (KIE), the largest exchange-traded fund (ETF) focused entirely on the insurance industry. It includes a variety of companies involved in different types of coverage (life insurance, auto insurance, etc.) as well as insurance brokers and reinsurance companies.
Simply put, KIE lets you own a bit of everything insurance. He has over $570 million in assets under management…including positions in the two stocks I mentioned earlier…
KIE holds WRB (2.03% of the portfolio) and ACGL (2.01%)… alongside 50 other insurance stocks. It pays a current dividend yield of 1.93% and has posted an average annual gain of 6.7% since its inception in November 2005.
As interest rates rise, insurance companies are poised to make a profit. KIE gives us an easy way to own the entire sector, which should thrive in this rising rate environment.
History tells us that these stocks can easily generate double-digit gains as Fed rate hikes unfold.
You don’t have to sacrifice growth to find revenue in this market…
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