Can't understand insurance stocks (banks and reits) during rising rates - help

[scorpioncapital]

So I've observed many of my insurance stocks are not responding upward as I thought as rates rise . Bank stocks do seem to be going up. Why? These insurance stocks are medium to long tail reinsurance & insurance stocks with large bond portfolio with duration of 5 years~. Is the market reducing their BV (unrealized loss position)? Is it in fact weighing whether in 5 years the insurance co will have forfeited income or not (depending what their average 5 year yield is). On the other hand insurance co's have very low cost funding liability if they run a good operation.

 

Basically is the market only temporarily discounting the stock prices now and later will come to their senses?

Or is it something else?

Likewise with REITS I imagine same dynamic. Pricing the debt cost now and not the future asset value to come.

 

Banks for some reason react much faster to higher rates, probably as they don't pass it on to their clients or because it is 'short term', similar to short-term insurance (like auto insurance).

 

Since nobody knows 5 years from now what these insurance bonds will do or if they misjudged their duration risk, the market is cautious now.

 

Is this a correct interpretation?

[oddballstocks]

re: banks

 

Banks with strong deposit franchises are going up. Why? Most banks loan portfolios are shorter duration, so as the portfolio rolls every 1-3 years they earn the higher yield.  A strong deposit franchise (read business accounts, business loans) means flat or slowly increasing interest expense.

 

Another factor is banks earn more on cash held on Treasuries, which admiditly has dropped to almost zero.  On the flip side there are a lot of banks holding MTM losses on their bond portfolios purchased the last few years.  Just ignore Comprehensive Income they say...

 

[randomep]

 

I have thought about this. I presume you are talking about P&C insurance.  But for life insurance it is more clearcut. For KCLI at one time I read they said for each 1% rise in interest rates, they take a $140M equity hit. For each 1% fall the same amount equity increase.  But on the other side when the interest rates rise, their products esp. annuities are more attractive, so they will have more business.... so in essence they say it is a mixed bag and they cannot say they prefer one way or the other.

[scorpioncapital]

I'm thinking specifically long tail versus short tail insurance. Long tail can be anything from run-off to reinsurance , short say yearly contracts or auto etc.. I am not so worried about short-term as they match their assets and liabilities with short-term debt so not much risk. Long tail however usually go out to 5 years maybe more. They sometimes have corporate bonds, real estate etc.. It seems that banks and investment banks make money from interest rate differentials. Insurance companies make money by leveraging and holding debt. If the speed of interest rate rises increases faster than the cost of servicing their liabilities or even just faster than what the market will eventually offer, there is a potential profit gap. This seems to depress prices in short term unless the insurance co is very short so they can roll over bonds quickly. I think even 5 years could be risky as rates are rising quite rapidly though steadly and inflation seems to be a little ahead of rates - which is the master game plan apparently to burn up national debt in high debt nations. Basically I have seen quite poor results in insurance stocks but quite good results in bank stocks, investment banks, even some REITs. I'm not sure if this is company specific or insurance stocks take time to reset to the new rates that will be available when they have to turn over their debt portfolios thus causing a large increase in potential profits (assuming inflation also doesn't inflate their liabilities to policyholders). Has Buffett ever wrote about insurance stocks in periods of rising rates or inflation since it is his bread and butter?

[HJ]

I'm thinking specifically long tail versus short tail insurance. Long tail can be anything from run-off to reinsurance , short say yearly contracts or auto etc.. I am not so worried about short-term as they match their assets and liabilities with short-term debt so not much risk. Long tail however usually go out to 5 years maybe more. They sometimes have corporate bonds, real estate etc.. It seems that banks and investment banks make money from interest rate differentials. Insurance companies make money by leveraging and holding debt. If the speed of interest rate rises increases faster than the cost of servicing their liabilities or even just faster than what the market will eventually offer, there is a potential profit gap. This seems to depress prices in short term unless the insurance co is very short so they can roll over bonds quickly. I think even 5 years could be risky as rates are rising quite rapidly though steadly and inflation seems to be a little ahead of rates - which is the master game plan apparently to burn up national debt in high debt nations. Basically I have seen quite poor results in insurance stocks but quite good results in bank stocks, investment banks, even some REITs. I'm not sure if this is company specific or insurance stocks take time to reset to the new rates that will be available when they have to turn over their debt portfolios thus causing a large increase in potential profits (assuming inflation also doesn't inflate their liabilities to policyholders). Has Buffett ever wrote about insurance stocks in periods of rising rates or inflation since it is his bread and butter?

 

While general interest rate environment is important for insurance and bank performances, it's not the only factor.  Risk underwriting environment, as in delinquency / charge off rates for banks and combined ratios for insurance companies is significantly more important than general rate concerns.  You are probably just seeing a relatively benign underwriting environment for banks, and a worsening underwriting environment for insurance companies in general.  Life insurance companies have morphed into much more complicated entities over the years, and to the extent mortality / morbidity prediction over large population pools is significantly better than loss ratio prediction for P&C insurance, the asset side, rate environment have become much more important performance driver for lifers.  But each business is different.  Hard to generalize like this.

[Cigarbutt]

^The underwriting culture does take precedence over the changes in inflation especially when changes are progressive or benign.

 

The invested assets can be seen as a hedge against the liability reserves especially for long-tail lines but the hedge is imperfect on many levels:

 

-The reserves are influenced by only certain components of CPI and there is the additional "social" cost inflation (courts etc)

-In the 70's when inflation was significant, it was a tough time for PC insurers because of the lag effect of premium adjustments, the difficulty to adjust rates in a competitive environment and because of the negative effect on investments (fixed income and also equities which, unlike conventional wisdom would suggest, did even more poorly than fixed income then, except if you invested like Mr. Buffett)

-deflationary periods also impact the hedge for different reasons (declining premium volumes and poor investment results)

 

Recently looked at Travelers and it seems that the rising rate environment has been a contributor to lower market values for the shares despite improving operating parameters (CR, net income, net investment income rising with reinvestment opportunities in fixed income securities) because reported book value took a "hit" from a large unrealized investment gains on their held fixed income securities became a large unrealized loss, lowering reported book value by about 3% even if the duration of their fixed income portfolio is only about 4 years.

 

Here's what Mr. Buffett has said about inflation over the years and some of it deals with the effect on PC insurers:

http://csinvesting.org/wp-content/uploads/2015/01/Buffett-inflation-file.pdf

 

On page 78, Mr. Buffett refers to what HJ describes above:

"Because of this one-sided experience {asymmetric surprises}, it is folly to suggest, as some are doing, that all property/casualty insurance reserves be discounted, an approach reflecting the fact that they will be paid in the future and that therefore their present value is less than the stated liability for them. Discounting might be acceptable if reserves could be precisely established. They can't, however, because a myriad of forces ¾ judicial broadening of policy language and medical inflation, to name just two chronic problems ¾ are constantly working to make reserves inadequate. Discounting would exacerbate this already-serious situation and, additionally, would provide a new tool for the companies that are inclined to fudge."

 

[scorpioncapital]

Thank you. I'm also looking at reinsurance stocks, and alternative transactions like reinsurance to close. I wonder if reinsurance has the same dynamics. Usually they are longer tail. But Buffett seems to have explained it pretty beautifully - bonds or bond like instruments don't keep pace with your costs. He mentions a mistake of 10 year bonds he held in the insurance company. Compared to that, it seems even 5 years is a little better. And 2 year might be the sweet spot.

[Cigarbutt]

Thank you. I'm also looking at reinsurance stocks, and alternative transactions like reinsurance to close. I wonder if reinsurance has the same dynamics. Usually they are longer tail. But Buffett seems to have explained it pretty beautifully - bonds or bond like instruments don't keep pace with your costs. He mentions a mistake of 10 year bonds he held in the insurance company. Compared to that, it seems even 5 years is a little better. And 2 year might be the sweet spot.

Good point. Most non-life (re)insurers are quite conservative and try to match their reserve liabilities with a highly graded and staggered set of fixed income instruments. Most achieve a fairly adequate match in terms of cash flows and duration. It is also possible to assess (sometimes need to look at regulatory filings) the loss payout patterns by line of business and the "duration" of the reserves, with a % paid per year for ten years and then assuming a linear amortization over a few years and to compare that with the duration of the portfolio. For reinsurers, one has to add a dimension of variance related to IBNR claims emergence and case reserve development which, for instance, can be very significant for long-tail excess reinsurers.

 

Some (re)insurers (BRK: with extremely short fixed income and cash duration now, FFH: with a varying exposure (type and duration) which contributed significantly to the bottom line over time and a very short duration now) deviate significantly in terms of matching and this can be a source of relative positive (or negative) return, especially if the investment leverage (float per equity) is high. Most (re)insurers seem to be positioned for higher rates going forward but it should not really matter for most of them unless there is a regime change as they can hold on to maturity and written premiums to statutory capital is fairly low across the industry.

 

"And 2 year might be the sweet spot." In the last 10 years, many re(insurers) opted for a lower duration which has hurt results compared to a subgroup reaching for yield but, in insurance and others, the jury is out until cycles are completed.