Insurers are poised for an economy-fueled surge

The recovery should enable them to push through long-delayed premium increases -- and interest rates won't be going any lower.

By StreetAuthority May 16, 2013 1:56PM
 Man meeting with financial adviser in living room copyright Chris Ryan, OJO Images, Getty ImagesBy David Sterman                                                      

Insurance agents reach for the antacids whenever the economy slows down.

Their clients start to look for ways to trim costs, and reduced insurance coverage (and the smaller premiums they are charged) eats into the insurers' bottom lines. Any hopes of actually raising insurance premiums go out the window, as a client will quickly jump ship to a rival in search of a better deal.
Yet as the economy strengthens, the whole dynamic changes. Once a clear economic upturn is underway, competition becomes less cutthroat, clients grow less sensitive to the cost of insurance, and insurers can finally push through long-delayed premium increases.

With the U.S. economy on the mend -- economists expect U.S. GDP to rise at nearly a 3% pace in the second half of this year -- the stage is set for insurers to move back into the sweet spot of their pricing cycle.

Right about now, you would expect investors to be rushing to insurance stocks. But another boulder lies in the way before this sector will be truly loved by investors. That boulder is interest rates.

Insurers hold millions of dollars' worth of clients' funds, and they typically make handsome profits by parking that money in bonds and other interest-bearing vehicles. Of course, interest rates are near generational lows these days, so insurers are generating puny profits from their hefty cash balances.

In effect, investors have concluded that insurance stocks lack timeliness -- and will be a lot more appealing when interest rates start rising, perhaps in a year or two. (I recently noted that the Federal Reserve might not hike rates until 2016, which affects short-term interest rates, but economic growth is expected to push up rates of longer-term bond yields sooner than that.)

How untimely and unloved are these insurance stocks? Most of them trade below tangible book value, some of them to a great extent. Here are 10 stocks that trade for less 90% of tangible book value.

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Anytime you see stocks trading below book value, you should automatically think about share buybacks. Reabsorbing company stock with cash can actually magnify the disparity between book value per share and stock price. The good news: Many insurers are following that playbook.

Take New York-based Assurant (AIZ) as an example. The share count stood at 137 million back in 2005 and had fallen to 119 million by 2009, thanks to steady buybacks. And then, Assurant stepped on the gas, shrinking the share count a further 29% since then to just 85 million shares.

You won't yet see the effects on per-share profits. Assurant is likely to earn around $5.50 a share this year, which is roughly what it earned in 2006 and 2007. That's the clear result of low interest rates and their effect on investment returns for Assurant's nearly $15 billion in parked cash. Yet when interest rates move back to levels seen in the past decade, per-share profits will surge toward the $10 mark, far higher than was seen in the last cycle.

Of course these stocks won't stay below book value forever. For instance, Assurant traded at around 65% of tangible book value a year ago, and that figure is already up to 86%. As that figure moves toward 100%, then it will make sense to pivot from share buybacks to dividend growth. Let's look at those same 10 companies and see what kind of dividend yields they offer.

Frankly, these yields are underwhelming, which is another reason this industry remains out of favor with investors. Yet the current setup should appeal to investors looking for stocks capable of robust dividend growth. Let's recap the lifecycle to see why that is.

Phase 1: Interest rates fall sharply, decreasing interest income.
Phase 2: Shares fall well below book value, triggering more aggressive stock buyback programs.
Phase 3: Shares (eventually) move back up to book value, making buyback programs less fruitful.
Phase 4: Interest rates start to rebound, boosting interest income.
Phase 5: Rising income, coupled with an emphasis shift from buybacks to rising payout ratios, may trigger share spikes in dividend payouts.

Risks to Consider: This scenario won't fully play out until rates have begun to rise significantly.

Action to Take: This is a great time to research insurance stocks. First, see how they are valued in relation to tangible book value. Then see if they are seizing on the disconnect by aggressively buying back stock and shrinking the share count. Then see what profits may look like when interest rates rebound, and how that relates to a smaller share count. Chances are you'll be looking at a company capable of posting record EPS -- and the surging dividends will be icing on the cake.

David Sterman does not personally hold positions in any securities mentioned in this article. 

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