Start with a history lesson: From January 3, 2001, to June 25, 2003, the Federal Reserve cut short-term interest rates 12 times, ratcheting down the federal funds rate to 1%. Stocks rallied sharply on the first reduction. But by the time Chairman Alan Greenspan and his colleagues announced the final cut, Standard & Poor's 500-stock index had fallen 28%.
Yes, there was 9/11 and an actual recession, as opposed to today's talk of one. But for investors, it was still an extraordinarily painful time, made more so by the conventional wisdom that Fed rate cuts are bullish for stocks.
But look at what some important insurance stocks did during that interval: Progressive (symbol PGR), up 114%; Markel (MKL), plus 42%; and Principal Financial Group (PFG), rose 53% from its initial offering price in late 2001.
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There were losers, too -- most notably American International Group (AIG), which lost 41%. But AIG's flop resulted mainly from its own accounting and management scandals. Fidelity Select Insurance fund (FSPCX), the only open-end fund dedicated to insurance stocks, wedged out an 8% gain.
Beam yourself back to the present, and you'll see that that insurance is a safe place to be when the economy is slowing and bank and real estate investments are under pressure. The Dow Jones Insurance Titans index was up 3% for the year through date September 26, while Dow Jones' indexes of banks and general financial services -- the latter includes Goldman Sachs (GS) and Merrill Lynch (ML) -- are off 7% and 5%, respectively, as of September 26. Fidelity Select Insurance has broken even.
Insurance is a huge and diverse category, but the weak spots are on the periphery. Bond insurers are out of favor because of a slowdown in issuance of unrated or low-rated debt (sold by the kind of borrowers who want to get de facto investment-grade treatment) and because of trouble with defaults in mortgage-backed securities. Auto insurance shares are having a bad year because of rate wars in many states.
The rest of the insurance sector, specifically life and property-casualty, is doing fine. The primary reasons are the absence of devastating hurricanes and the Fed's move to cut short-term interest rates, which should help insurers' earnings.
Other industries, including banks, also benefit from lower short-term rates. So why invest in insurance? Why are insurance stocks relatively safe and reliable when both natural and financial catastrophes are so random?
Here's a possible reason: The outfits that take your premiums and invest them are old-school and tight with a buck.
What's more, they invest this money for the ages and do it well. The most obvious case in point: Warren Buffett's Berkshire Hathaway (BRK.A). Or consider Markel, a Virginia company that insures things such as bars and restaurants. It looks a lot like a mini-Berkshire, with 17% of its assets in a stock portfolio that, over the past decade, has delivered an annualized return of 14%, a figure that includes a 26% gain last year.
Another reason they're relatively safe: Moody's reported a few weeks ago that, in reviewing the assets of property-and-casualty insurers, it found that only 1% of investments were related to sub-prime assets. The figure is 2% for life companies.
Even at companies with a higher position in subprime investments, the risks aren't especially high. Allstate's chief financial officer, Dan Hale, says that as of early September, Allstate held $4.8 billion of sub-prime mortgage-backed securities. That's about 4% of the company's total investments.
Allstate stock is down 13% for the year, a weak showing for a stock that's been a consistent double-digit gainer. But Hale says that because most of these sub-prime assets are in the higher-quality slices of the mortgage pools, it would take a 70% default rate on the underlying loans for Allstate to lose any money. That's just not going to happen.
This appears to be just another case of investors overreacting to the flow of news. Allstate's real business is fine. Auto insurance premiums are flat from the previous year, but homeowners' rates are up 3%. The company did sock away extra reserves for catastrophes, a legacy of Hurricane Katrina, but, to balance this, it also bought back enough stock to reduce the total number of shares outstanding by 7%.
The net of all this is that Allstate's book value per share, $32.43 a year ago, is now $36.39. And because a good property-casualty insurance stock is usually worth close to two times book value, that strongly suggests Allstate (ALL), which closed at $55.70 on September 26, up 0.6%, is a good buy. Plus, the stock yields 2.7%. Unless you expect the likes of Katrina or 9/11 to become regular events, the potential reward seems to be quite a bit greater than the risk.
Life insurance stocks are more directly tied to the interest-rate picture because death claims are more predictable than the financial toll from hurricanes and other disasters. The Fed's rate cuts are the main reason for being bullish on this subsector. Life insurers own lots of bonds and other fixed-income investments, but they also sometimes take the opportunity to borrow at short-term rates, invest in long-term assets and profit from the spread. Unless inflation breaks out and pushes long-term interest rates higher, which would result in lower bond prices, the rate cut should be a plus.
Moreover, industry consolidation has turned life insurers such as MetLife (MET), Prudential (PRU) and Manulife (MFC) into growth companies. They have gotten more involved in retirement planning, pensions and money-management. The result is higher profitability as measured by return on equity, another key tool for evaluating insurers.
The average ROE for life insurers is 12%, but it's 16% for Manulife, 18% for Prudential and 21% for MetLife. The five-year annualized returns of these stocks are 33% for Manulife, 28% for Prudential and 25% for MetLife. Even after those advances, I don't think these stocks are overvalued. Manulife closed at $40.87 on September 26, essentially unchanged; MetLife finished at $69.69, up 1.7%; and Prudential settled at $94.33, up 2.5%.
Insurance may be a boring business and dealing with insurers can sometimes be painful and aggravating, but those kinds of returns are nothing to scoff at. Next time you pay a premium, remember that it's possible to be both a policyholder and a shareholder.
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