Insurance Stocks Running Out of Steam - Industry Outlook

The U.S. insurance industry is running out of steam, with companies that have reported Q1 earnings so far showing a year-over-year slowdown. The insurers that are yet to report are unlikely to change the picture as the industry apprehends an 11.8% earnings decline. Moreover, the pace of premium rate increase, though not dramatic, has stalled thanks to the continued low interest rate environment.

Fundamental challenges such as weak underwriting gains and low investment yields also stand out. While loss of earnings momentum can be short lived, a respite from the underlying weakness is not expected before long. Earnings growth would also be stalled by heightened market competition.

The ongoing reserve development brings some relief. Also, increasing demand from economically recuperating American households should keep the endeavor to reach a favorable pricing cycle alive.

A lot depends on catastrophe losses too. The forecast of a below-average 2014 Atlantic hurricane season is expected to keep catastrophe losses modest similar to last year. This should lead to further recovery in underwriting and a lower combined ratio this year.

Looking at broader trends, the overall health of the industry improved to a great extent in the recent past riding on improved macroeconomic trends, after enduring pricing pressures and reduced insured exposure since the latest recession. Moreover, learning from past experiences, insurers are now resorting to expense saving measures.

If insurers manage to overcome the short-term resistance that may be holding back premium rate increase, they should ultimately witness margin expansion and mitigate the adversities of the still low interest rate environment to their investment income. Also, insurers now have ample capital to take on new challenges and increasing awareness on the risk of catastrophe.

That said, though the market condition isn't soft anymore, reasonable hardening is not expected at least in the near term. Moreover, stress on balance sheet, lack of real employment growth and legislative challenges are threatening insurers' ability to rebound to the historical growth rate.

Also, limited organic growth opportunities and more capital for regulatory requirement will push the industry toward consolidation. Insurers are seeking structural economies of scale through mergers and acquisitions for a bigger share of the market. While this will help insurers stay afloat, inter-segment competition will alleviate. So increasing profitability after complying with regulatory requirements would be quite a tall order.

Within the Zacks Industry classification, insurers are broadly grouped in the Finance sector (one of 16 Zacks sectors) and are further sub-divided into five industries at the expanded level: Insurance - Property & Casualty (P&C), Insurance – Multiline, Insurance - Accident & Health, Insurance – Life and Insurance - Brokers. The level of sensitivity and exposure to different stages of the economic cycle vary for each industry.

We rank all the 260-plus industries in the 16 Zacks sectors based on the earnings outlook and fundamental strength of the constituent companies in each industry. To learn more visit:

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As a guideline, the outlook for industries with Zacks Industry Rank #88 and lower is 'Positive,' between #89 and #176 is 'Neutral' and #177 and higher is 'Negative.'

The Zacks Industry Rank for Insurance - Property & Casualty is #31, Insurance - Accident & Health and Insurance - Life is #105, Insurance - Multiline is #150 and Insurance - Brokers is #168. Looking at the Zacks Industry Rank of the five insurance industries, it can be safely said that the near-term outlook for the group is ‘Neutral.'

So far 54.5% companies in the Insurance industry, which is the medium level (or M-level) component of the broader Finance sector, have reported Q1 results. The earnings beat ratio (percentage of companies coming out with positive surprises) is 75.0%, while the revenue beat ratio stands at 50.0%.

The broader Finance sector looks downbeat in terms of growth. So far, 68.4% of the sector participants have reported Q1 results, with decent beat ratios but disappointing earnings and revenue growth rates.

While the earnings beat ratio came in at 66.7%, the sector is expected to witness an earnings decline of 7.0% year over year compared with growth of 18.4% in the prior quarter. However, the sector is expected to register full-year earnings growth of 3.6%.

Revenues are also expected to decline 3.6% compared with a marginal fall of 0.6% in the prior quarter. For a detailed look at the earnings outlook for this sector and others, please read our latest

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Life insurers managed to increase net income in the last few quarters by trimming underwriting expenses and with the help of a modest increase in premiums. But downward pressure on investment yields due to higher hedging costs, lower income from the variable annuity business and more burdensome capital requirements will continue to mar profitability.

Moreover, life insurers have been struggling with low interest rates for years, as these primarily invest in long-term interest earnings assets which were not able to generate sufficient returns to match their future commitments related to the policies sold to various individuals.

Until the interest rate environment reverses, life insurers will have to continue to seek alternative asset classes to optimize return from investments. But the addition of any risky asset class in their investment portfolios with hopes of better yield may result in further losses.

However, continued tapering of fiscal stimulus raises the hope for rate increase, which should significantly benefit life insurers. In a higher rate environment, cash inflows of life insurers will lead to higher returns and increased profit margins.

The industry's statutory capital level improved significantly in the last few quarters, with the help of steady retained earnings and effective capital management. A beefed-up capital market should keep the industry's liquidity profile strong in the upcoming quarters and help industry participants confront challenges.

Moreover, continued economic recovery and higher disposable income will help life insurers broaden their customer base. Also, the carriers are transforming their products and businesses to make them attractive and profitable for customers.

P&C Insurers have been witnessing improvement across most segments in recent quarters. However, market hardening, which is the key to improvement, appears to have slowed again. After struggling with falling prices for years, the industry witnessed better premium rates in 2013, but lack of improvement in the interest rate environment is again restricting the improvement.

Moreover, the carriers are still feeling the pressure on their investment portfolios due to the overall low interest rate environment.

On the other hand, concerns related to weak capital levels are now things of the past, as the industry's capital position has been building up on the back of better-than-before earnings.

While a pause in improving pricing power and continued pressure on investment income are concerns, capital strength and stronger preparation to withstand catastrophe-related losses should prompt decent results from P&C insurers in the upcoming quarters.

As property-casualty insurers hold about two-thirds of the invested assets in the form of bonds, their capacity is highly sensitive to changes in credit market conditions. With credit and equity markets showing improvement, insurers are likely to incur lesser realized and unrealized capital losses on their portfolios in the quarters ahead.   

Moreover, insurance volume is expected to expand going forward on speedier economic recovery. With improved employment in the private sector and recovery, though uneven, in the housing markets, a number of carriers have seen growth in insurance sales in the recent quarters.

Further, the recent quarters have seen a rebound in claims-paying capacity (as measured by policyholders' surpluses), which reflects the industry's resilience. Conservative investment strategies and capital restructuring efforts will continue to help property-casualty insurers improve their financial footing in the upcoming quarters.

Most importantly, proactive steps on transformational measures, including adoption of technology solutions, will give a competitive advantage. Also, in order to meet evolving consumer demands, insurers must innovate.

The industry has been undertaking several structural changes that will make underwriting and pricing schemes even more attractive to consumers. Also, improving fundamentals on the back of favorable macroeconomic trends make the stocks of a number of industry participants appear attractive.

We remain positive on

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,

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and

with a Zacks Rank #1.

Other insurers that we like with a Zacks Rank #2 include

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and

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We expect continued pressure on investment yield and lower income from the variable annuity business to restrict the earnings growth rate of life insurers at least in the near term. Also, pressure on underwriting will hurt the earnings of many property-casualty insurers.

We would suggest staying away from the Zacks Rank #5 (Strong Sell) stocks such as

,

,

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and

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