There has been some musing lately that much battered insurance company Manulife Financial may be becoming a value play. Manulife’s declining share price may partially have to do with self-created issues caused by the selling of variable annuities which were not hedged to drops in the stock market. However, one of its larger competitors, Sun Life Financial, is also experiencing 52 week lows along with most of the the life and health insurance sector. It appears then that Manulife’s woes are part of a larger downward trend for the entire industry.
Why are life and health insurance companies struggling in general?
Insurance have just as complicated balance sheets as banks and suffer from the same interest rate sensitivities. An insurer’s largest liability are payout of insurance policies or annuities which tend to have much longer payout dates than the primary assets they hold, typically fixed income instruments. Thus, you end up with a fundamental issue of balancing a fixed long term liability versus a short-term asset which changes in value according to the interest rates. When interest rates decline, the value of the assets decline so more money has to be set aside to rebalance assets and liabilities.
(as an aside, Larry MacDonald pointed out how the mark-to-market rules hurt insurance companies, and most financial institutions, and has basically resulted in Manulife reporting a loss. Mark-to-market is an accounting rule requiring certain companies to report the value of an asset based on its current value and not the purchase price/book value. The issue with mark-to-market is that it works best in a stable market where the price of an asset is knowable. In unstable markets, it produces unintended consequences and can cause jittery investors to over-react. It is something to be aware of if you invest in financial stocks)
The second shoe to drop for insurance companies in low interest rate environments is that demand for annuities and most life insurance policies generally tends to decline. No one wants to lock into an annuity for a relatively low rate of return and yield chasing takes many consumers away from insurance products (here is a short primer on how annuities work).
A bank can continue to make the spread between what it lends out and what it pays its deposit base even in a low interest rate environment. Its spread may be smaller but it is still ahead of the game. An insurance company has the dual issue of propping up balance sheets while sales slow in the same environment. This problem frames the bank stock vs. insurance stock choice in favor of the former in certain economic conditions.
The medium to long term implication is that an extended period of low interest rates will continue to put financial pressure on insurance companies, reducing the chances of dividend hikes and healthy return on equity. The solution to this problem is, funnily enough, to transform insurance companies into large financial empires with banking, mutual fund and any financial service subsidiaries; in other words, create more too big to fail institutions which are interest rate immune.
In the short term, it may be unrealistic to assume a life insurance company will power your portfolio’s return.
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