US life Insurance: Nirvana-like

  • By Elizabeth Fry

Third-quarter profitability across the US life industry has surged reflecting solid underwriting results and healthy investment income. 

However, the big question is whether the Nirvana-like conditions - which bolstered company margins - can continue.

According to Morgan Stanley’s insurance analyst, Nigel Dally, not all of the upside the sector experienced in the third quarter is sustainable at the current pace. 

In a new report, the analyst examined the macro factors that have played a meaningful role in the improved outlook. 

With markets having moved to near record highs, he said, margins across equity sensitive products have expanded and returns on alternative investments have provided a substantial boost. 

Strong economy

However, as Dally points out, there are other factors also at play,

According to the analyst, the strength in labor markets appears to be driving favorable underwriting results, particularly in group disability. 

“And, the strength in the economy has also led to benign credit conditions, driving strength in capital across the industry, although higher stock prices has muted the accretion from stock buybacks. 

“We also expect some rollback in the regulatory burden across the industry and taxation reform also have the potential to be positive catalysts for the sector.” 

That said, Dally stressed that the industry is not without its challenges. 

Fourth quarter looking good

For instance, sales of annuities, while appearing to stabilise, still remain under substantial pressure. 

And some, but not all, companies have challenges with respect to long-term care, which remains a troubled product class.

"With markets continuing to rally in the fourth quarter, this positive trend will likely continue, barring a correction in the markets," Dally told clients in a note.

"That said, while strong equity returns is providing a boost to assets under management, a partial offset has been weakness in flows, particularly in variable annuities, but also for other products categories including asset management and pension."

As expected, above-average gains from alternative investments boosted results in the latest quarter, although the impact was not as sizable as prior quarters. 

"Looking ahead to the fourth quarter, we expect alternative investments' performance to continue to be strong, albeit not at levels seen in the first half of the year.

"Early indications suggest hedge fund performance could continue to remain strong in the 2017 fourth quarter.

Currency headwinds fade

The good news for the sector is the diminishing currency headwinds. 

Post election, Dally pointed out, the US dollar had rallied against most global currencies.

"However, through 2017, much of these gains have reversed, and currently the US dollar is meaningfully weaker from where it started the year against most major foreign currencies. 

“For companies with meaningful international operations, we now see this as providing a tail wind to their results in the back half of the year.”

Persistently low interest rates continue to be a bugbear.

Insurers cheap

According to Dally, after moving higher in the aftermath of the election, interest rates have now become range-bound between 2.3 per cent and 2.5 per cent. 

"Further, we have also seen substantial spread narrowing.

"While we still consider the risk of interest-rate related charges from annual actuarial reviews as being low, the continued low interest rate environment is nonetheless a headwind to earnings growth." 

The US life insurance stocks have rallied significantly over the past 12 months, Dally noted.

That said, the broader market is also trading at higher multiples.

"On an absolute basis, insurers are now trading at levels not seen since before the onset of the financial services crisis," the analyst said.

Historically, the sector tends to trade at a higher price earnings level relative to the market as interest rates rise.

When rates have been in the range of 2.25 per cent to 2.75 per cent, the industry has historically traded on a PE ratio of 62 per cent.

Currently the industry is trading at a PE of 57 per cent, which is considerably below historical average.