Favorable valuations for insurance stocks

Financial stocks had a quite difficult stand this year. On Wall Street the stock prices of banks and insurances trailed the overall market. During the last five years, the Dow Jones U.S. Bank Index could not compete with the performance of the S&P 500 Index. In comparison, the Dow Jones U.S. Insurance Index has done much better. Its performance is only slightly lagging behind the S&P 500 Index during the same period.  

Nevertheless, insurance companies, like banks, are confronted with critical questions by market participants.  

In Europe as well as the U.S., insurers’ ability to cope with the low interest rate environment is doubted, and their resilience in case of a new crisis is judged critically.  

Problems like these have accompanied the financial sector for years, but on top of that, new challenges emerge. Topics like the driverless car may seem to be only a vision of the future, yet one day, when these cars drive on the street and fewer accidents occur, their effect on the sale of casualty insurance coverage will be significant.  

Many of the risks are already priced in  

It remains to be seen how the sector will be able to deal with all these difficulties. However, it is often overlooked that the sector has always found adequate responses to all kind of issues and changing market environments. It is also worth noting that insurers, in contrast to banks, in the past were not as much at the epicenter of financial crises.  

Sector members currently tend to earn solid returns on their stock investments, which helps to at least partially compensate for the meager yields offered in the bond markets.  

Geographically, U.S. insurers have a small edge over European competitors because they are active in a country with a slightly better demography and an economy that currently shows more strength.  

An important investment argument is that insurance stocks are significantly cheaper on average than stocks overall. As a result, a lot of the mentioned risks already seem to be priced in. 

Interesting investing options can be found in the segments of life insurance and property and casualty insurance, as well as in the reinsurance business.  

How the insurance business can develop successfully was demonstrated recently by Mercury General. The U.S. property insurer beat profit expectations significantly in the second quarter. As a result, the stock price has risen to the highest level since October 2008. While the valuation of this stock on a price-earnings ratio basis is quite demanding at 18.8 for the year, that is a least partly offset by an attractive dividend yield of 4.8 percent. 

Stocks with single-digit price-earnings-ratios  

Compared to Mercury General, the most convincing argument that speaks in favor of the second buy recommendation – Prudential Financial – is its valuation. This group, which is often confused with British financial services company Prudential Plc, has not only a broad-based product portfolio, but also a low price-earnings ratio this year of 8.7. It is one of the reasons why investment bank Morgan Stanley considers this company, which was founded in 1875, as the most attractive big life insurer stock. The U.S. investment bank has fixed the price target at $106 for the S&P 500 Index member.

That makes Prudential Financial, which is classified as a systemically relevant institution, one of the stocks with the highest upside potential. But until now, neither this, nor the better than expected net profit of US$1.09 billon booked for the second quarter has helped the stock price to end its recently shown lethargy. 

The stock price of the XL Group showed more momentum recently despite a loss in the past quarter. This can be explained by the fact that the U.S.-listed Irish primary insurer and reinsurer had beaten the earnings expectations for the third time in a row. But the stock has even more upside potential if the worldwide active specialist for the coverage of complex property and liability risks is able to achieve its goal to improve the return on equity ratio to 10 percent. Together with the solid capitalization, which enables this company to buy back its own shares and to pay dividends, the valuation still seems to be too low.

Based on the earnings for 2014, the price earnings ratio stands at 10.35 and the price-to-book value ratio of around 1 is lower than the long-term average of 1.2. 

Reinsurers are also successful. Earnings were favorably influenced by the recently relatively low damage caused by natural disasters. If this important factor does not change, prospects can get even better as insurance premiums seem to go up. The U.S. reinsurer Everest Re increased its profit in the second quarter from $275.6 million to $290.2 million.

Although this was less than expected, the stock price did not get hit, since it is protected by a low price-earnings ratio this year of 8.7 and an undemanding price-to-book value ratio of roughly 1. The analysts of S&P Capital IQ judge this stock as a strong buy and set the 12-month price target at $195. 


Health insurers are also attractive  

The U.S. healthcare insurer Wellpoint is active in a different sector of the insurance business, but that does not make the stock less interesting. Obamacare seems to influence the development of that segment less negatively than originally expected. That can be seen by the fact that management recently increased the earnings forecast for 2014. With an estimated price-earnings ratio of 12.15 for 2015, the valuation is moderate and allows the stock to continue its recent record hunt. 

Also always worth a consideration for every portfolio is Berkshire Hathaway. The investment company of billionaire and investment guru Warren Buffett is traditionally making a significant part of its income with insurance companies. And that will continue to be an important asset of the company, although recently the earnings derived from that business have declined somewhat.