Despite the best efforts of characters like Flo and Jake to inject some levity, most people in America see insurance companies as boring. That is probably because “boring” basically describes the business, by design. Insurance, at its core, is about safety and risk reduction. For consumers, the products are largely things you buy because you feel you should, rather than because you really want them. What they do is important; insurance provides stability to our lives, but stability is far from sexy. Maybe that is also why insurance stocks often get overlooked in portfolios, even though there are times, like now, when they are ideally suited by conditions and a strong case can be made that everyone should own some.
Yesterday, I wrote that the evidence of other markets that I trust, bonds, forex, and commodities, pointed to more rate hikes in the face of sustained economic weakness, if not an actual recession. The conclusion was that the bounce in stocks we have seen over the last couple of months won’t last and that another drop is likely in the fall. That would indicate a defensive strategy for investors, and insurance stocks are defensive plays that are ideally suited to current and expected conditions.
Those two qualities, a defensive nature and suitability to a rising rate environment, are both products of the boring nature of insurance. Insurance companies take in money in the form of premiums, which they invest. However, they have to make sure they can always cover any potential claims from those investments, so they don’t take big risks. In institutional investing, that means big holdings of U.S. Treasuries and top-rated corporate bonds, and that suits where we are right now.
Yields on those bonds are rising, albeit not in a straight line, so the investment income accrued by insurance companies is rising. Their liabilities, in terms of the actuarial risks, are not. You may think that they are as the replacement costs of insured items like cars and houses are climbing but, as anyone who has ever totaled a car for any reason can tell you, things are usually insured for a fixed amount, not for whatever a replacement would cost. As the replacement costs rise on newer policies, so will premiums, covering the difference.
Insurance companies are therefore protected from inflation and actually benefit from the rate hikes the Fed is implementing to combat it. If that doesn’t make them a good buy to insure against a downturn, I don’t know what does. The next question for investors is how to play it.
As is usually the case when a particular sector or industry is favored by conditions, there are two ways to do that. You can take a broad-based approach and buy an ETF, or you can buy individual stocks. Either one works here but, given that boring and safe are the objectives, I would favor taking any possible single-stock risk off the table and buying an ETF.
The obvious ETFs for the job are the SPDR Insurance Fund (KIE) and the iShares version (IAK). They have actually tracked each other quite closely in terms of performance, historically, and have similar expense ratios at 0.35% and 0.39%, respectively. If forced to choose, though, I would favor IAK because it is more tilted towards the property and casualty businesses that fit the investment thesis outlined, a preference backed up by recent performance.
As you can see from the comparative chart above, IAK (the main, mountain chart) has outperformed KIE (green line) over the last year. That fits with the logic of the argument, as does the fact that most of that outperformance has been over the last six months, as rate hikes have moved from theoretical to real and their effects began to be felt. The Fed has told us that they will continue along that path until the data show inflation at or close to their 2% target for PCE and that is some way off.
In some ways, the most important thing to note from the chart is that both insurance industry funds have significantly outperformed the S&P 500 ETF (SPY), marked by the blue line. It is only logical that that outperformance by insurance funds will continue for a while and, given its better fit to conditions and proven outperformance against KIE, that makes IAK a logical choice for investors looking to insure their portfolios should things get ugly again.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
Martin Tillier
Martin Tillier spent years working in the Foreign Exchange market, which required an in-depth understanding of both the world’s markets and psychology and techniques of traders. In 2002, Martin left the markets, moved to the U.S., and opened a successful wine store, but the lure of the financial world proved too strong, leading Martin to join a major firm as financial advisor.
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