DGICA Donegal Group Inc

The U.S. insurance industry continues to move forward with consistent improvement in earnings and decelerating combined ratios from most of the primary insurers in the first half of 2013. The expectations for the upcoming quarters also signal optimism. The key driver of this betterment is the improvement in premium rates for over a year, after prolonged softness. Further, favorable reserve development and lower catastrophe losses helped insurers show their potency.  

The sector seems to be reaching a favorable pricing cycle and its near-term outlook for pricing power remains upbeat in the wake of rising demand from economically recovering American households. But a dearth of positive catalysts is delaying the recovery process of the insurers. Among the fundamental challenges, weak underwriting gains and low investment yields stand out.

Catastrophe losses further add to the concerns. Though the industry has not witnessed any severe weather disruption as of now, it is braving the peak of the hurricane season (mid-August to late October). So, any active storm as severe as last year’s Superstorm Sandy could cause widespread damage and result in billions of insured losses. Notably, insured property losses due to Sandy were much higher than the average over the last decade.

Though insurers are preparing themselves better to withstand significant losses, the increased probability of a natural catastrophe will continue to raise concerns. Some analysts expect catastrophic losses to double every 10 years and the pace of capacity buildup by the insurers to be insufficient to withstand the resulting insured losses.

Moreover, the events outside the country -- such as continued debt crisis in the Eurozone and financial issues in emerging markets -- will further limit the industry’s growth prospects.

However, the overall health of the industry has improved somewhat in the recent past riding on the ongoing economic recovery, after enduring pricing pressures and reduced insured exposure since the latest recession. Moreover, learning from past experiences, insurers are resorting to expense saving measures to support bottom-line growth.

Rising premium rates should ultimately translate into margin expansion and mitigate the negative impact of the still low interest rate environment on insurers’ investment income. Further, increasing awareness on the risk of catastrophe, strong underwriting discipline and favorable reserve development in the recent quarters should place the industry at least one step ahead.

That said, though the market condition doesn’t remain soft anymore, reasonable hardening is not expected at least until the end of 2013. Moreover, a stressed 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 strict regulatory capital requirements will push the industry more toward consolidation. Insurers are seeking structural economies of scale through mergers and acquisitions to enhance market share. While this will help insurers stay afloat, inter-segment competition will alleviate. So increasing profitability after complying with regulatory requirements and coping with the challenges of increasing catastrophic losses could prove difficult.

Zacks Industry Rank

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 - Accident & Health, Insurance - Brokers, Insurance - Life, Insurance - Multiline and Insurance - Property & Casualty. 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: About Zacks Industry Rank.

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

The Zacks Industry Rank for Insurance - Accident & Health is #22, Insurance - Multiline is #41, Insurance - Life is #65, Insurance - Property & Casualty is #86 and Insurance - Brokers is #180. 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 'Positive.'

Earnings Trend of the Sector

The broader Finance sector, of which the insurance industry is part, remains in excellent shape with respect to earnings. Full 100% of the sector participants have reported second-quarter results, which have been strong in terms of both beat ratios (percentage of companies coming out with positive surprises) and growth.

Both earnings and revenue beat ratios were pretty robust at 76.9% and 61.5%, respectively. Also, total earnings for the companies have shown an impressive 30.0% year-over-year increase on 8.5% growth in revenues. This compares with a substantially lower earnings improvement of 7.6% on 5.6% growth in revenues in the first quarter of 2013.

The consensus earnings expectations for the rest of the year also depict a fairly strong trend. Though earnings growth is expected to slow down to 7.4% in the third quarter, a stupendous improvement of 28.6% is expected in the fourth quarter. Overall, the sector is expected to register full-year growth of 16.9%.

For a detailed look at the earnings outlook for this sector and others, please read our weekly Earnings Trends reports.

Life Insurers

A reduction in underwriting expenses and a modest increase in premiums have been helping life insurers increase net income in the last few quarters. 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 going forward.

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

However, the recent rise in the U.S. Treasury yields is expected to change the fate of life insurers. Long-term bond yields finally started rising since the middle of the year, after staying low for a long stretch. As a result, cash flows of life insurers will be invested at higher yields, leading to higher returns and increased profit margins. Moreover, with rising rates, reinvestment risk will be lower.

On the other hand, until the rising trend of interest rates becomes prominent with the continuation of the same for a few quarters, life insurers will have to continue to seek alternative asset classes to optimize return from investments. And the addition of any risky asset class in their investment portfolios with hopes of better yield may result in further losses.

As the industry’s statutory capital level fell sharply during the recession, life insurers will need to optimize their capital levels to address the ensuing challenges. In the short term, traditional sources of capital are expected to fulfill most of what life insurers need in order to stay in good shape. However, non-traditional sources of capital will take years to strengthen financials.

The underlying trends amid a recovering economy indicate stability in the sector over the medium term with respect to credit profile and financial prospects. However, higher-than-average asset losses, primarily resulting from their real estate exposure, will remain a major concern.

Further, the sluggish pace of economic recovery is making it difficult for life insurers to expand their customer base. In fact, insurers are struggling to even retain their existing clientele.

Narrowed disposable income owing to a still high unemployment level and huge credit card debt has made it difficult for Americans to invest in retirement products such as life insurance. Americans, primarily the youth, have significantly reduced expenditures on life insurance products, and are instead choosing alternative investments that promise better returns.

Though the carriers are transforming their products and businesses to make them attractive and profitable for customers, significant improvement in demand is not expected in the near term.

However, rising long-term bond yields would increase investors’ appetite for spread-based products, such as fixed rate annuities.

Currently, the life insurers with favorable Zacks Ranks worth considering include StanCorp Financial Group Inc. (SFG) with a Zacks Rank #1 (Strong Buy), and Lincoln National Corporation (LNC) and Symetra Financial Corporation (SYA) with a Zacks Rank #2 (Buy).

Health Insurers

As U.S. health insurers continuously preparing themselves to comply with the mandates of the health care reform, their financials are beefing up. Broad-based moderation in utilization has been primarily boosting the bottom line of health insurers. Also, increased access to capital and better retention opportunities are helping them grow consistently despite tardy economic growth.

Moreover, the carriers have been witnessing better credit quality in the recent quarters, reflecting a moderate industry risk.

In 2010, the historic health care reform legislation -- The Patient Protection and Affordable Care Act (PPACA) -- was passed by the Congress with the intension of making health care facilities more affordable, preventing private health insurers from continuing with the pre-existing condition clause and at the same time reducing the number of uninsured by bringing in 32 million more people under coverage by 2019.

The legislation had many detractors who contested several of its stated benefits and considered it another entitlement program that the country can ill afford. Finally, in Jun 2012, the U.S. Supreme Court ruled in favor of the reform, rejuvenating the industry by removing major uncertainties. Further, Obama's re-election in Nov 2012 essentially ensured the law's future.

Controversies did not stop in 2013, with many states declining from participating in the new health insurance market and expanding Medicaid -- the public health insurance program for low-income families -- to avoid the additional costs involved in it. So far, less than half the states have approved of the Medicaid expansion.   

However, the development so far is expected to significantly reduce the number of uninsured, making the U.S. one of the economically sound countries that guarantees coverage.

While the legislative overhaul brings more regulatory scrutiny for private insurers such as WellPoint Inc. (WLP) and UnitedHealth Group, Inc. (UNH), the net negative effect is expected to be far softer than was initially feared.

Although the full implementation of PPACA will be in 2015, the industry is expected to see gradual changes through the reminder of 2013 and dramatic changes in 2014. While bringing more people under coverage will add prospects for growth, the requirement to reduce health care costs will lead to margin compression.

Also, while the reform will provide more cross-selling opportunities for health insurers, their overall profitability will be limited over the long run as the negative impact of Medicare Advantage payment cuts, industry taxes and restrictions on underwriting practices will more than offset the benefits of bringing more people under the umbrella.

Consequently, substantial growth in industry revenue is not expected until 2015 as insurers will be forced to adjust the benefits to comply with the health care legislation. Among others, providing coverage to everyone regardless of an expensive pre-existing condition would put their top lines at stake.

(Want to know more about the future prospects of health insurers? Read our Health Insurance Stock Outlook).

Property & Casualty Insurers

Market hardening has been the key to improvement for property-casualty insurers in the recent quarters. After struggling with falling prices for years, insurers seem to have finally reached a period of better premium rates. However, property-casualty insurers are still feeling the pressure on their investment portfolios due to the overall interest rate environment which is still low. This has been continuously reducing the capital adequacy of most carriers.

Along with continually improving pricing power, better preparation to withstand catastrophe-related losses should help insurers perform better in the upcoming quarters despite the pressure on investment income.

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. Moreover, with credit markets remaining weak and bond prices still hovering at low levels due to persisting concerns over defaults, insurers may incur significant realized and unrealized capital losses on their portfolios in the upcoming quarters. Moreover, catastrophe losses continue to keep the balance sheets of a number of carriers under pressure.

However, the ongoing recovery in the credit and equity markets is leading to a reduction in unrealized investment losses. Also, the recent rise in long-term bond yields is expected to somewhat increase the property-casualty insurers’ investment income. Moreover, once the economic recovery gains momentum, insurance volume will grow rapidly. With improved employment in the private sector and recovery in the housing markets, a number of carriers have already started seeing growth in insurance sales.

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

Currently, Alleghany Corporation (Y), EMC Insurance Group Inc. (EMCI) and Everest Re Group Ltd. (RE) -- all with a Zacks Rank #1 -- are worth a look in the property-casualty space.

OPPORTUNITIES

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 Employers Holdings, Inc. (EIG), FBL Financial Group Inc. (FFG), Eastern Insurance Holdings, Inc. (EIHI), Health Insurance Innovations, Inc. (HIIQ), Global Indemnity plc (GBLI) and State Auto Financial Corp. (STFC) with a Zacks Rank #1.

Other insurers that we like with a Zacks Rank #2 include American International Group, Inc. (AIG), Allied World Assurance Company Holdings, AG (AWH), Cincinnati Financial Corp. (CINF), CNA Financial Corp. (CNA) and Fidelity National Financial, Inc. (FNF).

WEAKNESSES

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, reduced financial flexibility and weak underwriting will hurt the earnings of many property-casualty insurers. Moreover, the overall industry is vulnerable to the ever-increasing threat of natural disasters.

We would suggest staying away from the Zacks Rank #5 (Strong Sell) stocks such as Meadowbrook Insurance Group Inc. (MIG), American Safety Insurance Holdings Ltd. (ASI) and Donegal Group Inc. (DGICA).
 
AMER INTL GRP (AIG): Free Stock Analysis Report
 
AMER SAFETY INS (ASI): Free Stock Analysis Report
 
ALLIED WORLD AS (AWH): Free Stock Analysis Report
 
CINCINNATI FINL (CINF): Free Stock Analysis Report
 
CNA FINL CORP (CNA): Free Stock Analysis Report
 
DONEGAL GRP -A (DGICA): Free Stock Analysis Report
 
EMPLOYERS HLDGS (EIG): Free Stock Analysis Report
 
EASTERN INSURNC (EIHI): Free Stock Analysis Report
 
FBL FINL GRP-A (FFG): Free Stock Analysis Report
 
FIDELITY NAT FI (FNF): Free Stock Analysis Report
 
GLOBAL INDEMNTY (GBLI): Free Stock Analysis Report
 
HEALTH INS INN (HIIQ): Free Stock Analysis Report
 
MEADOWBROOK INS (MIG): Free Stock Analysis Report
 
STATE AUTO FINL (STFC): Free Stock Analysis Report
 
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