A January 6th Industry Report from Sterne Agee focuses on the life insurance sector. SA analysts John M. Nadel, Wesley Carmichael and Michael A. Ward note that the U.S Treasury 10-year note yield has slipped below 2%, and argue that coupled with a strengthening U.S. dollar could spell trouble for life insurers.
Current macroeconomic environment
The Sterne Agee report begins by pointing out that the U.S. Treasury 10-year note yield hit 2.00% Tuesday morning, a level not seen since late May of 2013. The good news for life insurers is that credit spreads have widened out to close to historical average levels, with the Merrill Lynch Corporate Master yield at 3.16% implying spread versus the 10-Year at 115 bps, not too far away from the 30-year average of 122 bps.
Because of this spread widening, new money yields (using the Corporate Master as a benchmark) are around 35 bps higher than they were in May 2013 when the 10-year last yielded 2.00%. Never mind the fact that the S&P 500 is also over 22% higher in the same period. Given this improving macro background, our Life Index has risen an impressive 47% since May 2013.
Low bond yields spell trouble for life insurers
Nadel et al. argue that while strong equity markets are a positive for the life insurers, “…clearly the move higher in yields is not sufficient yet to negate the downward pressure on overall portfolio yields.” The SA analysts also caution with credit spreads widening back to 30-year average levels, there is reason for concern over an increase in credit-driven investment losses that could throw a monkey wrench into book value growth.
Furthermore, most life insurers have at least some international exposure, and the dollar has strengthening considerably against most key foreign currencies since May 2013 (stronger by 22% vs. the Yen, 9.5% vs. the Canadian Dollar, 8% versus the Euro, 20% versus the Brazilian Real, 14% versus the Australian Dollar) is hurting ex-U.S. investment returns.
Last but not least, Nadel and colleagues highlight that the median stock in their life insurer universe is trading at 9.9x 2016E EPS, a 30% discount to the S&P 500’s 14.4x 2016 P/E multiple. They note: “The long-term historical discount to the S&P 500 is closer to 35%, so while not necessarily overly expensive relative to the broader market, it seems near-term risk is to the downside.”
In concluding their report, the SA analysts urge caution regarding the sector over the short term: “With credit spreads widening, the long-term interest rate backdrop is not as bad as the drop in Treasury yields would imply. That said, the risk seems in the near-term to be more skewed to the downside as investors should expect negative estimate revisions in the coming weeks from sell side previews.”