The Fed’s decision to maintain the pace of the Quantitative Easing program, which involves $85 billion in monthly bond purchases, was perceived positively by the markets. The Dow Jones and the S&P 500 indices climbed after Fed Chairman Ben Bernanke announced the decision to hold of QE3 tapering on Wednesday, September 18, with the latter touching record highs. However the announcement came as bad news for insurance companies like Prudential Financial (NYSE:PRU) and MetLife (NYSE:MET) which invest primarily in bonds. More than 75% of both company’s assets are invested in fixed maturity securities like government and corporate bonds, the yields from which have been low due to the QE program. The program involves Federal purchases of assets like long-term treasuries and mortgage-backed securities from commercial banks and other financial institutions, thereby increasing liquidity and reducing long term interest rates.
We still maintain our forecast for a long term increase in yields from fixed maturity securities for both MetLife and Prudential. Our price estimates for the two companies are $51 and $80, respectively. However, there is a 10% to 20% downside for our estimates for both insurers should the tapering be held off for later rather than sooner.
The premiums collected by insurance companies from policyholders are invested to generate returns whilst maintaining policyholder account balances and reserves to pay off future policy benefits. Investment income is significant for the companies’ margins. Excluding investment income, Prudential’s expenses to premiums ratio (loss ratio) was around 130% from 2008 to 2011, but fell to 108% in 2012. MetLife has maintained an average loss ratio of 144% in the last four years in the U.S. while its international loss ratio improved from 135% in 2009 to 118% in 2012. This implies that if the companies were not generating sufficient returns from their investments, they would be running in losses.
The 10-year Treasury bond yield, which can be used as a benchmark for bond yields, was around 5% before the financial crisis but fell to around 1.5% in 2012, primarily due to the Fed’s policies.  As a result, MetLife’s fixed-maturities yield fell from 5.4% in 2008 to 4% in 2012 while Prudential’s yield fell from 5% in 2008 to 3% in 2012. MetLife’s decline in yield was lower due to the company’s hedging strategy, but its CEO, Steven Kandarian, has criticized the Fed’s strategy in the past saying that it is deleterious for people looking to save.  Prudential’s operating margin was close to 15% before the onset of the financial crisis but dropped to less than 2% in 2012.
Last week, former U.S. Treasury Secretary Larry Summers withdrew his name from the race for Ben Bernanke’s successor as Federal Reserve chairman. Summers was expected to be the frontrunner to take over the job in January and was considered to be hawkish, favoring higher interest rates.  The other potential candidates, Federal Reserve vice chair Janet Yellen and former vice chairman Donald Kohn are perceived to be more dovish, favoring lower interest rates to promote development, than Summers.  With Bernanke still to set a timeline for tapering, a near term end to the QE3 program seems unlikely.
We still expect a tapering in the mid-term, which will allow both companies’ margins to return to pre-recession levels in the long-term. We expect Prudential’s yield from fixed maturities to reach 2007 levels by 2015, but there is a 10% downside to our price estimate, should the yield fail to reach the expected levels by 2016 and a further 10% downside if the yield does not increase significantly by 2018. A similar scenario applies for MetLife. You can modify the interactive charts in this article to gauge the effects of a change in forecast on our price estimate.Notes:
- Daily Treasury Yield Curve Rates, U.S. Department Of The Treasury [↩]
- MetLife CEO Says Bernanke’s Easy Money a Tax on Savers, March 22, 2013, Bloomberg [↩]
- Summers Quit Fed Quest After Democrats Spurned Obama Favorite, Bloomberg, September 16, 2013 [↩]
- Treasuries Rise as Pimco Says Summers Withdrawal Is Supportive, Bloomberg, September 16 [↩]