The insurance industry has been gaining on speculation regarding the winding down of the quantitative easing (QE) program. Insurance companies invest primarily in low-risk securities like bonds to back up their obligations to policyholders, with close to 75% of the U.S. life insurance industry’s $3.5 trillion asset portfolio is invested in government bonds and corporate debt.  The Fed’s monetary policies have kept yields from these investments low for the last few years. But the outlook for the industry has been positive since Federal Reserve Chairman Ben S. Bernanke first suggested the possibility of the Fed cutting back on the pace of the QE3 program back in May.  The current QE program involves $85 billion in monthly purchases of assets such as long term treasuries and mortgage-backed securities from commercial banks and other financial institutions, thereby increasing liquidity and reducing long term rates. Short term rates have been influenced by Fed policy; the U.S. Federal Funds Rate, the rate at which banks borrow from each other to maintain capital reserves, is currently less than 0.1%. 
Prudential Financial (NYSE:PRU) and MetLife (NYSE:MET), two of the biggest life insurers in the U.S., have seen their stock surge more than 20% since Bernanke’s announcement even though the tapering has yet to begin. Around three-quarters of both company’s assets are invested in fixed maturity securities such as government and corporate bonds, the yield from which has dropped since the Fed initiated its policies. 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. Returns from investments are crucial for the companies. MetLife has maintained an average expenses to premiums ratio (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. Prudential’s loss ratio was around 130% from 2008 to 2011 but fell to 108% in 2012. This implies that if the companies were not generating sufficient returns from their investments, they would be running losses.
Our price estimate for MetLife is $49, in line with the current market price while that for Prudential is $80, implying a discount of 10% to the current market price. Below, we assess the effect of the possible tapering on the companies’ stocks.
- MetLife Q4 Earnings: Lower Profits, Moratorium On Share Buybacks
- MetLife Earnings Preview: FX Headwinds, Low Investment Income To Offset Business Growth
- FX Headwinds, Lower Interest Rates Soften MetLife’s Q1 Earnings
- MetLife Earnings Preview: Business Growth In Sight Despite Challenges
- India Opens Insurance Sector To Foreign Players
- Business Growth, Lower Investment Income Drive MetLife’s Earnings
Mr. Bernanke has suggested that the Fed will assess economic data before it starts winding down the QE3 program and has provided a threshold of 6.5% unemployment rate and an inflation rate target of 2% before it increases interest rates.  The unemployment rate has been improving through the year, from 7.9% in January to 7.3% in October.  This has led to speculation in the bond markets that the tapering will start sooner rather than later. The 10 year Treasury bond yield, which can be used as a benchmark for bond yields, was around 5% before the financial crisis and fell to around 1.5% in 2012 but has improved to 2.75% this year. 
However, the timeline of the tapering and the possibility of higher interest rates are still up for discussion. Mr. Bernanke’s tenure as Federal Reserve Chairman ends next January and he is likely to be succeeded by Federal Reserve Vice Chair Janet Yellen, who is perceived to be more dovish, favoring lower interest rates to promote development.  Even though the decline in the unemployment rate suggests that the job market and U.S. economy are improving, labor force participation is still on a downward slope, at a 35-year low of 63%.  This suggests that the decline in unemployment rate might be due to people leaving the labor force. The Fed might take this into account before deciding future monetary policies aimed at improving the U.S. economy. We expect the Fed to maintain low interest rates through 2015 with QE tapering possibly beginning in the second quarter of 2014.
The Impact On MetLife
We calculate the annualized spread earned by MetLife on the average account balance by subtracting the interest credited to policyholder account balances from the net investment income. According to our analysis, MetLife’s annualized spread in the U.S. dropped from 4.15% in 2010 to 4% in 2012. We expect a moderate increase in the annualized spread in the coming years, with the yield from fixed maturities reaching the pre-recession level of 5% by 2015. There is an upside of 5% to our price estimate for the company’s stock, should the yield reach the 5% level in 2014. However, MetLife’s margins could be significantly affected if the yield remains at the current level through 2017. There is a downside of 10% to our price estimate in this scenario.
And On Prudential
Like MetLife, we expect Prudential’s yield from fixed maturities to cross the 5% level by 2015. There is a downside of 20% to our estimate, should the insurer’s yield remain at the current level of 3% by the end of the decade.Notes:
- Life Insurers To Benefit From Rising Interest Rates [↩]
- U.S. 10-Year Yield Tops 2% as Bernanke Says Fed May Taper Buys [↩]
- U.S. Federal Funds Rate, Bloomberg [↩]
- Bernanke Offers Possible Timetable for Tapering [↩]
- U.S. Department of Labor, Labor Force Statistics from the Current Population Survey [↩]
- Daily Treasury Yield Curve Rates, U.S. Department Of The Treasury [↩]
- Treasuries Rise as Pimco Says Summers Withdrawal Is Supportive, Bloomberg, September 16 [↩]
- Labor Force Statistics from the Current Population Survey, United States Department Of Labor, November 21, 2013 [↩]