How Will Rising Bond Yields Affect Travelers?
Recent speculation around the Federal Reserve’s forthcoming tapering of its Quantitative Easing program has led to higher interest rates in the U.S. through the last few months. The program involves $85 billion in monthly 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. The Fed has indicated a threshold of 6.5% unemployment rate as a target for the economic recovery before it will end the program, [1] and the recent spurt in the job market has given rise to expectations that the tapering might come sooner rather than later.
The unemployment rate in the U.S. has recovered from 10.1% observed during the financial crisis in 2009 and reached a four-year low of 7.4% in July, down from 7.8% at the end of 2012. [2] Consequently, the 10-year Treasury bond yield, which can be used as a benchmark for most bond yields, has risen from around 1.8% at the start of the year to 2.8%, the highest level since the onset of the financial crash. The yield is still a long way off from the 5% level seen before the financial crash. [3]
Insurance companies like The Travelers Companies, Inc. (NYSE:TRV), which invest a large chunk of their assets in fixed maturity securities like government and corporate bonds have seen their stock climb. Travelers has gained around 12% since the turn of the year. Close to 90% of Travelers’ assets are invested in fixed maturity securities, the yield from which fell from 4.8% in 2008 to 3.7% in 2012. Investment income accounts for just 10% of the company’s revenue and operating income but is far more important for profitability. Insurance companies collect premiums from clients in exchange for coverage, and the income from these premiums is invested to generate returns for the insurer. The insured party is later paid claims if it incurs losses that are covered by the policy.
We presently have a price estimate of $96 for Travelers, implying a premium of 20% to the current market price.
See Full Analysis for Travelers Here
Strong Underwriting Performance
Travelers’ insurance operations can be divided into its business insurance that caters to corporate employers offering products like workers’ compensation and personal insurance that provides automobile and homeowners’ insurance to individuals across the U.S. The contribution to premiums from these lines is roughly 65% and 35% respectively.
With the exception of 2011, when hurricane Irene and other natural disasters like Tropical Storm Lee led to a spike in claims, the company has maintained a strong underwriting performance. The combined ratio (claims and expenses to premiums) was around 92% in 2010 and 94% in 2012 for the business insurance division while that for the personal insurance division was around 97% before 2011. This indicates a negative cost of float for the company as it is earning more premiums than it is paying out in claims and is running on an underwriting profit.
Most insurance companies are not able to maintain an underwriting profit and generally have to incur an underwriting loss or cost of float to generate money for investment. The P&C industry as a whole has run on underwriting losses for 37 of the last 45 years. [4] Despite the strong underwriting performance shown by Travelers, the company was severely affected by the fall in bond yields. The operating margin for the business and financial insurance division fell from 22% in 2010 to 13% in 2011, before rising to 19% in 2012 as claims and expenses fell. For the personal insurance division, the operating margin fell from 9% in 2010 to 2% in 2012.
For more on the insurance business, please read our articles, A Look At Travelers Personal Insurance Business; $94 Fair Value and Travelers Revised $94 Estimate: Business And Financial Insurance Overview.
So How Will Increased Investment Income Help Margins
For our long term forecast for Travelers, we expect it to maintain a combined ratio of 96% to 97% for the business insurance and 97% for the personal insurance division. This level is close to the historical averages for the two divisions. Our current forecast for investment yields is still based on the low interest rates that have been prevalent in the last few years with a gradual rise through the decade reaching the pre-recession level of around 5% by the end of the decade. However, should the company’s yield from bonds rise faster than we currently anticipate with a yield of 4.5% this year, there could potentially be a 25% rise in investment income. According to our analysis, the operating margin for the business insurance division will be around 16% while that for the personal insurance division will be around 15% in this scenario. Our forecast for operating income through the decade will increase by nearly 20% leading to around 20% upside to our price estimate. You can modify the interactive charts in this article to gauge the effect a change in our forecast would have on our price estimate.
Submit a Post at Trefis Powered by Data and Interactive Charts | Understand What Drives a Stock at Trefis
Notes:- 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 [↩]
- Berkshire Hathaway Sec filing [↩]