How The Federal Reserve Could Affect Travelers
Federal Reserve Chair Janet Yellen’s remarks during her inaugural press conference ruffled the bond markets last week. Yellen suggested that the Fed would begin to raise the federal funds target rate, from the current range of 0%-0.25%, six months after wrapping up the Quantitative Easing program. [1] Through its Quantitative Easing 3 program, the Fed has been purchasing 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. The Fed started tapering the QE3 program this year and has already cut down the monthly repurchase amount from $85 billion last year to $55 billion. [2] The federal funds rate is the rate at which banks borrow from each other to maintain capital reserves and has been kept low by the Fed to fuel economic growth.
Changes in the Fed’s policies will have a direct impact on insurance companies, such as The Travelers Companies (NYSE:TRV), which invest primarily in fixed maturity securities such as government and corporate bonds. More than 85% of Travelers’ investments are in the asset class. In this article, we will analyze the impact of shifting bond yields on the company.
We presently have a price estimate of $98 for Travelers, implying a premium of 15% to the current market price.
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Why Is Investment Important For Insurance Companies?
Investment income accounts for just 10% of Travelers’ revenue 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. 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 property and casualty insurance industry as a whole has run on underwriting losses for 37 of the last 45 years. [3]
Travelers’ insurance operations can be divided into business insurance, which caters to corporate employers offering products such as workers’ compensation, and personal insurance, which provides automobile and homeowners’ insurance to individuals across the U.S. The premium contribution from these lines is roughly 65% and 35%, respectively. With the exception of 2011, where hurricane Irene and other natural disasters like Tropical Storm Lee led to a spike in claims, the company has maintained strong underwriting performance.
To measure this performance, we look at the combined ratio, which measures the expenses borne by the company relative to the premiums earned. A combined ratio of above 100% implies that the company is running on underwriting losses, while a figure below 100% implies that the company is able to earn underwriting income. For Travelers’ business and financial insurance division, the combined ratio was 91% in 2010, 100% in 2011, 94% in 2012 and 89% in 2013, which shows that the division has generally been able to generate significant underwriting profits. For the personal insurance division, the respective combined ratios were 100%, 115%, 103% and 90%. The high losses in 2011 illustrate the unpredictable nature of future calamitous events. Since the company is exposed to such events across the U.S., we expect its combined ratio to increase to around 97% for both divisions in the coming years. The rest of the income will come from its investments, which are largely correlated with bond yields.
Margins Depend On Yields
The 10-year Treasury yield, which can be used as a benchmark for bond yields, was around 5% before the financial crisis began. However the yield dropped significantly in subsequent years, dropping below 1.7% in 2013. This was largely due to the Fed’s aforementioned policies. [4] However, the yields started to increase in May 2013 after the Fed first suggested the possibility of tapering the QE3 program. Travelers’ yield on invested assets was around 4.57% in 2010 but dropped steadily, along with bond yields, to 3.94% in 2013. We expect a gradual increase in Travelers’ yields through the coming years as the Fed tapers the QE3 program and gradually increases the federal funds rate.
Travelers’ operating margins have fluctuated with both yields and insurance expenses, as discussed in the last two paragraphs. For the business insurance division, the operating margin was 23% in 2010 but fell to 14% in 2011 before increasing to 19% in 2012 and 22% in 2013. For personal insurance, the respective margins were 6%, -9%, 2% and 14%. Taking into account our calculations for combined ratio and investment yields, we expect the operating margin for the business and financial insurance division to be around 15% in the coming years, while that for the personal insurance division will be in the low single digits. You can modify the interactive charts in this article to gauge the impact of a change in margins and yields.
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