KBWP - KIE: Is Equal Weighting Insurance Stocks Costing You Money?

2023-04-17 07:30:00 ET

Summary

• KIE tracks the S&P Insurance Select Industry Index and is one of three insurance ETFs available. Its expense ratio is 0.35% and the fund has $425 million in assets.
• Insurance stocks performed well last year as interest rates and margins rose in tandem. However, KIE's equal weight approach is not optimal. Larger companies are better positioned.
• My performance attribution analysis identifies poor security selection in the Life & Health Insurance and Insurance Brokerage industries as main reasons why KIE lagged IAK, a market-cap-weighted alternative.
• New legislation in Florida also primarily benefits larger insurers like Progressive and Allstate. However, all insurers will benefit from this sweeping tort reform bill to some degree.
• I don't recommend KIE because it holds too many small- and mid-sized companies that are less profitable and less able to handle economic shocks. IAK remains the better choice.

Investment Thesis

The SPDR S&P Insurance ETF ( KIE ) provides equal-weight total market exposure to approximately 50 U.S. insurance stocks. While this approach may seem prudent by spreading out the risk, it's not optimal because the largest insurance companies have the best chance at long-term success. This article evaluates KIE's fundamentals and performance over the last five years against the iShares U.S. Insurance ETF ( IAK ), finding that poor security selections in the Life & Health Insurance and Insurance Brokerage segments were key drivers of underperformance. I'll also examine how investors should treat Progressive ( PGR ) after the P&C insurer badly missed Q1 earnings expectations. Finally, I'll discuss the impact of recent tort reform in Florida and how it predominantly favors larger insurers. All factors lead me to prefer a market-cap-weighted approach to insurance stocks, and why I don't recommend readers buy KIE.

KIE Overview

KIE tracks the S&P Insurance Select Industry Index, selecting U.S. securities in equal weight based on Global Industry Classification Standards. In this case, five sub-industries are included, with relative weightings listed below.

• Insurance Brokers: 14%
• Life and Health Insurance: 25%
• Multi-Line Insurance: 9%
• Property & Casualty Insurance: 44%
• Reinsurance: 8%

KIE has a 0.35% expense ratio, in line with IAK and the Invesco KBW Property & Casualty Insurance ETF ( KBWP ). All three have about the same total assets and are considered Mid Value ETFs by Morningstar. However, IAK and KBWP follow some version of a modified market-cap-weighting scheme.

KIE's equal-weighting scheme seems advantageous, but half the portfolio is allocated to companies with market capitalizations below $10 billion. This composition isn't always detrimental, but these smaller businesses typically have lower profitability scores and are more volatile than their large-cap peers. A market-cap-weighting scheme addresses this issue by assigning higher weights to larger companies. This difference could be why KIE has underperformed over the last five years. KBWP was the top gainer, with an 8.51% annualized return through March 2023.

Ten-year returns are equal, while longer-term results favor KIE. I don't think the longer-term results are as relevant, but it's worth noting how KIE recovered from the subprime crisis two years faster than IAK. This recovery speed explains the performance differences described above. Still, the nine other worst drawdowns were similar for the two ETFs. KBWP is excluded because it launched after the subprime crisis in 2011.

Finally, the following chart highlights how the three insurance ETFs have performed relative to the SPDR S&P 500 ETF ( SPY ) since January 2011. KIE and IAK lagged by 1.65% and 1.69% per year, while KBWP beat SPY by annualized 0.26%. As these funds fall into Morningstar's Mid Value company, readers should note how all three easily outperformed the iShares S&P Mid-Cap 400 Value ETF ( IJJ ). You can check additional benchmarks using this link .

KIE Analysis

Performance Attribution Analysis: A Surprising Find

KIE has 14% less exposure to the Property & Casualty Insurance segment than IAK, which we know performed well, so there's every chance it explains the poor returns. A quick way to tell is to complete a simple performance attribution analysis. Ideally, this analysis is done regularly, so the following analysis doesn't account for turnover or weighting changes over the years. However, I only want a general idea of what's happening.

In performance attribution, analysts calculate two figures for each industry:

• allocation effect: measures the portion of excess return attributable to overweighting the better-performing industries
• selection effect: measures the portion of excess return attributable to selecting the better-performing stocks within each industry

In KIE's case, we see a -11.33% allocation effect for the Property & Casualty Insurance industry, confirming my earlier assumption. This industry was the second-best-performing of the six listed, but KIE underweights it by 13%. Underperformance is the logical conclusion. However, the allocation effect for Insurance Brokers fully offsets this negative effect. KIE overweights this segment by 7%, and the Insurance Brokerage securities in IAK delivered a 194% total return. The allocation effects for the other industries were small.

What's most troubling is the -12.03% selection effect, driven in equal parts by poor stock selections in the Life & Health Insurance and Insurance Brokers industries. IAK's Life & Health Insurance stocks gained a weighted average of 78.65% compared to 48.47% for KIE. KIE holds 13 stocks in this industry, with seven performing below par. Here they are, and notice how except for Prudential Financial ( PRU ), all are small- or mid-cap stocks.

For at least this subset of stocks, the equal-weighting scheme didn't work. Smaller companies are typically less profitable and carry more risk. Large-cap companies like Principal Financial Group ( PFG ), Aflac ( AFL ), and MetLife ( MET ) did substantially better.

Fundamental Snapshot By Company

The following table highlights selected fundamental metrics for KIE's top 25 holdings. Summary metrics for KIE, IAK, and KBWP are in the final rows.

KIE's smaller $20 billion weighted average market capitalization translates to a higher five-year beta (0.86) and a lower profitability score (7.07/10). In addition, KIE also trades at a higher forward earnings valuation than IAK (15.16x vs. 14.15x) and has lower estimated sales and earnings growth. Apart from the added diversification, which may only sometimes be beneficial, there isn't an apparent reason to select KIE over IAK using traditional metrics.

The Progressive Impact: Overweight or Equal Weight?

How you view Progressive will likely impact your decision to invest in KIE since it underweights the company by 9.58% and 6.21%, respectively, compared to IAK and KBWP. Last Thursday, Progressive declined 6.71% after it missed consensus Q1 2023 earnings on a surprise spike in its combined ratio.

The combined ratio is calculated by dividing the sum of an insurance company's claim-related losses and expenses by its earned premiums. A ratio below 100% indicates profitability, but markets weren't ready for the figure to spike nine points in March to 106.2. For the quarter, the company-wide combined ratio was 99.0, up 4.5 points from one year prior.

Insurance isn't a smooth-sailing business. Trends are more important than any single month, as are expectations. To illustrate, consider these monthly returns for Progressive after reporting a poor combined ratio (one month lag).

• August 2017: 4.17% (103.8)
• June 2021: -3.01% (100.5)
• August 2021: -6.18% (105.3)
• September 2021: 5.08% (100.1)
• September 2022: 10.58% (116.2)
• March 2023: -4.97% MTD (106.2)

There's no clear pattern. Instead, the reasons behind the numbers are more important. In September 2022, for example, the 116.2 figure was driven by $760 million in catastrophic losses due to Hurricane Ian, accounting for 19.6 points. August 2021 was driven by $342 million in losses related to Hurricane Ida, accounting for 9.7 points. Finally, 12.6 loss ratio points were attributable to Hurricane Harvey in August 2017.

Notably, this recent 106.2 figure occurred early in the year when catastrophic losses caused by hurricanes weren't a factor. The reason provided by management was auto-related, presumably due to increased used-car values. The Manheim Used Vehicle Index was 238.1 in March 2023, representing the change in wholesale used vehicle prices. You can see the pandemic-related spike in the graph below.

The risk is that the cost to repair or replace cars today exceeds the premiums generated. Technology is crucial to that problem, but insurance companies have responded in kind. According to Forbes , the average cost to insure a Tesla Model Y is $3,128 per year, $1,405 more than the Honda CR-V and Subaru Outback. The cost of auto insurance increased by 45% between 2013 and 2022, substantially more than the 29% inflation figure calculated by the Bureau of Labor Statistics.

It's difficult to say whether these premiums are sufficient yet or if car prices will continue to rise. However, larger companies have greater liquidity and can better ride out any storm. Given a choice, it's better to be overweight rather than equal weight Progressive, which IAK does. The recent pullback is most likely a good buying opportunity for a company that, on average, has consistently outperformed SPY over the last 30 years over all holding periods.

New Florida Legislation Favors Larger P&C Insurers

On March 24, 2023, Florida Governor Ron Desantis signed into law House Bill 837 , aimed at decreasing "frivolous lawsuits and prevent predatory practices of trial attorneys." One of the provisions includes making it more difficult for beneficiaries to be reimbursed for legal fees even if their lawsuits against insurance companies succeed. Fewer "bad faith" actors are now less likely to drag out the legal process. Still, another logical consequence is fewer lawsuits in general or those claimants accepting an earlier (and lower) settlement offer to limit legal fees.

The Tampa Bay Times' summarizes that it's now "harder, and more expensive, to sue insurance companies." Furthermore, recent analysis by S&P Global Market Intelligence, large property and casualty insurers in Florida stand to benefit the most. In its report, S&P specifically named Progressive and Allstate ( ALL ), two companies IAK overweights a combined 11.88% over KIE. That should provide a tailwind to an ETF like IAK, making KIE less attractive.

Investment Recommendation

KIE's equal-weight approach, as applied to Life & Health Insurance and Insurance Brokerage companies, was a substantial drag on returns over the last five years. KIE's weighting scheme also assigns too much weight to smaller companies with less liquidity. Auto claims by value are rising with used car prices, and new Florida legislation will primarily favor larger insurers more prominent in market-cap-weighted funds like IAK. Finally, KIE's estimated growth and valuation metrics are the weakest of the three ETFs presented. For these reasons, I don't recommend readers buy KIE, and I look forward to the discussion in the comments section below.

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