IAK - Why Insurance Stocks May Warrant A Closer Look

2023-10-18 02:30:00 ET

Summary

• Opportunities in insurance stocks.
• Banks dominate the financial sector, but insurance companies may provide the better option.
• Why investors sometimes overlook insurance stocks.

When it comes to the financial sector the focus tends to be on banks. Benjamin Gossack, Managing Director and Portfolio Manager at TD Asset Management, speaks with Greg Bonnell about potential opportunities with insurance-related stocks.

Greg Bonnell: When it comes to portfolio management, you're going to often hear discussions about the financial sector, or more specifically, the banks. Well, our guest today says investors may be forgetting another part of that sector, the insurance companies. And that could be a mistake.

Ben Gossack, Managing Director Portfolio Manager at TD Asset Management joins us now. Ben, great to have you back on the show. I always love your deep dives on the subject. So financials, people talk about them all the time. They might not be talking about the part you're looking at. Walk us through it.

Benjamin Gossack: Yeah. Thanks for having me back, Greg. We'll probably set the scene. I used to be a bank analyst when I covered stocks. And you just get inundated with bank questions. Even when I'm marketing, people always ask about banks. Rarely do we talk about insurance companies. And when we've gone back and looked at performance of banks versus insurers, the results were actually quite surprising. And there's been persistent outperformance by the insurance sector over banks. And yet this is often overlooked.

Greg Bonnell: I think we can actually show the audience a chart of that, in terms of taking the financial sector, parsing out banks against the insurance companies. So what does this tell us? This is obviously a line that goes up and to the right. But what does the line represent?

Benjamin Gossack: Yeah. Across my chart back, this stands out the most, because it's basically a 45-degree angle from the bottom left-hand corner to the top right-hand corner. But what you're looking at is a fraction. I've taken two ETFs that are managed by Standard and Poor's.

So the numerator for our fraction is the [[KIE]]. This is an insurance ETF that has about 50 insurers. What's nice about both ETFs is that the weights of the individual stocks that make up the ETF are fairly distributed. So I wouldn't say it's equal weight. But it's generally equal weight. So it's not as if one insurer dominates anyone other. And then our denominator is the [[KBE]]. This is the bank ETF. So again, it would have your money centers, regionals, and diversified financials. There are some alternative asset managers, anyone who lends. And there are about 250 companies in that ETF, also fairly distributed.

But it just shows you, and we're going back to 2006, the numerator is just dominating the denominator. And that just shows that insurance companies have been outperforming the banks over this time period.

Just to put that into perspective for people who like to look at these things on a returns basis, over that same time period, we did a total return analysis for those same stocks. And so for insurance, it's been compounding since 2006 at about 7% every year. If you held those banks over that same time period, your compounding is minimal. It's effectively flat. Just again, just to prove and really hammer our point, that people should be spending more time looking at the insurance sector, asking questions, taking a bit of a break. Take a lap from the banks. Let's spend some time in the insurance world.

Greg Bonnell: All right, we have another chart to show the audience too, if you can walk us through this one we were just talking about. So that one chart was showing the disparity. Is this the two ETFs paired off against each other, you were just talking about?

Benjamin Gossack: Yes. And this is what people call comparative return. So we're taking into account the price movement. And we're also taking into account that these companies pay dividends. And so what you get is a total return performance. And what's key for me is that insurance has been compounding at around 7% per annum. But holding those same banks, effectively you're flat since 2006. That's quite challenging, given how much markets move.

Greg Bonnell: Now, banking, obviously, can seem complicated. But from an investment point of view, I've always just thought of it in terms of, they're lending out money. They're also taking deposits. The spread on that is essentially the bank's business. Is part of this here that people don't truly understand? Even though insurance is, if you drive, you've got car insurance. You've got a house, you've got home insurance. You've got possession insurance. But do they really understand how the sector works from an investment point of view?

Benjamin Gossack: Yeah. I think banks are black boxes. But they're somewhat tangible. I mean, think of Christmas movies like It's a Wonderful Life. It's a community bank. It's part of pop culture. And to your point, that income statement -- so I have earnings assets. So I've lent out money. I make a spread on that. And then I have fees. So people are used to overdraft fees or maybe commission fees. I think a bank's income statement is very approachable.

Insurance companies, they don't have storefronts. So you don't drive and see a storefront. All you know about insurance companies are their mascots. So we know Flo from Progressive ( PGR ). We know the duck from Aflac ( AFL ). We know Mayhem from Allstate ( ALL ). But after that, we know we're paying them premiums. But what are they paying out on claims? I think all of that becomes a bit of a mystery. And that's why I think people have found it very confusing, in terms of understanding.

I know what an insurance company does. I need it. I can't, to your point, I can't drive a car off a lot without proof of insurance. And no bank is going to allow me to buy a house and get a mortgage without home insurance. But in terms of what that does in your portfolio and how those stocks perform, I think, has been a mystery to many.

Greg Bonnell: You mentioned some names there, some big American names. What do we need to think about the space globally as well? I mean, there are insurance companies everywhere, really.

Benjamin Gossack: Yeah, so I think we can break down the sector into four categories. Most people would be familiar with life insurance companies because most people probably have a life insurance policy. So you can think of life insurance companies will be collecting premiums and providing annuities to clients. Their liabilities would tend to be longer. And so they would build an investment portfolio that probably matches that. And they tend to get into longer-term private equity commercial real estate-type investments. Again, those are long duration assets.

Most people would be familiar with car insurance and home insurance. Most people would hear that, they call it P&C. So it's property and casualty. So I'm insuring my house. I'm insuring my car. But then I'm also making sure that I'm insuring myself against liability. So did I hit someone? Did someone get injured on my property? You want to be protected from those types of issues.

You'll also have reinsurers. So funny enough, insurers need insurance. And so there's a category of companies that provide insurance to insurance companies. It also helps them to manage their risks. So maybe they wrote a whole bunch of policies in a certain geographic area or to a certain, let's say, type of coverage. They can go to a reinsurer and adjust their exposures.

And then the last category is insurance brokers. People may be familiar going to a mortgage broker or even an insurance broker on an individual level. Companies have all sorts of risks. They need professional services. So you can think of these insurance companies as consultants. And they would help a company like TD Bank or any other company. Whatever your risks, how do we build a strategy and a plan, and then go out and source those insurance products for those companies.

Greg Bonnell: Now, if you go back to the top of the conversation and either throw up either of those two charts that we looked at, the outperformance of insurance versus the banks over that longer time frame. Of course, that is the past. Looking forward, what about some risks? There are always risks to an investment strategy.

Benjamin Gossack: Absolutely. There are risks in terms of owning bank equities. There are a host of risks in owning insurance companies. People should be cognizant that, like banks, insurance companies are levered. As well, there are regulatory issues to consider. What's nice about insurance companies, they tend to reprice their policies. But you have to understand certain regimes and regulatory environments. We're seeing a lot more catastrophes. Some of these secondary order effects. There could be lightning or thunder that has created damage.

And so depending on the jurisdiction you're in, you have to go to the regulator, which is the government, and ask for increases on those premiums. And we've seen some companies exit certain states, whether it be Florida or California because they don't think they can earn a proper return on their capital.

Other issues, interest rates affect-- these companies have investment portfolios. So depending if interest rates are going up or down. The other thing is, insurance tends to have sort of a cyclical nature. So there's a period of time where insurance companies are able to reprice their policies. And stocks tend to do well in those environments. And that's called a hard market. And then conversely, you would have a soft market. And that's where they're having challenges.

Today we had a CPI report for consumers, so our inflation. But insurers also have inflationary costs. So cars have gotten better over time. But when they do get into accidents today, the damage tends to be more severe, lots of electrical components, very expensive. And it used to be people, let's say, it's bumper-to-bumper type stuff. People have more severe crashes. So again, what are the damages involved? And have the policies priced these in? So many insurance companies are seeing a lot of inflation, even-- again, we saw lumber prices go up during COVID. So imagine now we have to insure your house. If there's an issue, we got to rebuild it. Was there enough insurance to cover that?

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