Jinda Noipho
The iShares U.S. Insurance ETF (NYSEARCA:IAK) contains broad based exposures to US insurance stocks, both in L&H (life and health) and in P&C (property and casualty). We think that macro factors play in favor of this ETF, particularly the opportunity to establish high yielding reserve portfolios to offset higher capital costs. But the other thing we like about insurance, much in the same vein as why we are looking at tire plays, is that the move to electrification, and the general increases in car sophistication, give automotive insurers pricing power. We expect good growth in automotive insurance, probably ahead of broadly held forecasts.
IAK Breakdown
We’ve covered IAK before. The sectoral exposures are quite different from before however, with P&C exposure much higher now at 68%, L&H at 23%, with less exposure to brokers and multi-line insurance which has been taken up in P&C. We like that development, as it means there is likely more exposure to automotive insurance through the major insurance providers within P&C.
Expense ratio of IAK is 0.4%, which is above the FactSet average of 0.38% among US insurance stock ETFs. That’s a negligible difference from the average, but we do note that it’s a little strange that such a liquid and large category would carry higher running costs, as it shouldn’t be that hard to index to an ETF like this.
Bottom Line
There are a couple of bottom line effects that should be considered with respect to IAK. Let’s begin with the inflation battle and prevailing rates, as the recent core inflation data has come out at levels below expectations and below the 3% mark. There has also been a slowdown in services inflation, albeit together with an increase in the inflation rates for goods.
Our house view that has guided our ETF coverage has been simple: wage growth is still too high and jobs data still to favorable for further wage growth for inflation to calm down. Optimism further undermines Fed policy transmission, as it loosens financial conditions. Finally, inflation expectations are still too high, and expectation of inflation begets actual inflation almost regardless of macroeconomic fundamentals.
This runs contrary to the notion that a cooling core inflation rate signals the end of the inflation battle, and therefore the beginning of cuts. We maintain our view, because we do not believe consumers make decisions based on what’s in the core basket, they make decisions comprehensive of their actual expenses. Core inflation is just a contrivance for the amusement of financial commentators, and we don’t regard it, and ultimately we think it’s not decisive for the Fed either, who are smart enough to realize that rent, food and gas are also very important for inflation expectations. We don’t see evidence that there is sufficient slowdown in these metrics for the inflation battle to be called over. We are still a long way off the 2% policy target and the longer inflation remains above target, the more ingrained the new level becomes and consequently the harder it becomes to actually bring it down to 2%.
That’s not such a bad thing for insurance companies at all, like those in IAK, because it means that longer-term rates may see some upward revision if the markets become disappointed with the aggressive rate cutting schedule they’ve priced in, giving insurance companies the opportunity to take longer duration positions at attractive rates. Indeed, it even lengthens the time that they have to earn great yields on shorter term maturities. This offsets pricing discounts that would happen on account of higher capital costs, making insurance defensive.
However, we feel there is a strong growth angle related to EV and the general increase in the sophistication in cars. While inflation has made repairs of cars more expensive, general increase in the intensity of technology, particularly sensors and others in cars, has also growth the price tags of repair claims. Moreover, the shift from EV, where working with powertrains are more complicated and expensive, also supports this general increase in the cost of fixing cars and also in the premiums. There has been a meaningful increase in insurance pricing rates since the onset of the pandemic in most areas, but it has been larger and more sustained in the large automotive segment. While claims will see secularly growth, if the same proportion of growth can be achieved on the premium side, profits will still grow meaningfully on a secular basis. We feel that these stealth trends go generally unnoticed, same as for tire companies, which are benefiting from faster wear on tires due to cars getting heavier, particularly as EV grows in the mix which are much weightier cars.
The P/E of the IAK is around 15x, which implies some growth but offers earnings yields in line with long-term market averages and consistent with lower growth companies. We think this automotive angle should help insurance work ahead of the general market in terms of growth over longer-term horizons. In addition to the higher financial income that will come in from higher yields in their reserve portfolios, which should actually be a more major and immediate source of incremental growth than the automotive effect, IAK looks attractive at its current P/E.
