Investing in insurance stocks comes with many large-scale variables ... or so we often think. The business model of an insurance company is rather simple: When something financially bad happens, it pays up. A logical way of thinking would be that the more claims an insurance company has, the more financially pressured it becomes. But is that rationale the best way to decide if insurance stocks are worth your investing dollars?
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The Elephants in the Room
There are two looming issues hovering over the insurance business: One is relatively short term, while the other could have implications for years or decades to come.
The short-term concern is Superstorm Sandy. Sandy ravaged the East Coast, causing billions in damage. The risk-modeling firm Eqecat reports that insurance companies could face between $10 billion and $20 billion in claims.
Insurance analyst Gregory Locraft believes that insurers will see a 26% hit in earnings, forcing him to cut earnings for companies such as Travelers (NYSE:TRV) and Allstate (NYSE:ALL) by 50%.
However, the industry has at least $500 billion on hand to pay claims, and even if the final cost from Superstorm Sandy comes in at the high end of the range, there will be little effect on the industry as a whole.
Insurance companies have done well over the past 10 years. As a result, they had too much capital and that caused a bidding war for customers. As premiums dropped by as much as 60%, insurers started paying out more than they were taking in.
Nevertheless, recent disasters such as the Japan earthquake and tsunami, Hurricane Irene, and now Sandy have given companies a reason to raise rates. As companies began charging more, stock prices rebounded, but many stocks are still undervalued. This is due to an overblown selloff stemming from fears of Sandy.
The longer-term unknown is the Affordable Care Act, or Obamacare as it is better known. Most people do not understand this 2,700-page law well. What is clear is that if the law remains as is, millions of new customers will be in the market for health insurance. That seems like a large profit boost for health insurance providers, but some analysts cannot confirm that at this point.
A story published on Wall St. Cheat Sheet looked at the long-term effects of Massachusetts' individual mandate law, dubbed "RomneyCare." What it found was that people would purchase insurance when their health care costs were high, but drop the coverage once their costs went back down. One report found that a good portion of new enrollees stayed on the policy for less than five months. They elected to pay the tax penalty because it was cheaper. Because of this, premium costs rose and insurance profits fell.
Whether this would be the result under Obamacare is unclear. Not only could the bill still undergo changes before it goes into effect, most analysts admit that the effect on insurance companies is largely unknown at this point.
Because of these unknowns, some health insurers are breaking into overseas markets where there is less regulation and more profit potential. UnitedHealth (NYSE:UNH) recently acquired Brazil-based Amil Participacoes for $4.9 billion to gain international exposure. Cigna (NYSE:CI) and Aetna (NYSE:AET) believe that growth rates higher than peers is a direct result of its international exposure.
So, Should You Buy?
With the effects of Superstorm Sandy now better understood, stocks like Travelers, Berkshire Hathaway, (NYSE:BRK.A, BRK.B) and AFLAC (NYSE:AFL) have caught the eye of investors who are looking for value plays. Health insurance companies still have many unknowns, although international exposure may provide a good hedge against any potential downside to Obamacare.
The Bottom Line
Do not judge insurance stocks by looking at the latest catastrophe. With more than enough capital to cover large disasters, the bigger question may be the effect Washington lawmakers exert and how insurers cope with these changes.
At the time of writing, Tim Parker did not own any shares in any company mentioned in this article.