Riding the Fed Higher

While we have no way of knowing for certain when the Federal Reserve will begin hiking interest rates, we all know it’s coming. The minutes from the latest Fed meeting, released earlier this week, showed officials debating an earlier-than-expected move as the employment situation continues to improve and inflation is ticking up. Since rates have nowhere to go but up, Fed Chairwoman Janet Yellen said that her emphasis is “naturally shifting” to when, rather than if, to raise them.

That’s good news for insurance companies, whose shares have generally lagged the broader indexes since the market bottomed in March 2009 precisely because rates have been so low. Instead of sitting on the premiums they collect and hoping for the best, insurance companies invest that cash mainly in highly rated bonds. As a result, their earnings are mostly derived from the spread between their investment returns and what they pay out in claims, known as the float. Needless to say, earnings have been under pressure for more than five years, especially as insurers have been competing fiercely for business.

Chubb Corp (NYSE: CB) is one of the largest property and casualty insurers in the US, collecting more than $11 billion in premiums each year for more than a decade now. In an average year, more than half of Chubb’s net income is made on from the float on its bond portfolio, with about a third coming from its underwriting activities and less than 10 percent from capital gains.

Given Chubb’s reliance on its float, it should be little surprise that its 5-year average net income growth has fallen from more than 20 percent in the aughts to -11.3 percent in 2012 and 5.4 percent last year. Catastrophe losses have also pressured earnings, particularly in the wake of Hurricane Sandy. The company has fared better than most of its competition though, using its rock solid balance sheet primarily to cater to high net worth individuals for their home and auto insurance and who face high switching costs when changing insurers.

The company has had some challenges though, reporting an 8 percent sequential decline in its net income for the second quarter, coming it at $2.03 per share. Chubb’s combined ratio – a measure of profitability made up of incurred losses and expenses dividend by earned premiums – also rose from 88.8 percent to 90 percent on a year-over-year basis largely because of catastrophe losses.

The real drag, though, was a sharp drop off in investment income, falling from $361 million in the same period last year to $345 million as yields on everything from corporate bonds to Treasuries remained compressed. Municipal bonds, which make up about half of the company’s portfolio, have also had their ups and downs so far this year, further impacting portfolio performance.

Those stumbles prompted management to reduce their full-year income per share guidance from between $7.10 and $7.40 to $6.75 to $6.95.

Second quarter earnings weren’t all bad news though, with premium revenue up 5 percent on a constant-currency basis as U.S. premium revenue grew 5 percent and international premiums were up 1 percent. The company expects premiums will continue growing between 2 percent and 4 percent for the full-year, largely in line with the historical average.

The real upside to the recent selloff is the slight boost in yield it has created, taking it up to about 2.2 percent. While net income might be off, that dividend is secure considering the company has a payout ratio of just 27 percent. It has also demonstrated a strong commitment to its dividend, increasing it for 32 consecutive years now, including the worst years of the financial crisis. It has also repurchased about 6 percent of its outstanding shares over the past year.

Chubb has stuck to its tight underwriting standards, resulting in lower insured losses than many of its competitors, since it hasn’t taken on more risk just for the sake of income growth. Thanks to the generally conservative approach management takes, it consistently generates strong returns on both assets and equity than its peers. Return on assets over the trailing 12-months comes in at 4 percent as compared to the industry average of 2.4 percent, while return on equity popped up to 12.8 percent, though its average peer returns just 9.8 percent.

Considering that Chubb continues to show strong premium growth and has a consistent track record of being shareholder friendly, it’s only logical to establish a position now before rising interest rates propel both earnings and market interest in the company. Chubb Corp is a bargain right now up to $100.