It’s a common investing belief that higher interest rates are a negative for stocks. As the world’s most famous investor Warren Buffett creatively described at the Berkshire Hathaway (NYSE: BRK.B) 2013 annual general meeting, “Interest rates are to asset prices, you know, sort of like gravity is to the apple.” Buffett’s argument was that as interest rates rise, there is a “gravitational pull” on the value of stocks.
The reason for this is that investing is a relative endeavour. The value of one investment is always relative to the other opportunities that an investor can make at any given time. The argument then goes that as interest rates rise, stocks become relatively less attractive compared with bonds and other fixed interest investments, for example.
However, it’s not entirely true that all investments perform poorly in a higher interest rate environment–Berkshire Hathaway included!
Higher Interest Rates = High Inflation?
High interest rates are often the result of a period of high inflation, or large increases in the prices of goods and services. In fact, central banks around the world typically have what is known as a “dual mandate” that involves changing macroeconomic policy to achieve low rates of unemployment and low and stable levels of inflation (this strategy of “inflation targeting” began in New Zealand in 1990 and has since spread around the world to become an accepted norm).
What this means is that if inflation is above the country’s target range, the central bank will likely continue to increase its benchmark interest rate. In Australia, this involves the Reserve Bank of Australia (RBA) increasing the overnight cash rate (OCR) when inflation is above the target range of 2% to 3%. This is designed to raise the cost of debt for both companies and consumers (primarily mortgages), which leads to lower demand for goods and services and therefore lower prices.
There are certain goods and services though, that consumers will continue to buy the same amount of, even with higher prices. These might be essential products (such as medication or spare parts for a car), they might be products that are so cheap that a moderate increase in price does not affect a consumer’s overall budget (potatoes, for example), or the brand might be so strong that a consumer is willing to pay the higher price and sacrifice in other parts of their life (Taylor Swift tickets come to mind).
Buffett explained this concept of “pricing power” to the Financial Crisis Inquiry Commission back in 2011:
“The single most important decision in evaluating a business is pricing power. If you’ve got the power to raise prices without losing business to a competitor, you’ve got a very good business. And if you have to have a prayer session before raising the price by a tenth of a cent, then you’ve got a terrible business.”
Insurance: An Underappreciated Winner…
Another type of business that may not immediately spring to mind, but certainly benefits from higher interest rates, is insurance. The reason for this is what Buffett termed “float” in Berkshire Hathaway’s 2010 letter to shareholders:
“Insurers receive premiums upfront and pay claims later…this collect-now, pay-later model leaves us holding large sums–money we call “float”--that will eventually go to others. Meanwhile, we get to invest this float for Berkshire’s benefit…”
Almost everyone would be familiar with this concept. Whether it’s for health, car, travel, or home & contents insurance, a consumer will receive their invoice at the beginning of the year and pre-pay the premiums for the period of coverage. They will then only receive a benefit or payout from the insurer when they make a claim–which might be months or years in the future (or maybe never, if the insurance company is lucky!).
In the meantime, the insurer benefits from this money sitting in their accounts. When interest rates are low, this benefit is relatively small. But given the rapid rise in interest rates over the past 2 years, it is now becoming a meaningful contributor to insurance companies’ bottom line–remembering that there is no extra cost for the company to have this in a fixed income investment returning 5% compared to a fixed income investment returning 2%!
…With One Condition
The one main proviso for insurance companies benefiting from higher interest rates is that they also profit from the insurance underwriting. Again from Berkshire Hathaway’s 2010 Letter to Shareholders:
“Let me emphasize again that cost-free float is not a result to be expected for the [Property and Casualty insurance] industry as a whole: In most years, premiums have been inadequate to cover claims plus expenses. Consequently, the industry’s overall return on tangible equity has for many decades fallen far short of that achieved by the S&P 500."
The fact that insurance companies have the opportunity to make money from investing the float means that they can often become lax on their underwriting standards. In fact, the insurance industry as a whole is notoriously competitive and generates low levels of profit.
This low level of profitability is particularly important during periods of high inflation because insurance (like banking) is one of just a few industries where the management team doesn’t know the cost of goods sold until years later. What this means is that insurance companies price their policies at a particular date, but will pay claims at a future date where the cost of the claim is likely to be different than at the time they collect the premium–usually higher, especially when there’s a lot of inflation. It’s therefore easy to make the mistake of pricing an insurance policy too low, and losing money on the policy when the company eventually pays out claims.
For investors, this means it’s important to choose insurance investments wisely, focusing on those with consistent underwriting profitability–particularly during periods of higher inflation.
Chubb: A Stalwart of the Insurance Industry
Chubb (NYSE: CB) has an incredible history dating back to 1882 when a father-and-son duo opened a marine insurance business in New York City. It also has an impressive history on the share market delivering on Buffett’s two main insurance criteria: consistent underwriting profits and high returns on tangible equity (Chubb’s return on total equity is lower due to several acquisitions over the years, which have allocated some goodwill and other intangible assets to the company’s equity value). The most recent quarterly results (for Q2 2023) were no exception, with an insurance operating margin of 14.6% (aka a “combined ratio” of 85.4%) and a return on tangible equity of 21.0%--both far above the industry averages. Growth was also strong, with insurance premiums up 16.1% year-on-year (YoY) to $11.95 billion
Chubb is also now beginning to see the boost to profitability from higher interest rates, after more than a decade of earning below its potential. In fact, in 2Q 2023, pre-tax net investment income was a record, increasing 28.9% YoY to $1.24 billion. And in even better news, this investment income should continue to rise as Chubb grows its insurance premiums further, and as parts of Chubb’s bond portfolio mature and the company reinvests the funds at higher rates. This combination of growing insurance premiums, consistent underwriting profitability and higher interest rates can be a real saviour for investors during a period of high inflation and high interest rates.
Disclaimer: Chubb (NYSE: CB) is currently held in TAMIM Fund: Global High Conviction
Markets & Commentary
At TAMIM we are committed to educating investors on how best to manage their retirement futures.
Sign up to receive our weekly newsletter:
TAMIM Asset Management provides general information to help you understand our investment approach. Any financial information we provide is not advice, has not considered your personal circumstances and may not be suitable for you.