The Federal Reserve and other central banks risk pushing the global economy into recession followed by prolonged stagnation if they keep raising interest rates.
The United Nations (UN) issued that statement in a report published on October 3, 2022.
The Federal Reserve (the Fed) had already raised its target interest rate five times by then, starting in March. Those hikes pushed the Federal Funds Rate – the rate at which banks lend to each other – from 0.25% to 3.25%.
So the Fed pushed its target rate 13 times higher in the span of less than seven months.
The UN publicly stated that this was an “imprudent gamble”. And many investors joined the chorus. They cursed the Fed up and down because these moves caused the S&P 500 to plunge 15.6%. Many individual stocks fell even harder.
The wailing and gnashing of teeth came from all directions. Except one.
The Fed’s bold moves had one industry smiling profusely. But nobody noticed… because nobody had paid much attention to this industry for years.
Well, it’s time to take notice. This one industry will benefit from the Fed’s rate hikes more than any other.
We’re talking about world-class property and casualty (P&C) insurance.
To understand why P&C companies will do so well in the coming years, we have to understand the business. It sounds boring… but there’s magic hidden within the nuances.
Believe it or not, property and casualty insurance is one of the best businesses in the world. I’ll explain…
P&C is about insuring against property damage and potential casualties. These are uncertain events that may never happen. But if they do, it could be catastrophic for the companies (or individuals) involved.
Therefore, we all buy P&C insurance.
As individuals, this is our homeowners insurance and our car insurance. We buy it and hope we never have to use it.
And the actuarial data shows that we’ll probably get our wish. As tragic as they are, car crashes impact very few people. And it’s even less frequent that somebody’s home burns down.
So the beauty of this business model is that the insurance company gets paid on every policy before it pays any claims. Even better, it may neverhave to pay a claim for a given policy.
If our home doesn’t burn down, the insurance company gets our money without doing anything for us. Same goes if we don’t wreck our car.
This is the exact opposite dynamic from what exists in most other businesses. Most companies need to provide goods and services first. Then they get paid afterwards.
And here’s why this is so powerful…
Insurance companies get to invest the premiums they receive right away. This allows them to constantly grow what’s called “the float”. The float is the difference between premiums collected and the amount of money set aside to satisfy claims.
In other words, the insurance company doesn’t only make money by selling policies. The good companies also make money by investing policy premiums well.
This dynamic is true for all insurance companies. But it’s especially powerful with P&C insurance.
That’s because property and casualty events aren’t frequent. Many policies may never file a claim.
The life insurance industry just doesn’t have the same luxury. Eventually every life insurance policy comes due.
And that’s why blue-chip P&C insurance companies are powerful investment vehicles. They safely compound returns for investors year after year. The best insurance companies essentially print money for their shareholders.
And that’s the key—we only want to invest in the world-class insurance companies. We want to own the best of the best.
That is to say, we are only interested in those companies who underwrite and price their policies well… and have a great track record of growing their float and generating investment income.
Underwriting is the process by which insurance companies evaluate and analyze the risks involved in insuring people and assets. This process determines what an insurance company is willing to insure and at what price.
And they have this down to a science. The top insurance companies know exactly what they are doing.
We have specific analytical metrics we use to determine just how good a company is at underwriting. Looking at these metrics over time paints the picture clear as day – the best companies do a great job at underwriting year after year.
If that’s the case, the other item we need to assess is investment income. How good is a given company at managing its investments and generating additional income?
The better a company is at this, the bigger dividends it can pay investors.
And this is why the P&C industry was beaming when the Fed aggressively raised rates last year. These companies invest primarily in bonds, money market funds, and mortgages—instruments that pay a yield based on interest rates.
So when rates go up, the P&C industry can earn more money on its investments. The higher rates go, the higher the yield. And that means more investment income.
And it’s already happening.
One of my favorite P&C companies just reported its third quarter earnings results. Its net investment income spiked 59.3% year-on-year. And the CEO explicitly said this was due to rising interest rates. Then he added that he expects this trend to continue.
I imagine this CEO thinks pretty highly of the Fed right now. Mr. Powell has at least one friend in the private sector.
And here’s the kicker – the property and casualty industry is largely recession proof.
This industry is resilient… for a simple reason. P&C companies service needs, not wants. Their customers need their products.
Think about it this way – do we cancel our homeowners or car insurance when we want to cut our spending? Nope. Because we can’t.
It’s the same dynamic on the enterprise side.
Large corporations need to insure their buildings, equipment, vehicles, and any other property deemed critical to business operations. They also need liability insurance to protect them from lawsuits. And then US regulations say they must also buy workers’ compensation insurance (workers’ comp) for their employees.
So here we have an industry that’s set to grow its profits and its dividends in the years to come thanks to normalized interest rates… and its products will remain in high demand even during the coming recession. What’s not to love?
The key is to only buy the best companies at the right valuation… and then let them run.
If we do, these world-class insurance companies will print money for us quarter after quarter. Especially if we automatically reinvest our dividends. That’s how we leverage the power of compounding interest.
When it comes to portfolio construction, I think it’s wise to allocate at least 10% of our portfolio into the World-Class Insurance bucket. And I would be comfortable going as high as 15% over time.
There’s a reason why Warren Buffett built his business on the back of world-class insurance. Let’s do the same…
-Joe Withrow
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