Insurance for your Insurance Stocks

For any keen market observer, it is hard to have missed the relative under-performance of the Canadian insurance stocks vs. the Canadian bank stocks. This divergence comes to a surprise to many investors that felt the stocks would rise together in the pronounced bull market. So what could be some of the underlying precipitating factors that could be driving the divergence in performance?

Macro Factors – Interest Rate Trends

In the world of zero interest rates and modest equity returns, insurers have to contend with considerable macro factors that relatively increase sensitivity to their earnings and balance sheets. Given the long duration of actuarial liabilities, there are a decreasing number of similar duration investments offering the yields necessary to not create company risk.

What if the broad consensus of higher interest rates is proven to be premature? What if the recent declines in interest rates, driven by pending new QE programs in the Euro zone, leads to a new pronounced decline in interest rates? Will the insurance stocks wear the lepers’ bell in fear that that current valuations were simply pricing in an unrealistic Goldilocks economy?

Technical Vulnerability

Unlike the resounding uptrend that many Canadian Bank stocks share, the insurance stocks are lagging and on the verge of breaking the 2014 year lows. If the insurance stocks technically break, it could lead to new selling pressure that could drive short-term weakness.

The first instinct is for an existing investor to respond two ways: either they immediately fall back to rationalizing that they are long-term investors and that everything will be fine over the long-term. The alternative reaction is for someone to rush to sell the insurance stocks and reinvest into another sector. I would like to debate a 3rd alternative of creating a short-term hedge using a put.

For this example, we will use Manulife (TSX:MFC)

• Manulife made its year high on January 22^nd at $22.22 CAD.
• Manulife is trading near its year low at $20.00.
• At its lows in 2013, Manulife traded in the $14.00 range.

While the optimist will suggest that the stock may continue to appreciate, the pessimist will be quick to observe that there remains vulnerability for the stock to decline towards its 2013 trading ranges. The question to be debated – does the potential profit opportunity outweigh the downside risks? An investor utilizing a protective put can let the market make that decision for them.

Example of investor utilizing a protective put on Manulife:

• Investor owns 1000 shares ($20,000) of Manulife (currently $20.00 May 28^th)
• Investor is concerned about the short term technical weakness and relative under-performance.
• Investor buys 10 July $20.00 put options for $0.50 or $500.00

The investor now has created a short-term plan to deal with the long-term. The investor with the protective put has now been able to remove the risk of an immediate technical breakdown as they have secured a guaranteed exit price at $20.00 until July 18^th. Now if Manulife was to technically break, the investor can exercise their right and sell the underlying at $20.00. Alternatively, if Manulife was to be able to turn bullish and begin an advance back toward the 52 week highs, the investor can continue to own the stock and let the protection expire. Some investors may find this a reasonable alternative to having to make an immediate sell or hold decision.