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Low interest rates aren't just bad for savers. They also put entire industries at risk.
That may sound counterintuitive, especially given that one of the primary justifications for the Fed's low interest rate policy has been to encourage businesses to borrow and spend. And certainly, some companies have benefited greatly from the low-interest rate environment. IBM (NYSE: IBM ) and Wal-Mart, for instance, were both able to borrow at rates of 1% or less, giving them more cash on their balance sheets without raising their interest expense substantially.
But for every borrower who's getting a great deal on a loan, there's a lender having to accept a smaller return as a consequence. Insurance companies rank among those hardest-hit by the situation, and some insurers are taking tough steps to try to shore up their profitability against the threat that low rates will last for some time to come.
Why insurance companies hate low rates
To understand how interest rates affect insurance companies, you have to consider the industry's business model. Insurance companies accept up-front premium payments in exchange for coverage over a specified period. Often, no loss will occur, and so the insurance companies will be able to count the entire premium as pure profit. Moreover, when an accident or other adverse event does occur, there's often a significant lag time before the company has to pay out a claim.
That gives insurance companies the chance to invest their available reserves, also known as float. Berkshire Hathaway (NYSE: BRK-B ) and Markel (NYSE: MKL ) are notorious for aggressively investing their float for the long term, owning a substantial amount of stocks. But many insurance companies prefer to invest in less volatile assets like bonds. When bond rates are low, the income those insurance companies have come to expect dries up, hurting their bottom line.
The impact can be significant. Last month, Travelers (NYSE: TRV ) estimated that if the company reinvests maturing 10-year bonds, it would earn an average of more than $100 million less per year in interest from 2011 to 2013 than it did in 2010. Hartford Financial (NYSE: HIG ) predicted that interest would plunge $130 million over the next two years if rates stay constant.
Phasing out products
The low-rate environment is even encouraging some insurers to give up on unprofitable lines of business. MetLife (NYSE: MET ) recently announced that it would stop offering long-term care insurance, with low interest rates playing a role in the decision. Even for existing policyholders, low interest rates could force insurance companies to seek higher premiums in the future.
In addition, low rates themselves discourage customers from buying some insurance products. AIG (NYSE: AIG ) said that sales of fixed annuities fell this year, largely because of low interest rates. Until they start moving higher, it may be difficult to raise business.
The silver lining
Although falling rates make it hard for insurance companies to invest new money, they do make the bonds they already own more valuable. That at least strengthens insurance-company balance sheets, which could use the help after suffering during 2008's financial crisis.
Of course, insurance companies are quite familiar with the interest rate cycle, and understand that weathering periods of low rates is just part of their business. They're simply concerned that an artificially sustained low-rate environment could put unusual pressure on their financial condition, straining their ability to do business.
For shareholders in insurance companies, it's important to keep an eye on interest rates and to understand how they'll potentially affect your stock's profitability. Although measures such as quantitative easing may support most stock prices, don't be surprised to see your insurance company stocks go the other direction if interest rates stay low for a long time.
Some stocks have benefited greatly from low rates and should continue to do so in the future. Click here to get The Motley Fool's free report, 5 Stocks the Motley Fool Owns ... and You Should, Too.