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
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
The impact can be significant. Last month, Travelers
Phasing out products
The low-rate environment is even encouraging some insurers to give up on unprofitable lines of business. MetLife
In addition, low rates themselves discourage customers from buying some insurance products. AIG
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.
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Fool contributor Dan Caplinger hates how confusing insurance policies are. He owns shares of Berkshire Hathaway. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool's disclosure policy ensures that you'll be happy with the way we do business.
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