Insurance companies are still cheap. Property and casualty insurance leaders like American International Group (NYSE:AIG) or The Hartford Financial Services Group (NYSE:HIG) trade at persistently low price-to-book multiples. Artificially low interest rates, thanks to the expansive monetary policy of the Federal Reserve, haven't helped much to awaken investor interest in financial institutions. Yet, with interest rates expected to move up, that might very well change in the near future.
The relevance of interest rates
The level of the prevailing interest rate in an economy is of extraordinary importance for insurance companies, because they invest insurance premiums into (mostly) fixed-income investments. Low interest rates tend to result in low returns from bond investments, which in turn makes investors avoid exposure to financial firms, including insurance companies, during periods of low interest.
Interest rate sensitive investments, like Hartford Financial Services, therefore make a lot of sense when the interest rate outlook is lightening up. Just look at the development of the U.S. real interest rate to see that rates have only one way to go -- up.
The Federal Reserve has already guided for higher interest in its latest Federal Open Market Committee meeting in September by preparing the market for a reduction in its bond buying program. Fewer purchases of mortgage-backed securities and long-term Treasury securities will put upward pressure on interest rates in the near term -- and likely lead to tailwinds for insurance companies, which in turn can expect higher investment returns as a result.
Earnings momentum and improving cost trends
Hartford Financial Services has seen some exciting earnings momentum over the last couple of years, which raises hopes that the insurance company will be able to sustain earnings growth in an environment of stronger economic growth as well.
Hartford Financial Services operates a strong property and casualty business, which brought in a whopping $9.9 billion in premiums last financial year. The majority of premiums originate from Hartford's commercial property and casualty business (63%), which has been an earnings driver over the last couple of quarters, whereas 37% of premiums, or $3.7 billion of premiums, came from its consumer markets business, which includes automobile and homeowner service lines.
Price increases for renewal policies as well as improvements in its combined ratio led to an explosion in Hartford's core earnings in its dominant commercial property and casualty business.
Hartford's commercial property and casualty combined ratio has steadily improved over the last three years and declined from 97.3% in fiscal year 2011 to 93% in fiscal year 2013.
Over the same time period, commercial P&C segment core earnings skyrocketed from just $389 million in fiscal year 2011 to $827 million in fiscal year 2013.
Earnings momentum also extended to Hartford's two other business units: group benefits and mutual funds. Total core earnings grew by a stunning 26% to $1.4 billion from 2012 to 2013 with further momentum in the first six months of 2014. So far, core earnings increased another 4% compared to the first six months of 2013, which makes it likely that Hartford Financial Services will be able to report another instance of year-over-year earnings growth.
The insurance company could further benefit from premium momentum and stronger performance in its commercial business as a result of improving fundamentals in the U.S. economy.
As mentioned in the introduction, insurance companies like Hartford Financial Services are for the most part not exactly investors' favorites just yet, which, on the other hand, makes them interesting investments.
Hartford Financial Services, for instance, still trades at a relatively low valuation compared to its accounting book value. With a 16% discount from book value, Hartford's shares also appear to be cheap in a historical context. Before the financial crisis, for instance, it was not unusual for Hartford to trade at twice the current book value multiple.
The Foolish bottom line
With strong earnings momentum, particularly in its dominant property and casualty business, and a sequentially improving combined ratio, it is difficult to see why Hartford Financial Services continues to trade at such a high discount from its book value. This is especially true if the assumption about a positive effect of rising interest rates on insurer profitability turns out to be correct.
In fact, if its own historical valuation is the benchmark, Hartford Financial Services has a lot of potential to increase its valuation if the U.S. economy continues to expand over the next couple of years.
Kingkarn Amjaroen owns shares of American International Group. The Motley Fool recommends American International Group. The Motley Fool owns shares of American International Group and has the following options: long January 2016 $30 calls on American International Group. Try any of our Foolish newsletter services free for 30 days. 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 Motley Fool has a disclosure policy.