A Quick Guide To Investing In Insurance ETFs

insuranceWith QE3 tapering off the table for the time being, the insurance industry – a likely beneficiary of a rising interest rate environment – could see a down phase in the near term as investors foresee a set back in its progression. But the strength that the industry has built up so far should push up the sector ETFs in the long run. So it’s better to look at any short-term price correction pertaining to the no-taper decision as a good entry point.

Before zeroing in on the top ETFs in the sector, let us see how the sector is shaping up for the long run.

The U.S. insurance industry continues to move forward with consistent earnings growth and decelerating combined ratios from most of the primary insurers in the first half of 2013. The expectations for the upcoming quarters also signal optimism. The key driver of this betterment is the improvement in premium rates for over a year, after prolonged softness. Further, favorable reserve development and lower catastrophe losses helped insurers show their potency. (Read: Buy these ETFs for the Brighter Insurance Sector Outlook)

The sector is heading toward a favorable pricing cycle and its near-term outlook for pricing power remains upbeat in the wake of rising demand from economically recovering American households. But a dearth of positive catalysts is delaying the recovery process of the insurers. Among the fundamental challenges, weak underwriting gains and low investment yields stand out.

Catastrophe losses further add to the concerns. Though the industry has not witnessed any severe weather disruption as of now, it is braving the peak of the hurricane season (mid-August to late October). So, any active storm, as severe as last year’s Superstorm Sandy, could cause widespread damage and result in billions of insured losses. Notably, insured property losses due to Sandy were much higher than the average over the last decade.

Though insurers are preparing themselves better to withstand significant losses, increased probability of natural catastrophe will continue to raise concerns. Some analysts expect catastrophic losses to double every 10 years and the pace of capacity buildup by the insurers to be insufficient to withstand the resulting insured losses.

Moreover, international events such as continued debt crisis in the Eurozone and financial issues in emerging markets will further limit the industry’s growth prospects. (Read: Play a Resurgent Europe with These ETFs)

However, the overall health of the industry has improved somewhat in the recent past riding on the ongoing economic recovery, after enduring pricing pressures and reduced insured exposure since the latest recession. Moreover, learning from past experiences, insurers are resorting to expense saving measures to support bottom-line growth.

Rising premium rates should ultimately translate into margin expansion and mitigate the negative impact of the still low interest rate environment on insurers’ investment income. Further, increasing awareness on the risk of catastrophe, strong underwriting discipline and favorable reserve development in the recent quarters should place the industry at least one step ahead.

That said, though the market isn’t soft anymore, it is not likely to harden reasonably until the end of 2013. Moreover, a stressed balance sheet, lack of real employment growth and legislative challenges are threatening insurers’ ability to rebound to the historical growth rate.

Also, limited organic growth opportunities and strict regulatory capital requirements will push the industry more toward consolidation. Insurers are seeking structural economies of scale through mergers and acquisitions to enhance market share. While this will help insurers stay afloat, inter-segment competition will alleviate.

Overall, the industry has been undertaking several structural changes that will make underwriting and pricing schemes more attractive to consumers. Also, improving fundamentals on the back of favorable macroeconomic trends make a number of industry participants appear attractive. (Read: 3 Top Ranked Financial ETFs to Buy Now)

3 Insurance ETFs to Buy Now

While an investor looking to play the insurance sector to benefit from the sector dynamics can directly invest in attractive insurance stocks, an ETF approach can spread out assets among a variety of companies and reduce company-specific risk at nominal cost.

There are only a few choices in this space among which we recommend the following three ETFs that look attractive at this point with a favorable Zacks Rank.

SPDR S&P Insurance ETF (NYSEARCA:KIE)

KIE closely follows the S&P Insurance Select Industry Index, which is an equal weight index. Launched in August 2005, the product manages $357.7 million in assets, which are currently invested in 48 securities.

The product charges a reasonable 35 basis points per year in fees. It currently pays out a decent dividend that yields 2.21%.

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