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How Investors Should Prepare for More Interest Rate Hikes

In an environment of rising interest rates, cyclical sectors such as energy, materials, industrials, and information technology perform well. This, of course, makes sense; interest rates begin to rise because the economy is becoming stronger, and these economically sensitive sectors benefit from this.

But financials, such as life insurance companies, are also clear beneficiaries when interest rates rise.

Life insurance companies have assets that are primarily financial in nature and are composed of bonds and stocks. Liabilities mostly consist of obligations related to the policies sold to various individuals. These companies invest their revenues and cash flows and pay their obligations with the money made from these investments.

Life insurance companies have high reinvestment risk, as they have high duration liabilities. So when interest rates decline, assets keep getting reinvested at lower and lower rates, which means lower and lower profits. Rising interest rates mean that cash flows will be invested at higher yields, and so the reinvestment risk turns positive.

Although, in recent years, in response to historically low interest rates, life insurance companies have taken steps to lower their sensitivity to interest rates and fluctuations in equities. We have already seen the benefits of this environment in life insurers’ results.

In the fourth quarter of 2016, Manulife Financial Corp (TSX:MFC)(NYSE:MFC) reported better than expected results, and the company continues to raise its dividend; its 2016 11% dividend increase ($0.02 per share) was the third time the company has raised its dividend in the last four years. According to Manulife, a 50-basis-point increase in interest rates doesn’t have an immediate effect on net income, but it does have a longer-term effect and has a meaningful effect on its minimum continuing capital and surplus requirement (MCCSR) ratio.

Great-West Lifeco Inc. (TSX:GWO) also reported better than expected results in its fourth quarter of 2016 and increased its quarterly dividend for the first time since 2015 by 6%.

Similarly, Sun Life Financial Inc. (TSX:SLF)(NYSE:SLF) reported better than expected results and increased its quarterly dividend by 3.7% to $0.42. According to the company, a 50-basis-point increase in interest rates would increase net earnings by $50 million and meaningfully increase the company’s MCCSR ratio.

Life insurance companies are poised to continue to be winners in this environment of rising interest rates. These companies are already benefiting from this dynamic, but it is not too late for investors to get into these stocks and see their portfolios benefit as well.

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Fool contributor Karen Thomas has no position in any stocks mentioned.

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