rising-interest-ratesInterest rates are on the rise, which has placed bank stocks squarely in the spotlight.  Many analysts believe bank stocks will continue to rise if interest rates continue to rise.

There’s already been plenty of share-price appreciation. The SPDR KBW Bank ETF (NYSE: KBE), an inclusive fund of bank stocks, is up 35% year to date.

Despite posting strong gains in 2013, I’m unconvinced banks are the best financial interest-rate play. I say that because I’m unsure how rates will rise. (Anyone honest with himself will acknowledge the same thing.)

If long-term rates rise and short-term rates remain near zero, banks that lend long (mortgage lending, for example) and borrow short will benefit. But if short-term rates rise with long-term rates, many banks will fail to meaningfully improve their net-interest margin.

Banks whose balance sheets are larded with assets sensitive to short-term rates – home-equity loans, credit cards, working-capital lines of credit – could also be left in the dust. If short-term rates fail to rise, so will interest income. Nothing will change.

I prefer to anticipate rising interest rates with insurance stocks. I view these stocks superior to bank stocks for the simple reason that you can be imperfect in soothsaying the interest-rate trend.

Insurance companies earn money not just from selling insurance but from investing premiums received. Premiums generate float – the time between premiums are received and claims must be paid.

This can be a wonderful business paradigm.

When someone pays a premium, money is received upfront. This money sits in a pool – the float – until a claim is paid. Unlike banks, which have to pay for deposits, insurance companies basically have an interest-free source of funds to invest. If short-term rates rise, banks have to pay more for deposits. Insurance companies always pay nothing on float.

I’m particularly keen on property-and-casualty (P&C) insurers. Most P&C insurers allocate their float to bonds and other fixed-income investments. Years of low interest rates have depressed interest income, as well as share price. Rising interest rates would reverse the scenario by allowing insurers to buy higher-yield bonds that will produce higher investment income.

Of course, not all P&C insurers are similarly constructed. Insurers that own a portfolio of long-term maturity bonds will see portfolio values drop materially if long-term rates rise. Insurers that fund operations with a lot of debt will also be hurt. Net interest income will be offset by higher borrowing costs if debt needs to be rolled over at a higher interest rate.

The key is to focus on P&C insurers that carry little debt, own a portfolio of bonds with a reasonably low average maturity, and actually make money underwriting insurance. (Believe it or not, many insurers lose money underwriting insurance.)

I’ve found a P&C insurer that has the potential to generate a high rate of return as interest rates rise. This insurer carries very little long-term debt, owns a portfolio of bonds with a relativity short maturity, and makes money underwriting insurance. What’s more, it’s already a solid income provider. Its dividend – which yields 5% – has been maintained and increased for the past 23 years.

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