The life insurer love affair

Nic Stein

The ongoing economic fallout from lockdown and pandemic will force asset managers and financial advisers to rethink both investment strategies and client portfolios. As we pass the mid-point of the first quarter of 2021, the focus is shifting away from managing extreme market volatility and picking growth stocks to finding and investing in stocks that are cyclical in nature. A cyclical company is sensitive to the overarching business cycle and will see profits and revenues take a hit during periods of economic decline; but recover rapidly as GDP growth resumes. A popular theme is to position equity portfolios to take advantage of the economic growth that is expected as countries make progress towards population immunity and resume ‘normal’ business activity.

A revival for life insurers

Investment analysts are quite positive on the outlook for South Africa’s banks and insurers through the upcoming recovery leg of the business cycle. I thought that our readers, many of whom operate as brokers or financial advisers in the life and non-life insurance markets, would appreciate a slightly different take on the sector. Today, with help from Coronation Fund Managers, we consider the prospects for diversified financial services provider, Momentum Metropolitan Holdings (MMH), through an investment lens. Coronation has taken a stake in the company on behalf of its clients. Nic Stein, a seasoned investment analyst at the asset manager, offered some great insights into why they are betting on a revival in the life insurance sector. 

“Life companies may be considered boring and mature, but there are four attributes that contribute to their desirability,” said Stein. The first is that they operate extensive distribution networks of brokers and financial advisers that are complex to manage and costly to replicate. FAnews loves the acknowledgement of the value that brokers add to the insurance market. Distribution networks create a barrier to entry that protects the dominant brands from new entrants to the market. A second positive is that insurers have greater defensive properties than many other companies. Firms in the hospitality and leisure sector suffered due to Covid-19; but insurers weathered the storm thanks to their large in-force books of business that generate ongoing fees, often based on asset levels. Stein added that the JSE offers compelling value at present and that a strong stock market will lift the asset levels on which these fees are earned. 

Singing the regulator’s praises

The third attribute that gives insurers an edge is that they offer above-average returns on equity throughout the business cycle. Fourthly, they have strong, regulated capital positions designed to withstand one-in-200-year stress tests, such as the pandemic we are currently experiencing. Companies that are inadequately capitalised are often forced into sub-optimal decisions at wrong points in the cycle. Love them or hate them, the scrutiny brought to bear by the Prudential Authority on banks’ and insurers’ solvency is a good thing! “We were surprised that while the prices of many domestic shares have recovered meaningfully from their March 2020 lows, most life insurers were not trading far off them,” said Stein. “We suspect the two main reasons for this valuation lag is that life companies’ earnings were hit very hard last year and that they ceased dividend payments”. 

Asset managers seldom take a short term view on their equity decisions. Coronation pointed out that local life insurers’ results to 30 June 2020 were adversely affected by the financial markets, which had not fully recovered by that time. Another issue is that credit spreads had widened materially through the first half of last year. These factors had a material negative impact on life insurer earnings for the half-year. The good news is both of these constraints have started reversing. “Perhaps more importantly, life insurers front-end loaded the earnings pain caused by Covid-19 by raising provisions for the expected financial impact, and expensing them through their income statements,” said Stein. The term front-end loaded is used here to describe the way in which insurers, like MMH, were quick to account for the likely impact of Covid-19 on their books. By doing so they ensured that their financials presented a worst case scenario for analysts to consider. 

Expensing the worst case lapse scenario

MMH also expensed for the possibility that half of policyholders who had requested premium holidays, and up to 10% of all other policyholders, might lapse their policies. Talk about locking in the worst case! This resulted in a R1.3 billion knock to embedded value and a R1 billion knock to reported earnings, to June 2020. Why, we wondered, would an asset manager add to its stake in a life insurer against this worst case scenario? Stein observed that by taking the pain upfront, life insurers should see 2021 earnings rebound quicker than the typical company. “We would also expect most companies in this sector to resume dividend payments when they report in February and March 2021,” he said. 

The following paragraphs, which make Coronation’s case for buying a stake in MMH, do not constitute financial advice. The asset manager was drawn to the share by the record 40% discount between the then-prevailing share price and its embedded value (EV). “We found this discount surprising for three reasons: The Covid-19 provision has resulted in a more conservatively stated EV; over the last few years, management has made the life and non-life valuations within the EV calculation more conservative; and the company’s business prospects are brighter,” said Stein. He added that the 40% discount to EV appeared overdone given that the calculation was far more credible and conservative than it was previously. 

On new management and turnarounds

The early bird catches the worm, and this could prove the case with Coronation’s early return to the insurance sector. The asset manager argue that the market was taking a wait-and-see approach rather than recognising the turnaround currently underway at MMH. Some divisions within the group, such as Employee Benefits and Guardrisk, are already performing well versus their peers. And there are now signs that previously lagging divisions are turning around too. “A driving force behind these improvements is the reintroduction of divisional profit and loss statements, which have boosted divisional management accountability,” said Stein. It would appear that returns on equity and earnings have also started picking up nicely off a low base. 

Stein argued that this trend will continue alongside divisional operational improvements, especially since Covid-19 provisions are now in the base. An example of the potential in the turnaround is that MMH’s recent Indian Healthcare Insurance joint venture would contribute a R300 million earnings improvement on breakeven. “If management’s internal profit expectations are realised, MMH trades on approximately a six-times, two-years-out earnings ratio,” concluded Stein. “We think this is a compelling multiple that provides us with a large margin of safety”. 

Writer’s thoughts:
It is sometimes difficult to reconcile the views held by different stakeholders in the insurance sector. As we read Coronation’s upbeat assessment of MMH, we wondered whether our readers held similar views. Your view of an insurer derives from your interactions with policyholders and an assessment of your new business vs cancellations, lapses and surrenders. Based on your 2020 experience, do you share Coronation’s upbeat assessment of the life and non-life insurance sectors? Please comment below, interact with us on Twitter at @fanews_online or email us your thoughts [email protected].