The business of uncertainty
Lynn Strongin Dodds takes a look at a sector beset by uncertainty over regulations, profitability and dividends
Although insurance companies were tarred with the same negative brush as their banking brethren in the wake of the Lehman collapse, they have become a favourite among income-hungry investors. However, uncertainty over the forthcoming Solvency II regulations, the prolonged low-interest-rate environment and recent dividend cuts have cast a pall and institutions are advised to be selective.
“For better or worse, insurers are part of the financial sector,” says Patrick Liedtke, head of the financial institutions group for EMEA at BlackRock. “They were caught in the general turmoil but they were not affected in the same way as the banks. They were seen as less risky to invest in, although the de-coupling was only partial. Today, one of the main problems is the incomplete reform of Solvency II which makes it difficult to quantify the impact on the sector.”
Since the financial crisis, banks have suffered more due to fears over the impact of de-leveraging and a contracting economy on their balance sheets. Insurance companies were seen more as a safe haven.
“However, banks have been through a long and painful regulatory process and are recovering, while this is not the case for insurance companies,” notes Nick Anderson, fund manager in Henderson Global Investors’ global equity team. “One reason is because there is more clarity around Basel III and banks are presenting results that reflect the incorporation of the new rules. By contrast, an insurance company does not have the same visibility with Solvency II. The earliest date for implementation is in 2017-18 and that leaves the industry in limbo.”
According to Barrie Cornes, an insurance analyst with Panmure Gordon, insurance stocks are about 20-30% cheaper than their highs before the financial crisis.
“Investors are more comfortable with the life sector now, partly reflecting increased confidence – which has also seen the bank stocks recovering,” he says. “There are still question marks over the impact of Solvency II, however. There is a perception that the rules as originally proposed could have hurt insurers’ medium-term profitability, which is why there was a push back from politicians and the Association of British Insurers.
Solvency II now appears to have been kicked into the long grass but should it re-emerge, the impact on insurers will depend upon their individual business models.”
The rules, which have been in the works for at least a decade, were initially approved by the European Parliament in 2009 with an intended start date of 31 October 2012. Under its Pillars I, II and III, insurance companies in the EU would be directed to calculate capital requirements for their different types of risk, implement a governance framework and conduct public and regulatory reporting, respectively. The aim is to replace a patchwork of local rules in different European insurance markets with harmonised regulations across the region.
However, deadlines have been continually moved mainly due to squabbling over the fine print among member states as well as industry leaders and trade organisations. This is particularly true regarding the proposal that more onerous charges should be applied to life products that guarantee returns to policyholders. According to analysts this could threaten to undermine the business model of life insurers in Germany, where these products are particularly prevalent.
European insurers with large US operations are also concerned that the stricter capital rules will put them at a competitive disadvantage against their American rivals. Late last year, the European Insurance and Occupational Pensions Authority (EIOPA) undertook a study to explore the ramifications. Results should be published by mid-June followed by a report from the European Commission by 12 July 2013.
David Butler, partner and head of global credit research at Rogge Global Partners, thinks that the prospect of Solvency II makes insurance companies a more compelling credit play than an equity play.
“With the advent of Solvency II, European insurers are having to issue new instruments which comply with the new standards and this has resulted in a steady flow of subordinated debt issuance which qualifies as tier-2 debt in the capital structure under the new rules,” he explains. “The yields are very attractive. For example, Munich Re subordinated debt issued last year is trading at around 270bps over bunds, and core Europe senior banks in the low 100s over bunds.”
Although regulation is a key focus, the prolonged low-interest-rates environment is also taking its toll on valuations. Insurers are under pressure to conserve capital and boost profits from underwriting as income from investments – a key source of revenue – dries up. This has led to a spate of dividend cuts, with Spain’s Mapfre Group and Paris-based Euler leading the way. Investors, though, were more shocked by RSA Insurance Group, the former Royal Sun Alliance, historically one of the most generous companies. Its decision in February to slash its full-year dividend payment from 9.16p to 7.3p sent shares tumbling, wiping off £650m (€753m) from the market value of the UK’s largest insurer.
Aviva soon followed suit, cutting from 26p to 19p, stunning the market into a 12% sell-off.
Aviva is undergoing a massive restructuring programme, and sold its US and Spanish divisions at a loss. Some comfort came when Swiss Re, the world’s second largest reinsurer, published its results showing payment of a special dividend of SFr4 per share on top of a 17% rise in its regular payment. This translated into a total of $2.8bn (€2.2m) returned to shareholders in 2012 – almost one-tenth of its market capitalisation.
Views were more mixed on Axa Group, which offered a more modest dividend hike of 4% to €0.72 per share but missed broker forecasts with a 4% drop to €4.2bn in 2012 net profit. Meanwhile, Allianz’s decision to keep its payout steady at €4.50 per share disappointed some investors who had hoped for a small rise.
Despite all this dividend action, Liedtke believes that more attention should be paid to the underlying fundamentals of each company.
“It is important to look at the health of an insurance company, especially its underwriting and investment results,” he says. “This is more important than any payouts. What insurers need to do is look at investing in new asset classes such as emerging market debt, commercial real estate and infrastructure so they can diversify and capture the illiquidity premium.”
Many are already laying the groundwork, if a recent study conducted by BlackRock and the Economist Intelligence Unit is anything to go by. They found that about a third of the 223 respondents, who together represent more than half of the European insurance market as measured by assets under management, planned to cast their nets farther afield into the alternative-investments world. Currently, 64% have their assets in corporate and government bonds, while 15% are in equities.
Alongside diversification of investment portfolios, diversification of insurance markets also gets the thumbs-up from investors. Companies such as Swiss Re, AXA, Generali and Allianz already have, or plan to gain, an emerging markets footprint. A recent study by the Swiss reinsurer shows these countries will continue to be “the main source of premium growth for both non-life and life insurance markets”. In China alone, the demand for insurance services has grown at an annual rate of 32% since the beginning of the century, making the country the third-largest market in the world.
A great deal of uncertainty remains around the regulations facing the insurance industry – but there is no doubt that its potential for growth is also considerable, particularly relative to its ‘peers’ in the banking sector.