The insurance industry entered 2005 gloriously poised to take advantage of positive economic sentiment and potentially spectacular growth in many underserved, emerging markets.
South Africa sits in a unique global position, making it difficult to compare its industry to others. South Africa has the highest life insurance saturation level of any country in the world compared to its gross domestic product. Yet, as a developing country, there is still plenty of growth potential in the market. Nonetheless, by mid-year optimism had given way to alarm as the industry reeled from the repeated rulings against it from the Pension Funds Adjudicator for excessive early termination penalties.
Despite positive results, the industry is struggling to grow life insurance sales as the rulings hang like a pall. When long-term insurer Sanlam declared an 85% increase in headline earnings in its recent interim results, the overall good news could not hide the poor new business growth.
Quite apart from the political fallout of adjudicator Vuyani Ngalwana’s controversial rulings, it has become rather tricky for the average investor to understand the audited results of insurers.
The reason? Most of their earnings come from investment performance — which themselves are accounted for at market values and benefit from the booming JSE — rather than new or annuity business. Investment performance is exceptionally volatile and insurance companies therefore have to be valued in a different way.
“A simple price:earnings ratio would not be relevant to a long-term insurer,” says Rajay Ambekar, analyst at African Harvest. “The markets go up 30% one year and reverse the next, creating highly volatile results which have no bearing on the underlying business performance.”
“Embedded value” is an increasingly popular, alternative measure of insurance company performance. Ambekar argues that embedded value, which is essentially the present value of distributable earnings, is the single best measure of valuing an insurance company.
In part, this is because local statutory and accounting rules are seen as overly complex, arbitrary and often conservative, whereas embedded value is a proxy for the value of the company.
Comparing p:e ratios to embedded value (EV) gives a precise measure of the accuracy of a listed insurer’s share price. According to this measure, says Ambekar, Old Mutual is trading at a 2,5% discount to its EV, Liberty Life a 3% discount, Sanlam 19% and Metropolitan Life 24%.
“This discount reflects the difference between the company’s return on embedded value (ROEV) and its cost of capital — essentially, its efficiency,” he says. If a company’s ROEV is higher than its cost of capital, then the company should trade at a premium to its EV. Most life companies trade at a discount, he adds.
The adjudicator’s rulings concern not so much the efficiency of life companies as the value-for-money proposition of life products. A retirement annuity, says one insurance industry investment analyst, is in fact excellent value if it runs its full term.
South African life companies do not make excessive margins on life products, he says. In fact, Old Mutual’s bid for Skandia revealed that Skandia’s margins are well over 20%, whereas Old Mutual and Sanlam make 12% to 15% on retirement annuity-type products.
Ambekar says these are global norms — high saturation markets operate on margins of about 12 to 15%, whereas high growth markets operate on margins in excess of 20%. A developing country like South Africa should be in the 20% range.
But local margins are currently under pressure, and will continue to be so as the adjudicator’s rulings bring further pressure to bear. “An element of margin will have to be sacrificed to the policyholder,” he says.
When Sanlam declared its results, CEO Johan van Zyl highlighted a 3% decline in new life insurance business flows, but a 14% fall in the company’s embedded value. That’s a far cry from the 85% increase in headline earnings.
Ambekar explains: “When you look at its last results, its operational ROEV was 4%, but when you add investment performance, it adds another 17% for a total of 22%. But only 4% was in operational efficiency — the rest was largely beyond its management control.”
Announcing the results on Classic FM, Van Zyl explained: “There have been shifts in the market — we do not only sell insurance products, we also sell a lot of investment business directly into our asset management. If you look at new business at a whole, it’s 11% up, which is very nice. If we look at the insurance part of what we’ve sold, it’s becoming a shrinking portion.”
It appears new business is starting to be affected by the bad publicity the industry has attracted.
Yet, insurance still accounts for the bulk of insurers’ profit. Despite its move offshore, 78% of Old Mutual’s profit is still generated in South Africa. Insurance contributes 46% of its profit, Nedcor 35%, asset management 8% and Mutual and Federal 11%. The other geographic entities have different balances based on the make-up of the local business: in North America, which contributes 17% of total profit, 50% comes from insurance and 50% from asset management; the UK accounts for 4% of group profit, primarily banking.
Sanlam has interests in Africa, but 95% of its profit originates in South Africa, of which the life business accounts for 73%, Santam 12% and asset management 12%.
Ambekar says the rulings debacle has not affected the revenue of life companies yet, but he expects it to have “quite a negative impact”.