A revival in the life insurance sector

CORONATION OWNS STAKES in both Sanlam and Momentum Metropolitan Holdings (MMH) on behalf of clients. Sanlam has long been a share we wanted to own, but its persistent premium to embedded value (a measure of a life company’s intrinsic value) left little margin of safety. The Covid-19-induced selloff in March hit high-quality and low-quality businesses indiscriminately and provided us with a good entry point to acquire shares in Sanlam below its embedded value. We suspect, however, that readers will find our Sanlam purchase uncontroversial and may be more interested in the thought process behind our MMH stake.

LIFE COMPANY ATTRIBUTES

Life companies may be considered mature and boring, but they have attributes that contribute to their desirability:

• Extensive distribution networks of advisers that are complex to manage and costly to replicate.
• A number of companies faced existential threats from Covid-19, for example, restaurants and landlords. Life companies have large in-force books of business that generate ongoing fees, often based on asset levels (which are driven by stock market levels). This makes them a bit more defensive.
• Tied to this, we believe the JSE offers compelling value at the moment. A strong stock market lifts the asset levels on which fees are earned.
• Above-average returns on equity through the cycle.
• Very strong capital positions designed to withstand 1-in-200-year stress tests. Companies that are inadequately capitalised are often forced into sub-optimal decisions at wrong points in the cycle.

And yet, while the share prices of many domestic shares have recovered meaningfully from their March lows, most life insurers are not trading far off them (Figure 1). We suspect there are two main reasons for this:

• Life companies’ earnings (and to some extent embedded values) were hit very hard this year.
• A dividend mainstay as life companies ceased dividend payments.

Yet these reasons are short term. When the life insurance companies reported their June results this year, markets had not fully recovered. Credit spreads also widened materially. Both factors impact earnings meaningfully (negatively to June), but have already started reversing. Perhaps more importantly, life companies ‘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. For example, MMH assumed its share of 40 000 Covid-19-related deaths and expensed this. The company also assumed that 50% of policyholders requesting premium holidays would lapse, and up to 10% of all other policyholders, too. MMH also expensed this. This resulted in a R1.3 billion knock to embedded value and a R1 billion knock to reported earnings. However, by taking the pain upfront, life companies 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.

MMH

MMH trades at a record 40% discount to embedded value (Figure 2). We find this surprising for three reasons:

• The Covid-19 provision has resulted in a more conservatively stated embedded value.
• Over the last few years, management has made the life and non-life valuations within the embedded value more conservative (effectively using a lower price earnings/discounted cash flow to value their own business).
• The new management team under Hillie Meyer, Jeanette Marais and Risto Ketola has done a good job in turning around the operating performance of the group.

As such, the 40% discount to embedded value is even starker than it first appears, given that the embedded value is far more credible and conservative than it was previously, and the company’s business prospects are brighter.

NEW BROOM UNDERESTIMATED

The last point on the new management team and the operational turnaround warrants further discussion. New management has been in place since early 2018. In our view, the market is not recognising the turnaround currently under way and is adopting a wait-and-see approach. Turnarounds often take time to fully manifest in reported numbers, but we believe there are some very encouraging signs that the market isn’t attaching sufficient weight to.

Some divisions within MMH, such as Employee Benefits and Guardrisk, have historically performed well versus their peers. However, there are also signs that previously lagging divisions are turning around. A driving force behind these improvements is the reintroduction of divisional profit and loss statements, which has boosted divisional management accountability.

• Both Metropolitan and Momentum have been growing their tied agency forces ahead of the broader market, suggesting life insurance agents are starting to view them as attractive places to work. Improved product offerings and service levels to agents support this.
• Metropolitan Life was seen as a likely victim of Old Mutual’s dominance in the entry-level market, as well as Capitec’s entry into funeral product sales. Yet the number of policies that Metropolitan’s advisers sell per week has never been higher – an impressive peak given that this includes the Covid-19 operating environment. Metropolitan’s earnings have remained resilient.
• Momentum Investments has languished relative to its peers, with its platform shunned. A concerted effort to improve service levels and re-engage with the independent financial adviser community has seen a big pickup in platform net flows and a trend of market share losses being reversed.
• Five years ago, MMH had the weakest franchise of the four mature life insurers. We don’t think it’s a stretch to say that the company is now on its way to the no. 2 spot (after Sanlam).

Returns on equity and earnings have started picking up nicely off a low base (figures 3 and 4). We think this trend can continue as the divisional operational improvements continue, given that Covid-19 provisions are now in the base and as loss-making divisions become profitable (if MMH’s new Indian Healthcare Insurance joint venture reaches breakeven, it would result in a R300 million earnings improvement alone).

If management’s internal profit expectations are realised, MMH trades on c. six times two-years-out earnings. We think this is a compelling multiple and provides a large margin of safety. +