By Drew Woodbury
In recent years, the financial results and stock prices of the life insurance companies we cover have been on a roller coaster ride. Heading into the financial crisis, most of these insurers carried significant exposure to the failing financial markets on both sides of their balance sheets. As margins on traditional life insurance products were shrinking, the industry turned to alternative products--including variable annuities--to boost returns. In addition to offering new products, life insurers increased both their balance sheet leverage and their investment portfolio risk in an effort to achieve acceptable returns on equity.
Once considered a stable and consistent business model, nearly all of the life insurance companies that we cover were forced to raise capital during the financial crisis, frequently at prices that were highly dilutive to shareholders. Since then, the balance sheets of these companies have improved significantly, mostly due to the rally in the capital markets and the broader improvement in the economy. Even so, we think this business remains inherently risky, and fundamentally unattractive. With some exceptions, we think long-term investors are best served by steering clear.
During the early part of the decade, many life insurance companies demutualized, which made the industry increasingly competitive. For whole and term life insurance products, the entire industry uses essentially the same actuarial tables to price life insurance, thereby making such insurance a commodity product. The Internet makes it easy for consumers to shop for the lowest price. Lower prices resulted in narrowing margins on these traditional products, which in turn forced industry players to promote new revenue streams--and differentiate themselves--by pushing new products. These new spread-based products included institutional funding contracts and variable annuities. The growth in annuities--in particular those with guaranteed minimum returns--became something of an "arms race" between industry players. As carriers could quickly match the products sold by competitors, the annuities carried increasing benefits and decreasing costs. Annuities fueled a large percentage of the growth in the industry leading up to the crisis and, over time, turned into a significant portion of life insurers' overall business. When the market declined, the guaranteed returns these annuities promised became increasingly burdensome, and placed significant stress on life insurers' liabilities.
While increasing reserves on variable annuity guarantees stressed the liability side of life insurers' balance sheets, falling investment prices hurt the value of its assets during the financial crisis. In an effort to maximize the revenue of its spread-based products--and to augment low returns on traditional life insurance products--most companies bought significant portions of commercial and residential mortgage-backed securities. These securities declined in value, and became increasingly illiquid in the financial crisis, forcing life insurance companies to mark their balance sheets to the traded market value. Price declines became somewhat of a self-fulfilling prophecy, as panicked sellers induced further sales by companies with increasing balance sheet stress.
Since traditional life insurance has a relatively consistent level of annual losses, reserves were thought to be generally stable. Consequently, life insurers believed they could afford to leverage the balance sheet, given that potential stresses were thought to be relatively small compared with other types of insurance companies. Most life insurance companies had equity-to-asset ratios below 10%, which is much lower than the levels above 25% that property-casualty insurers usually carry. This leverage caused stresses to both sides of the balance sheet to have a magnified impact on shareholders equity. During the crisis, life insurers found that the small equity cushions they held were insufficient to buffer against potential losses. Throughout the crisis, nearly all the life insurers we cover were forced to raise capital, often at low prices, which were highly dilutive to existing shareholders.
Especially during the latter part of 2009 financial market improvement--combined with fresh capital-- helped life insurers stabilize their balance sheets. After seeing book values plummet and implied leverage increase during the financial crisis, life insurers now find themselves almost exactly where they were heading into 2008. Still, we believe that the risk to these companies remains elevated and potential investors should treat these stocks with caution. A double-dip recession or a significant decline in the capital markets could send these stocks sharply lower again.
However, these risks are more the symptom than the disease. Fundamentally, we think the life insurance industry suffers from poor competitive dynamics. The commodity nature of their products puts life insurers in a tough spot. New product innovations convey limited benefits, given that they're easily replicated. It is because of their inability to differentiate their product lines that we think the life insurers' incentive to boost returns through increased leverage and risky investment remains persistent.
Also, given the nature of the insurance industry, the negative effects of poor decisions made today might have a delayed impact, thereby setting the stage for unpredictable and nasty future stock price movements. We give many of these companies uncertainty ratings of "high" or "very high" for that reason, which increases the margin of safety that investors should require before considering taking a position. MetLife (MET), Principal Financial (PFG) and Prudential Financial (PRU) carry our "very high" uncertainty rating, while Aflac (AFL) and Manulife (MFC) carry a "high" uncertainty rating.
The lone exception to this group is Torchmark (TMK), which carries our "medium" uncertainty rating. Torchmark has a much larger capital cushion than its peers, as evidenced by its relatively high ratio of equity to assets. At the end of 2009, this ratio stood at 22%, compared to around 10% for many of its life insurance peers. Furthermore, Torchmark makes consistent profits on its underwriting, a rarity in the life insurance group, making it much less likely to assume large risks in its investment portfolio in order to offset low insurance margins. In addition to its medium uncertainty rating, we believe that Torchmark benefits from a narrow economic moat, which protects its business from competition. The firm targets niche distribution channels, including direct sales and a subsidiary dedicated to selling to union members. While many of these channels are small, Torchmark has established itself as the dominant player in these submarkets, and its low-cost advantage helps keep competitors at bay.
We have also awarded Aflac and Principal narrow moat ratings. While classified as a life insurer, most of Aflac's products are supplementary insurance. These products are more easily priced, allowing Aflac to generate a strong underwriting margin. Furthermore, it has a low-cost business model, and a first mover advantage in Japan, allowing it to generate excess returns. Principal, on the other hand, has dug itself a narrow moat by being more of an asset manager and retirement product provider. The firm targets small businesses, a niche with lower penetration levels. It is also able to leverage its life insurance products, and sell to the executives of these small businesses, keeping customers sticky through a large suite of complimentary services. While none of these companies are currently trading at substantial discounts to our fair value estimates, we think that investors should focus on these firms first if considering an investment in the life insurance industry.
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