Picture from China.org.cn
China Life Insurance (LFC) Company is the largest commercial insurance group in Mainland China. It is largely state-owned (only 30% free-float) and it is one of the biggest institutional investors in China's capital market.
The stock trades in 3 different exchanges (Shanghai Stock Exchange in RMB as A-share, Hong Kong Stock Exchange in HKD, and NYSE in USD as ADRs), with different volumes and premiums.
- Net Profit after Taxes down 67% y-o-y.
- New Business Volumes up 50%, driven by aggressive recruitment.
- Improved product-mix at Bancassurance.
- Negative trading result, (-93.42% Net realized Gains on financial Assets vs 1H 15, -153.24% fair value gains through Profit / Loss vs 1H 15).
- Net investment yield held up despite decreasing interest rate.
LFC price since October 2015.
Aggressive Recruitment: good volumes but discipline is needed.
In 2015 the company hired 236000 new agents, bringing the individual channel work-force to 979000 (+31.8% vs. 2014). This strong recruitment is driving the volumes growth; however the number of agents with less than 2-year experience in the company is now about 300000, making future efficiency and productivity questionable. The underlying quality of earnings seems to decline, as commitment of new agents and agency management might become a key issue for profit margin in the future. At the moment the average annual productivity is 55719 new written premiums per agent.
Data from company reports. Author's own elaboration.
The big question is whether the economies of scale arising from a bigger work-force will offset the higher agency costs arising from managing such a remarkable growth. It is important to highlight that agents represent the biggest distribution channel, accounting for 62% of written premiums, and this is the reason why they are at the core of the company's growth strategy.
Data from company reports. Author's own elaboration.
Furthermore, assuming stable commitment and productivity of agents over time, the achievable growth of written premiums is really remarkable.
New Product Mix: Increasing the regular-payment products.
Last year, China Life Insurance sold 29 billions of 4% guaranteed return saving products (regular-payment products which last several years). As long as the income yield does not fall dramatically, these products should help to sustain profitability in the future.
Data from company reports. Author's own elaboration.
Negative Trading Result in 1H 16, but Investment yield still up.
Market movements affected total investment yield (4.36% in 1H 16 vs. 9.34% in 1H 15). Nevertheless, although corporate credit spreads are approaching 100bps and 10-year government yield is below 3%, the net investment income was at the same level of last year (4.68% in 1H 16 vs. 4.65% in 1H 15).
Data from company reports. Author's own elaboration.
Furthermore, it is important to point out that, should the interest rate decrease further, there is still some space to increase the alternative investments allocation, as we can see happening in European insurance sector.
Data from company reports. Author's own elaboration.
Considering the negative trading result, a 4.5% target seems reasonable for this year, excluding dramatic corrections in the market. However for the medium term, as bonds in the portfolio mature, that target will likely become less sustainable.
Data from company reports. Author's own elaboration.
Finally, it is important to remember, that the company is vulnerable to volatile investment returns, especially an A-shares drop could affect the investment result significantly.
Fee-based products might help to overcome low interest rate environment.
It is also important to notice that, in order to overcome a low interest rate environment, the company could launch new fees-based products as European life insurers are doing. These products would imply an approach more similar to the asset management business rather than traditional life insurance. Such strategy would make the company less vulnerable to low interest rate, improving the underlying quality of earnings.
Bottom Line
China Life Insurance represents a very interesting investment case, it is characterized by many moving parts, some already seen in other markets, some specific of emerging markets.
First of all, the growth strategy is a big challenge, as it demands proper training, strong discipline, motivating compensation schemes, and superior management capabilities. It is likely that such growth in business volumes will trigger some economies of scale mechanisms, but it is equally likely that such a fast growth will imply additional costs and inefficiencies.
On the other hand, one could argue that there is no advantage in having large volumes if the margin is deteriorating. More specifically, the investment result plays a huge role in characterizing earnings quality. Potentially, should the investment result be poor, an insurance company could increase profit just reducing new written premiums. Of course, we are far away from this scenario, nevertheless the low interest rate is clearly eroding the profit margin. A key issue in determining the company's success, as investment yield decreases, will be the ability to increase fee-based revenue share. Doing so, the company will be able to become less vulnerable to low interest rates.
Although FY 16 EPS will probably be down due to the poor trading result, assuming stable payout policy, the stock should provide a 2.5%-3.0% dividend yield.
Data from company reports. Author's own elaboration.
In conclusion, assuming no major corrections in the stock market, based on reasonable assumptions and on a DCF-methodology, the 12-month price target is 23.5 HKD, offering a 15% upside potential. That would imply a similar upside potential for the ADRs traded on the NYSE, with a price target around 15.5 USD (note that ADRs are affected not only by fundamentals, but also from other factors such as liquidity, Fx movements and so on).
The solvency ratio is about 330%, largely above the minimum level required by the regulator. According to the base scenario, as interest rate decreases, assets should inflate, implying a stable solvency ratio over the next years.
Data from company reports. Author's own elaboration.
Major downside risks.
- Volatile investment returns, especially A-share drop, may affect the investment result.
- Declining interest rate in China.
- Decrease in agents' productivity and inefficiencies of agency management.
- Changes in regulation affecting Chinese insurers (Premium deregulation).
- Declining premiums growth, due to market saturation.
Major upside risks.
- Good stock market performance, especially A-share rally, might improve the investment result.
- Strong discipline in underwriting and in agency management.
- Strong growth driven by the aggressive recruitment.
- Improvements due to digitalization initiatives.
Appendix
Profit & Loss
Data from company reports. Author's own elaboration.
Balance Sheet
Data from company reports. Author's own elaboration.
Data from company reports. Author's own elaboration.
Data from company reports. Author's own elaboration.
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