Balance sheets and operating fundamentals are generally healthy, and ROEs are expected to rise over time for life insurers. Stock valuations are at levels that have historically presented an attractive buying opportunity. Opportunities for international expansion through non-organic means would drive future growth for stocks like MetLife Insurance (MET) and Prudential Financial (PRU). We therefore recommend long positions in them and attempt to explore the reasons in the remaining thesis.
Life Insurance Industry Introduction
Life insurers operate on a thin margin between their cost of equity and their return on equity. Some of the factors that have a significant impact on the Life Insurance Industry include:
• Premiums earned: A strong growth in the regions that a particular insurer is concentrating geographically will generate strong top-line growth for the company.
• Margins earned on their investment, which are effected by variations in interest rates and volatility in equity markets.
• The changing regulatory environment.
• Impacts of the unfolding eurozone financial crisis: Investors need to be wary of the current relieved situation after the narrow election victory for Greece's pro-bailout parties and the fact that Germany has signaled that it may be willing to grant Athens more time to meet its fiscal targets to avert a catastrophic euro exit.
• High credit rating: Understandably, consumers want to buy policies from firms that they expect to be around when it comes time to collect. High-quality life insurers also have risk-based capital levels that are generally around twice the minimum level set by the insurer's state regulator.
Future demand for life insurance will largely be driven by the Asian region, especially Japan, where about a quarter of Japan's population is 65 and older, representing a huge market, and from China and India where insurance penetration is low.
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MET's expected ROE of 10.3% by 2013 will largely be driven by its management's strong resolve of international expansion, especially in Japan, and its strong balance sheet. The company has growth potential that the market has yet to fully realize. These are the reasons why we recommend a strong buy.
MetLife, Inc. is the largest life insurer in the U.S. in terms of total assets. Over the recent years MET has focused on growing its core businesses. The company is organized into six segments - Insurance Products, Retirement Products, Corporate Benefit Funding, Auto & Home and Japan and Other International Region. To better reflect its global reach and gain a strong foothold in the emerging markets, MET announced that it will now be reorganizing its business into three broad geographical regions; The Americas being one, Europe another, and the Middle East, Africa (EMEA) and Asia making up the third region.
Revenues and Earnings
MET posted net operating earnings for 1Q2012 of $1.49bn, resulting in an EPS of $1.37 per share, up 10% YoY. However, excluding extraordinary items, the company posted a loss of $94mn, down from $701mn reported net income a year ago. This was mainly due to the $2.0bn losses from derivatives during the quarter, along with investment losses and other items worth $440mn. These losses were partially offset by net income attributable to non-controlling interest of $64mn, income tax benefit of $871mn and income from discontinued operations of $14mn.
Total revenues of $16.69bn reported in the quarter climbed by 6.9% from the previous year, exceeding analyst expectations. Revenues from all sources witnessed growth. Premiums, fee revenues, net investment income and other revenues rose by 6.7%, 9.7%, 6.3% and 4.5% respectively. Growth in premiums was primarily led by the $16.2bn acquisition on ALICO. MET's operating expenses climbed by 6.6% YoY to reach $14.6bn.
The Asia segment remained the biggest operating earnings contributor in 1Q2012. It also witnessed the largest hike.
The Americas segment's operating earnings witnessed a growth of 6.5% YoY and touched $148mn, which was primarily led by solid annuity sales in Chile as well as strong pension sales in Mexico and Argentina. Market factors and claims favorably impacted the operating earnings by $18mn and $8mn respectively.
Operating earnings from the Asia segment were up by 8% QoQ. The impact of favorable changes in foreign exchange rates improved earnings by $6mn compared to the prior year's period. Sales growth in ordinary and universal life products in Japan driven by higher premium, which was partially offset by lower premiums in Hong Kong, improved earnings by another $42mn.
Operating earnings from the EMEA segment declined by 4% QoQ, largely due to unfavorable changes in foreign currencies. Though the segment experienced growth, it still continues to be challenged by the economic environment across Europe.
The Corporate and Other segment generated an operating loss of $68mn, primarily due to lower net investment income, lower earnings from the mortgage loan servicing business and higher corporate expenses.
Balance Sheet Strength
MET's reported book value (including accumulated other comprehensive income) per share escalated 23.5% to $52.94 versus $42.88 at the end of the year-ago quarter. Its book value per share (excluding AOCI) increased 10.8% YoY to $46.21.
Moreover, MET has total investments of $503.94 billion. Cash and cash equivalents surged by 78% to $18.67 billion from $10.46 billion, while total assets increased by 2.9% to $819.60 billion, long-term debt slightly moved down to $23.39 billion and total equity increased by 2% to $59.07 billion from 2011-end. The company has a relatively high proportion of debt when compared to its peers. Its total debt to equity ratio is 100 compared to just 58 for the average industry peer.
MET's price-to-earnings ratio of 5.55x is trading at a significant discount of 76% to its peers. It has a 5-year expected price earnings to growth ratio of 0.52 compared to 0.90 of the average industry peer. This indicates that the potential growth prospects in the future earnings of the company have not been properly incorporated in its stock price. We expect the stock price to appreciate.
Standard and Poor's (S&P) have revised their outlook to stable from negative for MET. The outlook revisions are based on MET's improved consolidated capital position and financial flexibility.
MET, in order to better reflect its global reach and gain a strong foothold in emerging markets, restructured its revenue streams on geographic differences. Going ahead, management estimates revenue to grow by about 20% per year through 2015 in Brazil, Russia, India and China. Revenue growth in the domestic insurance businesses is likely to be weak until employment rates improve. These firms expect MetLife's operating fundamentals to hold up better than most peers, given its large and diversified source of income. However, investors need to be wary of the regulatory delays on two fronts that are creating an overhang on MET's shares and stirring fears that the largest U.S. life insurer may not be able to return more capital to shareholders. If MET is unable to buy back stock, it will result in a cut in expected earnings per share by nearly 5% in 2013.
Based on the above analysis and the drivers for the future performance of the stock, we recommend a long position.
Prudential Financial Inc.
PRU's ROE target of 13-14% by 2013 will largely be driven by the management's strong resolve of international expansion and concentration on the core business. While it will drive top-line growth, the company's strong capital management policies will lead to bottom-line growth. In light of the analysis presented below, we recommend a strong buy.
PRU operates in the U.S., Asia, Europe and Latin America. It is the second largest diversified insurer in the U.S. Its AUM climbed by 9.8% YoY to hit $943 billion as of March 31, 2012, reflecting strong institutional and retail cash inflows.
The company's Financial Services Businesses consist of the U.S. Retirement Solutions and Investment Management, U.S. Individual Life and Group Insurance, and International Insurance divisions and Corporate and Other Operations.
PRU's businesses are impacted by the general economic and market conditions and are sensitive to the pace of and extent of changes in equity markets, interest rates and real estate valuations, as well as the changes in behavior of individuals and institutions that these changes in economic and market conditions may cause.
Revenues and Earnings
PRUS's reported 1Q2012 revenues were $10.7bn, up by 16% YoY, largely due to higher premium earned, policy charge and fee income, net investment income, partially offset by lower management fees.
The company's Financial Services Business reported $829mn of operating losses, translating into a loss per share of $2.09, in sharp contrast with an EPS of $1.0. The reversal in earnings was largely due to $1.5bn of charges relating to adverse movements in foreign currency as well as decline in the market value of derivatives.
The Closed Block Business posted $30 million of operating income, down 6% YoY. This segment consists of life insurance and annuity policies that were issued before the company went public in December 2001, but are still in force. Prudential doesn't offer these policies.
Financial Services Business Segment Review
U.S. Retirement Solutions and Investment Management Division remained the top contributor in operating income with 69% of total operating earnings. It also represents 16% of the total revenues earned by the company during 1Q2012.
Operating income of the U.S. individual life insurance sub-segment surged by 14% from the previous year to reach $112mn. This sub-segment benefited from improved mortality experiences. This hike, however, was offset by the group life insurance sub-segment, which saw a massive decline of 197%. The overall operating income from the U.S. individual and group life insurance division, resultantly, witnessed a decline of 46%.
The International Insurance and Investments Division's operating income decreased by 3.5% YoY to $606mn, due to lower contribution from Gibraltar Life, partially offset by higher income at Life Planners insurance operation.
PRU possesses a very strong capital position, enabling the company to capitalize on business opportunities that come its way. At the same time, management takes a balanced approach to investigate on the businesses and return capital to its shareholders.
The Corporate and Other segment reported a loss of $363mn, largely due to higher interest expenses net of investment income.
PRU's price-to-earnings ratio of 11.9x is trading at a significant discount of 48% to its peers. It has a 5-year expected price earning to growth ratio of 0.51 compared with 0.90 of the average industry peer. This indicates that potential growth prospects in the company's future earnings have not been properly incorporated in its stock price. We expect the stock price to appreciate.
Prudential Financial Life Insurance Company has been rated AA-, A2, and A+ by Standard and Poor's, Moody's and Fitch credit rating agencies.
Drivers for future growth include PRU's international business and its concentration on its core business.
PRU's international business is a driver for strong future growth. The 2011 acquisitions of AIG Star Life Insurance Co., Ltd. and AIG Edison Life Insurance Company from the American International Group, Inc. have the potential to significantly increase PRU's presence in Japan, which is the largest and most successful market of the company outside the United States. Even though PRU has bowed out of the bidding process to buy ING Groep's Asia life insurance, its management has a strong resolve regarding international expansion. PRU also has the potential to gather a large market share in India and China where insurance penetration is low.
Furthermore, Prudential is shedding off its non-core business. Such an action will help the company to focus on its core business even more.
Based on the above analysis and the drivers that will drive future performance of the stock, we recommend a long position.
American International Group (AIG)
AIG is another market player in the U.S. Insurance Industry, and is also serving customers in more than 130 countries. AIG companies are providers of life insurance and retirement services in the United States. The stock is trading at a discounted P/E of 11.7 when compared to its industry. It had an operating margin of 13% as compared to only 7% of the industry peers.
ACE Limited (ACE)
ACE Limited is a holding company of the ACE Group of Companies. ACE is a global insurance and reinsurance organization, serving the needs of customers in more than 170 countries. It offers commercial insurance products and service offerings, such as risk management programs, loss control and engineering and complex claims management. The stock, with a $24.4bn market capitalization, is trading at a discounted P/E of 11x when compared to its industry. It had an operating margin of 18% as compared to only 7% of the industry peers.
Investors can use the Financial ETF (XLF) to hedge the long positions in MET and PRU.