Brazilian Auto Insurance

Transcription

1 Equity Research Brazilian Auto Insurance Latin America Insurance, Full Line Sector Note 22 May 2013 The industry's "prisoner's dilemma" could mean that strong Q1 is, unfortunately, unlikely to be the new norm Porto Seguro s and SulAmerica s auto subsidiaries posted excellent operating results a couple of weeks ago. At Porto (where auto is 2/3 of premiums), underwriting results were so good that the stock rose despite missing earnings consensus by 20% (Q1 was hurt by poor financial results). Indeed, results were good across the board for most of the top players, but in our view, this is unlikely to be the new industry norm. Auto insurance industry is a typical example of a prisoner s dilemma Eduardo Rosman Brazil Banco BTG Pactual S.A. eduardo.rosman@btgpactual.com Marcelo Henriques, CFA Brazil Banco BTG Pactual S.A. marcelo.henriques@btgpactual.com We believe Brazil s auto insurance industry is a typical example of a prisoner s dilemma, a paradox that illustrates why two individuals may not cooperate, even if it is in their best interest to do so. Unfortunately, sustained positive pricing dynamics have historically been a rare bird in the auto industry. Competition periodically leads to irrational pricing, hurting the profitability of all market players. Ups and downs of the auto insurance pricing cycle When the industry is profitable (as it is now), with a combined ratio below 100%, insurers usually invest more in auto insurance underwriting. They cut prices to compete for market share, competition drives prices downwards, and underwriting profitability deteriorates. After a phase of falling prices, underwriting losses trigger capital depletion at insurers, who find themselves with no choice but to raise prices and rebuild reserves and capital. Prices thus start rising, and the cycle continues Combined ratios close to 100% + single-digit rates = ROE below 15% Even Porto Seguro, which we consider Brazil s best auto insurance player, was unable to post combined ratios recurrently far from 100% territory. In recent years, Porto s combined ratios have improved, but a lower Selic interest rate was a profitability drag, more than offsetting the benefits of better underwriting margins. That said, we don t see average ROEs for auto insurance players above 15%, which is why we believe Porto, the market leader, is more than fully priced-in at 1.6x P/BV13. What could make us more positive? New regulation could boost growth Though penetration for new cars is already high (~70% of total) in Brazil, total fleet penetration (~30%) has barely changed in recent years, mainly reflecting a very low penetration rate (12%) for older cars. A new regulation enabling insurers to fix vehicles with used auto parts could cut insurance prices by ~20% and drive much faster sector growth. ANALYST CERTIFICATION AND REQUIRED DISCLOSURES BEGIN ON PAGE 11 Banco BTG Pactual S.A. does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision.

2 22 May 2013 page 2 Auto insurance prisoner's dilemma : unfortunately, Q1 is unlikely to be the new norm Porto Seguro s and SulAmerica s auto subsidiaries posted excellent operating results a couple of weeks ago. At Porto (where auto is 2/3 of premiums), underwriting results were so good that the stock rose despite missing earnings consensus by 20% (Q1 was hurt by poor financial results). Porto s and Sula s auto subsidiaries posted excellent operating results a couple of weeks ago Chart 1: Auto Loss Ratios in 1Q13 were the lowest in years 80.0% Chart 2: enabling Porto/Sula to post strong auto underwriting results 70.0% 70.0% 60.0% 60.0% 50.0% 40.0% 1Q08 1Q09 1Q10 1Q11 1Q12 1Q % 1Q09 1Q10 1Q11 1Q12 1Q13 Porto Seguro Auto Loss Ratios Itau Auto Loss Ratio Azul Auto Loss Ratio SulAmerica Auto Loss Ratio Porto Seguro Consolidated Loss Ratio Source: Company reports Source: Company reports Market players said a more rational competitive environment, mainly driven by price hikes and lower theft, mainly explained the auto insurance industry s excellent Q1. But though Q1 was in fact better than market expectations, we believe investors shouldn t see it as the new industry norm. In our view, Brazil s auto insurance industry is a typical example of a prisoner s dilemma, a paradox showing why two individuals may not cooperate even if it is in their best interests to do so. Unfortunately, sustained favorable pricing dynamics have historically been rare in the auto industry. Competition periodically leads to irrational pricing, hurting the profitability of all market players. In general, the auto insurance industry is cyclical, and if investors know how to play the ups and downs they should do well in their stock-picking strategies. But in the current environment of single-digit interest rates, we don t think average ROEs for auto insurance players will top 15%, which is why we believe Porto Seguro, the market leader, is more than fully priced-in at 1.6x P/BV13. But though Q1 was in fact better than we expected, investors shouldn t see it as the new industry norm In our view, Brazil s auto insurance industry is a typical example of a prisoner s dilemma Unfortunately, sustained favorable pricing dynamics have historically been rare in the auto industry

3 22 May 2013 page 3 Q1 was excellent for the auto insurance industry; unfortunately, we don t think it will be recurring As the chart below shows, most auto insurance players posted a good operating performance. The market grew 16% y/y while loss ratios declined 7p.p. in 1Q13, a major improvement, mainly driven as per market players by a more rational competitive environment (mainly driven by price hikes and fewer thefts. The market grew 16% y/y while loss ratios declined 7p.p. in 1Q13, a major improvement Chart 3: A more rational competitive industry posting growth with lower expenses, mainly driven by price hikes and fewer thefts Loss Ratio (%) + Commission (%) Marítima Bradesco Itaú Liberty Allianz HDI Sula Auto Insurance Market Azul Porto Consolidated Porto Seguro Mapfre Tokio Marine Zurich Growth % Source: Susep and company reports Table 1: Across-the-board improvements for the whole industry 1Q13 vs. 1Q12 Comparison Market Share Loss Ratio Commission Market Premiums Variation Variation Variation Share Variation (p.p.) (p.p.) (p.p.) Porto Seguro (Consolidated) 25.7% -1.0 pp 20.0% -8.0 pp -1.0 pp Mapfre 15.7% 0.7 pp 29.0% -6.0 pp -4.0 pp Porto Seguro 13.6% -0.5 pp 21.0% -7.0 pp -1.0 pp SulAmerica 10.3% 0.5 pp 29.0% pp -2.0 pp Bradesco 10.2% -2.6 pp -2.0% -6.0 pp -3.0 pp HDI 7.3% 0.6 pp 34.0% -8.0 pp -1.0 pp Allianz 7.0% 0.3 pp 29.0% 0.0 pp -3.0 pp Itau 6.2% -1.0 pp 6.0% -6.0 pp -1.0 pp Azul 5.8% 0.6 pp 36.0% pp -2.0 pp Liberty 5.5% -0.8 pp 8.0% -8.0 pp -2.0 pp Tokio Marine 3.7% 1.1 pp 75.0% -4.0 pp -6.0 pp Zurich 3.4% 0.9 pp 86.0% 2.0 pp pp Maritima 2.2% - 9.0% -5.0 pp -1.0 pp Market 100.0% % -7.0 pp -2.0 pp Source: Susep and company reports

4 22 May 2013 page 4 Auto insurance prisoner s dilemma set to play out once again The prisoner's dilemma is a classic game theory showing why two individuals may not cooperate even if it is in their best interest to do so. In our view, Brazil s auto insurance industry fits the game s paradigm. Sustained favorable pricing dynamics have historically been a rare bird in the auto industry. Competition periodically leads to irrational pricing, depending on the appetite of foreign players. The auto market is highly competitive with virtually zero differentiation (our view here), as the gaps in underwriting tools and service levels have narrowed dramatically among competitors. In addition, while we see moderate price hikes for the industry in the future, we don t believe auto insurance companies will be able to meaningfully offset lower interest rates. Thus, we think amplified combined ratios will improve slightly but remain high. Auto insurance prisoner's dilemma set to play out Competition periodically leads to irrational pricing, depending on the appetite of foreign players In addition, we don t believe companies will be able to meaningfully offset lower interest rates After years of relative stability, commissions are stubbornly high at ~20%, reflecting the competitive landscape and a dependency on brokerages for distribution. To make things worse, inflation has increased claim costs in recent years (for auto parts, repairs, etc). As the chart below shows, even Porto Seguro, which we consider Brazil s best auto insurance player, was unable to post combined ratios far from 100% territory (when combined ratios = 100%, it means zero underwriting profit). In recent years, combined ratios have improved, meaning a more rational competitive environment. But the lower Selic interest rate has dragged down profitability, more than offsetting the benefits of better underwriting margins. Even Porto, which we consider Brazil s best auto insurance player, was unable to post combined ratios far from 100% territory Chart 4: Auto insurance is cyclical; The industry has been deteriorating 100% Chart 5: Porto s combined ratios stayed very close to 100% in the past 80% 60% 62,2% 65,5% 68,4% 69,3% 67,1% 68,7% 68,2% 40% 20% 0% Loss Ratio Comission Ratio Source: Susep; Data for the auto insurance industry Source: Company reports and BTG Pactual; ~2/3 of Porto s premiums are auto

5 22 May 2013 page 5 Auto insurance industry s pricing cycle Long-term upward trend: GDP growth, inflation and (slowly) expanding penetration have been driving prices upwards over the long term. Falling price phase: When the industry is profitable, with a combined ratio below 100%, insurers invest more money in auto insurance underwriting. They cut prices to compete for market share, competition drives prices downwards, and underwriting profitability deteriorates. Good investment returns also help the process, as they allow insurers to stay profitable despite lower underwriting returns. Trough: After a long phase of falling prices, underwriting losses deplete insurers capital. This point may also coincide with a period of low or negative investment returns (or a lower Selic rate). Insurers have no choice but to raise prices and rebuild reserves and capital, sending prices upwards. Rising price phase: After the trough, there is less capital in the auto insurance industry to support underwriting activities, meaning competition is less intense. Insurers can refocus on underwriting and raise prices to achieve a better combined ratio. As a result, reserves and capital are rebuilt. Peak: Capital returns to high levels, aided by strong underwriting and good investment returns. Competition intensifies, and insurers start cutting prices again to grow market share. Long-term upward trend Falling price phase Trough Rising price phase Peak Chart 6: Auto insurance pricing levels (%) 100% Source: BTG Pactual

6 22 May 2013 page 6 What could make us more positive on auto insurance? New regulations to allow used parts could boost growth Of all the insurance segments in Brazil, auto insurance is definitely one of the most penetrated, which explains its relatively low average annual growth in recent years. That said, Brazil s insurance market as a whole is still underpenetrated, and the auto segment is no exception. Of all the insurance segments in Brazil, auto insurance is definitely one of the most penetrated Chart 7: Average auto annual growth was among the lowest Chart 8: Auto and Health are mature segments: ~43% of total market* Auto * Health 11,3% 12,8% Others, 32.8% Auto, 23.1% P&C (without Homeowner) 13,9% P&C (with Homeowner) Life VGBL 13,9% 16,8% 24,2% 0,0% 5,0% 10,0% 15,0% 20,0% 25,0% 30,0% Average Annual Growth ( ) Saving Bonds, 15.5% Source: Susep / AT Kearney Source: CNSeg *Excluding VGBL/PGBL (data from 2012) Health, 19.4% Property, 9.2% We also note that while penetration for new cars is already high (representing ~70% of total), the penetration for auto insurance in Brazil (~30% of total fleet) has barely changed in years, mainly due to the very low penetration for older cars (only 12%). Chart 9: Insurance penetration is very low, particularly for old cars Chart 10: Auto insurance penetration has barely changed last years 90 30% % 28,2% ,8% 28% 27,4% ,8% 51m 26,1% 26,2% 26% % m % % 0 Total Fleet (million) Insured (million) Penetration (%) < 5 Years > 5 Years Insurance Penetration Light Car Fleet Insured Light Car Fleet Source: Susep / Denatran Source: Porto Seguro / Susep / Denatran As shown in the chart below, auto parts represent one of the main costs of fixing a car. And in Brazil, insurance companies are only allowed to use brand new auto parts to fix insured cars, even cars over 5 years old.

7 22 May 2013 page 7 Chart 11: The high costs of car pasts make it expensive to fix an old car Robbery and Theft; 40% Collision; 60% Total Loss; 45% Partial Loss; 55% Car Parts; 70% Labour ; 30% Source: Porto Seguro That said, the cost of fixing a brand new or very old car is similar. For this reason, the insurance price for an old car typically becomes too expensive, explaining why penetration is so low. Some are trying to convince the government/regulator to allow insurers to fix cars with used parts. According to some players, such a shift could add ~4mn new clients to the insurance industry. The main pushback to this new regulation is that it could boost the frequency of car thefts and create a black market for auto parts in Brazil. The cost of fixing a brand new or very old car is similar. For this reason, the insurance price for an old car typically becomes too expensive, explaining why penetration is so low In a recent presentation, Porto Seguro s management expressed its support for this new regulation. Since auto parts could be 70% cheaper, they believe car insurance prices could drop up to 20%, potentially allowing the sector to grow much faster in the years to come. One way to avoid the creation of a black market in Brazil is to have an entity controlling and certifying used auto parts that could be used in these repairs. As per the company, this new regulation could reduce the frequency of robberies (the number of stolen cars fell 20% in Argentina after a similar law was passed). New regulation enabling insurers to fix vehicles with used auto parts could cut insurance prices by ~20% and drive much faster sector growth

8 22 May 2013 page 8 More about auto insurance: some pluses and minuses Combined ratio is key in the auto insurance industry The combined ratio is the most important ratio in non-life/auto insurance, as it provides an overall measure of underwriting profitability. A 100% combined ratio is the breakeven level for non-life insurance underwriting. A combined ratio below 100% means the insurer is making an underwriting profit, and a combined ratio above 100% means an underwriting loss. A 100% combined ratio is the breakeven level for non-life insurance underwriting Auto insurance is more resilient to economic downturns... The top line growth of auto insurance is positively linked to inflation. Insurers should increase prices along with the value of insured vehicles. But competition can make raising prices difficult, meaning the correlation between pricing trends and inflation is imprecise. The correlation with the business cycle is limited. There is little expansion even in an economic boom, and premium growth is more resilient in a recession. Rather, auto insurance pricing has a cycle of its own, which drives much of the premium growth. The correlation with the business cycle is limited. There is little expansion even in an economic boom, and premium growth is more resilient in a recession Chart 12: Auto insurance is resilient to economic downturns 18% 16% 14% 12% 10% 8% 6% 4% 2% 0% 16% 15% 15% 13% 13% 7% 7% 4% Auto Premiums Growth GDP Growth Avg. Interest Rate (SELIC) 25% 20% 15% 10% 5% 0% -5% Source: Susep and IPEA Due to their nature, commercial lines are inherently more correlated to business cycles than personal cycles. In an economic downturn, businesses reduce expenses, including insurance fees. Companies also limit investment projects, cutting demand for associated insurance. Personal lines (most of auto insurance is personal) are less correlated to economic cycles, as individual consumers have less flexibility to reduce their P&C insurance expenses (such as car insurance or house insurance). They can, however, reduce savings through life insurance, making new life products more cyclical than non-life (i.e. auto). Personal lines (most of auto insurance is personal) are less correlated to economic cycles,

9 22 May 2013 page 9 Auto insurance is already a mature, highly competitive market Brazil s auto insurance industry is, in general, a mature and highly competitive market. Many insurers are willing to compete on price for sustained periods to gain market share, driving general underwriting profitability down. So, even though risk modeling and inflation determine an average level of prices, competition and availability of capital cause prices to fluctuate around the mean. Many insurers are willing to compete on price for sustained periods to gain market share, driving general underwriting profitability down Capital deployed and pricing cycles drive the combined ratio Just as the level of capital deployed drives the pricing cycle, it also drives underwriting cycles. If auto insurance has a healthy combined ratio below 100%, it will attract more capital. When more capital is deployed, prices go down and combined ratios go up. Some insurers then withdraw capital from this market, pushing prices upwards and combined ratios downwards. If we take a longer term view view, pricing cycles are the single most important factor driving the combined ratio: Losses: In addition to large-scale natural and other catastrophes, claims behavior does not change much over the span of a few years, nor do insurers have any influence over catastrophes. Expenses: Insurers cannot change their fixed costs significantly over a short period of time. The change in expenses is rather small relative to the change in prices, so cost-cutting can mitigate the effect of falling prices on profitability but not reverse it. From the above, we can draw non-life underwriting cycles as a parallel to the nonlife pricing cycle: Chart 13: Underwriting cycle and pricing cycle Chart 14: Real price and combined ratio 100% 100% Pricing Underwriting Result Pricing Underwriting Result Source: BTG Pactual Source: BTG Pactual Long-tail and short-tail When an insurance contract is elaborated, loss events can occur at any time. But claims may be filed and settled a few days later, or take years to process. This is basically the main difference between long-tail and short-tail businesses.

10 22 May 2013 page 10 Long-tail means there is a long time interval between the loss event and claim settlement, typically several years. Short-tail, obviously, means the opposite. Motor/auto and property lines are typically short-tail businesses. When a loss event occurs, the policyholder normally files the claim immediately, and the insurer then processes and settles the claim within a few months or even days. For a long-tail policy, it can take years between the loss event, claim filing and final settlement (if there is one). General liabilities and legal expense lines are long-tail insurance. One well-known example of long-tail insurance risk is asbestos-related health issues. Asbestos can cause lung cancer, among other health issues. The loss event occurs during the years the employee was exposed to asbestos, but it would then take years before the disease is diagnosed. It can take several more years, and probably multiple lawsuits, before the worker sees any compensation for asbestos. As such, the tail for asbestos risk may be decades long. For long-tail businesses, insurers must keep large reserves for a long period, as claims may materialize decades later and cause unexpected large losses.

11 22 May 2013 page 11 Required Disclosures This report has been prepared by Banco BTG Pactual S.A. The figures contained in performance charts refer to the past; past performance is not a reliable indicator of future results. BTG Pactual Rating Buy Neutral Sell Definition Coverage *1 IB Services *2 Expected total return 10% above the company s sector average. Expected total return between +10% and -10% the company s sector average. Expected total return 10% below the company s sector average. 46% 50% 49% 49% 5% 11% 1: Percentage of companies under coverage globally within the 12-month rating category. 2: Percentage of companies within the 12-month rating category for which investment banking (IB) services were provided within the past 12 months. Absolute return requirements Besides the abovementioned relative return requirements, the listed absolute return requirements must be followed: a) a Buy rated stock must have an expected total return above 15% b) a Neutral rated stock can not have an expected total return below -5% c) a stock with expected total return above 50% must be rated Buy Analyst Certification Each research analyst primarily responsible for the content of this investment research report, in whole or in part, certifies that: (i) all of the views expressed accurately reflect his or her personal views about those securities or issuers, and such recommendations were elaborated independently, including in relation to Banco BTG Pactual S.A. and/or its affiliates, as the case may be; (ii) no part of his or her compensation was, is, or will be, directly or indirectly, related to any specific recommendations or views contained herein or linked to the price of any of the securities discussed herein. Research analysts contributing to this report who are employed by a non-us Broker dealer are not registered/qualified as research analysts with FINRA and therefore are not subject to the restrictions contained in the FINRA rules on communications with a subject company, public appearances, and trading securities held by a research analyst account. Part of the analyst compensation comes from the profits of Banco BTG Pactual S.A. as a whole and/or its affiliates and, consequently, revenues arisen from transactions held by Banco BTG Pactual S.A. and/or its affiliates. Where applicable, the analyst responsible for this report and certified pursuant to Brazilian regulations will be identified in bold on the first page of this report and will be the first name on the signature list. Statement of Risk Latin American banks/financial companies can be affected by changes in both global and local economic conditions and are also subject to political, interest rate, and foreign exchange risks. Our target prices are highly dependent on the level of country risk. Company Disclosures Company Name Reuters 12-mo rating Price Price date Porto Seguro 1, 2, 4, 6, 10, 18, 19 N.A. Neutral R$ SulAmerica 1, 2, 4, 6, 10, 18, 19 SULA11.SA Neutral R$ Within the past 12 months, Banco BTG Pactual S.A., its affiliates or subsidiaries has received compensation for investment banking services from this company/entity. 2. Banco BTG Pactual S.A, its affiliates or subsidiaries expect to receive or intend to seek compensation for investment banking services and/or products and services other than investment services from this company/entity within the next three months. 4. This company/entity is, or within the past 12 months has been, a client of Banco BTG Pactual S.A., and investment banking services are being, or have been, provided. 6. Banco BTG Pactual S.A. and/or its affiliates receive compensation for any services rendered or presents any commercial relationships with this company, entity or person, entities or funds which represents the same interest of this company/entity. 10. Banco BTG Pactual S.A., its affiliates or subsidiaries makes a market in the securities of this company. 18. As of the end of the month immediately preceding the date of publication of this report, neither Banco BTG Pactual S.A. nor its affiliates or subsidiaries beneficially own 1% or more of any class of common equity securities 19. Neither Banco BTG Pactual S.A. nor its affiliates or subsidiaries have managed or co-managed a public offering of securities for the company within the past 12 months.

12 22 May 2013 page 12 Porto Seguro 30.0 Stock Price (R$) Price Target (R$) Buy Neutral Sell No Rating 22-May Aug Nov Feb May Aug Nov Feb May Aug Nov Feb May-13 Source: BTG Pactual and Economatica. Prices as of 21 May 2013 SulAmerica 30.0 Stock Price (R$) Price Target (R$) Buy Neutral Sell No Rating 22-May Aug Nov Feb May Aug Nov Feb May Aug Nov Feb May-13 Source: BTG Pactual and Economatica. Prices as of 21 May 2013

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