Insurance: Life Insurance April 4, 2015 Financial Services Sector Stock Rating Market Weight

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1 The Henry Fund Henry B. Tippie School of Management Stuart Hemesath [stuart Insurance: Life Insurance April 4, 2015 Financial Services Sector Stock Rating Market Weight Investment Thesis The investment recommendation is to market weight the life insurance industry. The industry is seeing positive growth drivers in its core operations and overall increased profitability in comparison to 5 year averages, but we do not anticipate an outperformance against the greater market. Drivers of Thesis Relaxed spread compressions through increased interest rates will drive net interest income and profitability for the industry long term, but will devalue the heavily weighted fixed income portfolios in the short term. A refocus on core operations and operating efficiencies has driven down cost structures, improving profitability and strengthening balance sheets. Risk management practices monitoring future underwriting policy standards, exposure to risky asset classes, and expansion into non core businesses have shifted conservatively, minimizing short to mid term risk. With the rapid increase of the US population over 65 years old, life insurers have an opportunity to capitalize on their breadth of annuity and investment products to cater to this demographic. Active life insurance policies continue to grow at a rate of 1.9% over the past 10 years, however, the percentage of the population covered by a life insurance policy continue to decline. Risks to Thesis While insurers remain proactive on risk and liquidity measures, the impact of new financial reform regulations, such as the ability for an insurance company to be classified as too big to fail, remains widely unclear. Despite the US s positive economic outlook, the weakening global economy and political instability in Europe could prevent or postpone domestic rate increases within the investment horizon. SPDR S&P Insurance ETF (KIE) Price Data Current Price $ wk Range $ Historical Return Rates YTD Return 0.07% 1 Year Return 11.42% 3 Year Return 20.01% 5 Year Return 14.50% Key Statistics Three Year Beta 0.93 Dividend Yield 1.81% Price/Earnings (TTM) Price/Earnings (FY1) Price/Sales (TTM) 1.16 Price/Book (TTM) 1.06 Price/Cash Flow (TTM) 4.43 Largest 5 Life Insurers by Market Share Northwestern Mutual 8.1% MetLife Incorporated (MET) 5.7% New York Life Insurance 5.3% Aflac Incorporated (AFL) 4.9% Lincoln National Corp (LNC) 4.6% Insurance Financials S&P P/E ROE EV/EBITDA Source: FactSet % 25% 20% 15% 10% 5% 0% 5% 10% 12 Month Performance Industry Description SPDR S&P Insurance ETF S&P 500 The life insurance industry offers financial services products including term life, whole life, universal life and group life insurance policies as well as long term care, disability insurance and an array of fixed and variable annuity products. Life insurers use various distribution channels to reach clients including captive and independent agents as well as third party brokers and financial advisors. Source: Yahoo Finance F M A M J J A S O N D J Important disclosures appear on the last page of this report.

2 EXECUTIVE SUMMARY The recommendation to market weight the life insurance industry within the financial services sector is driven by a number of factors. We see the interest rate environment favorably improving for the industry which will drive net interest income revenue, which accounted for 21% of the industry s revenue in While the industry depends on higher rates to improve margins long term, it will face several derogatory impacts in the short term. The immediate impact of rising rates will result in a devaluation of an insurers fixed income securities. Premiums on new business written may also decline as the insurer will be able to subsidize premiums through net interest income margins over the term of the product. We do see continued improvements in the cost structure, policy pricing and quality, and overall risk management practices, strengthening the industry moving forward. Many of these improvements are a result of the thin margins insurers have faced since 2009 to stay viable. As insurers strengthen their balance sheets we can expect dividend payouts or share repurchase programs to continue rising. Overall, these impacts will bolster an industry that has underperformed both the financial sector and the S&P 500 index over the past 12 months. The rapid increase in population of retirement age also plays favorably to the industry as we can expect to see a higher volume of annuities and other investment products. This could lead to an expansion of annuity product offerings as insurers compete with other asset managers for these retirement funds. INDUSTRY DESCRIPTION The life and health insurance industry is a large and mature industry consisting of over 800 life insurance companies operating within the US with the top 20 largest providers accounting for nearly 80% of the industry s total assets. In 2013, life insurers managed $5.8 trillion in assets with over $19 trillion in active life insurance policies, up 0.5% from the previous year. 2 There is continuous, competitive pressure from other financial intermediaries offering similar investment products as well as regulation changes and low interest margins making the insurance industry a difficult environment to compete in. Source: S&P Net Vantage Financial Services and Products Life insurers provide traditional life insurance policies such as term life, a policy lasting a specified period, whole life, a policy without expiration combined with an invested savings plan, universal life, a policy allowing the policyholder to use interest to cover premiums, as well as other life policies with additional features to the aforementioned options. 1 Another primary insurance function is long term care and disability insurance. Despite the rising costs of healthcare driving the costs of these products higher, demand remains strong, particularly in long term care for elders in need of a supplement to Medicaid. 4 Life insurers also offer an array of investment products, primarily various annuity options and stable value or guaranteed investment contracts, which cater to their liability driven investment practices. Annuities are also common product offerings within the life insurance industry as the two products durations hedge against one another throughout the payment cycle. Annuities provide variable or fixed income retirement solutions for risk adverse investors and individuals in or approaching retirement. As interest rates rise and individuals continue to approach retirement, we see these products as a key driver for industry growth. The industry in large abandoned variable annuity products after the financial crisis due to losses sustained in the underlying equity markets, but we expect these products to return to meet consumer needs with improved underwriting provisions. Page 2

3 Top 20 Writers of Individual Annuities, 2014 Company Sales ($mm) 1. Jackson National Life 13, AIG Companies 9, Lincoln Financial Group 7, MetLife 7, TIAA-CREF 6, New York Life 5, Prudential 5, AXA US 4, MetLife Annuities 4, Transamerica 4, Pacific Life 3, Nationwide Life 3, Security Benefit Life 2, RiverSource Life Insurance 2, Thrivent Financial 1, American Equity Investments 1, Great American 1, Symetrica Financial 1, MassMutual Life 1, Northwestern Mutual Life 1,245 Source: S&P Net Vantage Asset Groups and Classifications There are generally three groups of asset classes that life insurers hold on their balance sheets. The first, admitted assets, is the group of assets used to meet the liabilities and obligations of policyholders and, for that reason, is the most regulated portion of their invested assets. Given the time horizon of life insurance policies, a majority of these assets are invested in long term bond and fixed income arrangements. As insurers seek higher yields, there has been recent trends to increase alternative assets including commercial real estate and private placements. These higher risk investments require additional capital requirements that insurers must hold on their balance sheets. The second group of assets are referred to as separate accounts and are generally invested assets that are selfdirected by the policy holder or annuitant. Because of this, the policy holder or annuitant bears all the risk of these investments. Separate accounts are separated from admitted assets both on the balance sheet and to regulators insuring liquidity and risk measures are adequate. The third group of assets are troublesome or distressed assets, either in or approaching default. During the credit crisis, this included a significant amount of downgraded corporate debt and defaulting real estate mortgages, both retail and commercial. 2 Source: S&P Net Vantage Profitability Insurance companies categories their revenues into two sources, interest, or investment income, and non interest, or premium and fee incomes. Profitability from investments are a function of the company s net interest income, or the spread between the returns on their investments less the rate or amount owed to the annuitant or policyholder. This interest spread has remained substantially compressed since the Federal Reserve s rate adjustments in 2008, impairing profitability in this space. As the yield curve steepens and the outlook for interest rates begin to show signs of increasing, net interest income does look positive in the mid to long term. While this is positive for long term profitability, insurers will face a collapse in the pricing on bonds in their portfolio. Life insurers will be more heavily impacted than those in the property and casualty business as life insurers hold a much longer duration of fixed income investments, increasing their sensitivity to interest rate changes. 3.00% 2.50% 2.00% 1.50% 1.00% 0.50% 0.00% Treasury Yield Curve 2/3/2015 1m 3m 6m 1y 2y 3y 5y 7y 10y 20y 30y Source: US Department of Treasury Page 3

4 Non interest income, composed of premiums and underwriting fee income, also faced pressure in recent years due to the competitive fee environment of the industry in times of low yielding investment returns. With US markets in a mature state, many of the larger institutions have begun pursuing international growth to broaden and diversify their customer base both in developed and select emerging markets. With the US dollar strengthening, currency risk, or the devaluation of foreign earned income, could prevent insurers from aggressively pursuing such markets in the short term. Some US insurers already have a strong presence in international markets. Aflac, for example, generated 74% of its 2013 revenue from its Japanese business units. In 2013, premiums generated nearly three quarters of the total revenue for the industry. 3 Rising rates will also change the portion of revenues that are derived from premium income. In a healthier interest rate environment life insurers will often write policies with little to no premium as the higher interest income throughout the life of the product would subsidize the insurer s expenses. This kept insurers price competitive while still being profitable s. In addition, the average size of a new policy has decreased to $163,000 in 2012 from a peak of $183,000 in This may be due to the shift and increasing importance of contributing to a 401(K) plan for retirement as companies have continued to move away from defined benefit plans. The funds being allocated to a 401(K) plan may have traditionally been used for life insurance policies. This trend may have a larger impact on younger generations and could be a threat to the industry longterm. Changing Demographics A major driver changing the traditional customer landscape is a shift in demographics within the US. Individuals of retirement age, aged 65 or older, are expected to increase over the next 20 years from 13.7% in 2012 to 16.8% in 2020 and 20.3% in 2030, according to data from the US Census Bureau. 3 The average life expectancy of this group is also on the rise. These factors have caused a significant change in the financial products consumers are requesting, shifting toward retirementbased products from income protection. Reexamining Retirement Source: S&P Net Vantage INDUSTRY TRENDS While the total amount of active life insurance policies has continued to grow, averaging an increase of 1.9% in the past decade, the percentage of the US population covered by a life insurance policy has been on the decline since the There has been a fundamental change in the way many Americans view financing their retirement. Social security, once viewed as a safe source of retirement income in decades past, is continuing to become more uncertain to those starting as well as those nearing retirement. Concurrently, there has been a diminishing amount of employers offering defined benefit plans, shifting employees to define contribution plans, like 401(K) plans, and often requiring the employee to allocate their nest egg across various products and mutual funds. Add to that the continued growth in life expectancy and it becomes evident that the average retirement saver will need an increased sense of awareness of the retirement options available to them. We believe these changes will provide growth opportunities for life insurers as retirees will seek out annuity products to provide supplemental income in the event social security benefits end or decline. Departure and Revamp of Variable Annuities Following the 2008 crisis, insurers quickly realized their underwriting practices on variable annuity (VA) products were overly aggressive and returns would not meet their liability requirements. By late 2009, this led many insurers Page 4

5 to increase pricing levels, add consumer restrictions and scale back on VA products sales as a whole. As net interest margins remained thin, many large insurance companies, including Genworth Financial, Sun Life Financial, Hartford Financial and MetLife, exited the VA business or sold their holdings to other financial firms by While life insurers have yet to re enter this market, we believe insurers will return with a more conservative underwriting approach as customers create a demand for variable rate products. Despite these industry and policy changes, sales of VA s have nearly returned to pre crisis levels amounting to $145 billion in 2013 compared to $184 billion and $156 billion in years 2007 and 2008, respectively, for companies who retained or revamped their annuity product line. 2 While this appears positive, part of this growth could be attributed to a flight to risk adverse investments and further growth at this rate could be overly optimistic. Recovery Following the financial crisis of 2008, the life insurance industry as a whole was downgraded by rating agencies due to liquidity concerns and ties to falling equity prices. The industry reacted by decreasing or cutting dividends and share repurchase programs, raising capital to meet reserves, taking strong cost cutting measures and, in some cases, taking a stronger stance on policy quality. 3 Moving into 2014, life insurers have shown proven strength in their balance sheets and continued share repurchases which predominately resumed in Major buybacks in 2014 include Prudential Financial repurchasing $1 billion of outstanding stock, Hartford Financial repurchasing $500 million and Aflac repurchasing $415 million after also repurchasing $800 million in This activity is progressing concurrently with dividend increases across every major insurer, barring Genworth Financial which hasn t paid a dividend since 2008 and continues to face liquidity issues. Regulation Another topic within the industry is expanding banking overlays from the Dodd Frank Act to all financial institutions, including insurers. This could include increased capital requirements, amplified guidelines for consumer protection, or an increase of overall compliance within the industry adding additional capital and resources within each business unit. It would also be possible for the largest institutions to receive the designation systemically important financial institution (SIFI) or more commonly known as too big to fail. An institution with the SIFI designation would be required to pass stress tests such as those we ve seen within the banking sector. MetLife is currently in discussions with the Financial Stability Oversight Committee to determine if it meets these requirements. 14 This will likely result in significant pressure on the company s stock price and we feel this adds substantial risk to any company large enough to meet the criteria. MARKETS AND COMPETITION Largest Life Insurers by Total Assets, 2014* Company Assets ($mm) P/E P/Book Combined Ratio 1. MetLife 562, Prudential Financial 491, Manulife Financial 252, AIG Companies 247, TIAA-CREF 242, New York Life 237, Hartford Life 213, Northwestern Mutual 202, Lincoln Financial 192, ING North America 187, *Additional metrics provided if publicly available Source: S&P Net Vantage and FactSet As previously mentioned, the competitive landscape in this industry is increasingly strong with the top 20 life and health insurance providers controlling nearly 80% of the US market. These larger firms are able to use their cost efficiencies, brand recognition and vast distribution networks to overcome many of their smaller peers and prevent competitors from entering the market without pre established financial services products. Distribution channels remain one of the largest battle grounds within the industry. Insurers use agents, both independent and captive, as well as direct marketing, internet sales and partnerships in some cases. In the case of agents, insurers may have captive agents who only sell their company s Page 5

6 products, or contracts with independent agents who have access to several of their competitors products and must compete for the best financial solution for the client, often lowest fee for the necessary coverage or payment amount. Key Metrics Price to Book Ratio The price to book ratio (P/Book) holds significant importance in valuating insurance and other financial services companies. The book value, often equal to the shareholders equity, is the value of the company if liquidated. Since the assets on an insurer s balance sheet are predominately securities which can easily be marked to market, this ratio is a solid measure for determining the value of the current trading price. Generally, a price to book ratio under 1.0 is considered underpriced and a ratio over 2.0 is overpriced, ignoring other factors. It could also be a sign of distress. AIG, for example, has the lowest price to book ratio among the sample above but is trading at a price under 4% of its adjusted 2007 highs. MetLife, with a 2014 price to book ratio of 1.0 and P/E well below peer average, would be worth consideration out of this group. Combined Ratio The combined ratio is a profitability measure derived by comparing a company s losses and expenses to its earned premiums for the year. Generally, a ratio under 1.0 means the company is operating at a loss, excluding investment or other supplemental income. This ratio is indicative of an insurance company s underwriting profit and policy quality. Again, looking at the peers above, MetLife has the strongest underwriting performance within the largest peer group. Prudential, presumably, was operating at a loss within its insurance unit in Industry Peer Comparisons Northwestern Mutual The largest life insurer by volume and one of few top 20 insurers mutually owned by its policyholders, Northwestern Mutual competes with a vast network of captive agents with over 350 offices across the US. They boast as being one of the more financially fit insurance firms post crisis based on having minimal exposure to mortgage loans, which depleted many balance sheets in the industry. This led them to produce record setting results in 2012 while many insurers were still recovering. 7 Northwestern Mutual views their mutual ownership structure as their competitive advantage among their peers, paying dividends annually to its shareholders since In 2014 Northwestern Mutual paid a record high $5.2 billion in dividends (5.6% dividend yield) to its policyholders and anticipates paying another $5.5 billion in MetLife The largest life insurer by total assets, MetLife offers a broad range of financial services beyond life and health including property and casualty insurance, employee benefit services, and an array of investment products. With offices in over 60 countries they are among one of the largest and most recognizable financial services companies in the world. 9 In the midst of the recovery and increasing regulations through the Dodd Frank act, MetLife went through a process of refocusing on its core insurance business units after its bank failed the Federal Reserve s stress test and its mortgage servicing arm faced substantial losses. Those business units were each subsequently sold to GE Capital and JP Morgan Chase, respectively. MetLife services a large portion of its customers through corporate and other institutional agreements. Beyond ad campaigns, they rely on independent agents to serve many individual clients. Given MetLife s performance within the key insurance metrics, price to book and combined ratio, it would be worth consideration for further review. Aflac Aflac, headquartered in Columbus, GA, is a leader in providing supplemental health insurance, among other products, in the US and Japan. As mentioned earlier, its Japanese business units amounted to 74% of their annual income in 2013 and state that they serve 1 in every 4 households in Japan. Much of their sales are transacted through sales associates at corporate locations as well as through the use of independent and individual agents. 10 Prudential Financial Prudential offers insurance and investment management services to both retail and institutional clients across offices in over 30 countries, holding more than $2 trillion in life insurance policies. They also manage the largest private placement portfolios in the world with $72 billion Page 6

7 in private assets under management. As mentioned in industry trends, this remains an area of growth for many of its peers due to the higher yields. 11 Prudential relies on third party brokers, independent financial planners and advisors, and banking relationships to serve the majority of their clients. Despite is market share and impact on the life insurance industry, Prudential is trading at significantly high multiples with a poor combined ratio and would not be worth pursuing as an investment opportunity. ECONOMIC OUTLOOK There are three major economic drivers impacting the life insurance industry in the short to long term: demographics, the future of interest rates and consumer spending. Demographics, specifically the role baby boomers will play and how each insurance firm caters to their retirement needs. What we know is that there are a large volume of retirees coming in the next decade, many of which interested in retirement products. If rates return to a historically normal level we foresee a strong demand for traditional annuity products to accommodate risk adverse retirees. If rates remain low, we could see the return of variable annuity products. Regardless, there is a large market for life insurers to capitalize on this opportunity and see continued AUM growth. Percentage of US Population Age 65 and Above increase. This is presumably a result of the poor outlook globally with several countries in the Eurozone concurrently decreasing central bank rates, some with negative short term yields, as well as recent, unfavorable domestic employment data. We foresee the 10 year treasury to finally rise in the fourth quarter of 2015 or early This will drive long term optimism within the industry which will have a direct impact on the earnings of insurance companies. 10 Year US Treasury Yield Source: CNBC US 10 Year Treasury Economic metrics driving consumer confidence and consumer spending, such as GDP growth, unemployment data and consumer pricing index, will also drive the life insurance industry. Strong consumer sentiment will drive consumers to part with surplus assets and invest or contribute to a life or annuity policy. Strong GDP growth will increase income levels and also create jobs, both providing consumers with investable assets. CATALYSTS FOR GROWTH Source: FactSet Population Over 65, U.S. Interest rates are the most significant economic driver impacting the insurance industry. Rates, both short and long term, have remained artificially low for a number of years as a result of the Federal Reserve s monetary policy and quantitative easing measures. Because of this, the net interest margins for insurers remain compressed, hampering the profitability of their fixed income driven portfolios. Despite the US s up trending economic outlook and indicators, the Fed remains hesitant to allow rates to While the post crisis recovery process proved to be anything but easy for many insurance firms, it did create an opportunity for many institutions to take a step back, understand their core business units, and implement cost cutting measures to improve internal efficiencies. Many insurers were becoming increasingly involved in riskier, non core business units, which ultimately proved costly over the long run. This low interest rate environment and refocus on profitability from core business units resulted in revamping or, in some cases, removing many existing product lines, increase prices to compensate for the decreased net investment income, and take stronger stances on risk measures for new business moving forward. These industry changes not only allowed insurance companies to get through the recovery stages, Page 7

8 but also positioned them to perform stronger moving forward. This profitability growth will be seen both in earnings per share and also share repurchase programs. As previously mentioned, investment and retirement products will drive industry growth both short and longterm. Aging demographics will transfer investments from volatile securities to fixed income products which life insurers provide. There is also growth over a longer horizon with younger demographics. With the increased need to rely on an IRA and diminishing confidence in social security, we see long term growth from this demographic as well. Increased rates will also provide growth for life insurers. The rates or payouts their products are able to provide will make them more attractive to consumers driving demand. Increased rates will also provide higher investment returns on their fixed income securities within the investment horizon. INVESTMENT POSITIVES We anticipate seeing stronger net investment interest revenues as long term rates rise and provide expansion in net interest margins. As discussed in growth catalysts, we re seeing more efficiently managed cost structures with a focus on core business units. Many of the non traditional business units were sold at significant losses when liquidity issues arose. While we still expect to see acquisitions for growth, we feel future endeavors will prove to be more conservative and align with the company s core business. Demographics and the retirement of baby boomers create ample opportunity for insurance companies to utilize the breadth of their annuity product lines and see growth in their short term, non interest revenue streams. International expansion remains a large area for growth for many of the larger firms with most already having a global presence. The strengthening dollar will impede on the viability of these expansions and will continue to weaken incomes from foreign business units. KEYS TO MONITOR Interest rates play a significant role in the decision to overweight the life insurance sub sector of financial services and positive Fed announcements are integral to the performance of this industry. Rates, in addition to the overall credit performance of the U.S. economy, will need to be continually monitored to maintain this recommendation. Another event requiring monitoring is earnings announcements among the top 20 publicly traded life insurers and the potential guidance and outlooks their management provides and how that will impact the growth of the industry. CONCLUSION The companies best positioned to deliver shareholder value within the life insurance sub sector are those that have fully recovered from the financial crisis, but still have value. Fundamentally, we need an insurer with a price to book ratio at or below 1.0 with a competitive P/E to industry peers and a combined ratio in the mid 90% range or lower. While the strong dollar can contract international earnings, regional diversification within the investment portfolio could also provide some degree of hedging against a rising rate environment and devaluation domestically. Perhaps most importantly, the company must have strong policy quality and be well positioned to capitalize on the aforementioned demographic growth drivers. INVESTMENT NEGATIVES While the industry anticipates improving interest rates in 2015, it remains unknown how the global economy will stabilize and how the Fed will handle monetary policy moving forward. It would be a blow to the industry and their respective equity prices if rates remained unchanged in Page 8

9 REFERENCES 1. S&P Net Vantage, Insurance: Life & Health Industry Overview, October S&P Net Vantage, Insurance: Life & Health How the Industry Operates, October S&P Net Vantage, Insurance: Life & Health Industry Trends, October Congressional Budget Office, Rising Demand for Long Term Services and Supports for Elderly People, June US Department of Treasury, Resource Center, February 8, Fisher Investments Press, Fisher Investments on Financials, 2012 IMPORTANT DISCLAIMER Henry Fund reports are created by student enrolled in the Applied Securities Management (Henry Fund) program at the University of Iowa s Tippie School of Management. These reports are intended to provide potential employers and other interested parties an example of the analytical skills, investment knowledge, and communication abilities of Henry Fund students. Henry Fund analysts are not registered investment advisors, brokers or officially licensed financial professionals. The investment opinion contained in this report does not represent an offer or solicitation to buy or sell any of the aforementioned securities. Unless otherwise noted, facts and figures included in this report are from publicly available sources. This report is not a complete compilation of data, and its accuracy is not guaranteed. From time to time, the University of Iowa, its faculty, staff, students, or the Henry Fund may hold a financial interest in the companies mentioned in this report. 7. The Wall Street Journal, Quiet Company Thrives in Tough Times, January 10, Northwestern Mutual, Our Commitment to Financial Strength, Wikipedia, MetLife, February 10, Yahoo Finance, Aflac, Company Profile, February 5, Prudential Capital Group, Our Company, February 10, The Wall Street Journal, Economic Forecasting Survey, February 10, US 10 Year Treasury, CNBC, March 10, 2014, MetLife Sues Over Being Named Too Big to Fail, New York Times, January 15, 2015, tofight too big to fail status in court/?_r=0 Page 9