Acceptance level from the minority shareholders of Great Eastern Holdings G07 (GEH) is creeping up and stands at 89.34% as at June 19. Soon, the 116-year old life insurer will no longer be listed.
Oversea-Chinese Banking Corp (OCBC) is offering $25.60 per share or 0.7x GEH’s embedded value for the GEH shares it does not own. Interestingly, on June 14, Income Insurance announced it is “currently in discussion with Allianz on a transaction relating to the shares of Income Insurance”. Market watchers are expecting anything upwards of 0.9x.
On June 19, Zurich Insurance Company announced the acquisition of a 70% stake in Kotak Mahindra General Insurance Company from Kotak Mahindra Bank for the equivalent of US$670 million ($905 million).
Valuations of insurance companies are interest-rate sensitive. This applies to the value of the in-force business (VIF) used in embedded value (EV) calculations, and the newer contract service margins under IFRS 17.
To keep things simple, based on Milliman’s report focusing on EV which is published every August, it is clear that EV is impacted by a number of factors. Chief amongst these is interest rates.
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Factors affecting EV
Interest rate trends — which in turn are affected by inflation and commodity prices — affect markets, both equities and bonds. Life insurance companies have portfolios of equities and bonds (but mainly bonds) to match the duration of the life insurance policies of their customers.
For instance, the volatility in 2022, in the aftermath of the start of the Ukraine-Russia war, affected equity and bond market valuations globally.
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“Many Asian equity markets experienced large volatility during 2022, with the Indian equity market being the strongest performer in 2022. Most Asian markets experienced sharp declines in the first three quarters of calendar year 2022, due to the Ukraine-Russia conflict and associated supply-side issues, higher interest rates and concerns regarding global inflation. This trend reversed for most Asian markets in 4Q2022, with all Asian equity markets, except Vietnam, registering gains,” Milliman observed in its latest report.
Sometimes, EV can be affected by factors such as changes in the discount rate, an increase in the value of new business (VNB), higher-than-expected returns from the markets, and even a capital infusion, which was the case for Dai-ichi Life, the only insurer reporting EV in Vietnam.
According to the Milliman Report, Taiwanese EV declined in 2022 due to market prices of bonds and equities, an increase in hedging costs (interest rates again) and a decline in new business premium income.
In 2022, insurers in Thailand experienced growth in VNB, which was offset by falls in the market value of fixed-interest securities due to rising yields and modest equity market performance. The upshot was a 7.3% y-o-y growth in the EV of Thai insurers.
According to PriceWaterhouseCoopers (PWC), within an insurance company, EV may be used to determine executive remuneration, analyse profitability of a product or line of business and support capital allocation decisions. External parties, such as rating agencies, analysts and investors, may use the EV to benchmark against other life insurance companies when assessing the financial performance and strength of the company or determining the transfer price in merger and acquisition transactions.
EV comprises shareholders equity plus the VIF which uses a discount rate to obtain a net present value of the cash flows from a bunch of insurance contracts.
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Let’s get technical
Insurance companies moved to IFRS 17 — which introduces the contract service margin or CSM — in 2023.
CSM represents the unearned future shareholders’ profits for a group of insurance contracts. CSM eliminates day one gain and defers profit over the coverage period; however, day one losses are recognised immediately. The amortisation of CSM reflects the insurance contract services rendered during the period under review.
While CSM and the VIF used in EV are different, their values depend on interest rates. For IFRS 17, the discount rate can be determined using either a top-down or bottom-up approach. The top-down approach sounds esoteric; the reference portfolio is adjusted for characteristics that are irrelevant for insurance contracts. The bottom-up approach, which is being increasingly adopted, uses a risk-free discount rate plus an illiquidity premium that reflect liquidity characteristics of the liabilities.
IFRS 17 requires that the latest risk-free rates be used. Allowance for matching adjustment (MA) or illiquidity premium (IP) may be added to the base risk-free rates, depending on eligibility criteria set out by the regulator. For Singapore, this is set out in MAS Notice 133.
Total profits realised over the lifetime of a group of insurance contracts will be the same. However, the basis will affect the timing of profit emergence and potential earning volatility, lessening the volatility.
The risk adjustment under IFRS 17 is the amount of compensation an insurer requires to take on the non-financial risk associated with that insurance contract. This affects the CSM, and a larger risk adjustment means a lower CSM. That is going to have an impact on how profits are going to be released in the future.
A smaller CSM that limits the effect to which CSM can absorb future changes in the value of the fulfilment cash flows over time will also have an impact on profits.
The role of interest rates
The long and short of the EV system and IFRS 17 is that discount rates affect valuation. IFRS 17 equity represents the market value of net assets. “IFRS 17 equity may consist of intangible assets, such as deferred acquisition costs, that are related to the insurance contracts, where the value of most assets is measured based on observable market prices or market variables,” PWC says.
IFRS 17 follows a principle-based approach (i.e. either top-down approach or bottom-up approach) where the discount rates need to be reflective of the cash flow characteristics of the insurance contracts and be based on the latest available market information.
Back to EV. On April 25, representatives from Milliman displayed a P/EV table during GEH’s AGM. According to the presentation based on 2022 data, “most insurers are trading below 1x of P/EV, except for AIA and several insurers in India”, the Milliman representative indicated.
Milliman itself has collated 2022 data including the discount rates used to obtain the various EV (see Table 1). The Milliman representatives at GEH’s AGM may have missed the market’s reaction to these valuations.
Life insurers with more aggressive discount rates traded at lower P/EV multiples, while life insurers such as AIA with very conservative discount rates traded at higher P/EV multiples (see Table 1 and Table 3). Table 1 also shows risk-based capital required by the various regulators.
Going forward, the Federal Reserve has indicated that it is likely to implement at least one rate cut this year. Many market watchers including the local banks are penning in two rate cuts.
The upshot of the rate cuts is likely to lead to lower risk-free rates — which have already started to fall. As such, discount rates, or risk-free rates plus the illiquidity premium, may also start to fall provided that the illiquidity premium does not move. This could cause both VIF in the EV model, and CSM in the IFRS 17 model, to rise such that they may lead to higher EV and CSM-related valuations for life insurers.
More than that, GEH’s 1QFY2024 business updates indicated that total weighted new sales (TWNS) rose 34% y-o-y and new business embedded value (NBEV) rose 21% y-o-y.
Ong Chin Woo, GEH’s activist minority shareholder who has done a lot of research on life insurance companies, says: “OCBC is paying a substantial discount of around 33% for the VIF.” He arrived at this estimation by netting off adjusted shareholders funds and the additional capital requirement.
As for the interest rate cycle, Ong believes that the detailed impact on individual companies can vary greatly. “The computation is complex as there often exist duration mismatches between life policies and investable assets. Additionally, an inverted yield curve is problematic and this is what we are experiencing currently.”
To Wong Hong Sun, GEH’s third largest shareholder, OCBC is acquiring GEH at “trough” valuations, especially in the wake of its 1Q2024 growth in TWNS and NBEV. “There are trough valuations. Interest rates are likely to start falling later this year and that will impact discount rates used in valuing the in-force business of life insurance companies like GEH. As interest rates fall, the value of GEH’s portfolio is likely to rebound and so, probably, will GEH’s value.”
