Earlier this year, I was invited by China Capital Week to write an article discussing the hot topics about the Chinese insurance market. My research found that due to the significant growth in the market as well as the increasing complexity of products, regulation and economic environment, lots of investors did not have a deep understanding about insurance business, meaning that investment decisions were mainly driven by disclosed accounting measurements.
The aim of this blog is to provide a brief introduction to the standard valuation methodology for insurance companies, its limitations and why investors shouldn’t overly rely on the valuation.
Valuation of the Chinese insurance market
In Q2-Q3 last year, although the major banks in China announced their consistently improving profitability, the valuation for most of their shares deteriorated to an historical low. The average P/B (price to book value) was lower than 1 while the lowest of the stocks had reached 0.7 times P/B, below the liquidation value. The same phenomenon appeared in a lot of European and US bank valuations in 2008-2009 due to the credit contagion and concerns that unprecedented losses could deepen due to immense bad debts on their balance sheets. There were lots of surveys undertaken earlier this year which suggested the insurance sector was also ‘undervalued’ due to some accounting indicators.
The valuation for an insurance company differs from a lot of traditional valuation methods, e.g. PE and PB which depend on earnings and book values. The valuation is called EV - embedded value; an actuarial technique which estimates future cashflows and calculates the intrinsic value of the company based on risk adjusted discount rate. The calculation of embedded value is limited to the insurer’s existing policies, not including any future business. Therefore, it is considered to be a ‘conservative valuation’. After years of research and exploration, the theory of embedded value has been adopted and widely used in many countries, including China. Therefore, P/EV – price over embedded value - has become a general indicator to assess the valuation of insurance companies. The valuation of the industry is around 1-1.2×EV whereas Ping An and Pacific Life were traded at 1.06×EV, reaching historical lows. It was said by many investors that ”the insurance sector has reached its bottom line, current valuations indicate there is hardly any value for their future business despite the fact that the industry continuously expands due to its high demand.
” Indeed, most local securities firms and retail brokers upgraded the sector into their ‘buy list’ and proclaimed they were ‘deeply undervalued’.
Source: Guangfa Securities Co. Ltd
Assumptions and limitations of EV
Stock prices have high fluctuations in the short term. Although some financial indicators have appeared convincing, we need to understand the rationale behind those numbers. The so called embedded value calculation is a very complex process based on a variety of actuarial assumptions. For example, when Ping An Insurance calculated its EV, they assumed future investment returns to be 4.7% per annum and solvency adequacy ratio 185.6% etc.
Although the European Insurance CFO Forum has developed guidelines for EEV (European Embedded Value Principles) to increase transparency of financial disclosures, companies still have variations in methodologies and assumptions to calculate EV for their different policies. For example, risk discount rate assumption is a very popular discussion in the last few years and it still hasn’t formed a standard framework. According to some external reports and analysis, the EV calculations for many insurance companies are extremely sensitive to this assumption. Furthermore, the calculation of embedded value to some extent already includes presumed future profits for the current policies which mean if actual experience deviates from these assumptions (e.g. investment return, mortality experience, withdrawal rate etc), it could have a great effect on the company’s valuation.
The chart below shows P/EV for 14 European insurance companies in 2010 and 2011. It can be seen that apart from Zurich, all the other insurers’ market capitalization were below their EV. Furthermore, the average market capitalisation fell as a percentage of total embedded value from 82% in 2010 to 72% in 2011 due to uncertainty caused by the EU debt crisis.
Source: Milliman Research Paper
Therefore, it should not be sightlessly concluded that Chinese insurance sector, with an average 1-1.2 P/EV, is under-valued due to its current record low P/EV.
Embedded value calculations are based on complex actuarial techniques aiming to provide investors a true and fair view of the economic value of the insurance business. The results are highly sensitive to the underlying assumptions which the actuaries make, so investors should have a thorough understanding of the assumptions and limitations of the valuation instead of overly relying on the results. Finally, China is a developing country and it is economically and politically less stable. Although its insurance market is fast growing and is entering its transformation stage, there are also issues and challenges for investors to consider which I will explain in my next blog.
Please note that all opinions expressed in this blog are the author’s own and do not constitute financial legal or investment advice. Click here for full disclaimer