Life Insurance: Covering Our Bases

The four largest life insurers listed on the Johannesburg Stock Exchange are Sanlam Limited, Discovery Limited, Old Mutual Limited and Momentum Group Limited, when measured by market capitalisation.

Three of these insurers – Sanlam, Old Mutual, and Momentum – issue listed subordinated debt instruments in the debt capital market (which classify as regulatory capital) out of their South African life insurance subsidiaries. This debt is guaranteed by each of the respective holding companies.

Discovery, on the other hand – given the diversity of its operations and emerging nature of some of its businesses – issues listed senior unsecured debt out of its holding company, from which it allocates capital to its subsidiaries. Discovery’s debt profile is enhanced by the joint guarantee by two of its South African subsidiaries, Discovery Health Proprietary Limited and Discovery Vitality Proprietary Limited. This guarantee was introduced in the domestic medium-term note programme to be consistent with the structure of Discovery’s bilateral and syndicated bank debt facilities – which it had before entering the debt capital market. In our analysis of Discovery, we view the guarantee as a credit enhancement to senior noteholders.

We are active participants in the debt capital market. As such, the debt instruments offered by these insurers form part of our investable universe. 

The value in embedded value disclosure

What is embedded value?

In order to quantify the shareholder value of the long-term nature of life insurance policies, South African life insurers produce embedded value disclosures in addition to the usual International Financial Reporting Standards (IFRS) disclosures. Embedded value is the valuation of the current value of the long-term life insurance business, also referred to as the covered business. Embedded value is equal to the sum of the present value of the future profits of a firm’s in-force life insurance policies (referred to as value in force) and the net asset value of the firm (referred to as adjusted net worth). It is considered a conservative view of shareholder value, as it does not consider the value of new life insurance policies that the insurer might sell in the future. Group embedded value is the embedded value of the covered business plus management’s valuation of the non-covered businesses. Non-covered businesses typically include short-term insurance, banking, lending and asset management. Figure 1 below illustrates the composition of each insurer as set out in their embedded value disclosures. We consider each of these firms to be diversified financial conglomerates.

Figure 1: Group embedded value

Source: Company reports as at June 2024

Sanlam

While Sanlam has the highest group embedded value at R155 billion, its non-covered businesses dominate the composition at 60% of the total. This contrasts with the other insurers, where the majority of value is from the long-term life insurance businesses. Sanlam’s unique composition can be attributed mainly to its stakes in short-term insurer Santam, the Shriram lending and short-term insurance businesses (India) and the SanlamAllianz non-covered businesses (Africa ex-South Africa). Over time, we have seen that insurers’ offshore exposure is generally driven by markets exhibiting low insurance penetration, increasing insurance expenditure and awareness, demographic catalysts, a supportive regulatory environment and effective distribution channels. We view Sanlam’s strengths to be its scale, leading market positions and diversification by geography and business lines. Sanlam has engaged in extensive corporate activity in recent years (the majority of which has consisted of bolt-on transactions in the SA business) with the intention of fortifying its market position and bolstering its profitability.

Discovery

For Discovery, 95% of its group embedded value is from its covered businesses, of which 75% is attributed to the South African Health, Vitality, Life and Invest businesses. We consider key attributes of the Discovery investment case to be its differentiated shared-value model, market-leading health administration business, fast-growing Vitality Global operations (including Ping An Health Insurance in China), and increasing profitability and cash generation following a period of elevated investment in new initiatives – especially Discovery Bank.

Momentum and Old Mutual

Momentum and Old Mutual have similar contributions from its life insurance operations at 71% and 76% of group embedded value, respectively. The contribution of Momentum’s non-covered businesses to group embedded value has gradually increased from 19% five years ago to 29% today, driven by the growth of Aditya Birla Health Insurance (India), in which Momentum has a 44% stake, and the growth of the short-term insurance businesses – especially Guardrisk. In our view, one of Momentum’s key strengths lies in its leading market share in the retail affluent independent financial advisor (IFA) channel, aided by its knowledgeable broker consultant force. Old Mutual’s non-covered business contribution to group embedded value (consisting of asset management, banking and lending, and property and casualty operations) has remained relatively flat in recent years. We look favourably on Old Mutual’s industry-leading retail mass market share and retail mass new business profitability.

IFRS 17: what changes and what remains the same?

IFRS 17 was introduced in January 2023 and facilitates a greater comparability across insurers through a more consistent approach to the timing of profit recognition, with changes in (i) revenue recognition in the income statement; (ii) calculation of the insurance liability on the balance sheet; and (iii) release of margins from the insurance liability into earnings. We view IFRS 17 as an improvement over IFRS 4, as the latter allowed insurance companies to apply discretionary margins in the valuation of their insurance liabilities. The result of this, for example, meant that two insurers selling the same policy with identical experience and cash flows, could show differing profit emergence over time. IFRS 17 eliminates this difference. It is important to note that IFRS 17 is purely an accounting change, and there are insignificant impacts on key metrics such as cash generation, value of new business, embedded value, solvency capital and dividends.

Assessing the balance sheet impact on transition to IFRS 17 reveals an increase in equity balances and a reduction in insurance liabilities for Momentum and Sanlam. These insurers applied a more conservative level of reserving in their measurement of insurance liabilities under IFRS 4 than IFRS 17. The reverse is true for Discovery and Old Mutual, who previously recognised profits more aggressively than IFRS 17 allows, which resulted in a reduction in equity balances and an increase in insurance liabilities on transition.

How do we assess insurers’ ability to repay and recover debt?

Our approach to assessing the probability of default

In order to determine the probability of default for life insurers, we assess each counter’s scale, solvency, balance sheet composition, profitability and cash flow. It is important to note that the IFRS cash flow statement includes both policyholder and shareholder cash flows; however, policyholder cash flow is not directly available to cover each group’s cash interest expense. Therefore, we look for insurers’ disclosure on shareholder cash flow movements. In our view, the detail in Discovery’s disclosure should become an industry standard.

What industry developments are we tracking?

In South Africa, in-force life insurance policies have remained stagnant for the past five years. The relatively profitable funeral insurance market presents an attractive opportunity for insurers, but currently constitutes less than 10% of South Africa’s life insurance industry premiums. Old Mutual and Sanlam are best placed to compete in this market. The termination of Sanlam’s funeral insurance joint venture with Capitec increases the competitive landscape – especially from banks, which are actively targeting this market segment. Sanlam’s recent acquisition of Assupol will partially replace the new business volumes and profitability lost from the joint venture.

We will also continue to monitor the impact of the bancassurance distribution channel, with Old Mutual’s bank set to launch in 2025 and Discovery Bank reaching operational breakeven before new business acquisition costs.

Market share movements

For the six months to June 2024, the life insurance new business volumes of the industry’s five largest life insurers rose by 12% year on year. Here, we expected softer new business growth given elevated interest rates and cost pressures.

Momentum was the winner in life insurance market share over this period, benefitting from strong annuity sales in an elevated interest rate environment and its leading market share in the retail affluent IFA channel. However, Momentum is selling less profitable new business compared to its peers, especially in the retail mass market through its Metropolitan Life business. We expect this to improve given management’s interventions.

Old Mutual continued to show the strongest volume growth in the retail mass market. Discovery’s retail affluent new business margins are in line with Sanlam, with both firms leading this market. Overall, Sanlam retained its leading position in its sale of the most profitable new business in the industry.

A brief overview of profitability and balance sheet strength

In this year’s results releases, the operating profit of Sanlam, Momentum and Discovery have shown double digit growth relative to last year – and we expect profitability to continue to trend upward. However, Old Mutual’s operating profit, excluding new growth investments, increased by mid-single digits due to an idiosyncratic adverse mortality experience in its retail affluent business. Sanlam continues to show the strongest profitability (on a return on group equity value basis) and, on our calculations, debt service coverage (on a free cash flow cover basis). We were pleased that, for the first time since 2020, Discovery reinstated dividends in the second half of its 2023 financial year. We view Sanlam, Old Mutual and Momentum as having stronger balance sheet metrics than Discovery, after a comparative analysis of scale, balance sheet diversification, and cash generation ability.

Solvency: an input into our assessment of loss given default

South African insurance companies are regulated under the South African Insurance Act and the related Prudential Standards implemented from 1 July 2018. Regulated entities are capitalised in line with regulatory solvency requirements calibrated to withstand a one-in-200-year adverse event. All four insurers are well-capitalised at levels over 160% of the solvency capital requirement. As a reflection of the resilience of each insurer and the robustness of the sensitivity analyses performed, during COVID the four life insurers remained strongly capitalised at coverage levels similar to those presented today.

Issue spreads – how much lower can they go?

During the year, the four insurers raised in aggregate R7 billion in listed debt through debt capital market auctions. Collectively, they have R24.9 billion in outstanding listed debt. Most of this debt is in the form of floating rate notes. Post-COVID, the issue spreads of floating rate notes have been compressing. Figure 2 below illustrates the issue spreads over time (relative to 3-month JIBAR) of life insurers’ subordinated debt at the five-year tenor.

Source: Standard Bank research

Investor demand: the main driver of tighter credit spreads

A notable downward step change in issue spreads can be observed in the second half of 2023, which we attribute to fundamental improvements in the credit strength of the insurers, higher base rates, and demand-supply dynamics. We believe that the main driver of the spread tightening is demand, with investors searching for high relative all-in yields (on a risk-adjusted basis) across corporate issuers. From October 2023 to August 2024, issue spreads of subordinated debt instruments around the five-year tenor cleared at exactly 134 basis points (bps) over 3-month JIBAR. Before November 2024, we had expected this trend to have reached a trough. As a reflection of the persistence of the driving forces, Momentum’s November 2024 auction cleared at 129bps over 3-month JIBAR. This surprised us.

What is our expectation of credit spreads going forward?

We see spreads remaining tight due to strong demand, the systemically important nature of insurers, their improving financial positions, and their offer of higher spreads relative to senior unsecured bank paper.

After consideration of the credit profiles of the insurers, their systemic importance, and the yields on offer, we continue to remain active participants in life insurers’ activity in the debt capital market.