U.K. Life Insurers: Avoid the Winner, Look at the Underperformer

The recent stock performances of  Prudential (PRU)/(PUK) and  Aviva (AV.)/(AV)--both no-moat U.K. insurers--couldn't be more different. While Prudential's share price doubled in 2012, Aviva's shares remained sluggish. We think Prudential's risk has elevated significantly and the market valuation cannot be justified based on the company's prospects. On the other hand, we think Aviva has made some tough decisions to derisk its balance sheet and strengthen its capital position. Although we don't see Aviva as a growth company, we give it credit for being a safer company with higher predictability of cash flows. As a result, we would prefer an investment in Aviva to one in Prudential.

No-Moat Insurers See Sales and Margin Growth Under Pressure
A large part of Aviva's business in the United Kingdom and Europe is with-profit contracts (called participating life policies in the United States), which we think are commodified products that command no brand loyalty and can be replicated easily by another carrier. The company attempted the One Aviva campaign in hopes of increasing brand recognition and cross-selling life and general insurance, but we don't see any strong evidence that the campaign achieved its goal. The company distributes its products through an agent network to retail clients and through bulk sales to corporates. However, without any cost advantage in selling generic products, Aviva does not have an economic moat, in our view. Total sales have been dropping for the past three years and margins have seen little expansion, reflecting an increasingly competitive environment.

Prudential has a different emphasis in terms of geographies and products; more than 80% of its profits are derived outside the U.K. The company, using its relatively healthy balance sheet, has been actively expanding in international markets. Jackson National Life, the company's U.S. subsidiary, is the third-largest seller of variable annuities in the country, and Prudential has a long history and an enviable franchise in Asia. However, while the company has the scale and the bank relationships, neither does it have any meaningful cost advantage, making it a no-moat company, in our view.

Prudential's health insurance products are favored by the growing number of affluent middle-class families, especially in Southeast Asian countries where national health-care programs are lacking. The company's savings products also have gained in popularity, as interest payments on bank deposits are close to nil. As a result, high-margin products sold in Asia have given a boost to the group's overall margins. However, as with Aviva, Prudential's margins have shown little expansion.

The pace of growth in Asia is slowing, reflecting increased competition. This has been partly offset by the accelerated growth of variable annuity contracts in the U.S. While we appreciate that Prudential is finding growth in this difficult industry, we also view VAs as a riskier product. The company is trading low-risk growth from Asia for higher-risk growth in the U.S., lifting the overall risk profile, in our view.

High Asset Leverage Leads to Wide Swings in ROEs
A bigger problem with European insurance companies, including Aviva and Prudential, is high asset leverage on the balance sheet. On average, assets are about 30 times shareholders' equity for the European insurers we cover. With such leverage, a small drop in asset value could have a magnifying impact on the equity, making a company's returns on equity highly volatile. While Prudential has had better results recently, it has even higher asset leverage than Aviva, meaning that downside risk is higher if results turn south.

Capital Solvency Remains a Central Focus for Life Insurers
Because of the high asset leverage, capital strength remains a central focus for life insurance companies. Aviva's capital base has not improved much since the company emerged from the 2008 financial crisis. In fact, the company's economic solvency has subsequently fallen back to the crisis level. The decline in interest rates has a larger impact on life insurance companies, including Aviva, that carry long-duration liabilities relating to insurance and annuity products. The fall in the solvency ratio reflects the capital erosion resulting from duration mismatch in the face of falling interest rates. The capital improvement during 2012 was the result of Aviva's decision to exit nonperforming markets and products. The company achieved another 30-percentage-point improvement in the second half of the year following the sale of the U.S. business, which freed up capital and cut losses on VA products.

Prudential only reports its regulatory capital solvency ratio, which we think is less indicative of an insurer's true economic health, since a company's regulatory capital base is determined by a set of rules without adjusting for risk. Prudential appears to be well capitalized on a regulatory basis in the post-financial-crisis years, but it is unclear how much of the market risk relating to the U.S. VA contracts is captured in these ratios. We believe that some of the market risk is offset by an increased volume of fixed annuities issued. By grouping fixed and variable annuities together in a portfolio, the resulting cash flows might appear to be less risky and thus require less capital.

A Tale of Two Insurers
Compared with Prudential, Aviva has significantly underperformed since the end of the financial crisis. The two firms moved in lockstep through the financial crisis, but Prudential's recovery was relatively quick, while Aviva seems to have been stuck for the past three years. Aviva's shares are still down roughly 55% from their 2007 levels and have recovered only modestly from the bottom in 2009. Prudential recovered most of its share price losses by 2010 and traded in a similar pattern as Aviva for the following two years. But 2012 was the inflection point: Prudential's share price doubled, while Aviva's remained flat.

We believe the lack of a unifying strategy could be a contributing factor to Aviva's lackluster share performance. The firm has tried many different things to boost brand recognition, in hopes of increasing the volume of cross-selling, but nothing seemed to have any material effects on sales. In fact, new-business sales have declined approximately 9% per year for three consecutive years.

On the other hand, Prudential, with a relatively healthy balance sheet, took advantage of the situation and started expanding in Asia and the U.S. Its 2010 failed bid for AIA only made the company more interested in smaller targets in Southeast Asia. In the U.S., JNL became the third-largest annuity seller in the U.S. after MetLife and Prudential Financial.

Profitable growth is a key driver of share price performance, and the market is paying a very high premium for the growth prospects at Prudential. This is somewhat understandable because it is hard for no-moat companies to find growth in a highly competitive industry. However, we believe valuation multiples should also reflect the potential risk to the balance sheet from macro factors (low interest rates, high market volatility), as well as regulatory risk such as Solvency II.

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Aviva's Remaining Assets Are Highly Exposed to the U.K. and Europe
Aviva has engaged in a series of restructuring programs, hoping to turn around its depleting capital, stagnant new sales, and sagging stock price. Following a thorough review, the board decided to exit a number of markets that were underperforming and retreat from product lines that didn't meet the target return. Aviva sold down its minority stake in Delta Lloyd and some noncore businesses. It sold its U.S. business to Athene Holding and the 49% ownership stake of a Malaysian insurance joint venture to Sun Life. It also slashed its dividend. In our view, these actions have helped stabilize the company's capital base.

Aviva's heavy reliance on the U.K. and European markets could mean that growth will be muted in the near term. The pace of economic growth in the U.K. has again slowed to a grind, with no GDP growth for 2012. In addition, the OECD forecasts the U.K. economy to grow at meager rates of 0.9% for 2013 and 1.6% for 2014. The outlook for the rest of Europe is not any brighter. Spain, where Aviva sells a lot of its with-profit policies, is expected to have negative GDP growth for the next year and only 0.5% growth for 2014. As such, we would expect personal spending to shrink in all major European countries in the near term, which would inevitably have a negative impact on insurance sales.

We Think the New Aviva Will Be a Safer Company
Aviva has made some tough decisions in the turnaround process. Reducing leverage and strengthening capital remain its two priorities. Management is focusing intensely on protecting cash flows from the three core business lines--life insurance, general insurance, and fund management--which together offer a diverse mix of liabilities and spread versus fee-based revenue. At the same time, it is working to increase management cash flow remittance from operating subs to the holding company by improving operation efficiency. The new Aviva, which retains most of its businesses in the U.K. and European markets, is arguably a safer company with a higher degree of cash flow certainty. Yet, we would also argue that expanding the business, at least in the near term, has taken a back seat in management's mind.

The new Aviva also has a more streamlined corporate structure put in place this year. This is meant to improve the cash remittance ratio from operating subs to the holding company. Cash remittance rates had already improved from 37% in 2011 to 48% in 2012, as European subsidiaries were improving along with the recovery of the local economies. The new corporate structure should facilitate the upstreaming of funds by removing flow restrictions in the old structure.

In the past, Aviva was touted as a dividend stock that paid generous dividends. It essentially paid out a large part of the remittance, leaving little excess cash to bring down leverage. Consequently, management made the difficult decision to revise the longstanding dividend policy by reducing the payout by 44%, a move aiming to achieve a dividend coverage ratio of approximately 2 times.

In terms of strengthening capital, the quick and easy solution is through asset sales. The company retained the proceeds from the sale of the U.S. business, and the freed-up capital immediately boosted the solvency ratio by 30 percentage points. However, the disposal of the U.S. business required Aviva to take a GBP 2.3 billion loss on book equity, and as a result, the company's leverage increased from 40% in 2011 to 50% in 2012, compared with an industry average in the mid-30s. Aviva aims to bring the leverage ratio below 40% by paying down GBP 600 million in the next three years, with GBP 300 million alone in 2013 from the proceeds of the asset sales.

Prudential's Asia Growth Is Slowing, While VA Risk Is Increasing
Prudential has a long history of operating in Asia and the U.S. Growth in Asia has been strong, especially from Southeast Asia countries, including Indonesia, Singapore, and Malaysia. The failed bid for AIA in 2010 did not deter the company's Asia strategy; now, instead of hunting for the elephant, Prudential is more interested in smaller acquisitions that can strengthen its bank relationships and complement its existing distribution networks. In the U.S., Prudential operates through JNL, one of the largest annuity sellers in terms of sales. To strengthen its leadership position in both markets, Prudential has been bulking up its insurance assets.

While we are encouraged by the company's growth prospects, we are concerned about the slowing growth in Asia at a time when VA risk is picking up in the U.S. After years of explosive growth, new business sales in key Asian markets started to slow, reflecting higher competition in the region and the fact that the middle-class segment is getting saturated. Over the same period, VA sales at JNL increased significantly, as MetLife, Prudential Financial, and other annuity sellers are retreating from the market. Between 2007 and 2012, the Asian business reported a five-year compound annual growth rate of 8.8%, whereas the U.S. reported a five-year CAGR of 17%.

We think Prudential's capital position is vulnerable to the increasing risk related to VA products. One way to gauge the risk is by tracking the net amount at risk, which measures the excess of the guaranteed benefit amount over the policyholder's current account value. The excess is, in theory, the net amount the insurer is liable for. The account value has been growing at a three-year CAGR of 52%, and the at-risk amount relative to the total account value has been fluctuating widely depending on the market conditions. In our view, at the current level, a sharp increase in equity market volatility could have an adverse impact on the company's capital position.

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Although we haven't observed a material impact on the company's statutory risk-based capital ratio at this point, that doesn't necessarily mean that Prudential's available capital is keeping pace with the increase in required capital associated with the new sales. We think management feels somewhat comfortable with the explicit hedging programs and the implicit hedging by increasing the issuance of fixed indexed annuities to partly offset the risk. Additionally, much of the new sales were related to a new product that carries no guaranteed benefits but provides tax-efficient access to alternative investments. As a result, the company was able to lower the reserves associated with the overall annuity portfolio, thereby lowering the required capital while holding the RBC ratio essentially unchanged. While we like the pricing actions and the product enhancements the company has taken, we continue to believe that VAs feature a complex risk profile and their long-term profitability could be hurt by a number of factors that are outside the issuer's control.

We Think Prudential Is Overvalued
Prudential had a winning year in 2012 and its share price doubled. Prudential is currently trading at about 2.5 times 2012 fiscal year-end book value (or about 3.0 times 2012 fiscal year-end tangible book value), which we consider is overvalued for a no-moat company. The market clearly places a very high premium on future growth from this no-moat company, but we think it has extrapolated an unsustainable level of growth without considering the ongoing mix shift that increases the riskiness of that growth. The company's growth in Asia is slowing because of increasing competition and Prudential's eroding first-mover advantage in the region.

Our fair value estimate for Prudential is GBX 680 per share, which represents 1.7 times 2012 fiscal year-end book value. This valuation is at the very high end for a no-moat insurer, but Prudential has demonstrated its ability to scour for growth opportunities (even at the expense of higher risk) in a difficult industry. Based on our fair value estimate, we think the stock is overvalued by about 50%.

On the other hand, we think Aviva could be a feasible choice. New management has addressed investors' concerns about leverage and capital with a clear plan to build a sustainable business model with a robust balance sheet. The decisions to reduce the dividend and to sell its U.S. business and investment in Delta Lloyd are crucial steps in turning around the company, in our view. Near-term growth will be muted, as the mature U.K. and European markets are slowing. We don't think the company is interested in buying growth in emerging markets at the expense of cash flows and capital; on the contrary, the main focus is to increase capital generation from existing assets, through underwriting discipline and cost savings. Aviva is not the dividend stock it once was, but we think the market will start to appreciate a safer business model that delivers more-predictable cash flows and gives credit to the turnaround story. Our main concern is the relatively high leverage resulting from the U.S. sale. However, given the long maturity of the subordinated debt and the company's improving cash flow profile, we think the leverage is manageable and should not pose any immediate liquidity issue.

Our fair value estimate for Aviva is GBX 350 per share, which represents 1.2 times 2012 fiscal year-end tangible book value. Our fair value estimate implies 2% premium growth for the first two years and 3% in the last three years of our explicit projection. Our growth rates are consistent for the projected GDP growth in the U.K. economy, and we believe general insurance pricing is starting to firm in the current cycle. Recently trading around GBX 320 per share, the stock seems slightly undervalued, in our view. The key risk to our valuation is a sudden downturn of the European economies that causes a serious liquidity issue for the company.