Chinese insurers aim to get smarter

Institutional Investor, May 2008

Looking at the numbers, you’d be forgiven for thinking China’s insurance industry had hit a rut in a period of otherwise extraordinary expansion. Penetration in the life insurance industry is still around 2%, just as it has been for several years, compared to over 12% in the UK. New business margins are under pressure, industry premium growth has become modest and share prices have tumbled. But it is, in part, an illusion: it’s just Chinese insurers getting smarter.

“Earlier this decade, we saw an acceleration of penetration, driven by very aggressive selling of lower-margin, single premium products in the style of deposit replacements,” explains Chris Esson, director of research for insurance companies at Credit Suisse. “Subsequently the major insurers, and China Life in particular, have become much more focused and disciplined in improving their business mix to higher margin products. So industry premium growth has moderated and penetration seems to have stalled, but that’s misleading: on a value basis, growth has been quite solid.”

The insurance industry in China has immensely powerful drivers behind it – starting with that exceptionally low penetration rate. If China was to move to the 10% life insurance penetration common in developed markets, or even in many Asian nations like Taiwan, then that would mean the sale of policies to 130 million people – twice the UK’s entire population. Rising income is obviously another driver, as is urbanisation. On the property and casualty (P&C) side, the driver is even simpler: people own more things that need insuring. “You’ve seen pretty consistent growth in penetration in P&C, and I expect that would continue just as the amount of physical assets that needs to be insured grows,” says Esson. “Trends like rising car ownership and private ownership of property are driving demand as well.”

Another agent for growth has been changes in distribution models. Dorris Chen, analyst at BNP Paribas in Shanghai, says recent industry growth has been driven “not so much by initiatives on the insurance company side, but by changes in the banking sector and regulation. There’s not much difference in the product offerings from insurance companies, but distribution of life insurance has changed a lot because of the listing of China’s state-owned banks, who can put massive distribution networks into households.”

Chen notes that all of China’s major state banks, as they have listed, have followed the global trend of trying to shift away from a reliance on interest income, and towards fee income. That motivates them to sell mutual funds, wealth management and insurance products. In recent years that hasn’t made a huge difference to insurers, because from a bank’s perspective, it’s easier to sell mutual funds in a bull market. But with Chinese domestic stock markets falling more than 30% so far this year, the picture is changing. “The obvious acceleration for this year is insurance products, because banks have a much higher motivation to push insurance in a bearish stock market,” Chen says. “For banks, it doesn’t make much difference for them to push mutual funds versus insurance: one dollar of fee income is one dollar of fee income.”

Particularly on the P&C side, regulation is also pushing policy sales. The law now requires that almost all vehicles – and, most significantly, four-wheelers – must be insured for third party cover. “That roll out is pushing volume growth, but only for the top line,” says Chen. And indeed, while the dynamics on volume are very positive, the bottom line figures do look rather different in all areas of insurance.

Here, insurers are facing margin compression for the first time in years. On the P&C side, the government pushed insurers to implement a 10% drop in premiums in compulsory auto liability coverage in the second half of last year – but at the same time insurers were also obliged to double the coverage for that liability. “So a driver can pay only 90% of the old price to get 200% of the coverage,” says Chen. “The motivation to buy additional coverage for their auto is significantly reduced,” so from a bottom line perspective, “P&C is clearly on a downward trend.”

Also, while bank channels have increased the reach of life insurers into households, they bring a side-effect too. When an insurer sells a product through a bank instead of its own agency force, that limits the complexity of the product, because bank staff are doing the selling rather than trained agents. “It means the insurance company can only sell simple products and cannot structure them in a way to guarantee their margin,” Chen says. “Bancassurance has a much lower margin than the normal longer-term product that is distributed by individual agents.

“Imagine the scenario,” she adds. “Someone walks into a bank outlet, facing a broad selection of different products. It’s easy for them to compare the return for insurance, versus bank products, versus money market or trusts. Insurers in this environment are forced to push up insurance returns.”

Insurers have adapted to these new challenges in different ways. There are five insurers of interest to foreign investors, all of them listed in Hong Kong. China is dominated by two, China Life and Ping An, with three others, People’s Insurance Company of China Group (PICC), China Insurance International Holdings (CIIH) and Ming An, attracting increasing interest. China Pacific Insurance, the second biggest property insurer in the country and third biggest life insurer, is listed on the mainland but has not yet conducted an H share listing in Hong Kong.

China Life is the biggest. Its merits divide analyst opinion: while Credit Suisse rates it outperform, Citi rates it hold and downgraded its price target and future earnings in March. It certainly has scale – its agent force is 638,000 people, which according to the US census is bigger than the whole population of Boston. Still, an institution of this size has to work hard to stand still, never mind grow: it has RMB50 billion of maturing policies in 2008 alone. Citi analyst Bob Leung is “concerned over China Life management’s lack of acknowledgement of the need to transfer investment spread risks to policyholders as new business margin continues to compress for traditional and participating policies.” Leung feels the focus on these traditional businesses is a bet on lower growth market segments, and would like to see it move to universal life policies and unit linked products.

Chen at BNP Paribas things it is “lagging”, but that it should be seen in the context of being the largest state-owned company in its sector. “It has to have extra caution,” she says. “Lots of insurance companies are launching unit-linked products, for example. But China Life hasn’t done that because it has to balance the impact in the market of a leading state-owned company doing something like that.” That said, viewed from the west, it might seem extraordinary to criticise the growth profile of a company that logged a 94.8% increase in net profit in 2007 over 2006, to RMB38.879 billion.

Ping An, while smaller, could certainly not be accused of standing still. For several years now it has been building out a strategy to become a full service financial services business, covering insurance, banking and investments. In 2007 life insurance accounted for 56.6% of net profits, and P&C insurance another 10.8%, but the other segments of the empire are growing rapidly: banking went from 0.9% of net profit in 2006 to 8% in 2007; securities increased modestly to 7.8%; and other businesses climbed from 7.1% to 16.8%. (Net profit overall was up an extraordinary 140.2%, to RMB19.219 billion). Ping An is smaller in insurance than China Life – its own sales force, of 302,000, is merely equivalent to the population of Pittsburgh – but it has grown in banking through its Ping An Bank and the acquisition of Shenzhen Bank (now merged into a single banking entity), and in investments through securities, trust and asset management businesses.

Ping An really hit the headlines in March when it agreed to acquire a 50% stake in Fortis Investments, the global asset management arm of Fortis, which is in the midst of integration with ABN Amro Asset Management. It paid Eu2.15 billion for the deal and in doing so became a presence in global asset management, as well as gaining a platform for its Qualified Domestic Institutional Investor (QDII) program, through which Chinese institutions are permitted to offer international investment products to local investors within strict limits. Leung, more of a fan of Ping An than China Life and with a buy recommendation on the stock, says the deal “completes the back end of the wealth management value chain and represents a significant step for Ping An’s global asset management ambition.” He thinks it might just be the start, too, with similar partnerships possible in insurance and banking in Asia; Fortis does, after all, own a 24.9% stake in Taiping Life and all of Fortis Insurance in Hong Kong.

Esson likes the Ping An model. “There will be sceptics who point to the underperformance of some financial services supermarket approaches elsewhere in the world. But in the Asian and Chinese context there are some important differences, particularly the household balance sheet,” he says. “It seems the household is much more liquid in China; there is a much greater weighting in bank deposits and so the scope for cross selling and synergies is high. They are trying to position themselves across the value chain so they service and manufacture for a quite high value customer base.”

He adds: “The financial industry in China is evolving. Investing in things like securities, asset management and trusts does possibly position Ping An quite well in terms of the development of the industry.” For her part, Chen calls the Fortis acquisition “a brilliant move” which will produce fee income of RMB6 to 7 billion a year without a significant increase in risk or balance sheet leverage.

China Life has not been ignorant of these opportunities, but has chosen to do it in a different way. Instead, it takes stakes as a strategic investor in businesses like Guangdong Development Bank, or in China’s first homegrown private equity firm, Bohai Industrial investment Fund, rather than being an owner operator of those businesses. “From their public statements, that is the strategy they will continue to pursue: more strategic investments,” says Esson.

Foreign insurers are doing their best to take advantage of the opportunities in Chinese insurance. PricewaterhouseCoopers recently conducted a survey of these groups, interviewing 24 different companies who between them employ 14,818 people, and who project a 133% increase in that number, to more than 34,000, by 2010. Between them they operated 99 branches in 2007 and expect to more than double that, to 211, by 2010. Remember, too, that this isn’t the whole industry: most of the respondents expected there to be more than 55 foreign insurance companies in China by 2010.

They don’t, yet, have a big chunk of the market; even by 2010, the PWC respondents only expect foreigners to have around 10% of the market on average. The 15 life insurance companies who provided data on their agency teams had a combined 79,500 agents between them, less than one sixth of China Life alone.

“Foreigners will grow gradually over time,” says Esson. “They’ve been pretty sensible in how they have allocated and spent capital, and the approach of regulation has been to allow for this gradual expansion, only allowing one or two approvals for branches each year.” That has two impacts: it helps to protect domestic companies, and also the health of the industry overall.

One reason for that is staff. “One of the key constraints for all insurers in China is the availability of staff, be it technical, sales or management,” he says. “The problem they face is, if they allowed open slather, there would be an incredible increase in competition for a very narrow pool of human resources. You would end up with unhealthy inflation in terms of salary costs and it wouldn’t be helpful for anyone.”

For the moment at least, there is plenty of work for all of them to build sustainable businesses. That’s the appeal when you’ve got 98% of the population uninsured, growing in awareness, and getting wealthier.