Insurers under the gun to increase share value

For example, shareholders will demand a return on equity of about 14%, higher than most insurers are currently generating.

“There’s nothing like having a greedy shareholder looking over your shoulder to sharpen your focus on profits,” says Ken Clark at Toronto-based actuary consultants Eckler Partners Ltd.

Clark says 14% is a reasonable ROE for an insurance company. However, he says the banks have higher ROEs, and since insurance stocks will be competing with bank stocks as core blue-chip holdings, they may need to have comparable ROEs to ensure they don’t become takeover targets. Clark says insurers have been closing the gap, even though bank ROEs have been improving.

Neil Parkinson, Toronto-based vice president at management consultants KPMG, also emphasizes the change in mind-set that will come with demutualization. “In the past, mutual companies have had a primary thrust of safety and security of policyholder benefits. As stock companies, their raison d’être will change to making money. For example, they may be more inclined to accept a higher risk for a higher return.”

Insurers might also be a little less conservative in their accounting, including estimates of actuarial liabilities, thereby freeing up more capital, he adds.

The focus on shareholder value will be even stronger for demutualized companies once management and employees are able to participate in share ownership and stock option plans, says Tom MacKinnon, analyst at Scotia Capital Markets.

If you have clients who own shares in the companies or are considering acquiring them once demutualization is accomplished, there are a number of things you should watch, says Alan Mark, vice president at management consultants Ernst & Young Inc. in Toronto. Among them are: quality of management; feasibility of future strategy; a track record at acquiring and integrating companies; the quality of earnings – specifically how much is coming from fee-based and/or growing businesses; and asset mix. The more equity and real estate the firm holds, the higher the potential returns and the higher the risk.

MacKinnon suggests looking for companies with strong earnings growth that are contemplating share-based incentive plans. Also note whether the insurers are making effective use of the capital at their disposal. The Minimum Continuing Capital and Surplus Requirements ratio is a good barometer and ratios above 200% indicate a company that is overcapitalized.

More efficient use of capital is perhaps the single greatest efficiency that will come with demutualization. Mutual companies not only tend to have higher MCCSR ratios than their stock-company peers, but those ratios rise even higher at times when the company is trying to increase assets to finance acquisitions or business expansions. Since those assets tend to be invested conservatively, mainly in fixed income instruments, the capital is not being used very efficiently.

Push for profits

The difference between answering to shareholders rather than policyholders is enormous. Policyholders don’t manage, although they have the right to do so, says Clark. In contrast, shareholders are focused on dividends and growth in stock value.

Clark is working with four big insurers that are demutualizing and says many are already getting rid of businesses that don’t contribute enough to profits. For example, Sun Life Assurance Co. of Canada sold a small trust company in the U.S., and Manulife Financial is now out of the Caribbean and has sold its British operation, concentrating instead on Asia.

In contrast, Sun Life and Canada Life Assurance Co. consider Britain a core market and have increased their presence through acquisitions. Meanwhile, Mutual Life Assurance Co. of Canada “seems to want to concentrate in Canada,” says Clark.

Ron Neysmith, vice president at Canadian Bond Rating Service, says the mutuals are already trying to reduce their operating expenses, which have traditionally been much higher than stock companies. “They are going through their operations and divisions to see where they can cut or combine.”

However, he says the real gains in margins will come after demutualization, when the companies have the ability to merge or acquire and “pump more product through at a low marginal cost.”

Since life insurance is basically a commodity, being a low-cost producer utilizing economies of scale is essential. Companies must be dominant in their core business lines and have the clout to enter a new market like China. “The Chinese won’t be interested in you if you’re not big,” says Clark.

The need to grow through acquisition has spurred demutualization. Mutual companies have managed to make some acquisitions, but they have been severely limited by their lack of access to equity markets. They can only raise money through debt, and there are limits to how much debt they can carry. As a result, the four big mutuals couldn’t bid for London Life in 1997 and had to sit on the sidelines while Great-West Lifeco bought the company.

But consolidation does not mean globalization. Although most of Canada’s biggest insurance companies have some international exposure, the focus tends to be at home, says Neysmith. “It’s tough to diversify internationally unless you’re quite familiar with the country. Consider the number of foreign companies that are getting out of Canada.”

Life insurance is not a strong growth area, but health insurance and investment products are expected to do well. All the big mutuals have wealth management products, but their relative size differs. Sun Life, which owns Spectrum United Mutual Funds Inc. and Boston-based MFS Institutional Advisors Inc., has the most wealth management products.