From the November 2006 issue of Research Magazine • Subscribe!

Industry Spotlight: Insurance

Changing dynamics mean new opportunities in the insurance sector, equity analysts say.

Stewart Johnson

Friedman, Billings, Ramsey & Co.

212-381-9219

sjohnson@fbr.com

Area of Coverage: Life Insurance

Outlook: The industry outlook in the short term is similar to that of the long term in that I see a shift away from the traditional protection business towards the savings or accumulation business. The growth rate of insurance companies over the past 20 years has been in the low-single digits compared to the savings business that has been growing at 12 percent to 14 percent. Going forward, you should think of an insurance company as a place where you can save money on a tax-deferred basis or for retirement and then turn that savings into a lifetime stream of income.

Over the longer term, life insurance companies will become more like mutual fund companies than traditional insurance companies. But in the short term, what we have are new product introductions and guarantees targeted toward this savings side of the business.

Think of the savings business as consisting of two pieces. There's the piece that's linked to the equity markets. That's the variable annuity business where returns vary. The other part is the fixed annuity business. Fixed annuities pay an interest rate based on Treasury yields.

The variable annuity business has been doing very well recently. That is being driven by the new guarantees insurance companies are offering that help purchasers manage risk related to downside in the equity markets and outliving their assets. That's really the innovative corner of the savings business right now. Fixed annuities on the other hand have not fared as well. As interest rates have risen, CD rates offered by banks have also gone up and that has hurt the insurance company's ability to sell fixed annuities. For example, two years ago you could walk into an insurance company and buy a fixed annuity with an interest rate of 4 to 4.5 percent. Banks might be offering 2 percent on certificates of deposit. Today, that is not the case. Now the rates offered by banks and insurance companies would be pretty similar.

Outperforms: American Equity Investment (AEL); KMG America (KMA); StanCorp Financial Group, Inc. (SFG); and Unum Provident Corp. (UNUM)

One of our Favorite Ideas: Unum Provident Corp.

Why Unum Provident? Our favorable rating on Unum is centered squarely on return on equity, or ROE, improvement. There are two things driving that, and one of them is improving the benefit ratio within the U.S. brokerage business.

As background, Unum has been forced to review denied claims under a multi-state agreement. The company was investigated and as part of the settlement, Unum went back and reviewed disability claims that had been denied. The process of doing that costs money, and some of those denied claims are eventually approved or overturned. That has pushed up their costs.

Now, Unum has a program in place to help address that increase in claims cost. If Unum does this, it is going to help their ROE. Claims are generally the largest expense item for an insurance company. So if Unum gets a little improvement on their benefit ratio, it will help its ROE. The second initiative the company is putting in place to boost ROE is to do a capital markets transaction. This would help Unum remove capital from some of its businesses, effectively lowering the "E" in the ROE equation. So, even if returns were to stay the same, if you reduce E, your ROE goes up.

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Jukka Lipponen

Keefe, Bruyette & Woods

860-722-5905

jlipponen@kbw.com

Area of Coverage: Life Insurance

Outlook: This year, the valuation for the life insurance sector is trading above historical norms, both on an absolute and relative basis. I wouldn't call the valuations really rich, but they are above the historical median. On the other hand, the earnings outlook is still reasonably good, so I wouldn't expect valuation multiples to expand further; but I don't necessarily expect any deteriorations either.

The sector has continued to outperform the market so far this year -- not by a lot, but it has outperformed nonetheless. The one big variable right now is what happens to interest rates. On the up side, if rates were to continue to gradually increase that would certainly be the best-case scenario from an interest rate environment standpoint for the life insurance sector. On the other hand, we had some spread-compression issues in the declining interest rate environment when we got the really low rates. That situation has by and large stabilized. But if interest rates were to start to head down further again for whatever reason, then the spread compression issue would very quickly resurface.

Outperforms: Assurant (AIZ); Conseco (CNO); Manulife Financial (MFC); Protective Life Corp. (PL); StanCorp Financial Group (SFG); and Universal American Financial Corp. (UHCO)

Top Pick: Assurant

Why Assurant: Even though this stock has had a pretty good run over the past couple of years, I remain very bullish. That name has more to go. I really think Assurant has a very strong, disciplined and conservative management team. The company's business prospects are either favorable or improving in most of its key businesses.

Assurant is a diversified insurance company. The company's solutions business is expanding internationally, obviously adding to its growth. It is also one of the leaders in individual health insurance. Assurant was the first mover when health savings accounts were initially approved by Congress; so growth accelerated in that business, but then competition quickly came in and so growth got cut. The management of this company decided not to chase top-line growth if it meant having to give up margin.

But now the situation is changing. Individual health insurance is a very different business from group health insurance, and underwriting is absolutely critical. Group health insurance is more of an administrative-type business. Some of the competitors who came into the individual health insurance business, who were group health insurance providers, didn't achieve the results they expected, and now they are pulling back; so, the competitive environment is getting better. At the same time, Assurant just implemented, and is in the process of rolling out, a new platform called "Advantage Agent."

What Assurant is trying to do is to make it a lot easier and quicker to issue a health insurance policy, especially on healthy individuals. Assurant says it can issue a policy now in hours as opposed to the industry norm of weeks. This helps, in the sense that agents like Assurant now get their commissions quicker. There is no delay in the process of issuing the policy, so there's less chance that people might change their minds and end up not buying the policy.

Assurant is also trying to expand the distribution of individual health insurance products into as many viable points of sale as possible. One of the recent points of sale they are going into is Home Depot. Home Depot started this new program called the Home Depot Business Tool Kit. As part of this program, Home Depot offers products and services such as accounting and health insurance to electricians, plumbers and building contractors. While Assurant is not an exclusive provider, the company is the primary provider of individual health insurance as part of the Home Depot Business Tool Kit Program.

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Marc Thiele

UBS

+44-20-7567.5837

marc.thiele@ubs.com

Area of Coverage: Full-Line Insurance

Outlook: We believe the European insurance sector offers modest upside at these levels. We are overweight life insurance because of strong inflows into pension and unit-linked contracts. The increased levels of invested assets should raise fee income and therefore boost earnings. In addition, margins have recovered based on re-pricing efforts and we expect life insurance earning to surprise on the upside.

We are underweight on non-life insurance as we fear pricing pressure could lead to earnings deterioration as a result of intensifying competition and improved solvency levels. AXA is well-positioned to deal with non-life pricing pressure given previous de-risking of its balance sheet (securitization, reinsurance disposal etc). We believe the company will benefit from strong inflows in its asset management and life insurance division.

Buy-rated stocks: Aegon (AEG), AXA (AXA), and ING (ING)

One of our top picks: AXA

Why AXA: We believe AXA will generate strong cash earnings based on life insurance and asset management net inflows, property and casualty (P&C) underwriting results, and cost reductions. AXA should trade on a premium (1.9 times adjusted net asset value, or NAV) compared to the sector average (1.6) because of its superior risk/return profile (17 percent versus 14 percent). AXA's strong new business growth will offset increased competition in the near-term. However, we forecast slower new business profit in 2007 and 2008 because of a changing business mix in high margin areas like Hong Kong and Japan.

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