At a glance, underwriting looks a lot like guesswork at predicting the future. And it is predictive: the cost of any future payouts depends on what the policy holder actually experiences. Given that uncertainty, underwriting presents as a bit of a black box in terms of risk.
Why then, would probabilistically minded investors hold a meaningful weight in a predictive business model?
For one, the predictive aspect of underwriting is, in fact, based on probabilistic thinking—and, in Canada, they have had over a hundred years of experience in honing their skills. Two, lifecos can be fairly “steady Eddie” in terms of garnering a recurring stream of revenue when underwriting plain vanilla type polices. Three, Canada’s competitive landscape—an oligopoly of about only three major national players—offsets the highly competitive nature of insurance, which, at its core, sells commodities and therefore doesn’t offer much in the way of product differentiation. And the final reason: the return potential. Core life insurance is now a much smaller aspect of the overall business than it once was. Global wealth management is fast becoming the main focus and presents some attractive growth potential in new markets. For example, Manulife, a current holding in our Canadian equity strategy, derives over 30% of its core earnings outside of North America and has indicated that growing its wealth management and insurance business into Asia is one of its strategic priorities.
In short, Canadian insurance companies are no longer just in the business of selling insurance to Canadians. They function more like financial conglomerates, and that, for investors, is potentially a good thing.
I’ll have one wealth-creating plain vanilla policy, please
Good underwriting is still an important backbone of the protection business. And from a business quality perspective, the “boring” appeal of lifecos are those plain vanilla protection policies that provide certainty around revenue and an excess of capital for management teams to reinvest and allocate appropriately. Simply put, if you took out an insurance policy at 30, and most likely will live until you’re 80, that presents a 50-year period of collecting premiums on which the company can earn returns before paying out any contractual lump sum. Moreover, the amount of quality data and experience around longevity and probabilities that actuaries have built over time is substantive. In Canada, insurance companies have been around nearly thirty years before Confederation!
Still, insurance companies have run into fairly serious trouble by going out on the risk curve and mispricing products. In the case of Manulife, the underwriting track record is mixed at best. Since 2008 it has been rectifying a foray into long-term care in the U.S. This underscores the importance of management’s ability to direct the company’s efforts towards initiatives where they have a clear (and rational) competitive advantage. Management teams are critical to determining where the company will allocate excess capital, and their strategic decisions can very much dictate long-term returns for shareholders.
We view Manulife’s management team’s strategy to continue development of the wealth management aspect of the business as complementary to the protection side. One benefit of the long-term nature of protection products is that customers tend to remain loyal for many decades. Having such a sticky customer base well-positions insurance companies to offer other products outside the realm of insurance (i.e., wealth management products) to a somewhat receptive audience—another means to growth. The long-term nature of these customer relationships means lifecos are poised to target individuals with investment products that can meet their needs throughout their entire life cycle: from the time they start accumulating wealth to the time they need protecting it.
We also view Manulife’s decision to expand into growing regions such as Malaysia, Indonesia, and Thailand as well as continuing to build scale in regions like Singapore and Hong Kong, as a potential tailwind for more outsized growth over the long-term. In addition, the continued development of the wealth management business offers another means of diversification both in and outside of Canada.
On balance, insurance companies appear as a bit of a mixed bag to the investor: the underwriting core of the business model carries risk, while, if used for simple life insurance policies, can also generate a significant amount of recurring revenue. Given the commoditized nature of insurance products and saturated Canadian market, diversifying into complementary business lines such as wealth management is a good strategic move to stay competitive and take advantage of new growth opportunities.
While there are clear and inherent risks to this business model, we believe the high return potential pays for those risks. Currently, we see valuations of insurance companies as reasonable, and with those risks already priced in.
- Playing the plan: Mawer’s Canadian Equity portfolio
- Quarterly update | 2Q 2018 | EP11
- Beware the camel in the tent
- Inside Manulife’s plan for a massive Asian expansion (subscription required)
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