China Life Insurance Sector:Correction Overdone;Current Valuation Reflects Overly Bearish Assumption for Long-term Investment Yield

Share prices dropped ~20% within a month due to the A-share market correction: As a result of weak A-share market, share prices of four major life insurance companies under our coverage dropped around 20% during the past month. We believe the major concern from mar-ket should be on insurers’ investment return as other key factors were largely unchanged during the period. We admit that the market correction may bring negative impact on insurers’ short-term investment performance, but the current valuations imply an overly bearish view on the long -term investment return of major life insurance companies according to our test.

    Methodology of our sensitivity test: Since the major factors (including those about premium growth, mortality, morbidity, lapse rates, maintenance expenses, claims and etc.) should have no major changes within a month, we believe the concern is mainly on insurers’ investment return. We assume all factors remain constant except the investment return rate. We also collect the data of adjusted net worth (ANW), value of in-force business (VIF), impact on VIF if investment return drops 10% directly from insurers annual and interim reports. First, we use A=1-(Current P/ EV /Average P/EV during Past 5 Years) to calculate the current valuation discount applied by the market. Second, we use B= - “Impact on VIF if investment return drops 10%” * “VIF”/”EV” to cal-culate what will happen on EV if investment return drops 10%. Third, we use C=A/B*(10%) to get what the discount is assumed under current embedded value (EV). Finally, we use (1-C)* ”Long-term assuming investment yield according to company’s own assumption” to calculate the im-plied long-term investment yield set by the market according to current valuation. Thus, the over-all formula is: Current market view on investment yield base on current EV = (1-(1-”Current P/ EV” / “Average P/EV”)/ (- “Impact on VIF if investment return drops 10%” * “VIF”/”EV” )*10%)* ”Long-term assuming investment yield according to company’s own assumption”. Please note that there are limitations in this test as we are assuming the impact from investment return drops on embedded value will be linear but that is undoubtedly not. And we also ignore the correlation between investment return and other factors.

    The results shows market is expecting the long-term investment return rate will be around or less than 2.5%, we think market’s view is too bearish: According to our calculation, the market’s view on insurers long-term investment is quite low. Especially for Ping An [2318.HK] and Taiping [0966.HK], the current P/EV implies that the long-term investment return will be less than 1%, we admit that the extreme case may be possible for short-term if both equity market and bond market collapse at the same time but it is very unlikely to be a long-term phenomenon. Thus we believe these four major life insurance companies are undervalued.

    We maintain our positive view on the sector; Top pick is still Ping An: As we mentioned before, insurance premium growth remained high for Jan-Nov 2015 at 19.67% YoY. Looking forward, we believe the high growth outlook remain intact as 1) penetration rate and density rate are still low; 2) policy goals for 2020 are very encouraging; 3) awareness of insurance will in-crease. Besides, we believe potential implementation of C-ROSS in Q1 2016 and tax-deferred policies for commercial pension will be catalysts. We maintain our positive view on the sector and those insurance companies within our coverage. Our top pick is still Ping An [2318.HK] because of 1) Integrated finance strategy, cross-selling opportunities continuously arise; 2) Internet fi-nance achieved significant effects of business innovation and steady growth in scale and user base which would become a good distribution channel; 3) Best product structure as more than 90% of total premium income was from individual life insurance agent channel at the end of 1H2015.