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Morningstar | We Expect Limited Impact on Chinese Insurers From the Latest RRR

We think China’s latest cut in its reserve requirement ratio will have only a limited impact on the valuations of the Chinese insurers we cover. The RRR cut will affect insurance investment return and reserving charges as interest rates decline after the liquidity injection. However, we expect the negative impact on investment returns will be smaller than what the market is expecting, thanks to a five- to seven-year holding period of fixed-income investments, rising profit contribution from mortality or morbidity profits as result of product mix shift, and low embedded value sensitivity to interest rates for insurers in our coverage. Looking into 2019, we also expect limited impact on insurance reserving charges. The 720-day moving average government bond yield, a proxy for discount rate assumption in the calculation of future insurance liabilities, is likely to remain on its rising trend despite bond yield falls since 2018. Thus, we don’t expect an increase in reserving charges, which hamper insurers’ earnings growth in 2019.

We retain our fair value estimates for the Chinese insurers given the limited impact of falling interest rates. The Chinese insurance sector is trading near trough valuation as market concerns over falling rates are overblown. Our top pick for the sector is Ping An Insurance, with H shares trading at a 26% discount to our fair value estimate. We like its unique advantage in customer acquisition and leadership in adopting financial technology adoption to improve operating efficiency and customer stickiness.

Compared with an over 18% CAGR since 2006, China’s life insurance market is entering a new stage, with slower growth and shift in sales mix toward long-term savings and protection products. As consumer confidence drops and growth in disposable income slows, the difficult transformation is compounded by weakening demand for savings type insurance. However, we believe the long-term growth in China’s life insurance market will remain strong, thanks to China’s low insurance penetration and aging demographics.

Following the PBOC’s four rounds of RRR cuts since 2018, Interbank market rate, as measured by seven-day reverse repo rate has dropped to a new low at 2.4% from 2.9% in mid-2018. Accordingly, the 10-year government bond yield fell below 3.2% in Jan. 7 versus the peak of 4.0% in early 2018. This reversed the rising trend since mid-2016, at the commencement of China’s financial deleveraging campaign. However, the three-year moving average bond yield will still trend up by 4 and 2 basis points, respectively, assuming the government bond yield will fall to 3.0% and 2.8% in the second half of 2019. This compares with a 14-basis-point increase in 2018 and a 16-basis-point decline in 2017, suggesting that the impact on provisioning charges are quite manageable. Besides, interest-rate impact on embedded value, which is a key factor for life insurers’ valuation multiple price to embedded value ratio, is also low for leading companies. According to their sensitivity tests, every 100-basis-point decline will result in a 5% to 10% decline in life insurance embedded value for Ping An Insurance, China Pacific Insurance and Ping An Insurance. While this is likely to be offset by strong average embedded value growth from existing business, which ranged from 8% to 10% for three listed insurers. Besides, growth in new business value also contributed to embedded value growth by 8% to 14% for life insurance embedded value over the past five years.