China is getting older and wealthier. This sector is set to profit greatly from the trend.

China’s increasingly wealthy and fast-ageing population are driving massive secular demand for life and health protection insurance policies.

The low insurance penetration in China provides ample room for growth for major life insurers, as they progressively bridge the gap in insurance coverage.

Industry valuation is currently at historical lows and investors stand to benefit from massive potential upside as valuations rebound on rising optimism.

We value Ping An Insurance (HKEX: 2318) at HKD 100 and China Life Insurance (HKEX: 2628) at HKD 29.

This represent potential upsides of 7% and 34% respectively, based on their closing prices on 10 Apr 2019.

In our last article, we talked about the recent premium growth rebound in China and how the insurance industry is shifting towards a more sustainable long-term business model, focusing more on protection-type products. In this article, we explore in greater details the underlying demand for insurance in China responsible for fuelling the long-term growth trend of this industry.

(Related Article: China Life Insurers: Rebound in premium growth presents huge turnaround opportunity)

Growing societal needs fuel the secular growth of China’s insurance industry

China’s total insurance premiums reached RMB 3,748 billion in 2018, having grown at double-digits for the last ten years (Chart 1). Life and health (L&H) insurance accounted for a significant 70% of China’s gross written premiums last year, while property & casualty (P&C) insurance accounted for the remaining 30%.

Looking ahead, we remain optimistic on China’s L&H insurance sector, which primarily sells two distinct categories of products: protection-type risk management policies and savings-type wealth management policies. Propelled by key demographic trends such as expanding household incomes and a fast-ageing population, we believe China life insurers are poised to benefit greatly from the massive secular growth potential.

Chart 1: China’s fast-growing insurance industry propelled by a wealthier population

China, now home to the world’s largest middle class population, has seen its average household income rising steadily by a CAGR of 10% over the last decade. This surge in wealth quickly drove demand for capital preservation and savings-type wealth management products (WMP). Such overwhelming demand also inadvertently played a part in the rise of the unhealthy short-term high-yield “universal life” insurance that plagued the life insurance industry in the last three years.

Thanks to China’s fast-ageing population, demand for health insurance has quickly accelerated as well. The burgeoning elderly population has caused demand to far outstrip supply for medicinal products and healthcare services in China, leading to medical costs ballooning out of control the last five years. Healthcare costs grew more than double the pace of general retail prices in China since 2014 (Chart 2).

With the situation unlikely to improve anytime soon, demand for protection-type health insurance skyrocketed in China. Health insurance premiums rose 37% annually from 2014-2018, twice the growth rate of overall insurance premiums. As the expanding middle class increases their spending on healthcare, we expect the secular tailwind for health insurance to persist in the years ahead.

(Related Article: KURE: Get Ready For the Boom in China’s Healthcare!)

Chart 2: Healthcare cost has outpaced retail prices in China for the last five years

Ample room for growth in China’s underpenetrated life insurance industry

Despite the tremendous growth in the insurance industry, the overall insurance coverage in China remains relatively inadequate. China’s insurance penetration rate was 4.7% last year, still lagging the average rate of 7% among developed countries (Chart 3). The insufficient coverage, however, also means ample room for growth in the life insurance industry, as China attempts to close the significant gap in life protection coverage, which will grow increasingly essential in the next decade.

Chart 3: Ample room for growth in China’s underpenetrated insurance industry

Such a gap in insurance coverage primarily stems from an insufficient government provision, particularly for medical services. Out-of-pocket costs for healthcare still accounts for close to a third of total Chinese health spending, way higher compared to developed nations like Japan (13%) and US (11%).

Despite policies to lower medical expenses and improve affordability of healthcare, prices continue to expand rapidly from the strong underlying demand for healthcare services. China’s total health spending of RMB 5.16 trillion in 2017 accounted for 6.2% of total gross domestic product (GDP). It is widely projected to quickly converge towards levels seen in ageing societies like Korea (7.6% of GDP) and Japan (10.7% of GDP).

As healthcare spending continues to accelerate, the gap in health coverage is progressively brought into focus in the insurance sector. Chinese authorities have beaconed for commercial insurers to step in for supplementary coverage, especially for health and critical illness policies.

Therefore, we believe the major life insurers like Ping An Insurance (HKEX: 2318) and China Life Insurance (HKEX: 2628) are well-positioned to benefit from the rapidly expanding insurance market, as they bridge the widening gap in health insurance coverage in China.

Major life insurers to regain footing in China’s Insurance industry

Historically, while the life insurance market has always been largely dominated by the four major national insurers – China Life Insurance, Ping An, CPIC and New China Life – they have been losing significant amount of market share in the industry in the recent few years (Chart 4). The attractive growth potential of the industry and its low barriers to entry have drawn in many new entrants. The number of Chinese insurers has increased by about 1.5 times since 2010, reaching a total of 170 companies last year.

With the industry split among more players, the smaller insurers attempted to grab market share by pushing sales of relatively higher guaranteed-return (but low-margin) savings policies, including the notorious “universal life” policies, through their bancassurance channels.

Meanwhile, the major life insurers took on an exact opposite strategy: they tried to evolve their business models by selling higher-margin protection-type health insurance policies via their own sales agent channels, while reducing sales volumes on lower-margin savings policies in their bank-distribution channels. Consequently, the market share held by the major life insurers stumbled.

Chart 4: Major life insurers are well-positioned to regain their market dominance

However, looking ahead, we believe the market dynamics are about to shift in favour of major life insurers. Not only is consumer demand veering towards health and protection-type policies, the Chinese government is actively pursuing a ‘carrot and stick’ approach to ensure such industry development. Under the slogan, “insurance means protection” (“保险姓保”), regulators have since urged insurers to re-focus on protection-type products and stay away from savings-type ones.

Coupled with the regulatory ban on short-term savings-type life policies in late-2017, we believe the major life insurers are well-positioned to regain their market dominance in the industry. The abrupt ban on short-term savings-type products had a devastating impact on the smaller life insurers, which struggled to adapt and transform their business structures appropriately. Life insurers that relied heavily on bank-distribution channels were hit the hardest, especially since they now have the weakest sales agent distribution networks.

Therefore, we expect the position of major life insurers to be greatly strengthened from this year onwards. Not only have they oriented their product portfolios toward protection-type products, they also have large and well-established sales agent distribution networks necessary to drive sales of insurance policies. As smaller insurers are gradually flushed out of the industry due to their weak profitability, we also expect major life insurers to enjoy better profit margins, which have previously contracted due to the unsustainable price competition started by new entrants.

Massive upside potential as industry rebounds from historical low valuations

After a series of scandals surrounding Anbang Insurance group, the insurance industry earned itself a bad reputation and investor sentiment towards the industry became increasingly negative. Compounded with the ongoing crackdown on shadow banking activities, concerns over solvency risks and weak financial performance last year, the P/EV (price-to-embedded value) of the life insurance industry slumped to historical lows (Chart 5).

While the 5-years average historical P/EV of China life insurers (H-shares) is about 1.0X, the current industry P/EV ratio has declined to 0.7X. China Life Insurance (HKEX: 2628), despite being China’s largest life insurer, is currently trading at 0.6X, below both its peers and its historical average. As the business structure of the industry improves, we are optimistic on a positive re-rating in the sector, which will lift insurers’ valuations back up from the current historical lows.

Chart 5: Valuation of life insurers reached historical lows

As a sector, share price performance of China’s life insurers (H-shares) exhibits a strong positive correlation with capital market movements. Life insurers have a high 5-years beta between 1.2 and 1.4 (against Hang Seng Index), which means industry would decline more than the overall equity market during downturns. This is primarily because risky equity assets constitute a substantial portion of their investment portfolios, which returns are reliant on the performance of the capital markets.

The bearish China’s capital market last year has led to a double whammy of declines in both financial performance and valuation of the sector. On the flip side, this is also meant that the life insurance sector is poised to rebound strongly upon a recovery in the China and Hong Kong stock markets. We believe investors stand to gain massive potential upside as insurers’ valuations rise alongside the broad market.

(Related Article: You can still make 30% by investing in Chinese banks now)

China Life still provides decent upside potential

We remain optimistic on life insurers Ping An Insurance (HKEX: 2318) and China Life Insurance (HKEX: 2628), given their dominant foothold and strong growth prospects in China’s life insurance industry (Chart 6 & 7). Together, they accounted for almost 40% of all gross written premiums in China last year.

We value Ping An at HKD 100 and China Life at HKD 29, which represent potential upside of 7% and 34% respectively their closing prices of HKD 93.45 and HKD 21.60 on 10 Apr 2019.

Our fair value of HKD 100 for Ping An is derived using a Sum-Of-The-Parts (SOTP) methodology, due to its nature as multi-segment conglomerate. The calculations for the SOTP valuation are tabulated in Table 2. Our fair value of HKD 29 for China Life is derived by applying a 3-year industry average P/EV multiple of 0.85X on our estimated 2019 embedded value per share (EVPS) of HKD 34.

Table 1: Relative valuation among China’s life insurers

Table 2: Sum-Of-The-Parts Valuation of Ping An Insurance Group

Since our last article on the China Life insurers, the share prices of Ping An has ran up by 16% in barely two months’ time. While we still believe in the long-term growth prospects of Ping An Group (Chart 7), the current market price is starting to reflect its 2019’s fair value of HKD 100.

Hence, given the respective upside potentials, we favour China Life Insurance (HKEX: 2628) over Ping An Insurance (HKEX: 2318), with China Life providing over thirty percent upside (Chart 6). We also think investors may consider taking some profits off the table for Ping An.

Chart 6: China Life’s earnings to rebound strongly in the next two years

Chart 7: Ping An’s earnings expected to grow at double-digits over next two years

Declaration:

For specific disclosure, at the time of publication of this report, IFPL (via its connected and associated entities) and the analyst who produced this report hold a NIL position in the abovementioned securities.

The Research Team is part of iFAST Financial Pte Ltd.