Thursday, October 5th, 2017
Commonwealth Bank’s exit from life insurance underwriting in Australia and New Zealand is one of the better strategic decisions the bank could have made, and there should be more of it (Suncorp and AMP please take note). Life insurance underwriting in this country has been a serial disappointment for 15 years and ASX investors are better off without it. Actuaries have not been able to forecast claims accurately because they did not understand the links between the patchy economic conditions of the last 14 years and mental health claims.
The earlier strong Australian dollar weighed on non-mining, exporting and import-competing sectors then the end of the mining construction boom threw mining towns and regions into recession. Income protection claims, especially those triggered by mental illness, soared way above expectations as policyholders turned to their policies for income support. The sector is also commoditised, capital-intensive and prone to price-driven customer churn driven by foreign competitors who enjoy lower costs of equity and debt capital than Australian underwriters. The post-GFC era of ultra-low interest rates made this worse and also reduced investment income.
The profitability pressures on underwriters create incentives to avoid paying claims, which was alleged at CommInsure and is widely perceived in the community. Although the Future of Financial Advice reforms allowed life insurers to continue paying salespeople by commission (this practice was phased out for managed investments), Australians remain underinsured for personal risks and this is not resolving. One reason is the products and their providers lack credibility in the community.
CBA’s reasons for selling its life books to AIA are valid. Only underwriters with global scale, diversification and risk management systems will earn adequate returns in the future. CBA is better off as a distributor, hence the 20-year marketing deal with AIA.
CBA’s exit from life insurance underwriting will also be politically useful in the future, when the bank can push back against further inquiries or a royal commission by saying it is no longer involved in the design of policies and the payment of claims.
The sale for $3.8 billion is incrementally positive for value. Although CBA will lose businesses that contributed $236 million of after-tax earnings last year (2.4 per cent of total earnings of $9.2 billion), the 70 basis points of capital released will vault CBA to a proforma common equity tier one capital ratio of 10.9 per cent, higher than the 10.5 per cent APRA requires by January 2020. Depending on the size of the AUSTRAC fine and further capital charges applied by APRA for not reporting oversize cash deposits and allowing money laundering, CBA could by late-2018, after the sale completes, have surplus capital. We suggest the first priority is to neutralise the dilutive dividend reinvestment plan by buying back the same number of shares issued. Certainly it would be hard to justify discounting another DRP as with the 2017 final dividend about to be paid. Buybacks are another option. A special dividend is unlikely given CBA does not have surplus franking credits other than a precautionary buffer.
Although the sale reduces earnings, it could increase earnings per share if CBA more than offsets this by reducing shares on issue. The company will soon need to let the market into its thinking on capital management to ensure consensus expectations are valid and disappointments relative to these expectations are not allowed to happen. Other factors in the mix are any class action settlement, higher regulatory, compliance and legal costs, the trajectory of bad debts expense and likely ongoing high technology costs.
CBA also announced a strategic review of Colonial First State Global Asset Management with several options to be considered including listing on the ASX. Based on fiscal 2017 earnings of $229 million, proceeds of $3.5-4.5 billion are possible assuming a 15-20 times earnings multiple based on current trading multiples for ASX-listed fund managers like Janus Henderson, BT and Perpetual. An exit at these multiples will in the first instance detract from value given CBA trades on 13-14 times earnings but as with the exit from life insurance it depends on what CBA does with the sale proceeds and surplus capital created. Probably the most shareholder-friendly transaction would be an in-specie distribution of CFS GAM to CBA shareholders, with tax relief. This is because sale proceeds and the listed equity value of CFS GAM are likely to be substantially higher than its book value on CBA’s balance sheet, creating a capital gains tax liability.
Seventeen years after CBA acquired Colonial, the group is finally admitting it cannot generate sufficient value by cross-selling life insurance and funds management to its vast retail customer base – the original justification for the revolutionary and controversial acquisition. This is quite a strategic disappointment, if not a total failure. It’s also nearly incredible to be talking about surplus capital at CBA just two years after the bank raised over $5 billion of new equity in a one-for-23 entitlement offer at $71.50 over August-September 2015. The stock fell out of favour and went sideways for a year after that issue and the extra equity has weighed on the share price ever since. This regrettable outcome might not have happened had CBA been less aggressive in its pursuit of home loan market share post-GFC, a strategy which pushed the regulator APRA to demand higher mortgage risk weights, and had it exited life insurance and funds management earlier. CBA’s board has taken too long to understand how its ownership of wealth management businesses related to its growth in mortgage lending and the resulting need for more regulatory capital.
Post the sale of life insurance our valuation, which includes the capitalised value of franking credits, is $82. CBA is attractive towards $73.
David Walker is ASX Large-Caps Portfolio Manager at Clime Asset Management.