The euro has serious implications for the relative performance of European insurance companies, say Trevor Petch, Mikir Shah and Trevor Moss.
The significance of the role which insurers play as active asset managers has so far often been missing from the discussion of the potential effects of the change to a single European currency. The euro has serious implications for the relative performance of European insurance companies, and that can yield some important clues as to what will happen to asset flows in general.
Most major European insurers have been surprisingly slow in preparing for the new conditions; mid-1998 seemed very late for companies to announce steps to set up Europe-wide asset management operations.
Half of the top 20 asset managers in Europe are insurance companies. The volume of global assets invested and managed by insurance companies reached 40.5% of the total GDP of the 25 European countries measured by the Comité Européen des Assurances (CEA) in 1997, up from 37.8% in 1995. There is, however, substantial variation between countries.
This trend will continue, and probably accelerate, as the burden of welfare provision is shifted to the individual, and savings preferences move away from interest-sensitive products towards higher-yielding, investment-based life products. In both cases, the link with fiscal discipline by national governments is directly via currency convergence.
Proposition No 1: The euro will turn insurance companies from asset allocators into asset managers.
Currency matching of assets and liabilities will be a radically different thing in the euro-zone. With the advent of the euro, Portuguese or Austrian risks can be covered with investments in Paris or Frankfurt. This is true for all multinational insurers, whether based in the euro-zone or not. Less obviously, it is also true for all insurers based in the euro-zone, whether they are active internationally or not.
Proposition No 2: Insurers cannot afford to remain local investors.
The insurance sector is unusual among quoted equities in that its investment return is translated directly into its operating results and earnings per share. With capital in the industry relatively abundant and insurance margins declining, an adequate return on invested assets becomes ever more important; insurance companies will find it difficult to outperform the market unless their investment returns outperform the market.
For life insurers, investment returns are crucial in determining operating margins, but also, through returns to policyholders, a key factor in competition and marketing.
Multinational insurance groups, therefore, have no choice but to seek to maximise returns across the euro-zone as a whole, and as a result, so do non-multinational insurers. Otherwise, the better earnings of the multinationals will tend to create an increasing valuation gap between the largest insurers and smaller ones.
It seems clear to us that in the initial period of euro-market, insurers with already established, sophisticated European asset management operations will secure a competitive advantage. Those which have been slower may catch up in the medium term, but those which are too late, and, especially those national insurance companies which have failed to identify the problem or lack the will or the means to confront it, will form a pool of targets for future consolidation. Larger, more efficient groups will be able to add shareholder value simply by reallocating their invested assets.
The search for maximum investment returns implies flexibility. As well as a shift in the allocation of equity investments towards the best-performing markets, the investment behaviour of insurers appears to imply increasing volatility as investments are shifted in response to changing conditions.
While we expect bond rates across the euro-zone to converge, we do not expect them to be identical, so the same investment behaviour is likely in the bond as well as the equity markets.
Finally, since bond yields are likely to be lower than they historically have been in a number of countries, we would expect the euro-zone insurance (and, in time, the pension industry) to shift the balance of its investments away from bonds and in favour of equities.
Trevor Petch, Mikir Shah and Trevor Moss are insurance analysts at Robert Fleming Securities Ltd.