Lloyd's - Aon/Berkshire deal is fundamental challenge. Imaginative response required.

What has happened?

So, Aon has done a deal with Berkshire Hathaway under which the latter will take 7.5% of any 'retail' subscription business that Aon places in which Lloyd's participates. The deal is of course a private arrangement between Aon and Berkshire so the precise terms are not public. But we understand, and comment on, the deal as covering all business outside of reinsurance, aviation and space in which Lloyd's participates. Early reports said the agreement took effect from March.

Lloyd's has serious reservations about the deal and even last week Tom Bolt, the Lloyd's head of performance management was warning CEOs of Lloyd operators to be careful of their compliance obligations if they get involved in similar deals.

The nature of the deal means;

1. Berkshire will have no decisions to make either on pricing or even on whether or not to follow. They will automatically follow on all business.

2. Berkshire and Aon will therefore split between them and benefit from profits deriving from Lloyd's unique ability to attract business through creating a 'bespoke' price for any risks presented to the market, but they will not contribute anything at all to that pricing mechanism.

3. All Berkshire will need to do is operate like a post box - plus a claims settlement facility. It should be extremely profitable as they will be paid the same as other risk takers but, outside of opening the post box and administering claims settlement, they won't be doing anything else. This should mean a very low operating expense ratio - partly offset of course by an undisclosed but presumably fat commission paid to Aon.

Consequences

There have been various observations reported on the deal. For example that the arrangement is a compliment to Lloyd's (from Aon, Hiscox), that it takes business away from Lloyd's, that ultimately it might bring business to Lloyd's, that it raises a questions around whether leaders on subscription business are sufficiently rewarded, that it is a binding authority, and that it is an attempt to 'index' Lloyd's.

Comment

We would not disagree with the observations we have seen. They are all valuable additions to understanding this new and, in our opinion, extremely significant development. However what we believe is most important, and what we wish to focus on here, is the aspect that the deal is an attempt to index Lloyd's.

It is indeed, and that is something that Lloyd's should, and in our analysis can, react to in an appropriate, valid and innovative way. And yes, it has to be all three to be any!

To be clear the only management Berkshire will be involved with is the decision as to whether to renew the deal - at points in time that we've not seen disclosed publicly and, similarly, the negotiation of Aon's remuneration.

The description of  'indexing Lloyd's' is remarkably appropriate. The deal is very comparable to the operation of index funds in the equity markets. In this case the benefit of the cost savings will be split between Berkshire and Aon.

Left unchecked this sort of arrangement would, if replicated elsewhere, rip the heart out of the resources available for Lloyd's pricing infrastructure. The pricing infrastructure within managing agents would be working for Aon and Berkshire but they would not be paying a cent for it. On the contrary, that money is earmarked for Aon and Berkshire's profits.

There is no doubt an argument that Lloyd's must cater to Americans' wishes as so much business at Lloyd's comes from the US. But this argument has never been weaker. Lloyd's is gradually globalising, US entities have been continual buyers of Lloyd's operators and seem to need no inducements at all to maintain their interest - they clearly, and very keenly, appreciate the value of the franchise.

In the equity markets the diminution in resources available for active equity pricing and the increasing influence of indexed funds has contributed hugely, and fairly transparently, to anomalies that have been bad for investors and other market stakeholders. For example we have seen the listing in London of large non-UK companies, often resource focused and based in emerging economies, which would have struggled to obtain support were it not for the fact that if they start out big enough to get in to the FTSE 100 then a very high percentage of the shares (estimated variously but including  some estimates in the 60% region) are automatically bought by index funds. It is a mechanism by which mass-market UK pensions savings have disappeared into disastrous investments such as, for example, ENRC and Bumi. The upside of this is hard to see - unless perhaps you are one of the original owners of these businesses. And its the sort of fiasco that erodes a market's ability to attract new business.

No two cases are the same and some of the consequences might not be directly comparable to equity indexed funds, but the prospect of a downsizing of Lloyd's pricing infrastructure so that it can no longer serve  the same purpose is real enough.

It is curious that the FCA, which has a responsibility to promote efficient markets, has not so far appeared interested in the impact either of indexed funds on equity markets or of the Aon/Berkshire deal on Lloyd's. Denuding the pricing mechanism of resource erodes efficient markets.

Recommendation

Fortunately Lloyd's still is in control of its own house. Unlike the Stock Exchange of old it has not disappeared in to a 'quango'. We have to hope it does the right thing, and that is to counter Aon and Berkshire's exercise of  their unusual distribution and capital power through this deal by using its own unusual powers to promote efficient markets.

Lloyd's should assess the contribution to the market infrastructure that Aon and Berkshire are evading through the 'index' process and require Aon to pay that amount as a fee for using Lloyd's. Make no mistake, if Aon could not use Lloyd's for the business then Aon would be the loser.

Is this an escalation? Would it test Lloyd's control over its managing agents? Yes it is and it would. But Lloyd's needs to recognise the scale and the deeply pernicious nature of the challenge that has been thrown down for the sake of short-term gain on the part of Aon and Berkshire.

I suspect it does, and I hope we hear more over the coming months.

Ed - Outsure

Tell us what you think. All comments, absolutely all, are welcome.

Ed Outsure can be reached at citizent@live.com

A European insurer growth profile - Generali

Life insurers' can have locked in growth
One of the good things about being in the life insurance business is that customers are with you a long time. The new business you write today should produce profits for years to come. Strange then, you might think, that you don't hear a lot of comment in the form of "they only reported Y of operating profit this year but the new business would produce a multiple of that - NxY, of profit per annum". Or, to be precise, to say that is what would happen if they simply wrote the same amount of new business every year.

Well, we believe its a fair challenge. And its an approach that would separate the genuine growth stories from the others. We've been looking at that multiple, 'N', and one example we'd like to highlight is Generali, where we calculate the multiple at 2.4x. Yes, 2.4x. That is a very, very, impressive level of locked-in life profit growth, and one of the highest in the sector.

How to identify the multiple
Its calculated from the new disclosure of 'undiscounted new business profit'. But is the result for Generali some kind of distortion from the peripheral Eurozone crisis? Seems not. Its around where we'd estimated it before and the plain fact is that, on the ground, Generali, along with one or two others in the sector, is not reporting IFRS operating profit derived from legacy business with no real counterpartt in new business. And its that sort of thing that, relative to Generali and one or two others at least, depresses the multiple for many insurers with large businesses in European or US life insurance.

It is somehow poetic that despite all the fancy 'embedded value' (or 'EV') reporting and the esoteric trills added to the score by the high priests of the art in recent years, this sort of simple measure is not made a lot more obvious in life insurers' reporting. We call 'N' the 'locked-in growth multiple' and we estimate it using the procedure described below, plus a few adjustments to keep things comparable between the different life insurers, allow for investment management profits in the EV reporting, whether the undiscounted new business profit does or does not include costs on day one and such like.

So what we're doing is estimating the multiple of current IFRS life operating profit that would arise from writing the most recently reported new business every year. And if you've got that you can miss the box out for now if you wish!


                             LIFE INSURANCE LOCKED-IN GROWTH MULTIPLE

                   

What it means for Generali is important because ...
The important point is that in Generali's case it should mean reported life operating profit has real momentum. Not necessarily quarter to quarter, or even year to year. But it will be on a robust trajectory to much higher levels over the medium term and it's not easily going to be knocked off course.

As a comparison the multiple for Standard Life is nowhere near Generali's 2.4x. We calculate it at just 1.4x, and that is using the lower starting point  for IFRS profit of £650mln suggested by Standard Life as the new run rate (rather than the reported circa £900mln). Recent Q1 new business sales numbers were bouyant for Standard Life but the key will be whether the new business is very profitable. We expect it is low margin, and probably, at least in the case of the auto enrollment sales that provided half the growth, very low margin. In other words, not much future profit.

Generali's Q1 results are on Friday 10 May. Non-life is recovering. The p/e multiple on consensus forecasts is just under 11x. Life profits are on a robust higher growth trajectory, in our view, and the company has been transforming how it communicates with stakeholders under new MD Mario Greco.

We think Generali should have a great story to tell, the Italian negative is not what it was, and the share price has been showing some intriguing signs of life recently. We shall see.

All comments welcome

Ed Outsure can be contacted at citizent@live.com

Standard Life, non-standard remuneration, LTIP target ambushed

Standard Life's 2012 Report and Accounts were published yesterday (April 2). For the first time the financial target that determines share grants to the three top executives under the LTIP (long term incentive plan) is purely a matter of the reported figure for IFRS operating profit exceeding a pre-set level. That level was set in 2010. At the same time, curiously, the remuneration report no longer includes a sentence in the 2011 Annual Report which stated, on page 69, that

"In reviewing the outturn of both our short-term and long-term plans the Remuneration committee considers the details of the results to ensure that the reported figures reflect the underlying performance of the business."

To be clear, this sentence is no longer included. It is not in the remuneration report in the 2012 Annual Report. If shareholders do not want LTIP pay to be boosted by short-term one-off profits, they must rely on a slightly weaker sentence which does appear in both the 2011 and 2012 report and which states that the LTIP scheme

"requires the remuneration committee to be satisfied that operating profit performance reflects overall Group performance".

It may be that the remuneration committee felt they were at risk in some sense, perhaps including legal risks, from the 'underlying performance' commitment in light of the new LTIP targets. However that would raise huge concerns in itself and, overall, it is in our view deeply problematic that the safeguard provided by the 2011 commitment on underlying performance has been dropped. It surely is a rare backward step in remuneration governance. Still, the 'reflects overall group performance' requirement probably would be strong enough - if the remuneration committee can be relied upon to apply it rigorously.

In this context the figures themselves tell quite a story. So lets look at them.

2012 performance

The remuneration committee approved the maximum share grants to the CEO, CFO and head of the investment operation, SLI, under the LTIP. In other words shares worth 200% of salary for the CEO, using the share price as at the date when the 2012 scheme was set in motion in 2010, become the CEO's in June 2013. A 'back of the envelope' calculation suggests that, in light of the rise in the share price since 2010, the value has now become circa 350% of salary or more and has been calculated at over £2.8mln. For the sake of completeness we should add the three executives also receive other bonuses in addition, which are of a not dissimilar order.

LTIP schemes are, in general, cast as demanding performance hurdles for senior management.

The actual payout for 2012 is the maximum possible under the plan because IFRS operating profits exceeded the target of £600mln for the maximum payout. For 2013 the relevant figure is £800mln (see pages 80,81 of the 2012 Annual report). The threshold for zero LTIP payments is £400mln for 2012 and £650mln for 2013.

Operating profit was £900mln in 2012, or £892mln excluding associates. The latter being the actual number the scheme uses. The remuneration report quotes this result and then says

"in line with the above results, the Remuneration Committee determined that 100% of awards granted in 2010 should vest in June 2013"

So the remuneration committee decided that the operating profit did indeed reflect "overall Group performance" then?

But, errr, the CFO says quite explicitly in the transcript of the analysts' meeting following the 2012 full year results that the operating profit did no such thing (see below)!

2012 always was going to be the senior executives' best chance to hit maximum LTIP payouts given the target hike to £800mln in 2013 from £600mln in 2012. And when the 2012 year came into view the LTIP target met with quite an ambush.

Lets Tamper with the Incidence of Profits

On page three of the transcript of the analysts' call after the 2012 full year results, CFO Jackie Hunt describes several one-off features of the 2012 operating profit.

These include a £96mln payout in 2012 from a professional indemnity insurance policy held by Standard Life. The policy eventually paid out, in 2012, to protect Standard Life from costs incurred in 2009 in reimbursing investors in a Standard life 'cash' fund which turned out to be invested in asset backed securities that suffered over the credit crunch. In Canada sales of real estate and other 'management actions' crystallized in 2012 profits that have been built up over many years. These actions added over £150mln to the reported 2012 Canadian profit, all of which was included in operating profit. Jackie Hunt, the CFO, said there still are some more of these profits to come but that in 2013 such profits would only run at half the 2012 level, and so half should be excluded from any assessment of the "run-rate ... of profit on a sustainable basis" for 2012, as Jackie Hunt put it. Similarly she said that £91mln, which arose from assumption changes should be excluded.

It is good that the CFO explained these items so clearly at the analysts' meeting. But a point we would like to add is that restructuring costs of £109mln are excluded from 2012 operating profit. Restructuring costs appear to be a regular feature. They were £70mln in 2011 and £71mln in 2010. In a big business like Standard Life this is completely reasonable. On a group wide basis restructuring is a never ending, quasi continuous, process.

Jackie Hunt said the run-rate of operating profit at end 2012, which she calculated by including half of the one-off investment profits in Canada and excluding all of the restructuring costs, was in the £640 to £650mln range.

another way of doing it is ...

You could do it differently of course, and get a lower answer for operating profit that would more credibly reflect "overall Group performance". For example excluding the one-off investment profits in Canada and deducting restructuring costs would mean an operating profit on a "sustainable basis" of around £475mln.

The three executives would, on this basis, only receive a fraction of the amount they are currently in line for.

In using £892mln the remuneration committee are, we suggest, taking an unnecessarily weak view of the "overall group performance" commitment to which they still are subject when assessing if LTIP targets are met; indeed they are giving it no effect at all. And in our view they clearly are relying on the absence in 2012 of the "underlying performance" commitment. If so, they certainly cannot argue that the change of wording does not matter. In any event, shareholders have not voted for one-off profits to trigger LTIP remuneration! Also, the wording change may make a big difference to LTIP payments for 2013.

And as for 2013

For what it is worth our analysis is that Standard Life's new business profitability does not currently support a sustainable IFRS profit of much above GBP550mln (after restructuring costs).

The analysis behind this is a separate piece of work which uses the "undiscounted new business profit". These are new numbers disclosed for the first time by Standard Life in their 2012 Annual Report and we use them, along with several adjustments, to assess  the medium term outlook for IFRS profit. We intend to elaborate the research in further posts. What we can say here though is that Standard Life's position is not enormously out of line (taking the suggested £640-650mln as a base level for reported profit). A wider comparison of undiscounted life new business profit with reported IFRS operating profit suggests one or two life insurers are in a worse position by this measure than Standard life. Equally there are two or three life insurers across the UK and Europe in a far better position and which we view as storing up an impressive growth outlook for IFRS profit through their new business profitability.

But the point is the analysis suggests it would be a big stretch for Standard Life to generate IFRS profit much above the threshold for zero LTIP payments in 2013, at least on a sustainable basis.

Is this right? Well here's a straw-in-the-wind - after becoming entitled to her wopper 2012 related LTIP payment CFO Jackie Hunt promptly upped sticks and left to join Prudential plc as CEO of UK and Europe - funny that!

All comments welcome.

Ed Outsure

Ed Outsure can be contacted at citizent@live.com

Banks, lending for some, pretending for others

Revealing figures from the British Bankers Association last Monday.

As we all know, the banks are supposed to be supporting business through the 'funding for lending scheme' - except they appear not to be doing so. And as we all know they are at the same time under pressure, supposedly from new regulation but also from a starting point of over gearing, to reduce their balance sheets - but this also looks to be a highly selective process.

It now looks like the banks are taking the government's cheap funding for lending money and effectively using it not to support SMEs, small or medium, but to roll-over lending to larger corporates. I'll show how this is suggested by the figures below, but, perhaps more controversially, I'd like also to point out here that larger corporates have been hoarding cash rather than borrowing.

How are we to square the actual lending recorded by banks with the picture we have of risk averse larger corporates hoarding cash, paying off debts, and raising funds from bond markets?

I fear there is of course no real problem. We are describing the real world so the reality has to be out there somewhere. What surely is happening is that lending recorded as corporate-not-SME includes buy-out lending 'crammed down' in to the operating entities, and that this is the component that is expanding.

Whilst real business people are being squeezed by banks and are handing real cash over to pay down debt, those fortunate enough to live in the make-believe world of private equity (you know, the one where banks lend without cross guarantees from owners across the different projects they are involved in) are being supported by banks. The banks know that attempting to enforce the buy-out debts would knock their clients off their precarious pedestals. These bad debts have not been acknowledged yet by banks.

Large buy-out loans are handled by well paid-bankers who have clout and bonuses. SME loans are handled by lower forms of life and/or computers. Actually its the latter that generate profits for shareholders. But when banks talk about supporting business, it appears they mean their private equity friends.

The SME loans are real lending, lending that can be and is being repaid. The buy-out loans are a pantomime which in good times rewards all those who benefit from the call option generated either by obtaining a job as a private equity banker or knowing the phone number of one. A pretty good description of 'noughties elites that!

And as for the the BBA figures, here they are:

   GBP bln                                        Dec 11                   Dec 12                   change

1   Small business  (a)                    33.0                       32.7                     -0.3                       -1%

2   Med business   (a)                     58.3                       54.9                     -3.4                       -6%

3  Larger business (b)                   200.3                     200.5                     +0.2                       0%

4  Total non fin business (c)      291.6                     288.1                     -3.5                       -1%

5  Total Financial (c)                     331.1                     350.1                    +19.0                     +6%

6  Total                                               622.7                     638.2                    +15.5                     +2%

a)      From SME BBA statistics Monday 7 March

b)      Difference 4 and sum of 1 and 2
c)       From December 2012 BBA statistics

SME lending down, larger business lending flat, financial lending (which probably includes some private equity amongst other things), up.

All comments welcome.
Ed, Outsure     11 March 2013

Ed Outsure can be contacted at citizent@live.com

It's started ...

Here you will soon find genuine opinion pieces about the unique circumstances of European insurers.

We will be focusing on the commercial environment for listed insurers. So product/distribution controversies will be discussed if they are relevant to the overall picture for the corporate concerned or for the industry as a whole.

We will start with one of the most important issues out there - the asset aside of insurers' balance sheets, and the questions being asked of insurers' investment approach.

It should be up for discussion, and we will talk about it here.