Insuring Success SAUDI ARABIA INSURANCE SECTOR August 2016 SAUDI ARABIA INSURANCE SECTOR Murad Ansari [email protected] Shabbir Malik [email protected] TABLE OF CONTENTS I. Executive Summary 03 II. Key divers of growth 06 III. Consolidation - Survival of the fittest 12 IV. Investments - Better opportunities for longer players 16 V. Valuation and risks 20 VI. Market Structure - Strongly regulated market 24 Appendix: Glossary of Insurance terms 32 Appendix: Saudi Insurance sector - Key regulations 34 Tawuniya - Initiation of Coverage 35 Bupa Arabia - Initiation of Coverage 52 Non-rated Insurers 70 SAUDI ARABIA INSURANCE SECTOR 25 August 2016 Insuring success Initiation of Coverage Financials | Saudi Arabia Murad Ansari +966 11 2506149 Initiating coverage; Tawuniya is our top pick [email protected] We initiate coverage on the Saudi Insurance sector with BUYs on Tawuniya and Bupa given their i) superior profitability profile; ii) strong risk mgmt track Shabbir Malik +971 4 363 4009 record; iii) comfortable solvency levels; and iv) opportunity to enhance [email protected] returns. Our detailed review of all 35 listed insurers leads us to believe that scale and consistent risk management puts them head and shoulders above Short-term catalyst the rest. Our top pick is Tawuniya (a conviction Buy) given its exposure to Loss ratios should ease off in 3Q16 motor insurance as better enforcement should drive stronger premium (seasonality), which should support Q-o-Q earnings improvement growth in the ST. Bupa, with its robust profitability (sustainable ROEs of c30%), is the quality health insurance play in the sector, and is well Medium-term catalyst positioned to gain more market share as the sector consolidates, in our view. Improving enforcement in mandatory lines of insurance Changing dynamics creates opportunities; large insurers best placed Long-term value drivers The Saudi insurance landscape is changing. After two years of solid volume Growth in insurance penetration, privatisation of public healthcare system and price-driven growth, sector GWP growth is moderating. We estimate the and new insurance lines – mortgages, sector’s GWP grew 7.5% Y-o-Y in 1H16 versus an average of 20% for the past bancassurance and travel & pilgrimage three years. The weakening economy has created cost consciousness, and we We initiate on: expect GWP growth to remain weak in the ST. However, the govt’s fiscal BUPA: FV SAR155, upside 22% challenges could accelerate the reform process, which should be favourable Tawuniya: FV SAR117, upside 30% for motor and health insurers. Bupa and Tawuniya are strongly positioned to Other interesting insurers: benefit from these medium-term drivers due to their scale and consistency of Al Rajhi: Third largest motor insurer risk management – the holy grail for insurers. Near term, we believe that with improving combined ratio Tawuniya has stronger earnings growth profile than Bupa. SAICO: multi-line, competitive loss rates Arabian Shield: A multi-line insurer, with steadily improving under-writing Consolidation has already started and could gain momentum business Rationalisation is perhaps the apt word, as industry sources suggest six Buruj: A motor play, with improving underwriting discipline insurers are in the process of winding down their businesses. Moreover, regulatory changes restricting direct sale of health insurance to individuals is likely to hit a number of health insurers’ business models, in our view. Our review of all listed insurers indicates that, excl. Bupa and Tawuniya, only two non-life insurer have been able to maintain a combined ratio below 100% over the past two years. While recent capital increases may provide some breathing space, slowing GWP growth is likely to challenge a number of insurers who have been chasing growth. This could hasten consolidation in the sector, in our view. Investment risks Key sector risks are weaker enforcement of mandatory insurance lines, aggressive pricing in the market, regulatory risks and volatility in investment returns due to exposure to equities. As of 2Q16, allocation to equities was 14% of the investment book for Tawuniya and 3% for BUPA. Insurance terms – cheat sheet: GWP - total premiums receivable for the period of cover provided by the insurer. Loss ratio - net claims incurred to net earned premiums. Expense ratio - underwriting expenses to net earned premiums. Combined ratio - sum of loss and expense ratios. Please refer to the disclaimer and disclosures at the end of this note. SAUDI ARABIA INSURANCE SECTOR Financials | Saudi Arabia I. Executive summary Strong potential for medium-term growth At 1.4% of GDP, insurance penetration in Saudi Arabia is amongst the lowest in the region as well as globally. We believe a young and growing population remains the key driver for sustained double-digit growth over the medium term. Enforcement of mandatory lines – health and motor – will remain the key driver in the short to medium term. Industry experts estimate that only 45% of the cars are covered by insurance, while only 57% of the private sector Saudi workforce has medical insurance. We believe enforcement of mandatory lines still holds significant potential for growth. As low oil prices weigh on public finances, the government is likely to look to share its cost burden with the private sector, particularly in insurance. Bupa and Tawuniya – Head and shoulders above the rest Our analysis of the listed companies indicates that excluding Bupa and Tawuniya, there are only four listed Saudi insurers that have been able to maintain a combined ratio of less than 100% for the past two years. Of the four, two are pure life insurers - Aljazira and Alahli - which is a long-tail business and can maintain low loss ratios, but claims could surge in a year sharply. Clearly, a large majority of the insurers operating in the country lack the scale and consistency in risk management to maintain underwriting profitability. This makes Bupa and Tawuniya unique within the Saudi insurance sector, in our view, and the obvious candidates for exposure to the sector. While Tawuniya suffered underwriting losses in 2013 as price war intensified, it has recovered sharply, helped by strong pricing discipline. Bupa – The healthy choice amongst Saudi insurers We initiate coverage on Bupa with a Buy rating; our fair value of SAR155.0/share implies 22% potential upside. A mono-line insurer, Bupa is the largest health insurance company, in terms of GWP size. It is the dominant player in the health insurance segment by a big margin, with c43% market share of sector health premiums; the combined market share of the next two biggest players is approximately equivalent to Bupa’s. The scale allows the company to negotiate services at a better price for its customers compared to peers, allowing it to manage claims inflation. While premium growth should moderate, Bupa’s quality proposition should allow it to continue gaining market share. We expect Bupa to deliver sustainable ROEs of c30%, as the company leverages off its strong risk management and scale of operations to maintain a combined ratio of around 90%. We see strong potential for investment return enhancement, as the company better manages its liquidity, which has -so far- delivered below- average returns. Moreover, reduced capital intensity due to slower-than-historical premium growth should free up capital, increasing potential for increase in dividend pay-out. Tawuniya – Saudi insurance juggernaut We initiate coverage on Tawuniya, Saudi Arabia’s largest insurer (market share of c20%), with a Buy rating. Our FV of SAR117 implies 30% upside. Strong capitalisation, economies of scale, and focus on customer service give it a clear edge over small insurers, and we expect it to gain market share, as the industry heads towards consolidation. The company has the second largest market share (14% of sector GWP) in the motor insurance segment, where we expect premium growth to remain robust. We expect motor to be the key driver of premium growth over the next three years as i) the market is under-penetrated (only c40% of motor vehicles have insurance coverage); ii) the authorities take steps to enforce compulsory insurance; 3 SAUDI ARABIA INSURANCE SECTOR Financials | Saudi Arabia iii) competitors grapple with capital constraints; and iv) direct sales through electronic channels opens a cost-effective mode of distribution. The company’s scale allows it to benefit from bargaining power over service providers; thus, keeping its claims costs under control. We expect Tawuniya to generate of ROE of 26-27% over 2016-18, and it trades at 2017e P/B of 2.5x. We believe regulatory oversight by SAMA and Tawuniya’s multi-line business model mitigates risks to profitability. After strong expansion during 2010-15, growth looks set to moderate Low-hanging fruit already in the bag The strong regulatory enforcement of mandatory lines has driven strong GWP growth in the sector. In particular, health insurance of expatriates in the country is just shy of 90%, suggesting limited room for structural growth. Some near-term hiccups to growth as the economy falters….. The weakening of the economy is filtering through to sectors, even ones that are considered defensive. After strong growth during the past two years, GWP growth has decelerated sharply, so far, in 2016, driven mainly by health and P&C segments. Motor insurance premium growth, however, has remained robust, up 30% Y-o-Y in 1H16. Fig. 1. Sector GWP growth to Fig. 2. Driven by slowdown in Fig. 3. Motor premium growth moderate health premium growth should remain strong Y-o-Y growth Y-o-Y growth Y-o-Y growth 25% 25% 40% 35% 20% 20% 30% 15% 15% 25% 20% 10% 10% 15% 5% 10% 5% 5% 0% 0% 0% 1H16 2014a 2015a 2016e 2017e 1H16 1H16 2014a 2015a 2016e 2017e 2014a 2015a 2016e 2017e Source: SAMA, EFG Hermes estimates Source: SAMA, EFG Hermes estimate Source: SAMA, EFG Hermes estimates Insurance – two sides of the coin On the face of it, the concept of an insurance business is quite straightforward.