Analyst Note (22/06/10)
Global insurer Aegon has announced its intent to sell its US-based Transamerica Reinsurance life reinsurance operations. It also will prune some of its operations in Europe and apply greater focus on better-performing growth businesses in Central Europe, Asia, and Latin America.
The planned sale of the life reinsurance operations may reduce some of the uncertainty in this complex, highly leveraged, and troubled but recovering financial services giant, but the book value of those operations amounts to less than 20% of the firm as a whole. Aegon had been exploring the sale of its UK operations as well, but has decided to scale back those underperforming businesses amid an apparent lack of buying interest. Aegon still has the Dutch government waiting on repayment of support extended during the financial crisis, and uncertainty remains regarding the nature of the European Commission's final consent to that aid, which may include further negotiations over asset sales and other measures. Our fair value uncertainty rating remains very high, and our fair value estimate is unchanged.
Fair Value Estimate: EUR 5 ¦ Fair Value Uncertainty: Very high ¦ Economic Moat: None
Thesis (25/05/10)
Aegon is a global life insurance and asset management enterprise and can trace its roots to the development of savings vehicles for burial expenses in the Netherlands nearly 200 years ago. In 2008, the company itself faced a near-death experience, brought down by the combination of difficult external financial conditions and its own high financial leverage. Aegon has survived that crisis, with government assistance playing an important role. The firm has taken a variety of initiatives to reduce risk and pave the way for future expansion. But Aegon still faces a difficult and uncertain future in a highly competitive marketplace, and we believe it has no moat.
Aegon has been unable to insulate itself from the high competition and related risks facing the life insurance industry. It is difficult to differentiate services in consumers' eyes, and Aegon (and many fellow competitors) find it difficult to resist pressures to take on higher leverage and pursue other risky behaviours to try to offer products at prices that attract consumers. In turn, recurring episodes of market instability have been particularly damaging for Aegon's shareholders.
Some longer-term perspective is in order. Aegon grew pretty rapidly in the 1990s, and developed a growing global franchise along with apparently spectacular shareholder returns. But Aegon left itself significantly exposed to the global financial market downturn in the early 2000s--in its investment portfolio, through its customer response to that downturn, and the combination of those effects with its own high leverage (shareholder equity was less than 5% of total assets at year-end 2000). But Aegon apparently did not learn an important lesson from that episode. At the outset of our latest financial crisis, group equity at year-end 2007 ran just 6% of total assets, and heavy investment and related losses helped lead to a decline of over 50% in Aegon's common shareholder equity by the end of 2008. Extraordinary government support has helped the firm make it through the crisis, but its shares are trading at just 10% of their 1999 peak.
Aegon does have a card to play in the current environment. The firm's product development teams have developed a relatively high-quality and diversified portfolio of service offerings, and Aegon has a bit of an edge in the flexibility its product mix provides for responding to changing consumer preferences. But competitors have recognised the value of that flexibility after the recent turmoil and have been developing their own broader set of service offerings, dampening that advantage.
Aegon has been focussing on pension and other relatively attractive market segments in developed countries and is also pursuing growth in emerging markets. But it is not the only firm aware of demographic trends leading to higher needs for retirement services, nor is it alone in spreading its wings to emerging and relatively rapidly growing economies. In fact, we think much of the low-hanging fruit in emerging markets has already been plucked. For all the growth potential, we are expecting increased consumer sophistication and greater producer competition to erode returns for life insurers in the developing world.
Valuation
After updating our model for 2009 results, our fair value estimate is EUR 5. Our fair value estimate is a weighted average of three scenarios. In all three of our scenarios, we project modest growth in premium income averaging 3% through 2014, the terminal year in our valuation model. Our assumptions for policyholder claims and benefits and administrative expenses in our base scenario lead to a recovery in net income, rising to roughly two thirds of its 2005-07 average by 2014. We weight this scenario at a 60% probability. In our downside case, we include unrealised investment losses of 10% of the corporate bond holdings in Aegon's investment portfolio in 2011 on top of our other assumptions, leading to a dilutive capital raise at an assumed EUR 2 per share and a fair value estimate of EUR 2. Our upside scenario includes a 2% unrealised gain on corporate bond investments and yields a fair value estimate of EUR 5.84. The second and third scenarios are each weighted at 20% probability, and our overall weighted average fair value estimate is EUR 5.39. Our cost of equity estimate is 13%. Our fair value uncertainty rating is very high.
Risk
Aegon faces interrelated interest rate, credit market, and equity market risks, all of which are compounded by its own high financial leverage. At year-end 2007, Aegon's investments for its own account totalled over six times its equity, magnifying the impact of investment losses on its capital during the financial crisis. Aegon's sophisticated hedging programme may help to control market risks and interest rate risks, but it is difficult to assess how effectively (or even whether) that programme hedges risk amid rapid and shifting market conditions.
Management & Stewardship
Alex Wynaendts serves as CEO as well as chairman of Aegon's executive board; he has been the company since 1997. We normally would prefer that the CEO and chairman roles be split, and we note that Wynaendts has been a member of the executive board since 2003, helping lead the company into and through its recent crisis. But we also note a welcome influx of new blood into Aegon's senior executive ranks in recent years. Still, there appears to be little check on managerial autonomy from any concentrated shareholdings. Only one shareholder accounts for over 5% of Aegon's common shares, and a voting rights agreement with that shareholder dilutes the possibility of a takeover that could promote minority shareholder interests. A slim ownership stake among senior executives has been a red flag and may even help explain Aegon's outsized exposure to the financial crisis. Further clouds have arrived as the Dutch government gained a significant say in the direction of the firm along with its 2008 investment. Aegon does appear to have developed a senior management compensation policy weighted toward incentive compensation, with incentives tied to longer-term operational performance targets.
Overview
Growth: Aegon grew total revenues at a compound annual rate of 17% from 1990 to 1999, while internal growth has slowed significantly in the last decade. Today the firm faces constrained prospects in mature markets, and heightened competition in the developing world
Profitability: Investment and related losses hammered Aegon's common equity in 2008, which was supported in important part by a EUR 3 billion capital infusion from the Dutch government. Pretax income turned positive in the fourth quarter of 2009 for the first time in six quarters.
Financial Health: Aegon's financial health has been improving in the past year along with the recovery in financial markets. Aegon has taken significant steps to de-risk its credit, equity, and interest rate risk exposure, but it remains a highly leveraged life insurance company.
Profile: Aegon offers life, accident, and health insurance and related asset management services in Europe, Asia, and the Americas. Aegon's Transamerica operations have long and deep roots in the United States, and Aegon has also developed a significant presence in its domestic market (the Netherlands) and the UK.
Strategy: Aegon has developed a diversified set of life insurance and annuity products, enabling it to shift its sales focus depending on market factors. The company has been expanding internationally to higher-growth markets, as its earnings base was relatively dependent on mature, slow-growth markets. Following the financial crisis, Aegon has taken steps to reduce its exposure to equity and credit market volatility, to reduce interest rate risk, and to scale back costly product guarantees.
Bulls Say
1. Demographic trends support expectations for significant growth in retirement services that Aegon provides flexibly and well.
2. Fiscal strains facing government and larger corporate pension programmes, and related support for the elderly, couple with demographic trends to promote growth potential in otherwise mature established markets.
3. Aegon may have learned important longer-term lessons in the recent financial crisis that could stand it in better stead in any challenging times that recur.
Bears Say
1. Life insurance and related service markets are highly competitive and inherently unstable places to attempt to produce superior shareholder returns.
2. Aegon's management hasn't proved a reliable steward of shareholder value, and it remains headed by one of the key senior executives leading the company before its trials in the recent financial crisis.
