An Annuity That is Actually a Good Buy?
(Guest Commentary by Rick Konrad - February 15, 2007)
Dear Subscribers and Readers,
Before I go on and present to you Rick Konrad's guest commentary, I want to briefly mention our views on the Euro vs. the U.S. Dollar and the Yen. As many of you should know, I have been extremely bearish on the Euro since the end of last year – bearish enough to actually take a long position in the U.S. Dollar at the end of November of last year.
In light of the recent economic strength in the Euro Zone (4Q GDP surprised on the upside for Germany, France, and Italy) and in light of the fact that I may have been overly bearish on the impact of higher taxes in both Germany and Italy, I would not be surprised to see more Euro strength going forward over the next few weeks. In the long-run, a faster-growing Euro Zone is good for everyone. Moreover, continued strength in Germany and other major European economies will inevitably mean higher wages going forward (the biggest unions in Germany are now demanding a 2006 pay increase of 5.5% to 6.5%) – which creates a further incentive for the European Central Bank to raise its discount rate.
On the other hand, while 4th quarter GDP growth in Japan surprised on the upside (4.8% actual vs. 3.8% consensus), traders are currently only pricing in a 50% chance of a Bank of Japan hike next week. The good news is that there is now more evidence that Japan is exiting out of its deflationary spiral. In light of the size of the Yen carry trade (JP Morgan estimates it to be over $300 billion – the largest size of its kind since before the previous Yen carry trade exploded in late 1998), and in light of the oversold condition in the Yen vs. the Euro, however, I am disappointed that the Yen has not spiked further to the upside. Following is a chart showing just how oversold the Yen is currently against the Euro:
As the above chart shows, the Euro-Yen cross rate has been anywhere from 4% to 6.5% higher than its 200-day moving average since late November of last year. In normal circumstances, this would make the Euro very vulnerable vis-à-vis the Yen – but so far, we have not witnessed any spikes of the Yen against the Euro just yet, despite the rhetoric that came out of the G-7 meeting last weekend and the latest upside surprise in the 4th quarter Japanese GDP number. Is this a sign of further Euro strengthening going forward? Whatever the case is, I do not believe the Euro Zone can garner sustainable economic growth if the Euro continues to appreciate. Perhaps it can continue to do so at US$1.35 or 160 Yen – but definitely not at $1.40 or 170 Yen. Politicians in France and Italy will have a fit before the Euro will appreciate to that level. Readers please stay tuned.
And now, I present to you Rick Konrad!
For those who had wanted to learn more about picking stocks, evaluating companies, and other issues related to the stock market, we have again brought in one of our regular guest commentators, Mr. Rick Konrad for a mid-week discussion. As I mentioned in a previous commentary, Rick will be one of our guest commentators going forward (besides Bill Rempel) and will be publishing a guest commentary on our site during the third Thursday of every month.
In this commentary, Rick is going to discuss the current potential opportunity in the equity-linked annuity market, and more specifically, American Equity Investment Life Holding Company (AEL). Without further ado, following is a biography of Rick:
Rick is author of the excellent investment blog “Value Discipline” and is a regular guest commentator of MarketThoughts (please see “Keep on Trucking!” for his last guest commentary). Prior to his current role, Rick has been a professional portfolio manager for institutional investors for over 25 years. You can view a more complete profile of Rick on his blog and should you have any questions or thoughts for Rick after reading his commentary, you can also email him at the following address. Rick is a very genuine teacher of the financial markets and treats it very seriously. Case in point: Rick has also been responsible for running the education program for the CFA Society in Toronto (which is the third largest CFA society in the world besides the New York and London Societies) and had also been responsible for grading CFA papers.
Disclaimer: This commentary is solely meant for education purposes and is not intended as investment advice. Please note that the opinions expressed in this commentary are those of the individual author and do not necessarily represent the opinion of MarketThoughts LLC or its management.
Growth ideas rarely are found in the life insurance arena. It is incredibly difficult for people to get excited about a life insurance company from just about any angle. The average investor in stocks tends to look at other more exciting or enticing ideas that evoke growth. As far as buying the product, the old adage applies; life insurance is sold, not bought. In my view, it is a vital part of your financial planning and needs, but I want to address one particular aspect of insurance, the annuity business, and one particular segment, the equity-linked annuity business.
American Equity Investment Life Holding Company aka American Equity Life (AEL) was taken public in December 2003. It is licensed to sell in 49 states and the District of Columbia, and sells its products through more than 52,000 independent agents and 70 national marketing associations. Despite what appears to be a rather brief history (established in 1995,) it is one of the leading providers of EIA equity-indexed annuities (fixed annuities with interest tied to an external equity or bond index). The company also offers life insurance products and fixed annuities. Annuities account for some 95% of the company's business.
The EIA market share in the US is lead by Allianz (AZ) with about 28%, followed by ING at about 9.4%. Numbers 3-6 all have somewhere between 7 and 9% share. AEL as number six is the purest EIA provider. Number five, Midland National is becoming employee-owned. American Equity is the purest public play. This segment of insurance has been subject to consolidation…a little more about that later.
First, from a product perspective let me provide a little background on annuities and their regulation. Annuities are frequently used as a retirement product. They offer some assurance of backing from a stable life insurance company as a “guarantee.” They can have an equity “kicker” that provides better than fixed income returns. They are frequently sold as an “income that you cannot outlive,” a significant concern to many retirees. There are essentially three types of annuities that are available:
Fixed Annuities: The insurance company bears all the risk and provides a minimal return. The guaranteed returns are paid out of the general account. Risk is borne by the life insurance company. Fixed annuities must be sold by life-insurance registered salespeople. Regulation is by each State's Insurance Commission.
Variable Annuities: The investment is directed into a separate account (like a mutual fund) where the risk is borne by the owner, not the life insurance company. There is no guarantee that there will be no losses. Policyholder can pay additional fees for a guarantee. Salespeople are Series 7 holders regulated by the SEC.
EIA: This is a hybrid product with both fixed and variable characteristics. It offers a “capped” return based on an underlying equity index. However, at all times, the principal is guaranteed. EIAs at this point are not considered registered products like variable annuities. Who can sell EIA's? That's something up in the air at the moment which creates the opportunity in my view.
The SEC is studying the question of whether EIAs are securities or insurance products. In August of 2005, the NASD issued a Notice to Members which warned broker-dealers against allowing associated employees to sell unregistered index annuities due to the uncertainty. The SEC has promised that it would provide additional guidance within the next few months.
AEL's products seem to be designed to “look” more like fixed annuities rather than securities. Their marketing materials emphasize safety. Their guaranteed rates resemble those of fixed annuity products unlike those of some of its competitors. An SEC ruling that confirms that annuities such as AEL's are insurance products would be a strong impetus for sales in my view.
How does an annuity company grow? Essentially, growth is a function of new business and the retention of that business. Surrender charges for EIA's are very high, at AEL somewhere around 13%.Consequently, most new business that gets written, sticks.
The next variable to be considered is the spread that is earned between rates earned on the investment portfolio and rates that are paid on the annuities. Depending on the company's investment prowess, degree of risk aggressiveness, and the yield curve, the spread tends to be somewhere between 2% and 3%. Over the last five years, AEL has grown its book of invested assets at a rate of almost 40% versus large industry participants that have grown somewhere in the 5-10% area. AEL's spread has hovered near 2.5% over most of that time.
AEL also has the luxury of investing in a higher-yielding and a less liquid portfolio owing to the surrender protection fees that cover virtually all the reserves that relate to the EIA business. Consequently, AEL need not maintain much liquidity for potential redemptions. The high surrender charge nature of their book of business makes redemptions highly improbable.
AEL sells through 52, 000 independent agents as it claims. Many life companies create the illusion of size with these types of statistics. Yet, the reality is that an 80-20 Pareto rule applies. For 2006, only 8,000 of these agents produced for AEL. This is different than a captive sales force…these guys are truly independent and will respond to other inducements.
The yield curve was a negative for the company through 2006…volumes were down substantially, some 30% for the first three quarters of the year. A flat yield curve produces little inducement to use anything other than fixed annuities. A normal yield curve environment would help. There was a 15% improvement in sales in the fourth quarter as the inverted yield curve moved toward normalcy.
One other inducement…I mentioned that there are 70 national marketing organizations through which AEL sells. Very early in its history, AEL established a deferred compensation plan to enable agents to earn common stock in addition to their normal commissions. Awards are calculated using formulas determined annually and are based upon new annuity deposits. There is a nine year vesting and deferral period…you can imagine how agents will go out of their way to ensure that client retention rates stay high. It is possible for agents to lose their stock if they do not maintain production levels. What a great plan! Keep in mind that this plan is only applicable to the national marketing organizations.
However, AEL has introduced a new plan for independent agents. AEL has structured a new option plan to incentivize these agents starting in 2008 for 2007 production. The company claims to have allowed for the cost of these stock options in the pricing of its annuities.
So here's the best case scenario. The SEC rules that AEL's type of annuities are an insurance product, not a security product. AEL could respond quickly to broker-dealers that had dropped them after the NASD ruling. Also, other distribution channels such as banks could open up.
Worst case: The SEC rules that EIA's are a security. Many agents would seek their security licenses to supplement their insurance license. There would likely be a lot of competition between EIA's and VA's and a lot of confusion in the marketplace. AEL decides to simply pack it in and stop writing policies, In this unlikely circumstance, I suspect that the downside might be book value, down about 35%.
What's the upside if things go right? The price to tangible book for AEL is 1.36X versus the industry at 1.77X so on that alone, about 30% undervalued. More importantly, the company has an ROE of 14.76% versus its peers at 8.2%. I come up with a fair value of about $17.
As I mentioned, this segment of the industry has been subject to takeovers in the past. The number three player in this segment was created in November of 2006 by Aviva's takeover of AmerUS Group. Based on the metrics of that deal, a value of around $20 can be calculated.
This is a competitive industry. Annuities are a huge business and large companies can dominate. However, smaller nimble players can capture the love and attention of their agents through clever incentive plans.
AM Best, the well-recognized ratings agency upgraded AEL last summer to an A- rating. This certainly opens up the possibilities for many agents who will not use lesser rated insurance companies.
On a P/E basis, AEL is trading at 9.25 times the 2007 consensus of $1.48, about a 30% discount to its brethren.
I think the risks of an adverse ruling by the SEC are priced into the stock. Though not for the faint-hearted, aggressive investors should think about owning this interesting growth company. With about $750 million in market cap and average daily volume of about 460,000 shares, it is an interesting small cap idea.
Disclaimer: Neither I, my family, nor clients own a current position in AEL.