RGA Analysis 8/12/2005

RGA Analysis 8/12/2005


The following is an analysis of the risks for the RGA 5.75% PIERS position. The biggest risk is credit risk, which I feel is minimal due to the nature of RGA’s business, conservative management and current financial strength (A- rating). A second risk is if RGA stock goes above $48, thus making the PIERS callable and causing investors to lose the premium. Based on my conversation with management, I feel the company is not likely to call them. A third risk is a takeover of RGA which would also cause investors to lose the premium. This is unlikely due to a lack of potential buyers but still a possibility. The fourth risk is RGA raising dividends. I feel that RGA will likely raise its dividends in the 10% per year range but not much higher given that it needs to raise about $100M in capital annually to meet its growth plans.

The following is a description of RGA and the Life Reinsurance industry followed by a detailed discussion of the aforementioned risks.

Business and Company background

RGA is the world’s largest publicly traded pure-play life reinsurer and largest facultative life reinsurer. RGA was spun-out as the reinsurance division of General American Life in 1993 where it existed since it was formed in 1973. In 2000, MET acquired a 52% stake in RGA when it bought General American. MET considers its RGA holding as a non-core investment.


The purpose of life reinsurers is to 1) absorb risk from primary life insurers 2) reduce the volatility in earnings for life insurers and 3) provide underwriting capital to the market

Life insurance companies sell policies to holders that guarantee a payout when a policyholder dies. Policies are priced based on actuary assumptions about the mortality rate. However, no insurer can precisely predict mortality and could experience swings in payouts and earnings in any given quarter. Reinsurers will insure the primary writers by taking on some of the risk in exchange for a portion of the premiums collected.

Types of reinsurance –  Traditional

Automatic treaties – the primary insurer and reinsurer agree on risk type, level of retention, and other terms ahead of time and the business is done automatically at time of primary issuance. Primary writers have a pool of reinsurers with whom they will place their automatic treaties. These reinsurers will meet the primary company’s requirements for liquidity, balance sheet strength, and claim payment ability as rated by AM Best. As new business opportunities arise, all companies in the pool will submit their bids as to the price they are willing to pay. The company will accept the lowest bids and come to a common price for the pool. Those who are above that price are out of the pool for that iteration. Therefore, regarding the price competitive nature of the business, unless there are a significant number of competitors attempting to gain market-share at the expense of margins, pricing on automatic business remains rational. Returns from these contracts are determined by the reinsurers’ ability to predict mortality, control expenses and ability to price to meet hurdle rates.

Facultative reinsurance – these agreements are done on a case by case basis when conditions fall outside traditional terms such as policyholders with bad health or an outsized policy. The pricing is determined on a case-by-case basis. The retention levels are also decided on a case-by-case basis. These policies tend to be shopped around to multiple carriers with the best price winning. Facultative reinsurance agreements can pose a greater mortality risk to the reinsurer, as the winning bid tends to be the one with the most aggressive mortality assumptions of those considered. This is the reason we stress that successful reinsurers are conservative and do not acquire top line growth at the expense of margins.

Types of reinsurance –  Non Traditional

Annuity Reinsurance – insurance for annuities

Financial reinsurance – reinsurer provides balance sheet financing in exchange for part of the profits

Catastrophe insurance – reinsurer provides insurance against catastrophe insurance for events such as 9/11.

Retrocession – reinsurer provides coverage for another reinsurer.

Contract types

Blocks and in-force – primary writer sells a block of business to the reinsurer.

Coinsurance – primary writer sells a proportionate share of all of the risks and cash flows of the policy. Coinsurance is more risky than blocks in force. RGA does not have high exposure to coinsurance while its competitor Scottish Re has high exposure.

Soft Call Risk

I spoke with John Hayden, the VP of finance, about their capital structure. They are very happy with the structure of the PIERS and would like to keep these outstanding even if they become callable. They like the accounting and tax treatment of the securities, non-dilutive nature of the securities, the low cost of capital and the ratings agencies treatment. He said the only scenario where they would want to call them was if rates were low enough to justify a refinancing. In that case, BBB+ yields combined with new issue costs, remarketing of the old preferred, and other costs would have to be low enough to make it worthwhile, which he didn’t think they were currently. Additionally, a call would result in about 6% dilution to EPS.

He said S&P gives them full equity credit for the preferred as long as it is less than 15% of total capital. Moody’s only treat the warrant piece as equity so the higher their stock price goes, the more equity credit they get.

Dividend Risk

RGA raised their dividend for the first time since the IPO in 1993 to 9c (0.86% yield) from 6c per quarter in October 2004. John said the reason was to keep RGA on the radar screens of funds that require a certain level of dividend yield. The company had grown in size and it was appropriate for them to raise the dividend. Scottish RE, one of the few publicly traded life insurers, has a dividend yield of 0.84% and the RGA’s dividend raise got them to that level. Going forward, he said the board will continue to review the situation on a periodic basis and he wasn’t aware of what their current thinking was.

I asked him if MET has an influence on the dividend since they are a 52% holder and his reply was that they are a passive holder that doesn’t get involved with the business and had no desire to have RGA pay higher dividends. He believed, although he wasn’t positive, that the 3 MET directors on the board (out of 7) do not participate in the dividend discussions.

The current dividend of 9c per share costs them about $23M per year. John said the company generates positive cash from its North American operations but their expansion into International markets uses all of that cash and them some. He expects RGA to have to raise about $100M per year in capital to funds that gap. Given that RGA requires capital to grow, it would seem unlikely that the company can afford to raise dividends significantly without levering up. The most likely scenario is that they raise dividends at the rate of earnings growth, which is expected to be in the 10% range.

Takeover Risk

There are a limited number of companies who can buy RGA. RGA is the second largestU.S.life insurer at 16% share. It would be tough for the number one or two player to acquire RGA because the primary writers do not want any reinsurer to have over 25% market share because that would limit their options. It would be hard to complete a merger if your main customers are against such a deal and can easily shift their business elsewhere. Other possible acquirers are Property Casualty reinsurers such as XL or ACE but according to analysts their strategies are to grow organically.

Initially, MET tried to shop its 52% stake to pay for its acquisition of Travelers but did not find any buyers. Instead, they sold their real estate companies and have since restated their intention to keep RGA as a non-core investment. Apparently, MET did not find anyone who was interested in buying their stake.

Credit Risk

Life reinsurers must maintain a high rating in order to give customers confidence that they will be around for a long time. RGA is rated A- by S&P, Fitch, AM Best and Baa1 by Moody’s. The preferred is one notch down at BBB+.

RGA’s credit is very solid. Due to the long-tail nature of the business, it is very difficult for a life insurer to experience a dramatic drop in credit quality although once it does, the company will find it very difficult to write new business. In the past, some life insurers went bankrupt or became distressed because it ventured into non-traditional businesses. For example, Annuity Re became distressed in 2001 because of its variable annuity insurance business. The company guaranteed future payouts of annuities at a time when stocks were falling which hurt them significantly. In 2001, Conseco went bankrupt because it bought GreenTree Financial whose loans to mobile homeowners went bust. Some others became distressed because of bets on interest rate products.

RGA is a plain vanilla, very conservative life reinsurer that does not venture outside of its core areas of life reinsurance. They have experienced very steady growth throughout its existence, which indicates that they do not chase growth or try to buy business by underpricing policies. Any deterioration in business would be a slow one because claims do not get paid out for many years after the initial policy is signed.

The most recent concern about RGA is that 2Q results were below expectations due to higher than expected claims payout. Investors pushed the stock down (from $47 to $42) on fears that RGA may have mispriced its book and is now showing up in the results. However, a closer look at the policies that caused the high payouts show that these problem policies were spread across the board without any one type of policy sticking out.

Business could be mispriced if a company assumes that people will live longer than they actually do. There are concerns that policies written in 1998-2002 were mispriced because mortality assumptions were too aggressive. However, in the RGA case, the problem policies were written across a wide range of years and not concentrated in any time frame. This indicates that the problem is more likely due to normal quarterly fluctuations as opposed to any block of business being mispriced.

Even though he does not officially cover RGA, the MS credit analyst does not think the problem was part of a trend but rather part of the normal variance. He said that RGA had a similar problem during a quarter in 2001 only to bounce back with 6 straight quarters of better than expected results. He is positive on the RGA credit and the industry in general.

Moody’s comments on the credit

Factors that could positively influence the rating include a reduction in financial leverage to less than 15%, a sustained NAIC RBC level for both RGA Re and consolidated entities of at least 350%, GAAP net income for RGA consistently above $300M annually, and holding company cash coverage of interest expense and common stock dividends of at lease 6 times.

A negative rating pressure could develop if financial leverage rose above 25%, NAIC RBC for both RGA Re and consolidated entities declined below 290%, GAAP net income for RGA fell below $200M annually, or holding company cash coverage of interest expense and common stock fell below 3.5 times.

Equity positives

1)      Management has a solid track record. RGA has grown EPS in 8 of 9 years since its IPO and avoided the risky products that led the downfall of some competitors.

2)      Exposure to high-growth life reinsurance markets of Europe andAsia

3)      Pricing power is coming back to reinsurers following a round of recent consolidation in the industry

4)      The slow rise in interest rates is a good operating environment for life reinsurers.

5)      RGA trades at 1.2x book value, a discount to the group’s 1.5x ratio.

Equity concerns

1)      Possible mispricing of policies based on aggressive mortality assumptions.

2)      International growth may not be as fast as expected.

3)      Sustained low interest rates could affect the company’s ability to maintain spreads on some of their blocks of annuity business.

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