Left out of PSX rally: Insurance Companies

 

Since the announcement of the IMF staff-level agreement, the Pakistani stock market has witnessed a spectacular rally. However, during this rally, certain sectors have received more attention than others. One of the sectors which has been largely left out of the rally – despite being a direct beneficiary of the rally – is the insurance sector.

The insurance business model consists of collecting premiums from clients and investing those premiums in fixed income and equities. The difference between net premiums received plus income from investing those premiums and claims paid out plus expenses is the earnings of an insurance company.

Usually, net premiums received, and expenses are not volatile figures. But claims paid out and investment income can be volatile. This is because claims paid out can vary heavily depending on the amount and frequency of claims. For instance, a large, insured factory might have a fire incident leading to an unexpectedly high claim amount paid in a particular quarter.

The smaller the insurance company, the more volatile the earnings tend to be due to variation in claims paid out – a result of the law of large numbers. This is why large insurance companies, particularly in the life segment, tend to have stable and rising earnings as their liabilities take longer to mature and their size allows them to take advantage of the law of large numbers.

Investment income – too – can be volatile depending on the capital allocated between fixed income and equities. Fixed income investment tends to be of low risk and thus less volatile, while equities are far riskier and hence, their investment value is more volatile.

Adamjee Insurance allocates roughly half of its investment portfolio to fixed income and the other half to equities. This is why you’ll notice that its earnings are highly volatile:

From the photo above, one would quickly notice that Adamjee Insurance’s earnings peak in years where equities rally and staggers in periods where equities perform poorly. So, stock market performance has a profound impact on the earnings of insurance companies, particularly those who allocate their capital more heavily towards equities.

So, why hasn’t the market taken notice of it? Well, it has – kind of. Following the IMF SLA, Adamjee Insurance’s share price has risen 28%. However, it took three weeks for the market to notice that Adamjee Insurance would be a key beneficiary of the stock market rally.

Following this, other insurance companies saw slight reratings. For example, Jubilee Life Insurance’s share price rallied 11% in July. All of this is quite rational since insurance companies such as Adamjee and Jubilee Insurance tend to have stable payout ratios, thus if earnings go up, so will dividends.

Yet, the market is not correctly pricing in expected rise in earnings. A caveat to the stock market rally affecting insurance earnings is that the earnings will only rise from CY23Q3. Because the first trading day after the IMF SLA was 3^rd July. This means the rise in investment income from the recent stock market rally will show up in the third quarter’s financial reporting.

Despite this, there are a few insurance companies who would benefit due to massive improvements in the value of their investments. Analyzing their financials can be a good guide to finding undervalued insurance companies which would reveal bumper earnings in Q3 and onwards.

Century Insurance is a small-cap insurance company. Much like Adamjee Insurance, it allocates roughly half of its portfolio to equities and the other half to fixed income. This makes it well positioned to benefit from the stock market rally. But it will likely see supersized earnings in Q2 as well.

Century Insurance owns 0.037% of Colgate Palmolive. It owned 44646 shares of Colgate Palmolive at the start of Q2 – worth Rs 59.6 mn. Post bonus issuance, that turned into 89291 shares which at the end of Q2 were worth Rs 100.2 mn. That imputes an unrealized gain of Rs 40.6 mn.

Now, Century Insurance’s Q1 investment income was Rs 61 mn of which Rs 2.6 mn was from its investment in Colgate Palmolive. Holding all else constant, Century Insurance’s investment income for Q2 should be Rs 99 mn. That would imply an earnings per share (EPS) of Rs 2.29 – a 44% increase over Q1.

Obviously, the final EPS might be more or less depending on claims paid as well as how Century Insurance’s other equity investments performed. In other words, all else is likely to not be constant. But one thing is for certain, the gain from its investment in Colgate Palmolive creates a significant enough buffer to say that Century Insurance’s Q2 earnings should be significantly higher.

Investments by insurance companies and the value of most of these investments can be found through publicly available information. Using this information, an investor can make a good estimate of which insurance companies are primed to benefit most from the stock market rally.