Things are looking up for insurers

I recently received an email from a genealogy website called Ancestry.co.uk offering me a DNA test for just £79 (reduced from £99).

“Our DNA matching combines ground-breaking science with traditional research to give you the most accurate family history results available. The technology pinpoints relatives you never knew existed; you can then work with your new-found cousins to discover your shared history…”

All I had to do to meet the cousins that I never knew existed (a curiously unappealing thought) was to take a swab of saliva and post it off to them.

Being of a suspicious mind set, my first thought was that Ancestry.co.uk might be a front for MI6. Once they’ve got our DNA profile on their infernal databases they can no doubt track us everywhere we go, cross-referencing our movements with our Google searches.

Dismissing that thought, my second was that if it is really now so cheap and simple to profile an individual’s DNA, then why isn’t the National Health Service doing it already? The cost has fallen to less than that of a single doctor’s appointment.

I predict that within five years – the lifetime of the new parliament – most of us will have had our DNA profile tested to some degree and it will be stored on somebody’s computer database, hopefully our GPs’ in the first instance. But the biggest of these databases will be maintained by insurance companies.

Insurers are going to harness DNA and other technologies which are already facilitating data-driven underwriting.

What is new for the insurance sector is that, thanks to technology, insurers can quantify the risks that each policy involves much more precisely. Car insurers in the USA have begun to set premiums based on observed driver behaviour. They can do this because they are installing tracking devices in people’s cars which record if and when drivers exceed the speed limit, how heavy they are on the brakes, and so forth.

Not only does this enable insurers to distinguish bad drivers from good, but by offering feedback it also incentivises bad drivers to improve. That reduces accidents and hence claims. It also means that safe drivers can be charged lower premiums than dangerous ones.

At present, the over-50s generally pay lower car insurance than under-30s because, on average, they have fewer accidents. But some over-50s are poor drivers and some under-30s are skilful. Technology will increasingly permit insurers to penalise and reward accordingly.

Progressive, an American auto insurer, already does this. For drivers who demonstrate good driving habits and who stay off the roads at night the premium discount can be as much as 30%[i]. And policies written by Progressive rose by 28% last year.

Similarly, some health insurers such as Discovery, based in South Africa, gather data on customers’ lifestyles through digital fitness bands (and possibly going forward through, for example, the new Apple smartwatch).

It’s quite conceivable that, in future, we might all wear sensors or carry implants which beam data about our blood pressure, cholesterol and glucose levels to a central processor. Thus health insurers could calibrate premiums in accordance with our eating, exercise and drinking habits. (As they already do by reference to whether we smoke).

Now monitoring devices of one kind or another are one thing, but Big Data offers rich pickings too – if only you can learn to interpret it. A pilot scheme by Aviva in the US found that by analysing people’s spending habits using credit card histories they could anticipate potential health risks.

One study by Stanford University even showed that it is possible to predict accurately from people’s Facebook “likes” whether they smoke or take illegal drugs. There is plenty more research going on in this space, apparently.

Now the issue of using data about our genetic make-up to calculate health insurance premiums is highly controversial.

In 2011 the European Union banned insurers from using gender to determine the value of annuities, even though it is an objective fact that women, on average, live longer than men. Thus men now get lower annuities than would otherwise have been the case. It’s quite possible that the EU or national governments will seek to regulate further in this area.

But it’s unlikely in my view that they would seek to ban insurers from keeping DNA databases. That would be like banning actuarial science.

The fear is that insurers might cherry pick the customers with the fewest risk indicators. It’s therefore tempting to advocate a don’t ask, don’t tell approach to DNA testing in the field of health insurance.

But the fact that you have a genetic marker for a particular condition does not mean that you are bound to get it. It just means that you have a propensity to develop it given the relevant triggers (lifestyle being one, the environment another). The way in which these triggers are pulled is something still only vaguely understood.

If we know what our weaknesses are, however, we might better manage our health.

So the insurance companies, which after all, are supposed to be risk managers, will never be able to abolish risk altogether, nor should they try. While scientists can identify the DNA sequence that determines your eye colour, unfortunately for life insurers, there is no sequence that spells out exactly when you will die.

DNA testing and varieties of monitoring will help insurers better to align premiums with risk. That will also incentivise the insured to reduce unnecessary risk-taking. The result, potentially, is a world of lower insurance premiums and fewer claims. And possibly more profitable insurance companies.

Now there are three major insurance groups in the UK: Aviva, Prudential and Standard Life. For me the second biggest UK insurer by assets, Aviva PLC, stands as the most going-places.

Last year Aviva poached Adam Kornick from Progressive as Head of Global Insight (great title). Kornick is now setting up a research lab to think big thoughts about artificial intelligence, genome decoding and such like.

Aviva already has a great business model and has developed global brand recognition since it arose out of the merger between CGU and Norwich Union in 2000. While the Norwich Union brand has now been discontinued, Aviva traces more than 300 years of history through that name.

Aviva operates across the entire range of insurance products and asset management. Across 16 business units it protects 31 million customers, paying out £24.6 billion in claims last year. Aviva Investors has £246 billion assets under management.

In the UK, Aviva is the largest general insurer and a leading life assurance and pension provider. Plus it has huge global reach across 16 countries. In Europe, Aviva focuses on seven countries (the UK, Ireland, France, Spain, Italy, Poland and Lithuania). In Asia it is big in China, India, Turkey, Vietnam and Indonesia. It’s also the second largest general insurer in Canada.

The group has consolidated, operating a Not Everywhere strategy which focuses relentlessly on markets where they have a competitive advantage. In December 2012 they withdrew from the US market selling Aviva USA Corp for US$1.8 billion. That boosted shareholder returns and reduced the group’s capital requirements.

In December 2014, Aviva agreed terms for the £5.6 billion takeover of Friends Life Group. Andy Briggs, CEO of Friends Life became CEO of Aviva UK Life, with Mark Wilson continuing as CEO of the enlarged Aviva Group.

Underlying financials are impressive. In the year to 31 December 2014 Aviva reported operating profit of £2.173 billion, up 6% on the previous year. It wrote £1 billion of new business last year. A key ratio that analysts tend to apply to insurers is the operating expense ratio (operating costs as a percentage of general insurance premium income). For Aviva last year it was 51.5%. The target is to bring it below 50% for 2016.

Good insurers pay decent dividends out of their surplus cash. In 2014 Aviva paid 18.1 pence per share, up from 15 pence the year before. Be aware that Aviva cut its dividend in 2012 and 2013 after disappointing results which prompted changes in management and a strategic review. The forecast dividend yield for 2015 is 3.7%.

In value terms, Aviva has been trading at a lower price earnings ratio than its two big UK rivals – 10.99 against 25 for Standard Life and 18.66 for Prudential[ii]. This is presumably because of expectations about growth in organic EPS. And yet, looking at the bottom line, in terms of operating margins, Aviva recorded 6.1% as against 4% for Standard Life and 4.4% for Prudential[iii]. Since CEO Mark Wilson’s took over in January 2013 cash generation has gone up 65%.

The insurance industry has taken the recent pension reforms in its stride. According to the association of British insurers[iv], the more liberal regulatory framework will actually stimulate demand for pensions.

In theory, good insurers balance premium income against claims and make their money on their investment portfolios. They are investment companies which profit from a free float of cash (premiums are received before claims are paid out).

As well as having high exposure to the stock market, insurers also hold large portfolios of bonds. More technically, their pension liabilities (the value in today’s money of all future pay-outs on such products as annuities) are calculated using discount rates that are derived from gilt market yields. That means that if UK gilt prices rise, and yields fall further (as has already happened in Europe this year), the value of their pension liabilities will increase – thus damaging their balance sheets.

That could happen, short-term. Though some believe that UK gilt yields could actually rise with increased political risk.

Aviva was hit by the 2010-13 downturn in the Eurozone and its share price flat-lined for several years. That changed in the spring of 2013, since when it has gone from below 300 pence to around 523 pence now. If Aviva’s price earnings ratio were to come into line with Prudential’s, and assuming continued growth in earnings per share, then Aviva shares could surge over a one year time horizon.

The market for Aviva’s products continues to grow, especially in countries like China, Turkey and Poland where they are already market leaders. The potential for data-driven underwriting and DNA testing in these markets is mind-boggling.

They might even open a global genealogy website – it could be a profitable business line.

[i] The Economist, 21/03/2015

[ii] Google Finance, accessed 15:30 on 04/06/2015.

[iii] See http://www.fool.co.uk/investing/2015/04/07/3-point-checklist-should-you-buy-aviva-plc-standard-life-plc-or-prudential-plc/

[iv] See website at: http://blog.abi.org.uk/2014/10/changes-to-the-pensions-landscape-and-the-impact-on-insurers-the-challenges-and-opportunities/