AMP – the elephant in the room

Financial journalist and commentator on 3AW and Sky Business
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Financial services heavyweight AMP, Australia’s largest life insurer and pension manager, has already rebuilt itself twice in the last 10 years, firstly in 2006 after the Australian Securities and Investments Commission (ASIC) took it to task for its advisers’ in-house product-flogging, and secondly after it negotiated a 2011 merger with long-time rival AXA Asia-Pacific, the former National Mutual.

The elephant

Now it has to do it again, to address a worrying problem in its life insurance business.

The financial giant has to get this right before it can start to close the performance gap that has opened up between it and the big four banks, as shown in the accompanying table. Investors wanting financial services exposure have no reason to favour AMP over the big four banks.

Performance comparison

The problem that AMP has to address is in its wealth protection business, which accounts for about 30% of earnings.

The number of policy lapses – people cancelling or not renewing their wealth insurance policies, particularly income protection – is hurting AMP, and other insurers, badly. Lapse rates are running at up to 15%, their highest level in a decade. Simply put, too many people are balking at $2,000-plus premiums, and either reducing their level of cover or opting out completely, and taking the risk of going uninsured.

There is a claims management issue as well: people concerned about their job security will attempt to claim on their insurance on stress-related grounds, and there is a degree of subjectivity on the payout eligibility, that the insurers have to try to manage.

AMP alerted the market to the problem in June, when it warned investors to expect a lower first-half underlying profit than initially estimated, at between $415 million to $435 million, compared to $491 million in the first half of 2012, following poor claims and lapse experience in its Australian wealth protection business in the second quarter. (Underlying profit strips out the impact of investment market volatility and the ongoing costs associated with the AXA Asia-Pacific merger.)

That downgrade cost the share price 17%, down 10% on the day of announcement, and it dropped from $5.10 to $4.23 in a fortnight. However, in August, the interim profit report showed that AMP had been too cautious in its profit warning, with underlying profit coming in at $440 million. While that was 9.8% down on the 2012 interim, it beat consensus estimates: and net profit rose by 5.4% to $393 million. But there was a one-cent cut to the interim dividend, to 11.5 cents.

Wealth drag

As expected, wealth protection was the root of the problems in the interim result. Operating earnings fell 52% to $64 million, dragged down by a higher level of claims and insurance policy lapses than expected. If wealth protection was excluded from the picture, said AMP, combined earnings from its businesses were up by 17% at the June half.

For example, AMP recorded its best net cash flows in wealth management since 2007, with net cash flow up about six-fold to $1.4 billion. Operating earnings for the wealth management business unit rose by 20%, driven by a 31% surge in profit at AMP Bank. Net cash flows to the North platform – which came with the AXA Asia-Pacific merger in 2011 – nearly tripled, driving a strong performance from AMP Financial Services.

The market had slowly lifted AMP back to $4.94 by Thursday, but on Friday, the company came out with a second warning, telling the market that higher-than-expected policy lapses are still a problem, and it now expects fourth-quarter operating earnings to fall by as much as $65 million.

That forecast follows $24 million in losses from AMP’s wealth protection business during the September quarter.

AMP has some big decisions ahead of it. Craig Meller, who will take over from Craig Dunn as chief executive officer in January 2014, has already flagged a change in the way the wealth protection business sells product: at the moment, customers pay stepped premiums, which means cover gets more expensive as people get older. If, like the UK – where, incidentally, Meller comes from – the market were to move to level premiums, which stay the same year on year, the lapse rate may be different.

The flipside to such a change would not be good for advisers, because traditionally, these products are sold with the aid of hefty upfront payments to financial advisers: sometimes a commission as much as 100%–120% of the first year’s premium. The insurer needs to claw-back its commission out of the subsequent premiums – so if the policy is cancelled or lapses before enough time has passed, the insurer makes a loss on it without there even being a claim.

An expert opinion

Switzer Super Report spoke to John Trowbridge, a member of the Australian Securities and Investments Commission’s External Advisory Panel, a former leading actuarial consultant, executive member of the Australian Prudential Regulation Authority, Chairman of the Federal Government’s National Disaster Insurance Review (established after the January 2011 floods) and member of the Treasurer’s Financial Sector Advisory Council, as well as chief executive of a major general insurer.

Trowbridge says the insurers face a “quadruple whammy” of underwriting, pricing, customer retention and claims management – all of which have to be improved. As well as pricing and adviser remuneration, he says they have to get on top of the risks they select – and then manage claims better. But he says it is really crucial to avoid the situation where they lose money on a policy purely on the acquisition cost, i.e. the commission.

All of this AMP says it is changing – but such change will take a long time to introduce and bed down. For shareholders, this discussion is not just academic, it is already hitting AMP’s numbers – they have just seen a hit to their interim dividend.

The numbers

At present, market consensus is looking for EPS of 26.8 cents this year (AMP uses the calendar year as its financial year), rising to 30.8 cents in 2014. But after Friday’s announcement, there will be further downgrades.

But working on those numbers, at $4.75, that places AMP on a price/earnings (P/E) ratio of 17.9 times expected 2013 earnings and 15.6 times 2014 earnings.

On dividend grounds, the consensus expects a payout of 23.3 cents this year, for a prospective FY13 yield of 4.8%, rising to 25.2 cents in FY14, for a yield of 5.2%.

In both FY13 and FY14, the dividend is expected to be 70% franked, meaning that the FY13 prospective yield equates to about 5.60% for a self-managed super fund (SMSF) in accumulation mode and about 6.33% for a fund paying a pension.

In FY14, the equivalent accumulation phase yield to an SMSF is about 6.2%, rising to about 7.0% for a fund in pension phase.

Remember, there will be downgrades to these consensus numbers. You could make a case to hold AMP on yield grounds, and to buy on a long-term view, because the superannuation, financial planning, life insurance, banking and fund management giant is virtually a proxy for the Australia’s massive – and growing – retail super industry; but the stock is already trading at about market consensus target price. In the short term, AMP does not look like it will be closing that performance gap with the banks any time soon.

Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.

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