Description

Reinsurance Group of America is a globally diversified reinsurer of life and non-medical health insurance products, which generates earnings via reinsurance of mortality, longevity, and morbidity exposure.  RGA business units are broken out into (i) traditional reinsurance (50%), (ii) asset intensive (38%) and (iii) financial solutions (13%). The traditional life reinsurance segment underwrites mortality exposure and provides reinsurance for individual or gross-issued term, whole life, universal life and joint and last survivor insurance policies. The asset intensive reinsurance segment concentrates on the investment risk within underlying annuities and other investment-oriented products. The financial solutions segment assist companies in meeting applicable regulatory requirements while enhancing their financial strength and regulatory surplus position. Pre-tax earnings are geographically derived as follows: U.S. & Latin America (48%), Canada (14%), EMEA (20%) and Asia Pacific (17%). 

RGA is typically among the more defensive life companies given its relative consistent returns and predictable mortality experience. RGA is less exposed to interest rates and equity market volatility due to the company’s focus on mortality risk that is underwritten. This compares to life peers whose income is heavily dependent upon annuities, asset management, group benefits and retirement plans and whose income is based on earning a spread between assets and liabilities. 80% of the global life reinsurance market is held by the top 5 players with RGA being #2 with roughly 18% market share. By operating in a highly concentrated market, the global life reinsurance market has higher barriers to entry, which insulates - to an extent - the entrenched players from new competition. Counterparty risk is also a very important consideration for life insurance companies when using reinsurance. In the case of a reinsurer’s insolvency, the primary life insurance company is ultimately responsible for the reinsured liabilities. RGA’s strong reputation and financial strength make it a strong counterparty and serves as a competitive moat.  COVID-19 has become one of the biggest challenges for RGA as a company. To date, RGA’s business has remained intact and the company has remained profitable despite the exceptionally difficult period reinsuring mortality in the midst of a pandemic.

What is the mortality effect of COVID-19 on RGA's Traditional Life Insurance Business?

Mortality exposure makes up ~50% of RGA’s pre-tax operating earnings and is generated through the reinsurance of traditional life insurance products. While mortality experience tends to be relatively predictable over the long-term, it can be volatile in the short term. In 2020, RGA found itself in one of those volatile periods with the onset of the COVID-19 pandemic. In the 1Q20, RGA issued guidance for $400m to $500m pre-tax mortality claim cost for every additional 1.4m global death (including 100K U.S. deaths). Importantly, RGA lowered that previously issued guidance by ~50% when it reported 2Q to $200m to $300m for the same level of additional deaths. According to the company, the lowered mortality assumption was due to COVID disproportionately affecting 3 main groups that generally do not have life insurance policies: (i) elderly, (ii) individuals with pre-existing conditions, and (iii) low-income. For these three groups, life insurance is generally too expensive or unattainable in the case of people with pre-existing conditions. According to the CDC, over ~80% of all COVID-rated deaths were individuals 65+ years of age or older. This was confirmed in RGA’s 2Q20 results, where the majority of excess claims were concentrated in policies over the age of 70. Importantly, the 70+ age group only makes up 6.9% of RGA’s U.S. morality book of business and naturally insulates itself from the population most adversely affected by COVID-19.    

 In the 2Q20 (March – June), there were 128K COVID-19 related deaths in the United States. During that period, RGA reported $300m of COVID-19 related claim costs in the quarter, of which $240m were in the U.S. individual mortality business and the remaining $60m in the UK and Canada. Despite the elevated claim costs during the quarter, RGA still made money and produced a +3% annualized ROE in the quarter. Since the start of the 3rd quarter, there have been an additional ~72K U.S. COVID-19 related deaths, but still below the 128K that occurred in 2Q20. While the threat of a new spike in the fall/winter is real, there are several datapoints that point to improving mortality. First, new cases in the US peaked in July at 70K daily new cases, but deaths were down over ~50% (2.5K to 1.0K daily deaths) during that same time period (see here). Why the decline? Data suggest that the most vulnerable population (i.e. elderly with pre-existing conditions) were most affected during the start of the pandemic.  Second, we learned about the disease and how to better protect the most vulnerable people in our population. Third, the second wave was made up of a younger portion of the population with a lower likelihood of death. Fourth, therapeutics are improving resulting in lower mortality. See exhibit 1 for the mortality rate trend.

Exhibit 1: Number of COVID-19 Cases in U.S

According to the human mortality database, the number of weekly deaths (from all causes) in August was equal to the number of deaths over the previous five (2015-2019) years. This metric is down from an elevated level of over 40% during the height of the pandemic (see exhibit 2). The CDC has a similar dataset (see here) showing that the United States is now below normal level of seasonal deaths (from all causes) compared to prior years. Overall, these data points highlight a return of average mortality across the United States. We are also seeing benefits from COVID-19 related to other illnesses. For example, the flu season in the southern hemisphere have been extremely benign (see here) as a result of increased flu vaccinations, face covering, and social distancing. For example, flu cases in Australia are 21K to date compared to 247K a year ago. This points to countervailing forces that will affect mortality this fall/winter between the flu and COVID-19. The flu has historically been a big driver of mortality in 1Q for RGA.  

Exhibit 2: Number of COVID-19 Cases in U.S

Last, The CDC report noted 94% of COVID deaths had at least one other pre-existing condition with the average being 2.6. As such, COVID could result in a meaningful pull forward of deaths resulting in better results in the coming quarters/years. Despite this, we have not modeled any meaningful improvement in mortality until the 2Q21. Overall, we believe COVID-19 is a manageable situation for RGA. Notably, the company was still able to produce a profit in 2Q20 despite potentially peak deaths and has $1.4bn of excess regulatory capital. We also do not assume any change to the model from a potential vaccine. 

What is the impact from  lower interest rates on profitability and what are the credit risks in RGA’s investment portfolio?

RGA derives a majority of its income (~50%) from life reinsurance, which is sensitive to mortality but not as sensitive to rates. In particular, RGA is much less exposed to (i) annuities and (ii) pension products, which rely on earning a spread between liabilities and interest-earnings-assets. The annuity/pension exposure that RGA does have is lower interest rate risk because RGA is reinsuring seasoned blocks of business that are re-priced upon the transaction. Importantly, RGA’s business is 100% reinsurance where it is easier to match the duration of assets and liabilities when compared to writing new primary business. As a result, RGA’s earnings are much less affected by declines of interest rates relative to its peers.  With that said, low interest rates still present some earnings headwind for the company, given the long-term nature of RGA’s businesses. The CFO cited a $(30)m-(35)m annual pre-tax impact on earnings or $0.33 - $0.39 of EPS, for every (50) basis point decline in earned rates. Currently new money rate was 3.57% in Q2 2020 vs. current investment yield of 4.07%. 

With regard to the investment portfolio, approximately 95% of RGA’s investment portfolio was rated investment grade at 2Q20, with an average credit rating of A. RGA’s CLO portfolio ($1.8bn – 2.5% of investment portfolio) has an average credit rating of AA. The commercial mortgage loan portfolio ($6.0bn – 8.3% of investment portfolio) has an average loan-to-value of 58%. The average commercial loan size is $10.2 million, which equates to a diversified portfolio of over ~575 individual loans. The company implemented interest only or payment deferral modifications on approximately 10% of its CML portfolio, as of 2Q20, and expects to collect all deferred interest. There were no loan impairments in the 2Q20, although CECL reserve increased due to macro-economic factors. The company reported -$22m of credit impairments in 2Q20. For context, this is 0.03% of the total investment portfolio of $72 billion.

Management

The CEO has been with the company since 2014 and CFO since 1995.  We give management credit for growing book value per share at a +11% CAGR since 2008. Hindsight may prove that the capital raise in June at a steep discount to book value was a poor decision; however, to be fair there was substantially greater COVID-19 uncertainty at the time.   

Valuation

RGA currently trades at 0.49x book value, 0.72x book value (excl. AOCI) and 7.5x 2021 EPS. RGA has a long-term track record of generating an 11% ROEs since the great financial crisis and double-digit book value growth. To date, COVID-19 has been an earnings event, not a capital event for the company, and it increasingly looks like that will continue to be the case.   As such, our fair value target is $135 (~45% upside) based on 0.70x estimated 2021 book value.  Over the next few years we believe the shares can effectively double to $180 if the stock simply trades back to a 0.80x BV multiple.   For the past 15 years, the stock has generally traded between 0.8x-1.2x book value, so anything above a 0.8x would offer further upside potential.

Modeling Assumptions

Risks

• COVID-19 mutation increasing mortality; larger waves of infections during the Northern Hemisphere winter

• Continued declines in rates further pressuring investment yield 

Catalyst

• There is an opportunity to have positive new flows on therapeutics and the vaccine in the coming quarters. 

• 2Q results showed that the mortality exposure for RGA remains manageable with the company still generating an operating profit despite elevated deaths related to COVID-19. Since that time, there are signs that mortality is improving with CDC data showing that U.S. deaths (from all causes) is now below its seasonal trend compared to prior years.  The next couple of quarters should provide increasing comfort to investors that COVID-19 will definitively be an earnings event and not a capital event.

• The pandemic has driven greater demand for life insurance policies with life insurance applications for the industry up +18.9% YoY in July and +9.1% in August. RGA stands to benefit should a secular growth trend emerge