The anatomy
Recent sector performance & key themes
Despite being “financial”, the insurance sector has outperformed the wider market by 8% so
far this year, and has only underperformed by 3% since the start of the credit crunch1. Is it
just a short squeeze? Possibly this is a contributor, and in the short-term volatility seems
likely to remain high. But we do see valid fundamental reasons why the sector should be
showing relative health:
􀂄 Part reversal of substantial underperformance over 2007: The insurers
underperformed the wider market by 9% overall in 2007, with much of this actually
occurring in the early part of the year, as well as during the credit crunch. In the first half,
it reflected a lack of M&A activity which was spurring the rest of the market, and, in the
second half, initial mis-pricing or misperception of the risks being run by insurers, as the
macro environment started to deteriorate. A case of “shoot first, ask questions later”.
􀂄 Growing understanding of asset risks: The assumption that, as in history, the insurers
would be caught out by an emerging financial crisis has proven misplaced. There are, of
course, isolated pockets of remaining concern, but in the main, we believe investors are
becoming more comfortable with insurers’ exposure to risky credit assets.
􀂄 Earnings support: Despite the financial market issues, many of the insurers produced
all-time record earnings in 2007. That is not to say there are not risks ahead if the real
economy continues to deteriorate, but the financial storm, at least, has been weathered
well thus far. Moreover, though they have not been completely immune, earnings have
been substantially more robust than they have in the banks sector. This has led to
outperformance of insurers against banks since the credit crunch started to unfold, and
we most likely expect this relative performance to continue (Figure 2). Moreover, the
volatility of insurance share prices continues to fall relative to banks (Figure 3).
􀂄 Healthy balance sheet strength: Controllable asset risks and good earnings power
means thus far that there has not been even so much as a sniff of an emergency rights
issue in the sector. Certainly, financial strength is lower than it otherwise would have
been, but capital ratios remain above management target levels of comfort in most
cases, and are well above the level where we would consider equity issuance to be a
risk.
􀂄 Increasingly active capital management: In many cases, the reverse has been true. In
other words, earnings support and balance sheet strength have led companies to send
strong signals of confidence to the market, with full-year results disclosures typically
accompanied by substantial increases in dividends, and further buyback plans. Proposed
dividends to be paid this year increased by 25% over 2007 levels, with two thirds of
companies in our coverage universe posting double-digit percentage increases.
􀂄 We expect share buybacks to be at broadly the same level as last year. The total “yield”
for the sector, at 7.3% – comprising 5.0% dividend yield and 2.3% share buybacks –
continues to be attractive.
Despite a little outperformance year to date, we believe the risks in the sector are still well
over-discounted, with many stocks offering outstanding value here by historical standards:

Upside to our stressed valuations: We still factor in a 50% likelihood of our full stress
test scenario, which amongst other things, factors in a further 25% fall in equity markets
from these levels. And even on the full, ‘worst case’ basis, we still see only 4%
downside in the sector. Upside on our traditional sum of the parts basis, with no
allowance for these recessionary risks, is 28%. We discuss this further on page 15.
􀂄 P/E ratios still close to lows: The sector average multiple, on our DB adjusted basis, is
therefore still close to record lows (Figure 1). The weighted one-year forward adjusted
P/E for the sector averaged 11.1x prior to the emergence of the credit crunch in June last
year, 28% higher than its current level, even after the recent bounce.
􀂄 Sector overlooked by investors: We think that, at least to some extent, this has been
driven by the sector being overlooked. Many investors, especially generalists, have been
keen to avoid financials altogether. But for the financials specialists the pace of
newsflow and developments in the banking sector has absorbed materially all of their
resource. As such, we think the sector has been getting less attention than it normally
would, though we have detected a nascent re-emergence of interest with some
investors, given the absence of blow-ups and valuation.
Earnings risk in a “real” recession
However, while the sector has, so far at least, navigated the financial crisis admirably, there
are earnings risks in the future if the damage to the real economy starts to become more
severe. As comfort over insurers’ balance sheets improves (as we think is likely for most
stocks), we believe that share price performance will largely be based on earnings
momentum:
􀂄 The areas most sensitive to a further economic downturn from here are firstly, life new
business sales, which tend to lag the onset of a market or economic downturn by 6-9
months. Future life new business volumes account for 18% of our sum of the parts
valuations across the sector, though this ranges from zero to over 40%.
􀂄 Third party asset management, which accounts for 9% of the sector’s valuation, where
operational leverage is high.
􀂄 Embedded values in the life sector are sensitive to both the development in equity
markets, and also surrender activity.
We examine these themes in more detail in the following sections.

Table of Contents
The anatomy ...................................................................................... 3
Recent sector performance & key themes ...............................................................................3
Investment strategy .......................................................................... 7
Overview..................................................................................................................................7
Key recommendations ..............................................................................................................8
Valuation ................................................................................................................................11
Key sector drivers............................................................................ 15
Reappraisal of sector risk profile.............................................................................................15
Balance sheets and capital management................................................................................16
Earnings quality.......................................................................................................................21
M&A angles ............................................................................................................................25
AEGON (Hold) .........................................................................................................................26
Alleanza (Hold) ........................................................................................................................27
Allianz (Buy)............................................................................................................................28
Aviva (Buy) ..............................................................................................................................29
AXA (Hold)..............................................................................................................................30
Azimut (Hold) ..........................................................................................................................31
Baloise (Hold) ..........................................................................................................................32
Banca Generali (Hold)..............................................................................................................33
Fondiaria-SAI (Hold).................................................................................................................34
Friends Provident (Hold)..........................................................................................................35
Generali (Hold) ........................................................................................................................36
Hannover Re (Hold).................................................................................................................37
ING (Hold) ...............................................................................................................................38
Just Retirement (Buy) .............................................................................................................39
Legal & General (Hold) ............................................................................................................40
Mediolanum (Buy)...................................................................................................................41
Munich Re (Hold) ....................................................................................................................42
Prudential (Hold)......................................................................................................................43
RSA (Hold)..............................................................................................................................44
Sampo (Hold) ..........................................................................................................................45
Standard Life (Hold) ................................................................................................................46
Storebrand (Hold) ....................................................................................................................47
Swiss Re (Buy) ........................................................................................................................48
Unipol (Hold) ...........................................................................................................................49
ZFS (Buy)................................................................................................................................50
Appendix 1 – Insurance earnings risks in a recession .................. 51
Non-life insurance ...................................................................................................................51
Life insurance.........................................................................................................................52