Discovery: Time to win over the cynics
The firm is no longer viewed with the reverence it once was. CEO Adrian Gore faces a long slog to win over the cynics
Discovery has been the feeblest performer in SA’s life assurance sector over the past year. It is down 33%, even worse than the hapless Old Mutual.
Since its record high of R190, Discovery’s decline looks precipitous: the share peaked in September 2018, but by this week it had slid to below R100 — a slump of around 47%. While its interim results to December 2019 show that many parts of the business remain robust, Discovery is burning through cash as it struggles to bring its new business ventures, like banking, to anything resembling scale.
More than half its operating profit is provided by Discovery Life in SA, which recorded a 25% increase in operating profit to nearly R1.9bn. Some analysts, such as Renaissance Capital’s Francois du Toit who recently re-joined Renaissance Capital, believe this is overstated.
But Discovery group CEO Adrian Gore says: "Our shared-value model, centred on the Vitality wellness programme, has had a proven effect on mortality and morbidity."
However, Warwick Bam, head of research at Avior Capital, says recent spikes in death claims and risks from a deteriorating SA economy heighten investor concern. "Another issue is the poor cash generation as new business strain [upfront commission costs] and reinsurance payments lead to a mismatch between cash flow and earnings."
Discovery’s far older competitors, such as Old Mutual and Sanlam, do not have this problem, as they have huge back books pushing out cash.
Building a business organically can look messy, and is certainly tougher than an acquisition strategyAdrian Gore
Gore says Discovery isn’t misunderstood by the market, "but building a business organically can look messy, and is certainly tougher than an acquisition strategy".
In fact, Discovery has made only one significant acquisition in its history: Standard Life Healthcare in the UK.
Elsewhere in the business, the stop-start launch of Discovery Bank has caused many clients to wait for three months or more to get on board. There are 192,000 Discovery credit card users who still have to be moved from FNB, though 42% of card holders on the Discovery platform are newcomers since the bank opened.
Discovery now claims it can "onboard" clients in eight minutes.
Gore says it aims to be a retail-heavy bank of scale that can’t be compared with a "thin fintech offering" (such as TymeBank or Bank Zero).
Discovery Bank has 78,000 clients, while TymeBank has more than 1-million. But unlike Tyme, Discovery has a chunky R1.2bn in retail deposits and R1bn in credit granted.
Discovery Bank is not a purely digital bank either, as it will be part of the bag of tricks offered by 1,300 tied agents and 4,500 independent financial advisers, with more salespeople joining up soon.
It is surprising how Discovery Health, with its dominant market share, continues to grow. New business revenue is up 26% to R4.4bn. But Gore says the number of members from existing employers is falling sharply.
That has been offset by new employer groups, and particularly by 18 new closed (in-house) schemes.
Gore says it would not help anyone if the SA private sector were destroyed by National Health Insurance (NHI), as the private sector’s survival rates are comparable with those of developed countries such as the US. But, of course, a worst-case outcome for NHI is in the back of many shareholders’ minds.
As for Discovery’s thrusting efforts to make Vitality a worldwide programme, it remains to be seen whether it will become one of the few SA companies to make a success internationally. After all, Discovery gave up on its first overseas venture, Chicago-based Destiny Health, in 2008.
Discovery’s life and health ventures in the UK proved more successful, not least because of the brand and distribution power of Prudential, its joint-venture partner in the first 10 years of the business.
But in the interim results to December 2019, some cracks appeared in what is now called VitalityLife. Record low interest rates make it harder for it to earn the income it needs to pay its future liabilities in the form of death and disability claims. And to ensure that the problem doesn’t get even worse, Discovery initiated a hedge, at a substantial cost of £16m (R310m) — more than VitalityLife’s entire first-half operating profit. Because of that, VitalityLife posted a loss of R134m for the interim period.
Essentially, Discovery has bought a package of interest rate swaps and options to immunise it from any further fall in interest rates.
It argues that, potentially, the fall in value of the life book could be a lot more than the £16m it is spending if UK interest rates continue to fall, which makes the hedge worthwhile.
"The loss is a reduction in the valuation of the business rather than a cash loss, but with every basis point reduction in interest rates it looks worse," says Gore. He’s warned of a loss for the full year, though the hedge should ensure a return to profitability in the year to June 2021.
But interest rates weren’t the only factor, as claims were ahead of expectations and there was unusually high churn.
Commissions for life products in the UK are not subject to the tight regulations of investment products, and brokers can earn up to 200% of the first year’s premium as commission. "But we aren’t making excuses; we should manage this by working only with the more responsible brokers and reorganise our franchise distribution model," says Gore.
Vitality is changing the time in which it can claw back commission — from two years after the policy is issued to four years.
Health insurer VitalityHealth had a stronger first half. Its operating profit increased by 9% to £27m and lives covered increased by 12% to 674,000. It is leveraging off Discovery’s huge health database in SA to help determine its reserving and pricing.
Gore says VitalityHealth and VitalityLife will increasingly be run as one business, and group functions are being merged.
It is too early to say how the third leg of the UK business, VitalityInvest, will do in the crowded investment platform space against giant competitors such as Standard Life, Hargreaves Lansdown and Quilter, but it has a respectable £105m under administration and Discovery needs this business to complete its product suite to financial advisers.
Ping An Health in China is also now making reasonable profits for Discovery. At R68m it is 467% higher than in the first half of 2018, and has increased written premiums by 59%, to R11.1bn.
That might sound impressive, but it is still 10 times smaller than Ping An’s short-term insurance business and about 20 times smaller than its life business.
The coronavirus could put a spanner in the works. But Gore says the business impact should be limited. "We don’t operate in Hubei province [the centre of the outbreak], though it is on our shortlist, as it is quite wealthy."
The Chinese government is also paying all medical expenses related to Covid-19 — the disease caused by the virus — and Ping An Health is facilitating this.
But Gore admits that "if there is an impact on the Chinese economy as a whole, of course we would be hit. If clients can’t afford our policies, lapses would naturally increase."
Gore hints that the next development could be in short-term insurance. Bam predicts a Discovery Insure clone will be launched in the UK, and perhaps beyond, over the next two years.
The market is clearly no longer willing to give Discovery — once viewed as one of the JSE’s most promising performers — the benefit of the doubt.
Gore maintains that he and his team are feeling strong about their numerous ventures, but concedes they’ll have to "earn their spurs".