Insurance Sector A LL S ET FOR A B UMPER C ROP. Troika Dialog Research. Insurance. November 2003

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1 Troika Dialog Research Russia. Insurance November 2003 Insurance Sector A LL S ET FOR A B UMPER C ROP Andrei Ivanov, CFA Phone: 7 (501) Fax: E mail: Andrei_L_Ivanov@troika.ru

2 Contents 2 Executive Summary 4 Market Structure and Penetration 5 Key structural problems 6 Life Insurance 6 Market structure and penetration 7 Growth drivers 8 Triggers 9 Outlook 10 Mandatory Third-Party Motor Liability Insurance (MTPL) 11 Outlook 12 Other Insurance For Individuals 13 Commercial Insurance 14 Consumer Lending Should Drive Insurance Growth 15 Main Profit Drivers 15 Premiums remain main source of profit 15 Investment income 16 Cost control 17 Market Liberalization Is Not a Threat For Local Players 19 Key Players 21 Prospects for investment 22 Rosgosstrakh 23 Ingosstrakh 24 ROSNO 25 RESO Garantia 26 VSK 1

3 Executive Summary Russiaís insurance industry is only just starting to build up a real competitive market, but it is already clear that the seeds of retail-oriented products, sown by leading domestic insurers, could offer a bumper harvest in the years ahead. For now, however, the range of services offered to retail clients is limited. Captive companies associated with large industrial groups control a whopping 36% of the market, smothering much of the competition. Sectors remain opaque and poorly regulated, with 98% of life insurance and 30-40% of non life insurance policies signed as part of tax avoidance schemes. That said, potential structural changes in the next two years could encourage the industry to sprout forth. Next year heralds the implementation of mandatory third-party motor liability insurance (MTPL), which is likely to force large players to focus on operating efficiency and could cause market consolidation. Also expected in 2004 is the partial liberalization of the industry for European companies. Although unlikely to encourage a massive inflow of new capital, this should provide further momentum for the emerging life insurance segment, the target of existing foreign players. Finally, pension reform and growth of the consumer loan market in the next couple of years should stimulate an environment in which new financial services can prosper. Estimated at a mere $3.2 bln after adjustments for tax avoidance schemes and mandatory cover, the Russian insurance industry is Lilliputian. That said, two crucial features could encourage an inflow of capital in the medium term. First, unlike the banking and pension sectors, where statecontrolled enterprises dominate, the insurance market is free from direct government participation, which bodes well for fair competition in the future. Second, the underdeveloped retail-oriented sector offers an excellent opportunity for newcomers looking to invest major financial and managerial resources in building franchises. We estimate the industryís CAGR growth potential over the next five years at more than 16%. This should come mostly from the catch-up effect in two segments, initially motor insurance and then life insurance, whose penetration rates are 5-10% of those in countries with similar income levels. The two products promise respective annual growth of 27% and 59%. Retail insurance is a key growth driver 12 (premiums, $ bln)* Market 2003 Life insurance Casco** MTPL Property (commercial) Property (individual) Medical Other Market 2008 * adjusted for tax avoidance schemes and mandatory insurance ** vehicle theft and damage insurance Source: Troika Dialog 2

4 Life insurance in particular looks set to be the epicenter of expansion. In an optimistic scenario, the segment could grow from $0.15 bln to $2.4 bln in the coming five years, and the ability of the current players to secure a decent chunk of this will be key in determining the future value of their business. The last two years have seen the first stage of power redistribution in the sector, whereby most large companies have been bought by strategic investors. This could lead to further consolidation and the emergence of new market leaders who are focused on creating value by developing national brands and franchises. As regards companies going public, we expect the leaders of the pack to be ready in three or four years at best. Moreover, such a move would depend on structural changes taking place in the sector. We believe that Rosgosstrakh, Ingosstrakh and RESO Garantia may have both the ability and the willingness to go public in the years ahead and could represent future investment opportunities. 3

5 Market Structure and Penetration The Russian insurance industry is at a very early stage of development and lags far behind its East European peers in terms of both structure and service penetration. The size of the life insurance segment, usually a reliable gauge of the overall marketís development, is miniscule in Russia. The most developed business is that of commercial property/liability insurance, which does not require major investments in infrastructure or brand positioning and is dominated by captive companies. The most promising sectors for newcomers willing to invest in building a strong franchise are the retail-oriented ones (life, retail property and motor insurance). Official statistics depict an insurance market whose structure resembles those in Eastern Europe, with life insurance accounting for 30% of premiums collected in Russia. However, after we adjust for tax avoidance schemes, an image of a much less-developed industry emerges. Life insurance accounts for only 3.4% of premiums, while the size of the market (excluding mandatory insurance) is around $3.2 bln, or just 52% of the official figure. Structure of non life insurance should change 100% 100% 80% 80% 60% 60% 40% 40% 20% 20% 0% 0% Motor insurance catches up most Russia official Russia adjusted East European average Casco MTPL Liability Medical Property Others Source: State Statistics Committee, PIU, Swiss Re, Troika Dialog What is more, the industry is highly fragmented, with the top three insurers controlling less than 25% versus the East European average of 50-70%. As we see it, the existence of so many players with such low levels of capital is due mainly to fairly weak industry regulation and overly liberal solvency requirements. These conditions reduce the incentives for leading companies to consolidate their market share and create opportunities for niche players involved in tax avoidance schemes. Insurance services in Russia have a long way to go before they catch up with the average penetration levels in Eastern Europe. Our adjusted figures put the current penetration of non-life insurance at around 1.1% of GDP, which is only 60% of the East European average and well below the 3.5% average for the European Union. The penetration of corporate insurance looks in line with the current state of the domestic economy, while the low figure for retail insurance products suggests that this segment should catch up most. 4

6 Key structural problems In terms of development, Russiaís insurance industry arguably trails other financial sectors, such as the banking or pension segments, where the last two years have seen the start of structural reforms. That said, it enjoys freedom from the government, which controls over 35% of banking assets and over 60% of total pension reserves (i.e. both voluntary and obligatory payments). Competition in the insurance industry could therefore become much fiercer than in other financial sectors after the following structural issues are addressed: Domination of corporate insurance by captive companies. This makes the segment opaque and uncompetitive. We estimate that captive companies control over 36% of the non-life insurance business. They are widely used by the large industrial groups with which they are associated to manipulate profits. Retail insurance is most competitive segment 80% (market share of captive companies) 80% 60% 60% 40% 40% 20% 20% 0% 0% Cargo Commercial property Voluntary medical Third-party liability Commercial transport MTPL Casco Retail property Source: Interfax, Troika Dialog estimates Lack of focus on increasing business value and on long-term market leadership. Small and mid-sized companies aim to exploit short-term market opportunities. One example of this is tax optimization schemes, which we believe account for 98% of life insurance and 30-40% of property insurance policies. Weak regulation and low risk management requirements. These seriously reduce market transparency and create ideal conditions in which insolvent and badly managed companies flourish. This in turn leads to insurance products being massively overpriced, as even the best-managed companies have to pass on the cost of market inefficiency to clients. Restrictions on foreign insurers operating in the market. These have prevented proper competition and service standards from being established. Some might be lifted next year. The industryís highly controversial legal environment and the lack of tax incentives to encourage the development of life insurance. An illustrative example of the uncertainty surrounding the industry is the State Dumaís recent attempt to revoke the law on mandatory third-party motor insurance after companies invested heavily in building an infrastructure and sales teams. Unlike the banking and pension sectors, where attention from policymakers eventually gathered enough momentum to precipitate reform, the insurance industry remains racked with structural problems. That said, the emergence of the new niche for mandatory third-party motor insurance with decent levels of competition and transparency could encourage players to set about improving the market environment. 5

7 Life Insurance Market structure and penetration Although official statistics put the size of the life insurance segment at around $3.6 bln, we believe that 95-98% of premiums sold represent schemes offered by small insurance companies to avoid payroll taxes. We therefore estimate its real size at $ mln, most of which is controlled by Rosgosstrakh, AIG and subsidiaries of international insurers. Based on the adjusted figures, the penetration of life insurance in Russia is a tiny $0.9 per capita, versus the East European average of $46. Premium per capita Life insurance penetration in Russia is tiny, $ Malaysia Chile Greece Czech Rep. Slovenia Hungary Slovakia Argentina Thailand UAE Poland Mexico Panama 20 0 Russia Brazil ,800 4,800 6,800 8,800 GDP per capita 10,800 12,800 Source: Swiss Re, Troika Dialog Recent times have seen market leaders moving away from tax optimization services, mainly due to the recent drop in payroll taxes and their increasing focus on building proper national brands. This brought down total reported premiums by 30% last year and has prompted smaller companies to move into the void. Most have only the minimum required capital and a small infrastructure and report artificially high claims on policies. We see several structural problems that hamper the development of life insurance in Russia: Absence of tax incentives. In many countries, life insurance premiums are tax-deductible expenses, making them more attractive than banking deposits and other instruments on a net basis. In Russia, this system is flawed because premiums are not tax-deductible for individuals and the overall level of tax discipline is very low. Low focus on savings. We estimate that Russians spend over 45% of their income on foodstuffs, while only 7% is set aside as savings. This is a fair reflection of the current mentality of the population, which focuses primarily on consumption and shuns the financial system. Volatile macro environment. Despite Russiaís average expected GDP growth of 5-6% over the next five years and falling inflation, people are not yet confident enough to invest longterm in the domestic currency. As experience in Poland, Hungary and the Czech Republic has shown, one event that can trigger increasing demand for life insurance is inflation stabilizing at the single-digit level. We do not expect inflation in Russia to stay under 10% for two consecutive years before

8 Uncompetitive market environment. The lack of regulation benefits small players looking for one-off gains from tax avoidance schemes rather than those wanting to promote competitive insurance products. This decreases the incentives for international companies like AIG to expand in Russia, which in turn delays the adoption of international business standards in the market. Growth drivers As life insurance is not as basic a financial need as a bank account or medical cover, development of the segment depends primarily on the emergence of an upper middle class. Various estimates put the number of Russian households in this stratum, in terms of income (over $500 monthly per family member) and consumption patterns, at over 1.2 mln. We expect further growth of the class and its personal income levels to be a major driver for the sector. Evaluating the segmentís potential is frustrated by an absence of reliable market statistics, with growth rates of ìrealî life insurance over the last three years varying from 38% to 60%. However, one thing is clear: the sector is only just taking root and has a long way to go before catching up to the penetration level implied by the fundamentals and to its peers. High growth rates could therefore be sustainable for several years. There are two main ways to forecast how the segment will grow over the next five years. The first is to assume that it will follow the pattern of development seen in Poland, or other country with a similar macro environment (although, in Polandís case, changes in the tax regime gave a major boost to the insurance industry). The second is to assume that life insurance in Russia will reach 50-60% of its fundamentally justified penetration level within five years. This is based on our review of the growth of branded products in the consumer goods industry. Poland in the 90s is a proxy for Russiaís market, $ Premium per capita í92 í93 í94 í95 í96 í97 í98 í99 í00 í01 í02 í03e Life premiums per capita Source: PIU, IMF Non life premiums per capita GDP per capita, $ í000 (r. h. scale) As regards the first method, in terms of GDP per capita and inflation, Russia is quite similar to Poland in , which thus serves as a starting point for the growth projection. This gives a CAGR through 2008 of 43%, to $0.9 bln, then slowing to 13% in the five years thereafter. Moreover, insurance penetration in Poland increased when GDP per capita exceeded $3,000; our macro analysis suggests that Russia should hit this level by end

9 The second and more optimistic approach suggests a CAGR through 2008 of over 59%, to $2.4 bln. A useful proxy is the retail deposit market, which has seen a CAGR of 34% over the last five years but still seriously lags behind Poland in terms of retail deposits to GDP (9.6% versus 30%). Another comparison could be drawn with the beer market, which took six years to ìcatch upî fully at a CAGR of 17%. However, this was in a highly competitive environment where the regulatory eyes were more attentive. The more opaque, less competitive insurance sector would need much longer to mature. Life insurance has the best growth potential 80% (expected annual growth to 2008) 80% 60% 60% 40% 40% 20% 20% 0% 0% Life insurance Casco Property (individual) MTPL Property (commercial) Other Medical Source: Troika Dialog Triggers As mentioned above, fundamental indicators such as income per capita and the size of the uppermiddle class suggest that life insurance penetration in Russia should be much higher. Moreover, the segment needs to catch up to the requisite level before growth will be driven solely by fundamental factors. One major catalyst of this process could be strategic jostling by certain players. However, by far the most important potential triggers for growth over the next two years are, we think, liberalization of the overall insurance market and pension reform. The removal of certain restrictions on foreign companies operating in the insurance market is under discussion in the Duma and looks set to be approved by the start of While we do not expect this to cause a massive inflow of foreign capital, it should increase the incentives for existing overseas players to expand in the retail insurance segment. Meanwhile, the pension reform, which started last year, should have an indirect but important influence on the life insurance sector. Under the new system, all working individuals in Russia must select a company to manage their pension funds. The results of the investment return on the first contributions should stimulate public interest in saving long-term and thus help companies to position life insurance products. However, these factors would give only a slight boost to the segment. The trigger for a real boom would be the creation of tax incentives for individuals, as seen with commercial property insurance last year. All life insurance premiums are currently non tax-deductible, making their net return at best equal to that on bank loans, yet with greater liquidity risk. Unfortunately, we see no indication that income tax legislation will be changed any time soon. 8

10 Outlook If our assumptions about growth triggers are correct, the next three years will be a critical period in the formation of the segment. As seen from the earlier developmental stages of the pension and life insurance sectors in Eastern Europe, securing a substantial market share early on is important, as opportunities for subsequent redistribution are limited. As the life insurance segment in Russia is almost non-existent, there are excellent opportunities for players willing to invest heavily in building professional sales teams and a solid reputation. Among the existing players, those best positioned to dominate are AIG, Allianz and other foreign companies, followed by domestic insurers with a nationwide infrastructure, such as Rosgosstrakh (if it manages to reposition its brand). 9

11 Mandatory Third-Party Motor Liability Insurance (MTPL) The introduction of mandatory third-party motor insurance could lead to major structural changes throughout the whole of the insurance market. With the new product comes a new niche, which requires that existing players develop expertise and competitive advantages. Empirical evidence shows that such a situation in fragmented industries often triggers consolidation. This is likely to lure major players from the adjacent banking sector, who have the financial resources and expertise to participate in this process. Interestingly, before the new cover was originally due to be introduced this year, almost all leading domestic insurance companies were acquired by new strategic investors. We view this as a strong indication of the importance that domestic capital attaches to the segment. With third-party motor insurance to become mandatory as of January 2004, we expect the premiums collected to grow exponentially in 4Q03. That said, with the State Duma still debating whether the relevant law needs revising, its introduction might be delayed. This obviously populist move could hit the whole industry hard, as the expected revenues from premiums would not cover the large investments made in infrastructure and sales teams. Motor insurance market to emerge within a year, $ bln E 2004F 2005F 2006F 2007F 2008F MTPL Casco Source: State Statistics Committee, Troika Dialog We estimate the mandatory third-party motor insurance segment to exceed $1.2 bln in the next five years, consisting of a one-off hike from $50 mln to $780 mln this year followed by more modest annual growth of 11% over This assumes that around 80% of the 35 mln cars, buses and trucks registered in Russia are in use and that the average policy costs around $60. The market is unlikely to reach its maximum potential this year, as over 20% of drivers do not use their cars in winter and will probably not buy a policy until next year. We also assume that the number of cars in Russia will increase by an average of 4.5% annually in the years ahead. As this growth should be concentrated in regions outside Moscow and St Petersburg where premiums are lower, we expect the average policy cost to trail inflation. A company wanting to secure a large slice of the segment early on should have a diversified infrastructure and large existing sales force. Proper risk management and customer service would then be vital for keeping this share over the next two or three years. As we see it, two different groups of companies have set their sights on the mandatory third-party motor insurance business. 10

12 The first consists mainly of newcomers who intend to use the segment as a base from which to target other niches and national companies and who have aggressive plans to maximize their share. These include Rosgosstrakh, Alfa Insurance, NIKoil Insurance and RESO Garantia. The second comprises companies that expect their strong track records and customer service to enable them to win market share from the leaders after the risks and returns from the new product have become clearer. These include ROSNO, VSK and most captive companies. The cross-selling opportunity that the new insurance offers looks fairly attractive. On the basis of our discussions with various players in the industry, we estimate that 3-7% of people who purchase third-party insurance policies will also buy vehicle theft and damage cover. Given last yearís average policy cost of $350, these would be worth $ mln, or over 50% of the existing motor insurance sector. Number of mandatory third-party motor insurance policies, 3Q03 Premium, $ mln Number of contracts, 000 Average contract, $ Rosgosstrakh 116 2, RESO Garantia Ingosstrakh Spasskiye Vorota SKPO Alfa Insurance NIKoil Insurance VSK Nasta MAKS Top , Share of total 72% 78% Others 86 1,102 Total 310 4, Source: Interfax, RSA, Troika Dialog As the 3Q03 results indicate, companies with large franchises (Rosgosstrakh, RESO Garantia and Ingosstrakh) have secured a major chunk of the business. At the same time, the top 10 companies in the sector featured at least five new aggressive players. Outlook The mandatory third-party motor insurance sector has evidently been occupied by the existing major players. We believe that it heralds an opportunity for companies to build a proper distribution chain and develop operating and risk management expertise. We also expect the activity of the leaders to trigger off consolidation in the market. This process is likely to accelerate in the next two or three years, when companies that have not generated a critical mass or built an efficient risk-management business will be forced to sell out to better-managed peers. 11

13 Other Insurance For Individuals Initially, the most attractive and profitable niche in the retail insurance segment looks set to be cover for vehicle damage or theft (Casco). Last year, demand for motor insurance was up 32% to $0.3 bln, while the average premium per policy rocketed by 60%, from $279 to $440. We explain this by a change in attitudes and personal wealth, particularly among the upper-middle class, whose rising income led to imported car sales jumping by 35% last year. The introduction of mandatory third-party motor cover also undoubtedly boosted demand. Casco market may reach $2 bln in five years, $ bln % % % % 0.5 0% 0.0 ñ20% í98 í99 í00 í01 í02 í03e í04f í05f í06f í07f í08f Total market Growth (r. h. scale) Source: State Statistics Committee, Troika Dialog Such a critical mass of potential customers for property insurance has yet to build up and the segment is stagnating at a mediocre $170 mln. Most of the current business comes from pensioners wanting to insure summer houses, which keeps the average premium per policy at a low $11. Even the soaring real estate markets in Russiaís largest cities (especially Moscow, where prices over the last three years have grown by an average of 15-20% annually) have done little to promote property insurance. Nonetheless, we are optimistic that demand will be driven in the medium term by the inevitable emergence of a domestic mortgage market. Retail property insurance to remain small, $ bln % % % 0.6 0% 0.3 ñ25% 0.0 ñ50% í98 í99 í00 í01 í02 í03e í04f í05f í06f í07f í08f Total market Growth (r. h. scale) Source: State Statistics Committee, Troika Dialog 12

14 Commercial Insurance Adjusted for tax optimization schemes, the commercial insurance segment stands at $1.8 bln, most of which is commercial property cover. It is occupied mainly by large domestic insurers, led by the oldest, Ingosstrakh. This situation is in line with the evolution of other financial sectors (such as the banking and non-state pension segments), where companies worked first with large corporations rather than individuals, as the latter required major investment in infrastructure. As mentioned above, the figures for commercial property insurance are seriously inflated by tax avoidance schemes, which we believe account for around 40% of the segment. These schemes have become increasingly popular since insurance premiums became fully tax-deductible in 2001, which triggered the signing of multibillion-dollar contracts with Base Element, Norilsk Nickel and other leading commodity producers. This creates artificial prices for risks and dissuades foreign insurers from taking the plunge, despite the absence of legal restrictions. Comparing Russia with its peers indicates that the penetration of commercial insurance is in line with the current state of the economy. As a result, we do not see much potential for the segment to catch up. Indeed, analysis of the market in Poland suggests that over the next five years, penetration could at best increase from $8 to $14.7 in terms of premiums per capita. This translates into a CAGR of around 14%, which is small compared with other sectors of the insurance market. Premium per capita ìcatch upî in non life insurance is limited, $ Argentina Panama Russia Russia Croatia 20 Turkey Bolgaria 0 Romania 0 0 1,000 2,000 3,000 4,000 5,000 6,000 7,000 8,000 GDP per capita Source: Swiss Re, Troika Dialog Slovakia Hungary Poland Mexico Nonetheless, we forecast the sector to grow slightly faster than the economy thanks to the accelerating development of small and mid-sized businesses, few of which have property or accident insurance. Additional momentum should come from rapid expansion of the loan market coupled with increasing requirements that collateral be covered. 13

15 Consumer Lending Should Drive Insurance Growth Demand for all types of insurance should be driven by structural changes on the domestic loan market, although these might become visible only after a few years. The main change will be banks switching their focus to project financing and consumer lending. Unlike working capital loans (the most popular current alternative), project financing is secured using not stock and revenue but production assets and therefore requires insurance. Consumer loans, meanwhile, particularly for cars or homes, require that borrowers take out both asset and life insurance. Although the market for such loans remains largely undeveloped, it is the main growth driver for the banking sector in the near term. This in turn reinforces our optimism about the potential of insurance by products. The development of the car loan sector also promises to create business for insurers, as domestic banks require that both the collateral and the borrowerís life be covered. Overall, this generates a premium of over 10-11% of the loan value. Car loans are currently rare in Russia, with penetration at less than 5% of new car purchases, versus 50-60% in Central Europe and 20% in China. However, the increasing focus of domestic banks on the segment could boost the figure to 20% by This alone would boost related premiums from the current $60 mln to $450 mln in five years. As for the mortgage market, the outlook for the next three to four years is less optimistic, as the process of developing the legislation and infrastructure for a proper system of refinancing lenders is slow. Another restricting factor is the disparity between high interest rates and low personal incomes. Nonetheless, we forecast the market to take off in when the mortgage loan infrastructure is in place and interest rates become affordable for the middle classes. Loan market to drive demand for insurance, $ bln CAGR 34% CAGR 51% E Commercial loans Retail loans Source: Central Bank, Troika Dialog 14

16 Main Profit Drivers Premiums remain main source of profit On a risk/return basis, we view most non-mandatory insurance products as seriously overpriced. The reason for this, we think, is that companies are passing on costs related to the segmentís low transparency and poor returns on investments. Although such a policy obviously dampens demand, particularly from price-sensitive retail customers, the situation is unlikely to improve until structural changes are made in the industry. Our conclusion is based on the fact that payments on benefits are unusually small compared with net premiums (after reinsurance). This can be measured using the loss ratio, which ranges from 30% to 50% depending on the insurance product, versus the international average of 70-80%. This is particularly true for commercial property insurance, which has the lowest ratio of 30%. Meanwhile, claims in the mandatory insurance segment account for 80% of premiums, which we view as a fair representation of Russian risk. Investment income The composition of the insurance industryís investment portfolio clearly reflects its main structural problems. The largest portion, over 43%, is in promissory notes, which is a good indicator of the captive nature of most companies. Promissory notes require very little information from the issuer and are widely used to redirect profits or cashflows within a group of related companies. Also popular are banking deposits, which account for over 18% of the portfolio. Such a large share ensures that insurers have sufficient flexibility to manage liquidity risk, which remains high due to both the low share of long-term life insurance policies and the concentration of risk among several large clients. These also explain the high share of cash (12%) and the lack of investment in bond and equity instruments (which each account for less than 10%). Related party transactions dominate the industryís investment portfolio 43% Bills of exchange 7% Corporate bonds $2.7 bln 4% Municipal bonds 18% Deposits Equity investments 6% Others 5% Real estate 5% Cash 12% Source: Expert RA, Troika Dialog Investment income reported by domestic insurance companies for last year varied greatly. Nonetheless, the respective 12% and 9% returns announced by AIG and Ingosstrakh, we believe, fairly represent the average profitability of the life and non life insurance companiesí portfolios. The leaders of the insurers that focus on classic products were Rosgosstrakh and ROSNO, whose portfolios each brought in a 26% return. 15

17 We expect increasing competition in the industry and in the development of the life insurance sector to boost investment income noticeably, both in absolute terms and as a percentage of total revenues. That said, domestic insurers are unlikely to become major players on the local stock market. Even in an optimistic scenario, where the industry expands to $11 bln by 2008, its overall investment portfolio is unlikely to exceed $6 mln. The equity part of this will be less than 2% of the Russian stock marketís free float and 60% below the overall equity investments of pension funds, which we forecast at over $3.5 mln by A similar picture is likely on the corporate bond market, where the insurance companiesí overall portfolio is estimated at less than $3.5 bln, well below that of banks ($35 bln) and pension funds ($14 bln). Cost control Aggressive expansion into the new mandatory third-party motor insurance niche required that a large infrastructure be built, despite the unknown ratio between risk and return. We therefore view cost control as crucial for the survival of the market leaders. As our analysis shows, local insurers and their East European peers have fairly similar cost structures. That said, the profitability of the large domestic players could be better due to relatively high product prices. As mentioned above, these result from poor market transparency and low competition. A similar situation arose in the banking sector several years ago, when the largest banks managed to keep costs relatively low, thanks to operations being concentrated among a handful of customers. Moreover, they were able to dictate prices due to the shortage of loans in the economy. However, when clients got access to the competitive international debt market, the situation changed completely. All leading banks were forced to refocus on small businesses and retail customers, which caused an immediate rise in operating costs. On average, domestic insurers operating in the retail segment pay underwriting fees of 12-15%, which is comparable with the average in Eastern Europe but higher than the 6-7% figure for the developed countries. This is due to local companiesí heavy reliance on agent networks, whereas peers tend to use less expensive distribution channels, such as direct marketing or bank branches. The situation is unlikely to change massively, as agents remain by far the most efficient sales system in Russia, where the population remains largely uninterested in insurance products. Companies that specialize in commercial insurance benefit from lower underwriting fees (less than 12% of net premiums). Interestingly, excluding underwriting fees, Russiaís market leaders have lower operating costs as a percentage of net premiums (15-16%) than their East European peers (23%). That said, the pre-tax margin of most domestic insurers is a mediocre 1-6%, versus the 9-10% of the international peers. We attribute this to a combination of low investment revenue and high share of reinsurance. The latter is directly linked to low capital consolidation in the industry, which prevents domestic players from taking large risks on the basis of their position, thus forcing down profitability. 16

18 Market Liberalization Is Not a Threat For Local Players We view domestic insurersí protests that they will be killed off if the market is opened to international players as unfounded. We believe that liberalizing the industry will actually create some momentum in the life insurance segment and raise service standards. That said, it is unlikely to massively change the structure of the non life insurance sector, which presently accounts for 90% of the whole industry in Russia. As we see it, foreign insurance companies have worked round the current, fairly rigid restrictions and settled into the niche that they believe offers the best ratio of risk to return: the reinsurance sector, where their market share is significant. Moreover, their plans to expand aggressively to other segments are limited by high legal risks, low client transparency and the domination of captive companies. Incoming liberalization of insurance market Main existing limitations Insurance companies that incorporate over 49% of foreign capital may not offer the following services: ñ Life insurance ñ Mandatory insurance ñ Property insurance for state and municipal entities. The share of foreign capital in the industryís consolidated charter capital may not exceed 15% (the current level is around 5%). Residents should occupy CEO and CFO positions in insurance companies that incorporate foreign capital. Strict limits for foreign subsidiaries reinsuring with their headquarters. International insurance companies may not open branches in Russia but can operate only via subsidiaries, which requires investment in charter capital. Proposed changes to Law on Insurance (September 2003) All limitations for subsidiaries of EU companies whose capital is over 49% foreign-owned to be lifted. Quota for foreign capital to be increased from 15% to 25%. No changes No changes Direct branches are considered a strong competitive advantage for foreign insurers and this limit is likely to remain unchanged. Status Passed second reading in the Duma Passed second reading in the Duma Was not included in liberalization package The table above summarizes the main restrictions for foreign insurers operating in Russia and the market liberalization measures that are expected as part of the requirements for the countryís entry into the WTO. The most important change, we think, is allowing foreign-controlled companies into the life insurance and mandatory insurance services. In addition, the quota for the share of foreign capital in the sector was raised from 15% to 25%, despite the previous allowance not being fully used. This is therefore unlikely to change market structure much, as most foreign players already operate via vehicles that are controlled by domestic capital only nominally. It will, however, make the situation more transparent for clients. 17

19 Market liberalization should stimulate the life insurance segment, in which foreign companies already have a major hand. However, as discussed above, progress will depend mostly on changes in the macroeconomic and tax environments and penetration will remain very low. Although foreign players benefit from low risk perception here, they lag well behind domestic players in terms of infrastructure, brand awareness and customer loyalty in all other segments. We do not therefore expect major reallocation in the sector, although overall service standards should improve. The domestic banking sector, which is due to be liberalized before the insurance industry, reinforces our opinion that the main obstacle to an inflow of foreign capital is a non-competitive environment rather than formal restrictions. Despite foreign banks having been allowed to create 100% subsidiaries in Russia and carry out a whole range of activities, the market share of such subsidiaries remains flat at around 8% while their share of total capital is below 10%. This indicates that international banks are not interested in entering the Russian market by forming subsidiaries and investing in infrastructure. Instead, they focus on lending to domestic majors directly from their headquarters, a practice that already accounts for 40% of the domestic loan market. 18

20 Key Players We have compiled a list of the top 15 insurers in Russia based on the non life insurance premiums collected last year. We believe that this approach eliminates the effect of tax optimization schemes, most of which are life insurance policies. Top of the leaderboard is Ingosstrakh, one of the former Soviet insurers, which collected $190 mln in premiums in 1H03 and reported reserves of $320 mln. Second is another forefather of the modern insurance industry, Rosgosstrakh, whose recent acquisition by a consortium of strategic investors has seriously strengthened its market positions and capital. In third place is RESO Garantia, which represents the new generation of insurers who are targeting the retail-oriented segments. The next three places are occupied by captive insurers controlled by leading industrial groups: Gazprom, InterRos and LUKoil. We estimate that the top 15 companies have consolidated over 60% of the industryís capital and reserves. This suggests that the industry remains chronically undercapitalized, with total equity of just over $1 bln, which is miniscule versus the figure for the bank sector of around $25 bln. Top 15 insurers, 1H03, $ mln Non life premiums Equity Reserves Net profit Loss ratio Specialization Ingosstrakh % Universal Rosgosstrakh ñ2 30% Universal RESO Garantia % Universal Sogaz % Oil and gas Soglasie % Large corporations Capital % Oil and gas ROSNO % Universal VSK % Universal Alfa Insurance 64 ñ ñ ñ 25% Universal MAKS ñ 38% Universal NIKoil % Universal Renaissance Insurance % Universal Guta Insurance % Universal Energogarant % Oil and gas Neftepolis % Oil and gas Total 1, , Source: Expert RA We carried out a brief analysis of five companies that we believe focus increasingly on value creation and are likely to be key players in the industry. We would point out that our analysis of the companiesí market position and profitability is only indicative, as non-market operations affect both official market information and companiesí financial reports. 19

21 As mentioned above, all the chosen companies enjoy relatively low loss ratios, from as little as 30% for ROSNO to the East European average of 60% for RESO Garantia. Obviously, the business concentration risk makes domestic insurersí loss ratios very volatile. In this respect, the 40-50% ratios reported by Ingosstrakh and Rosgosstrakh, which both boast a reasonably diversified client base, are fairly representative of the industry and indicate that domestic companies still benefit from high product pricing. Most players benefit from low loss ratio, % 80% 60% 60% 40% 40% 20% 20% 0% 0% Source: Companies, PIU, Troika Dialog Unlike their East European peers, domestic insurers (even the largest) generate a small part of their operating income from investments. The leader of the pack is Rosgosstrakh, whose portfolio brings in 40% of its income. We explain this by a highly diversified client base, which reduces the companyís exposure to liquidity risk. Investment income is low as % of operating income, % 100% 80% 80% 60% 60% 40% 40% 20% 20% 0% 0% Developed average Poland average Rosgosstrakh Ingosstrakh ROSNO RESO VSK Developed average ROSNO VSK Poland average Ingosstrakh Rosgosstrakh RESO Source: Companies, PIU, Troika Dialog That said, the unwieldy infrastructure that Rosgosstrakh inherited from Soviet times generates high operating costs. However, once the new owners have finished restructuring the management system, the network should offer great potential for efficiency gains. On a relative basis, other domestic insurersí operating costs are below the East European average. However, we view this as a temporary advantage that is linked solely to their concentration in terms of both geography and market sectors. We expect the emergence of a large infrastructure and national brands to bring operating costs in line with average levels. 20

22 Operating costs* as % of net premiums, % 50% 40% 40% 30% 30% 20% 20% 10% 10% 0% 0% Rosgosstrakh Poland average ROSNO Ingosstrakh VSK Developed average RESO * excluding underwriting fees Source: Companies, PIU, Troika Dialog Prospects for investment As we see it, the insurance industry has only just emerged from the first stage of power redistribution and its future form is only starting to take shape. What is more, the strong potential for growth and consolidation should create decent opportunities for the leaders to expand. We expect the market landscape to take around three years to form, which gives an idea of when some companies might float their shares. Also, should our growth projections prove correct, the leading insurers would offer attractive opportunities for direct equity investments. We view the best value-adding opportunity for insurers as maximizing market share in emerging retail-oriented segments, namely retail property, vehicle and life insurance. The latter creates the greatest value; according to international statistics, life insurance companies trade at 2.2 times their book value, versus an average of 1.3 for property/liability insurers. 21

23 Rosgosstrakh, market share, % 60% 50% 50% 40% 40% 30% 30% 20% 20% 10% 10% 0% 0% Total non life Medical Source: Interfax, Troika Dialog Commercial property Retail property Casco Rosgosstrakh, financials (RAS), $ mln Non life insurance Net premiums Loss (38) (71) Change in reserves (10) (19) Underwriting expenses (25) (33) Others (29) (35) Operating income, non life Operating income, life (1) (1) Total operating income Net investment income 5 17 Operating expenses (38) (53) Pre-tax profits (2) 43 Equity Reserves Source: Interfax, Troika Dialog Liability MTPL Rosgosstrakh Rosgosstrakh dates from the Soviet times, when it enjoyed the monopoly on providing insurance services. In , the company was sold to a consortium of domestic and foreign investors led by Troika Dialog. With over 2,300 regional sales offices and over 60,000 agents, Rosgosstrakh has the largest insurance network in Russia. This has helped the company secure over 56% of the retail property insurance market and is also a strong advantage in the mandatory third-party motor cover segment, of which it controlled over 50% as of 9m03. At the same time, Rosgosstrakh seriously needs to reposition its brand and target the wealthier classes, which have been off the companyís radar. Another problem area is cost efficiency, with the companyís 42% expense ratio at the lower end of the industry average. That said, we expect the introduction of proper operational management and budgeting to unlock greater efficiency gains. We believe that Rosgosstrakhís infrastructure, strong brand recognition in the regions and new management team will combine to create a strong competitive advantage in the retail insurance markets, which we expect to lead growth in the industry. 22

24 Ingosstrakh, market share, % 30% 25% 25% 20% 20% 15% 15% 10% 10% 5% 5% 0% 0% Total non life Medical Source: Interfax, Troika Dialog Commercial property Retail property Ingosstrakh, financials (RAS), $ mln Non life insurance Net premiums Loss (86) (135) Change in reserves (9) (42) Underwriting expenses (21) (32) Operating income, non-life Operating income, life 0 0 Total operating income Net investment income Operating expenses (17) (22) Pre-tax profits Equity Reserves Source: Interfax, Troika Dialog Casco Liability MTPL Ingosstrakh Ingosstrakh was established in 1947 as a specialist in insuring international trade operations in Russia. Thanks to the nicheís competitive environment and long credit history, the company has taken a leading position on the non life insurance market, of which it currently controls over 12%. Ingosstrakh is the only Russian insurer to have a diversified international network (of over 20 branches) in addition to 120 domestic offices. The company enjoys strong brand recognition nationwide, having managed to avoid the financial problems that plagued Rosgosstrakhís reputation in the early 1990s. In 2001, Ingosstrakh was acquired by structures close to Oleg Deripaska, an owner of leading domestic aluminum producer Base Element. We consider the share of non-market operations in Ingosstrakhís portfolio to be one of the smallest on the market. In many respects, this makes the company a good benchmark for evaluating the profitability of the non life insurance business in Russia. Last year, the company reported a pretax margin of 15% and a ROE of 60%, which we believe stemmed mainly from the fairly low loss ratio of 46%. Its 15% expense ratio is in line with the industry average but below that of the East European peers. We believe that Ingosstrakh will benefit significantly from the more competitive environment in the corporate insurance sector, particularly in the liability, cargo and unique risks segment, where it has already secured a market share of over 20%. In the retail sector, of which it controls between 5% and 10%, the company is likely to continue concentrating on Moscow and St Petersburg, where its strong reputation is an advantage for targeting the upper-middle class. Ingosstrakh has the largest equity capital and reserves in the industry and could be considered the most likely candidate for the stock market over the next few years. 23

25 ROSNO, market share, % 16% 12% 12% 8% 8% 4% 4% 0% 0% Total non life Medical Source: Interfax, Troika Dialog Commercial property Retail property ROSNO, financials (RAS), $ mln H03 Non life insurance Net premiums Loss (51) (61) Change in reserves (42) (6) Underwriting expenses (8) (7) Others (4) (3) Operating income, non-life Operating income, life (30) (4) Total operating income Net investment income 13 4 Operating expenses (28) (17) Pre-tax profits 13 2 Equity Reserves Source: Interfax, Troika Dialog Casco Liability MTPL ROSNO ROSNO was established in 1992 and is currently part of Sistema, a diversified holding whose assets include 51% of MTS. Another strategic owner is global insurer Allianz, which we believe already plays a key role in the operational management. We expect Allianz to buy out the company as soon as the existing limitations on foreign insurers are lifted. ROSNO has a relatively small network of 100 sales offices. From the outset, ROSNO positioned itself as a universal insurer. This policy, we believe, has earned the company a 7-12% share of all segments of the non life insurance sector. ROSNO is the leader in two segments: medical insurance (where its share is 9%) and Casco (14%). Last year, ROSNO decided to reduce the share of tax optimization schemes in its portfolio. This brought down life insurance premiums by 70% in 1H03, although the companyís operating profits remained largely unchanged. ROSNO is a major player in the voluntary third-party motor insurance sector, but was cautious in its approach to the mandatory segment. The companyís main target niche is seemingly life insurance, where Allianzís strategic participation is a competitive advantage. 24