insurance sector: all set for a bumper ropnewsletters.cii.in/.../november07/images/insurance.pdf ·...

Andrei Ivanov, CFAPhone: 7 (501) 258 0511 Fax: 258 0582

E�mail: [email protected]

November 2003

Insurance Sector

ALL SET FOR A BUMPER CROP

Troika Dialog Research Russia . Insurance

NOVEMBER, 2003 INSURANCE SECTOR: ALL SET FOR A BUMPER CROP

11

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


22

Executive Summary

Russiaís insurance industry is only just starting to build up a real competitive market, but it isalready clear that the seeds of retail$oriented products, sown by leading domestic insurers, couldoffer a bumper harvest in the years ahead. For now, however, the range of services offered to retailclients is limited. Captive companies associated with large industrial groups control a whopping36% of the market, smothering much of the competition. Sectors remain opaque and poorlyregulated, with 98% of life insurance and 30$40% of non life insurance policies signed as part oftax avoidance schemes. That said, potential structural changes in the next two years couldencourage 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 marketconsolidation. Also expected in 2004 is the partial liberalization of the industry for Europeancompanies. Although unlikely to encourage a massive inflow of new capital, this should providefurther 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 yearsshould stimulate an environment in which new financial services can prosper.

Estimated at a mere $3.2 bln after adjustments for tax avoidance schemes and mandatory cover,the Russian insurance industry is Lilliputian. That said, two crucial features could encourage aninflow of capital in the medium term. First, unlike the banking and pension sectors, where state$controlled enterprises dominate, the insurance market is free from direct government participation,which bodes well for fair competition in the future. Second, the underdeveloped retail$orientedsector offers an excellent opportunity for newcomers looking to invest major financial andmanagerial resources in building franchises. We estimate the industryís CAGR growth potentialover the next five years at more than 16%. This should come mostly from the catch$up effect intwo 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 annualgrowth of 27% and 59%.

* adjusted for tax avoidance schemes and mandatory insurance** vehicle theft and damage insurance

Source: Troika Dialog

Retail insurance is a key growth driver(premiums, $ bln)*

12 12

9 9

6 6

3 3

Mar

ket 2

003

Life

insu

ranc

e

Cas

co**

MTP

L

Prop

erty

(com

mer

cial

)

Prop

erty

(indi

vidu

al)

Med

ical

Oth

er

Mar

ket 2

008

0 0


33

Life insurance in particular looks set to be the epicenter of expansion. In an optimistic scenario, thesegment could grow from $0.15 bln to $2.4 bln in the coming five years, and the ability of the currentplayers 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 mostlarge companies have been bought by strategic investors. This could lead to further consolidationand the emergence of new market leaders who are focused on creating value by developingnational brands and franchises.

As regards companies going public, we expect the leaders of the pack to be ready in three or fouryears 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 thewillingness to go public in the years ahead and could represent future investment opportunities.


44

Market Structure and Penetration

The Russian insurance industry is at a very early stage of development and lags far behind its EastEuropean peers in terms of both structure and service penetration. The size of the life insurancesegment, usually a reliable gauge of the overall marketís development, is miniscule in Russia. Themost developed business is that of commercial property/liability insurance, which does notrequire major investments in infrastructure or brand positioning and is dominated by captivecompanies. The most promising sectors for newcomers willing to invest in building a strongfranchise 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 adjustfor tax avoidance schemes, an image of a much less$developed industry emerges. Life insuranceaccounts for only 3.4% of premiums, while the size of the market (excluding mandatoryinsurance) is around $3.2 bln, or just 52% of the official figure.

What is more, the industry is highly fragmented, with the top three insurers controlling less than25% versus the East European average of 50$70%. As we see it, the existence of so many playerswith such low levels of capital is due mainly to fairly weak industry regulation and overly liberalsolvency requirements. These conditions reduce the incentives for leading companies toconsolidate their market share and create opportunities for niche players involved in taxavoidance schemes.

Insurance services in Russia have a long way to go before they catch up with the averagepenetration levels in Eastern Europe. Our adjusted figures put the current penetration of non$lifeinsurance at around 1.1% of GDP, which is only 60% of the East European average and wellbelow the 3.5% average for the European Union. The penetration of corporate insurance looksin line with the current state of the domestic economy, while the low figure for retail insuranceproducts suggests that this segment should catch up most.

Structure of non life insurance should change100% 100%

60% 60%

80% 80%

40% 40%

20% 20%

Russia official Russia adjusted East European average

Source: State Statistics Committee, PIU, Swiss Re, Troika Dialog

CascoMTPL

LiabilityMedical

PropertyOthers

0% 0%

Motor insurancecatches up most


55

Key structural problems

In terms of development, Russiaís insurance industry arguably trails other financial sectors, suchas the banking or pension segments, where the last two years have seen the start of structuralreforms. That said, it enjoys freedom from the government, which controls over 35% of bankingassets 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 financialsectors after the following structural issues are addressed:

Domination of corporate insurance by captive companies. This makes the segment opaqueand uncompetitive. We estimate that captive companies control over 36% of the non$lifeinsurance business. They are widely used by the large industrial groups with which they areassociated to manipulate profits.

Lack of focus on increasing business value and on long4term market leadership. Small andmid$sized companies aim to exploit short$term market opportunities. One example of this istax 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 markettransparency and create ideal conditions in which insolvent and badly managed companiesflourish. This in turn leads to insurance products being massively overpriced, as even thebest$managed companies have to pass on the cost of market inefficiency to clients.

Restrictions on foreign insurers operating in the market. These have prevented propercompetition and service standards from being established. Some might be lifted next year.

The industryís highly controversial legal environment and the lack of tax incentives toencourage the development of life insurance. An illustrative example of the uncertaintysurrounding the industry is the State Dumaís recent attempt to revoke the law on mandatorythird$party motor insurance after companies invested heavily in building an infrastructureand sales teams.

Unlike the banking and pension sectors, where attention from policymakers eventually gatheredenough momentum to precipitate reform, the insurance industry remains racked with structuralproblems. That said, the emergence of the new niche for mandatory third$party motor insurancewith decent levels of competition and transparency could encourage players to set aboutimproving the market environment.

Source: Interfax, Troika Dialog estimates

Retail insurance is most competitive segment(market share of captive companies)

80% 80%

60% 60%

40% 40%

20% 20%

Car

go

Com

mer

cial

prop

erty

Vol

unta

rym

edic

al

Thir

d$pa

rty

liabi

lity

Com

mer

cial

tran

spor

t

MTP

L

Cas

co

Ret

ail

prop

erty

0% 0%


66

Life Insurance

Market structure and penetration

Although official statistics put the size of the life insurance segment at around $3.6 bln, webelieve that 95$98% of premiums sold represent schemes offered by small insurance companiesto avoid payroll taxes. We therefore estimate its real size at $120$150 mln, most of which iscontrolled by Rosgosstrakh, AIG and subsidiaries of international insurers. Based on the adjustedfigures, the penetration of life insurance in Russia is a tiny $0.9 per capita, versus the EastEuropean average of $46.

Recent times have seen market leaders moving away from tax optimization services, mainly dueto 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 smallercompanies to move into the void. Most have only the minimum required capital and a smallinfrastructure 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$deductibleexpenses, making them more attractive than banking deposits and other instruments on a netbasis. In Russia, this system is flawed because premiums are not tax$deductible forindividuals and the overall level of tax discipline is very low.

Low focus on savings. We estimate that Russians spend over 45% of their income onfoodstuffs, while only 7% is set aside as savings. This is a fair reflection of the current mentalityof the population, which focuses primarily on consumption and shuns the financial system.

Volatile macro environment. Despite Russiaís average expected GDP growth of 5$6% overthe next five years and falling inflation, people are not yet confident enough to invest long$term in the domestic currency. As experience in Poland, Hungary and the Czech Republichas shown, one event that can trigger increasing demand for life insurance is inflationstabilizing at the single$digit level. We do not expect inflation in Russia to stay under 10%for two consecutive years before 2007.

Source: Swiss Re, Troika Dialog

Life insurance penetration in Russia is tiny, $140 140

120 120

60 60

80 80

100 100

40 40

20 20

800 2,800 4,800 6,800 8,800

GDP per capita

10,800 12,800

Prem

ium

per

cap

ita

0 0BrazilRussia

UAE

Panama

ChileMalaysia

Greece

Argentina

Mexico

Czech Rep.Hungary

PolandThailand

Slovakia

Slovenia


77

Uncompetitive market environment. The lack of regulation benefits small players lookingfor one$off gains from tax avoidance schemes rather than those wanting to promotecompetitive insurance products. This decreases the incentives for international companieslike AIG to expand in Russia, which in turn delays the adoption of international businessstandards in the market.

Growth drivers

As life insurance is not as basic a financial need as a bank account or medical cover, developmentof the segment depends primarily on the emergence of an upper middle class. Various estimatesput the number of Russian households in this stratum, in terms of income (over $500 monthly perfamily member) and consumption patterns, at over 1.2 mln. We expect further growth of the classand 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, withgrowth 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 upto the penetration level implied by the fundamentals and to its peers. High growth rates couldtherefore be sustainable for several years.

There are two main ways to forecast how the segment will grow over the next five years. The firstis to assume that it will follow the pattern of development seen in Poland, or other country witha similar macro environment (although, in Polandís case, changes in the tax regime gave a majorboost to the insurance industry). The second is to assume that life insurance in Russia will reach50$60% of its fundamentally justified penetration level within five years. This is based on ourreview of the growth of branded products in the consumer goods industry.

As regards the first method, in terms of GDP per capita and inflation, Russia is quite similar toPoland in 1995$6, which thus serves as a starting point for the growth projection. This gives aCAGR 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 2004.

Poland in the 90s is a proxy for Russiaís market, $100 6.0

80 4.8

60 3.6

40 2.4

20 1.2

í92 í93 í94 í95 í96 í97 í98 í99 í03Eí02í01í00

Source: PIU, IMF

GDP per capita, $ í000 (r. h. scale)

Life premiumsper capita

Prem

ium

per

cap

ita

Non life premiumsper capita

0 0.0


88

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 lastfive years but still seriously lags behind Poland in terms of retail deposits to GDP (9.6% versus30%). Another comparison could be drawn with the beer market, which took six years to ìcatchupî fully at a CAGR of 17%. However, this was in a highly competitive environment where theregulatory eyes were more attentive. The more opaque, less competitive insurance sector wouldneed much longer to mature.

Triggers

As mentioned above, fundamental indicators such as income per capita and the size of the upper$middle 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 byfundamental factors. One major catalyst of this process could be strategic jostling by certainplayers. However, by far the most important potential triggers for growth over the next two yearsare, we think, liberalization of the overall insurance market and pension reform.

The removal of certain restrictions on foreign companies operating in the insurance market isunder discussion in the Duma and looks set to be approved by the start of 2004. While we do notexpect this to cause a massive inflow of foreign capital, it should increase the incentives forexisting overseas players to expand in the retail insurance segment.

Meanwhile, the pension reform, which started last year, should have an indirect but importantinfluence on the life insurance sector. Under the new system, all working individuals in Russiamust select a company to manage their pension funds. The results of the investment return on thefirst contributions should stimulate public interest in saving long$term and thus help companiesto position life insurance products.

However, these factors would give only a slight boost to the segment. The trigger for a real boomwould be the creation of tax incentives for individuals, as seen with commercial propertyinsurance last year. All life insurance premiums are currently non tax$deductible, making theirnet return at best equal to that on bank loans, yet with greater liquidity risk. Unfortunately, wesee no indication that income tax legislation will be changed any time soon.

Source: Troika Dialog

Life insurance has the best growth potential(expected annual growth to 2008)

80% 80%

60% 60%

40% 40%

20% 20%

Life

insu

ranc

e

Cas

co

Prop

erty

(indi

vidu

al)

MTP

L

Prop

erty

(com

mer

cial

)

Oth

er

Med

ical

0% 0%


99

Outlook

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


1010

Mandatory Third-Party Motor Liability Insurance (MTPL)

The introduction of mandatory third$party motor insurance could lead to major structural changesthroughout the whole of the insurance market. With the new product comes a new niche, whichrequires that existing players develop expertise and competitive advantages. Empirical evidenceshows that such a situation in fragmented industries often triggers consolidation. This is likely tolure major players from the adjacent banking sector, who have the financial resources andexpertise to participate in this process. Interestingly, before the new cover was originally due tobe introduced this year, almost all leading domestic insurance companies were acquired by newstrategic investors. We view this as a strong indication of the importance that domestic capitalattaches to the segment.

With third$party motor insurance to become mandatory as of January 2004, we expect thepremiums collected to grow exponentially in 4Q03. That said, with the State Duma still debatingwhether the relevant law needs revising, its introduction might be delayed. This obviously populistmove could hit the whole industry hard, as the expected revenues from premiums would notcover the large investments made in infrastructure and sales teams.

We estimate the mandatory third$party motor insurance segment to exceed $1.2 bln in the nextfive years, consisting of a one$off hike from $50 mln to $780 mln this year followed by moremodest annual growth of 11% over 2004$08. 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. Themarket is unlikely to reach its maximum potential this year, as over 20% of drivers do not usetheir cars in winter and will probably not buy a policy until next year. We also assume that thenumber of cars in Russia will increase by an average of 4.5% annually in the years ahead. As thisgrowth should be concentrated in regions outside Moscow and St Petersburg where premiumsare 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 diversifiedinfrastructure and large existing sales force. Proper risk management and customer service wouldthen be vital for keeping this share over the next two or three years. As we see it, two differentgroups of companies have set their sights on the mandatory third$party motor insurance business.

Motor insurance market to emerge within a year, $ bln2.5 2.5

1.5 1.5

2.0 2.0

1.0 1.0

0.5 0.5

2001 2002 2003E 2004F 2005F 2006F 2007F 2008F

Source: State Statistics Committee, Troika Dialog

MTPL Casco

0.0 0.0


1111

The first consists mainly of newcomers who intend to use the segment as a base from which totarget other niches and national companies and who have aggressive plans to maximize theirshare. These include Rosgosstrakh, Alfa Insurance, NIKoil Insurance and RESO Garantia. Thesecond comprises companies that expect their strong track records and customer service to enablethem to win market share from the leaders after the risks and returns from the new product havebecome clearer. These include ROSNO, VSK and most captive companies.

The cross$selling opportunity that the new insurance offers looks fairly attractive. On the basis ofour discussions with various players in the industry, we estimate that 3$7% of people whopurchase third$party insurance policies will also buy vehicle theft and damage cover. Given lastyearís average policy cost of $350, these would be worth $150$300 mln, or over 50% of theexisting motor insurance sector.

Number of mandatory third-party motor insurance policies, 3Q03

Premium, $ mln Number of contracts, 000 Average contract, $

Rosgosstrakh 116 2,390 48

RESO Garantia 34 365 93

Ingosstrakh 17 203 84

Spasskiye Vorota 12 135 87

SKPO 10 210 46

Alfa Insurance 8 116 67

NIKoil Insurance 8 106 72

VSK 7 106 67

Nasta 7 92 73

MAKS 7 98 67

Top 10 224 3,821 71

Share of total 72% 78%

Others 86 1,102

Total 310 4,923 62.4

Source: Interfax, RSA, Troika Dialog

As the 3Q03 results indicate, companies with large franchises (Rosgosstrakh, RESO Garantia andIngosstrakh) have secured a major chunk of the business. At the same time, the top 10 companiesin the sector featured at least five new aggressive players.

Outlook

The mandatory third$party motor insurance sector has evidently been occupied by the existingmajor players. We believe that it heralds an opportunity for companies to build a properdistribution chain and develop operating and risk management expertise. We also expect theactivity of the leaders to trigger off consolidation in the market. This process is likely to acceleratein the next two or three years, when companies that have not generated a critical mass or builtan efficient risk$management business will be forced to sell out to better$managed peers.


1212

Other Insurance For Individuals

Initially, the most attractive and profitable niche in the retail insurance segment looks set to becover 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 $440. We explainthis by a change in attitudes and personal wealth, particularly among the upper$middle class,whose rising income led to imported car sales jumping by 35% last year. The introduction ofmandatory third$party motor cover also undoubtedly boosted demand.

Such a critical mass of potential customers for property insurance has yet to build up and thesegment is stagnating at a mediocre $170 mln. Most of the current business comes frompensioners wanting to insure summer houses, which keeps the average premium per policy at alow $11. Even the soaring real estate markets in Russiaís largest cities (especially Moscow, whereprices over the last three years have grown by an average of 15$20% annually) have done littleto promote property insurance. Nonetheless, we are optimistic that demand will be driven in themedium term by the inevitable emergence of a domestic mortgage market.

Retail property insurance to remain small, $ bln1.5 75%

0.9 25%

1.2 50%

0.6 0%

0.3 ñ25%

í98 í99 í02í01í00 í03E í04F í05F í06F í07F í08F


Total market Growth (r. h. scale)

0.0 ñ50%

Casco market may reach $2 bln in five years, $ bln2.5 160%

1.5 80%

2.0 120%

1.0 40%

0.5 0%

í98 í99 í02í01í00 í03E í04F í05F í06F í07F í08F


Total market Growth (r. h. scale)

0.0 ñ20%


1313

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 largecorporations rather than individuals, as the latter required major investment in infrastructure.

As mentioned above, the figures for commercial property insurance are seriously inflated by taxavoidance schemes, which we believe account for around 40% of the segment. These schemeshave become increasingly popular since insurance premiums became fully tax$deductible in2001, which triggered the signing of multibillion$dollar contracts with Base Element, NorilskNickel and other leading commodity producers. This creates artificial prices for risks anddissuades 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 linewith the current state of the economy. As a result, we do not see much potential for the segmentto 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 translatesinto a CAGR of around 14%, which is small compared with other sectors of the insurance market.

Nonetheless, we forecast the sector to grow slightly faster than the economy thanks to theaccelerating development of small and mid$sized businesses, few of which have property oraccident insurance. Additional momentum should come from rapid expansion of the loan marketcoupled with increasing requirements that collateral be covered.

Source: Swiss Re, Troika Dialog

ìCatch upî in non life insurance is limited, $80 80

40 40

60 60

20 20

0 1,000 2,000 3,000 4,000

GDP per capita

5,000 8,0007,0006,000

Prem

ium

per

cap

ita

0 0Turkey

Croatia

Panama

Slovakia

Russia 02

Russia 08

RomaniaBolgaria

Mexico

Hungary

Poland

Argentina


1414

Consumer Lending Should Drive Insurance Growth

Demand for all types of insurance should be driven by structural changes on the domestic loanmarket, although these might become visible only after a few years. The main change will be banksswitching their focus to project financing and consumer lending. Unlike working capital loans (themost popular current alternative), project financing is secured using not stock and revenue butproduction assets and therefore requires insurance. Consumer loans, meanwhile, particularly forcars or homes, require that borrowers take out both asset and life insurance. Although the marketfor such loans remains largely undeveloped, it is the main growth driver for the banking sector inthe 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 domesticbanks require that both the collateral and the borrowerís life be covered. Overall, this generates apremium of over 10$11% of the loan value. Car loans are currently rare in Russia, with penetrationat 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 2008. Thisalone 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 theprocess of developing the legislation and infrastructure for a proper system of refinancing lendersis slow. Another restricting factor is the disparity between high interest rates and low personalincomes. Nonetheless, we forecast the market to take off in 2005$06 when the mortgage loaninfrastructure is in place and interest rates become affordable for the middle classes.

Loan market to drive demand for insurance, $ bln80 80

60 60

40 40

20 20

1997 1998 1999 2000 2001 2002 2003E

Source: Central Bank, Troika Dialog

Commercial loans Retail loans

0 0

CAGR51%

CAGR34%


1515

Main Profit Drivers

Premiums remain main source of profit

On a risk/return basis, we view most non$mandatory insurance products as seriously overpriced.The reason for this, we think, is that companies are passing on costs related to the segmentís lowtransparency and poor returns on investments. Although such a policy obviously dampensdemand, particularly from price$sensitive retail customers, the situation is unlikely to improveuntil structural changes are made in the industry.

Our conclusion is based on the fact that payments on benefits are unusually small compared withnet premiums (after reinsurance). This can be measured using the loss ratio, which ranges from30% 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, whichwe view as a fair representation of Russian risk.

Investment income

The composition of the insurance industryís investment portfolio clearly reflects its main structuralproblems. The largest portion, over 43%, is in promissory notes, which is a good indicator of thecaptive nature of most companies. Promissory notes require very little information from the issuerand are widely used to redirect profits or cashflows within a group of related companies. Alsopopular are banking deposits, which account for over 18% of the portfolio. Such a large shareensures that insurers have sufficient flexibility to manage liquidity risk, which remains high dueto both the low share of long$term life insurance policies and the concentration of risk amongseveral large clients. These also explain the high share of cash (12%) and the lack of investmentin bond and equity instruments (which each account for less than 10%).

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, whoseportfolios each brought in a 26% return.

Source: Expert RA, Troika Dialog

Related party transactions dominate the industryís investment portfolio

Equity investments 6%

Real estate 5%

Others 5%

Cash 12%

43% Bills of exchange

4% Municipal bonds

18% Deposits

7% Corporate bonds $2.7 bln


1616

We expect increasing competition in the industry and in the development of the life insurancesector to boost investment income noticeably, both in absolute terms and as a percentage of totalrevenues. That said, domestic insurers are unlikely to become major players on the local stockmarket. Even in an optimistic scenario, where the industry expands to $11 bln by 2008, its overallinvestment portfolio is unlikely to exceed $6 mln. The equity part of this will be less than 2% ofthe Russian stock marketís free float and 60% below the overall equity investments of pensionfunds, which we forecast at over $3.5 mln by 2008. A similar picture is likely on the corporatebond 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 alarge infrastructure be built, despite the unknown ratio between risk and return. We thereforeview 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 productprices. 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 managedto keep costs relatively low, thanks to operations being concentrated among a handful ofcustomers. Moreover, they were able to dictate prices due to the shortage of loans in theeconomy. However, when clients got access to the competitive international debt market, thesituation changed completely. All leading banks were forced to refocus on small businesses andretail 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 thedeveloped countries. This is due to local companiesí heavy reliance on agent networks, whereaspeers 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 salessystem in Russia, where the population remains largely uninterested in insurance products.Companies that specialize in commercial insurance benefit from lower underwriting fees (lessthan 12% of net premiums).

Interestingly, excluding underwriting fees, Russiaís market leaders have lower operating costs as apercentage of net premiums (15$16%) than their East European peers (23%). That said, the pre$taxmargin 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. Thelatter is directly linked to low capital consolidation in the industry, which prevents domestic playersfrom taking large risks on the basis of their position, thus forcing down profitability.


1717

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 tointernational players as unfounded. We believe that liberalizing the industry will actually createsome momentum in the life insurance segment and raise service standards. That said, it is unlikelyto massively change the structure of the non life insurance sector, which presently accounts for90% of the whole industry in Russia.

As we see it, foreign insurance companies have worked round the current, fairly rigid restrictionsand settled into the niche that they believe offers the best ratio of risk to return: the reinsurancesector, where their market share is significant. Moreover, their plans to expand aggressively toother segments are limited by high legal risks, low client transparency and the domination ofcaptive companies.

The table above summarizes the main restrictions for foreign insurers operating in Russia and themarket liberalization measures that are expected as part of the requirements for the countryís entryinto the WTO. The most important change, we think, is allowing foreign$controlled companiesinto the life insurance and mandatory insurance services. In addition, the quota for the share offoreign capital in the sector was raised from 15% to 25%, despite the previous allowance notbeing fully used. This is therefore unlikely to change market structure much, as most foreignplayers already operate via vehicles that are controlled by domestic capital only nominally. Itwill, however, make the situation more transparent for clients.

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.

Status

Passed second reading

in the Duma

Passed second reading

in the Duma

Was not included in

liberalization package

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.


1818

Market liberalization should stimulate the life insurance segment, in which foreign companies alreadyhave a major hand. However, as discussed above, progress will depend mostly on changes in themacroeconomic and tax environments and penetration will remain very low. Although foreign playersbenefit 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 majorreallocation 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$competitiveenvironment rather than formal restrictions. Despite foreign banks having been allowed to create100% subsidiaries in Russia and carry out a whole range of activities, the market share of suchsubsidiaries remains flat at around 8% while their share of total capital is below 10%. This indicatesthat international banks are not interested in entering the Russian market by forming subsidiariesand investing in infrastructure. Instead, they focus on lending to domestic majors directly from theirheadquarters, a practice that already accounts for 40% of the domestic loan market.


1919

Key Players

We have compiled a list of the top 15 insurers in Russia based on the non life insurance premiumscollected last year. We believe that this approach eliminates the effect of tax optimizationschemes, most of which are life insurance policies.

Top of the leaderboard is Ingosstrakh, one of the former Soviet insurers, which collected $190 mlnin premiums in 1H03 and reported reserves of $320 mln. Second is another forefather of themodern insurance industry, Rosgosstrakh, whose recent acquisition by a consortium of strategicinvestors has seriously strengthened its market positions and capital. In third place is RESOGarantia, which represents the new generation of insurers who are targeting the retail$orientedsegments. The next three places are occupied by captive insurers controlled by leading industrialgroups: Gazprom, InterRos and LUKoil.

We estimate that the top 15 companies have consolidated over 60% of the industryís capital andreserves. This suggests that the industry remains chronically undercapitalized, with total equityof 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 190 138 321 10 32% Universal

Rosgosstrakh 171 32 191 ñ2 30% Universal

RESO Garantia 122 26 115 1 40% Universal

Sogaz 106 41 160 13 62% Oil and gas

Soglasie 89 32 33 2 8% Large

corporations

Capital 86 91 79 73 33% Oil and gas

ROSNO 83 46 118 0 37% Universal

VSK 77 29 93 1 62% Universal

Alfa Insurance 64 ñ ñ ñ 25% Universal

MAKS 45 16 122 ñ 38% Universal

NIKoil 42 78 36 0 115% Universal

Renaissance Insurance 35 17 34 21 34% Universal

Guta Insurance 24 21 25 0 22% Universal

Energogarant 24 28 29 0 18% Oil and gas

Neftepolis 23 22 21 7 12% Oil and gas

Total 1,180 617 1,377 127

Source: Expert RA

We carried out a brief analysis of five companies that we believe focus increasingly on valuecreation and are likely to be key players in the industry. We would point out that our analysis ofthe companiesí market position and profitability is only indicative, as non$market operations affectboth official market information and companiesí financial reports.


2020

As mentioned above, all the chosen companies enjoy relatively low loss ratios, from as little as30% for ROSNO to the East European average of 60% for RESO Garantia. Obviously, the businessconcentration 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 clientbase, are fairly representative of the industry and indicate that domestic companies still benefitfrom high product pricing.

Unlike their East European peers, domestic insurers (even the largest) generate a small part of theiroperating income from investments. The leader of the pack is Rosgosstrakh, whose portfolio bringsin 40% of its income. We explain this by a highly diversified client base, which reduces thecompanyís exposure to liquidity risk.

That said, the unwieldy infrastructure that Rosgosstrakh inherited from Soviet times generates highoperating costs. However, once the new owners have finished restructuring the managementsystem, the network should offer great potential for efficiency gains. On a relative basis, otherdomestic insurersí operating costs are below the East European average. However, we view thisas a temporary advantage that is linked solely to their concentration in terms of both geographyand market sectors. We expect the emergence of a large infrastructure and national brands tobring operating costs in line with average levels.

Source: Companies, PIU, Troika Dialog

Investment income is low as % of operating income, 2002100% 100%

80% 80%

60% 60%

40% 40%

20% 20%

Dev

elop

edav

erag

e

Pola

ndav

erag

e

Ros

goss

trak

h

Ingo

sstr

akh

RO

SNO

RES

O

VSK

0% 0%


Most players benefit from low loss ratio, 200280% 80%

60% 60%

40% 40%

20% 20%

Dev

elop

edav

erag

e

RO

SNO

VSK

Pola

ndav

erag

e

Ingo

sstr

akh

Ros

goss

trak

h

RES

O

0% 0%


2121

Prospects for investment

As we see it, the insurance industry has only just emerged from the first stage of powerredistribution and its future form is only starting to take shape. What is more, the strong potentialfor growth and consolidation should create decent opportunities for the leaders to expand. Weexpect the market landscape to take around three years to form, which gives an idea of whensome companies might float their shares. Also, should our growth projections prove correct, theleading insurers would offer attractive opportunities for direct equity investments.

We view the best value$adding opportunity for insurers as maximizing market share in emergingretail$oriented segments, namely retail property, vehicle and life insurance. The latter creates thegreatest value; according to international statistics, life insurance companies trade at 2.2 timestheir book value, versus an average of 1.3 for property/liability insurers.

* excluding underwriting fees


Operating costs* as % of net premiums, 200250% 50%

40% 40%

30% 30%

20% 20%

10% 10%R

osgo

sstr

akh

Pola

ndav

erag

e

RO

SNO

Ingo

sstr

akh

VSK

Dev

elop

edav

erag

e

RES

O

0% 0%


2222

Rosgosstrakh

Rosgosstrakh dates from the Soviet times, when it enjoyed themonopoly on providing insurance services. In 2002$03, thecompany was sold to a consortium of domestic and foreigninvestors led by Troika Dialog.

With over 2,300 regional sales offices and over 60,000agents, Rosgosstrakh has the largest insurance network inRussia. This has helped the company secure over 56% of theretail property insurance market and is also a strongadvantage 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 repositionits brand and target the wealthier classes, which have been offthe companyís radar. Another problem area is cost efficiency,with the companyís 42% expense ratio at the lower end of theindustry average. That said, we expect the introduction ofproper operational management and budgeting to unlockgreater efficiency gains.

We believe that Rosgosstrakhís infrastructure, strong brandrecognition in the regions and new management team willcombine to create a strong competitive advantage in theretail insurance markets, which we expect to lead growth inthe industry.

Source: Interfax, Troika Dialog

Rosgosstrakh, market share, 200260% 60%

30% 30%

50% 50%

40% 40%

20% 20%

10% 10%

Tota

lno

n lif

e

Med

ical

Com

mer

cial

prop

erty

Ret

ail

prop

erty

Cas

co

Liab

ility

MTP

L

0% 0%

Rosgosstrakh, financials (RAS), $ mln

2001 2002

Non life insurance

Net premiums 140 188

Loss (38) (71)

Change in reserves (10) (19)

Underwriting expenses (25) (33)

Others (29) (35)

Operating income, non life 37 32

Operating income, life (1) (1)

Total operating income 36 31

Net investment income 5 17

Operating expenses (38) (53)

Pre4tax profits (2) 43

Equity 13 67

Reserves 80 112



2323

Ingosstrakh

Ingosstrakh was established in 1947 as a specialist in insuringinternational trade operations in Russia. Thanks to the nicheíscompetitive environment and long credit history, thecompany has taken a leading position on the non lifeinsurance market, of which it currently controls over 12%.Ingosstrakh is the only Russian insurer to have a diversifiedinternational network (of over 20 branches) in addition to120 domestic offices.

The company enjoys strong brand recognition nationwide,having managed to avoid the financial problems that plaguedRosgosstrakhís reputation in the early 1990s. In 2001,Ingosstrakh was acquired by structures close to OlegDeripaska, an owner of leading domestic aluminum producerBase Element.

We consider the share of non$market operations inIngosstrakhís portfolio to be one of the smallest on themarket. In many respects, this makes the company a goodbenchmark for evaluating the profitability of the non lifeinsurance business in Russia.

Last year, the company reported a pretax margin of 15% anda ROE of 60%, which we believe stemmed mainly from thefairly low loss ratio of 46%. Its 15% expense ratio is in line withthe industry average but below that of the East European peers.

We believe that Ingosstrakh will benefit significantly from themore competitive environment in the corporate insurancesector, particularly in the liability, cargo and unique riskssegment, where it has already secured a market share of over20%. In the retail sector, of which it controls between 5%and 10%, the company is likely to continue concentrating onMoscow and St Petersburg, where its strong reputation is anadvantage for targeting the upper$middle class.

Ingosstrakh has the largest equity capital and reserves in theindustry and could be considered the most likely candidatefor the stock market over the next few years.


Ingosstrakh, market share, 200230% 30%

15% 15%

25% 25%

20% 20%

10% 10%

5% 5%

Tota

lno

n lif

e

Med

ical

Com

mer

cial

prop

erty

Ret

ail

prop

erty

Cas

co

Liab

ility

MTP

L

0% 0%

Ingosstrakh, financials (RAS), $ mln

2001 2002

Non life insurance

Net premiums 144 269

Loss (86) (135)



Operating income, non$life 17 38

Operating income, life 0 0




Pre4tax profits 22 47

Equity 51 97

Reserves 303 365



2424

ROSNO

ROSNO was established in 1992 and is currently part ofSistema, a diversified holding whose assets include 51% ofMTS. Another strategic owner is global insurer Allianz, whichwe believe already plays a key role in the operationalmanagement. We expect Allianz to buy out the company assoon 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 universalinsurer. This policy, we believe, has earned the company a7$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 taxoptimization schemes in its portfolio. This brought down lifeinsurance premiums by 70% in 1H03, although thecompanyís operating profits remained largely unchanged.

ROSNO is a major player in the voluntary third$party motorinsurance sector, but was cautious in its approach to themandatory segment. The companyís main target niche isseemingly life insurance, where Allianzís strategic participationis a competitive advantage.


ROSNO, market share, 200216% 16%

12% 12%

8% 8%

4% 4%

Tota

lno

n lif

e

Med

ical

Com

mer

cial

prop

erty

Ret

ail

prop

erty

Cas

co

Liab

ility

MTP

L

0% 0%

ROSNO, financials (RAS), $ mln

2002 1H03

Non life insurance

Net premiums 148 95

Loss (51) (61)



Others (4) (3)






Pre4tax profits 13 2

Equity 46 46

Reserves 112 219



2525

RESO Garantia

RESO Garantia was formed in 1991 and positioned itself asa universal insurer. Its shareholder base is fairly diversifiedand includes quite a high proportion of state$controlledexporters. That said, we believe that control lies in the handsof the management. The company has a network of around200 sales offices and 7,000 agents throughout the country.

In 2002, RESO Garantiaís property/liability premiums grew bya solid 140% y$o$y to $150 mln, but its decision to reduce itsfocus on tax optimization schemes brought life insurancepremiums down almost tenfold to just $5 mln.

RESO Garantiaís two target businesses are for motor coverand liability insurance. We estimate that the company led thethird$party motor insurance segment in 2002, with a marketshare of around 18%. That said, the introduction ofmandatory third$party motor cover and the entry of a strongnew player like Rosgosstrakh are likely to change the sectorísoverall structure. While RESO Garantia might be able todefend its position in Moscow, Rosgosstrakh is likely to takecontrol of the regional markets.

Like ROSNO, RESO Garantia has a fairly low net margin, ofless than 2%. That said, shareholders support the companyísexpansion drive, which includes raising around $50 mln byplacing shares via closed subscription in October.

The companyís diversified infrastructure, well$known brandand strong positions in the retail$oriented business shouldmake it a primary target for foreign insurers. One trigger forsuch a deal could be liberalization of the market. That said,if the management decides to go public and develop as anindependent insurer, the company will be one of the mostattractive plays on the stock market.


RESO Garantia, market share, 200220% 20%

15% 15%

10% 10%

5% 5%

Tota

lno

n lif

e

Med

ical

Com

mer

cial

prop

erty

Ret

ail

prop

erty

Cas

co

Liab

ility

MTP

L

0% 0%

RESO Garantia, financials (RAS), $ mln

2001 2002

Non life insurance

Net premiums 66 148

Loss (35) (38)








Pre4tax profits 0 2

Equity 24 24

Reserves 42 151



2626

VSK

VSK was established in 1993 and has traditionally specializedin servicing state military$oriented companies and theemployees of the defense, interior and other ministries.However, the last two years have seen the company start toexpand aggressively in the retail$oriented market. Weestimate its share of the motor insurance segment at 6%. VSKhas a network of around 300 sales offices.

As regards life insurance, VSK has lain relatively low. The$1 mln that it collected in premiums in this segment representproper accident insurance contracts. In the property and liabilitysegments, the company increased its premiums by over 80%last year, most of which came from fully comprehensive motorpolicies and liability insurance.

VSKís profitability as compared with that of its peers is fair.Its pretax margin last year was 6%, which we attribute toimproved gains from the investment portfolio and savings onunderwriting commissions. The companyís 62% loss ratio,which is within the average range for the industry, indicatesa relatively high share of market contracts in its portfolio.

In our opinion, VSK represents a new trend in the sector,whereby insurers previously associated with a single segmentare adopting a new strategy and pushing into the competitiveretail markets.


VSK, market share, 20028% 8%

6% 6%

4% 4%

2% 2%

Tota

lno

n lif

e

Med

ical

Com

mer

cial

prop

erty

Ret

ail

prop

erty

Cas

co

Liab

ility

MTP

L

0% 0%

VSK, financials (RAS), $ mln

2001 2002

Non life insurance

Net premiums 74 122

Loss (43) (75)

Change in reserves 3 (16)


Others (14) 3


Operating income, life 0 0




Pre4tax profits 2 7

Equity 26 29

Reserves 53 77


This report was prepared by Andrei Ivanov, who certifies that: all of the views expressed in this report accurately reflect his personal views about the securitiesand issuers covered in this report; and no part of his compensation was, is, or will be, directly or indirectly, related to the specific recommendations or viewsexpressed in this report.

This research report is prepared by TROIKA DIALOG or its affiliate named herein. It is being distributed in the United States by TROIKA DIALOG USA,which accepts responsibility for its contents. Any U.S. person receiving this report who wishes to effect transactions in any securities referred to herein shouldcontact TROIKA DIALOG USA, not its affiliate. This information herein has been obtained from, and any opinions herein are based upon, sources believedto be reliable, but no representation is made that it is accurate or complete and it should not be relied upon as such. All such information and opinions aresubject to change without notice. From time to time, TROIKA DIALOG USA or its affiliates or the principals or employees of its affiliates may have positionsor derivative positions in the securities referred to herein or make a market or otherwise act as principal in transactions in any of these securities or mayprovide investment banking or consulting services to or serve as a director of a company being reported on herein. This information does not constitute anoffer to buy or sell securities. Further information on the securities referred to herein may be obtained from TROIKA DIALOG USA upon request. This reportmay not be reproduced, copied nor extracts taken from it, without the express written consent of TROIKA DIALOG.

© TROIKA DIALOG 2003

President,Chief Executive Officer

Ruben Vardanian

Managing Director, Capital Markets

Jacques Der Megreditchian

Chief Economist

Evgeny Gavrilenkov

Executive Managing Director

Sergei Skvortsov

CONTACT DETAILS

Phone 7 (501) 258 0500Fax 7 (501) 258 0547Internet http://www.troika.ru

Research

Phone 7 (501) 258 0511

E$mail [email protected]

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Phone 7 (501) 258 0550


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Phone 7 (501) 258 0510


Trading

Phone 7 (501) 258 0525


Structured Products

Phone 7 (501) 258 0572


New York Office

Phone 1 (646) 613 8585


RESEARCH

Chief Equity Strategist,Head of Research James Fenkner, CFA

Consumer, Industrial, BankingSenior Analyst Andrei Ivanov, CFA

Corporate GovernanceAnalyst Elena Krasnitskaya

EconomyEconomist Anton Stroutchenevski

ElectricitySenior Analyst Lauri Sillantaka, CFA

Fixed IncomeAnalyst Alexander Kudrin

Metals and MiningAnalyst Vasily Nikolaev

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