[M&A Essentials] Posted a Loss, Yet Net Assets Rose by 300 Billion Won... The Secret Behind Lotte Insurance's Acquisition Price

Liability valuations fall as interest rates rise
Capital could shrink if rates fall
"Cushion the impact with long-term bonds"

The company posted a loss, yet its net assets rose by hundreds of billions of won. This is the story of Lotte Insurance, which Shinhan Financial Group has agreed to acquire. How could its net assets—the value of its assets minus its liabilities—increase when it was not making money?

Insurance companies invest premiums in bonds and other assets, then pay out claims when customers fall ill or have accidents. When interest rates rise, the value of the bonds they hold falls, but their liabilities, calculated as the present value of future insurance payouts, can also decline. In this installment of M&A Essentials, separate from the synergies expected after the acquisition, we examine how interest rate-driven changes in net assets affect the valuation of an acquisition price.

Was it a good deal? Valuation changes with interest rates, even at the same acquisition price

On October 13, Shinhan Financial Group signed a share purchase agreement to acquire a 77.04% stake in Lotte Insurance for 693.3 billion won. It plans to secure the remaining shares and integrate the company with Shinhan EZ General Insurance, subject to regulatory approvals and other requirements.

At the end of June this year, Lotte Insurance had net assets of 993.5 billion won. The acquisition price, extrapolated to 100% of the shares, is about 900 billion won. Applying the price-to-book ratio (PBR)—the share price divided by book value per share—to the acquisition price gives a figure of about 0.9 times. In other words, Shinhan is securing control of the company while paying less than its book net assets. By contrast, comparing the same acquisition price with net assets of 613.5 billion won at the end of last year gives a PBR of about 1.47 times. The acquisition price did not fall; rather, the PBR fell because the net assets used as the comparison figure increased.

Yet Lotte Insurance posted a net loss of 18.5 billion won in the first half of this year. Kang Seung-gun, a researcher at KB Securities, explained that the increase in net assets was "due to an increase in gains from liability valuation as long-term bond yields rose." In other words, net assets rose not because the company earned money from operations, but because interest rate changes reduced the book value of its liabilities. Net assets increased despite the net loss as the "accumulated other comprehensive income" item in equity, which reflects these valuation changes, improved.

Why do liabilities decline when interest rates rise? Consider 1 million won payable in 10 years. If invested at a compound annual rate of 3%, about 740,000 won is needed today, but at 5%, about 610,000 won is enough. Because the investment earns more interest, less money needs to be set aside now. Insurance liabilities are calculated using the same discounting principle, so even when future payouts remain unchanged, their present value falls as the discount rate rises.

When newly issued bonds offer higher interest, the prices of existing fixed-rate bonds fall, reducing the valuation of the bonds held by insurers. However, if the decline in liabilities is greater than the decline in assets, net assets can increase even while the company posts a loss.

When interest rates fall, liabilities rise... Long-term bonds can cushion the impact

Conversely, when interest rates fall, bond prices rise, but insurance liabilities can also increase. If the increase in liabilities is greater than the increase in assets, net assets fall again.

That is why asset-liability management (ALM) is important. ALM involves managing assets and liabilities together to ensure funds are available to pay insurance claims and to prevent capital from falling sharply when interest rates change. Insurers consider the timing of investment recoveries and insurance payouts, and assess how much the valuations of their assets and liabilities will change as interest rates move. "Duration" measures how sensitive value is to interest rates.

All else being equal, the longer the maturity of a fixed-rate bond, the more its price responds to interest rate changes. A company whose assets are less sensitive to interest rates than its insurance liabilities can buy long-term bonds to narrow this gap. The aim is for long-term bond prices to rise significantly when interest rates fall and insurance liabilities increase, offsetting the increase in liabilities.

In a recent report explaining the impact of rising interest rates, Park Hee-woo, a research fellow at the Korea Insurance Research Institute, said, "At an insurance company with effective ALM, the decline in the value of liabilities is similar in scale to the decline in the valuation of bonds," adding that "there is ultimately little change in capital."

"Post-acquisition management is key"

On the challenges following the acquisition of Lotte Insurance, Kang said, "The company needs to focus on duration management by purchasing large amounts of long-term bonds going forward." He added, "The PBR metric will be meaningful only if interest rates hold steady until the acquisition and long-term bond purchases are completed." In other words, if interest rates fall and net assets decline before the asset mix is adjusted, the current calculation of "0.9 times net assets" could also change.

Shinhan also said during a conference call that the PBR at closing could change depending on interest rate movements and other factors. However, it said the deal was based on net assets at the current point in time, as it expects to complete the transaction by year-end while interest rates remain at their current, elevated levels.

Shinhan Financial Group also expects earnings to improve after the acquisition. Based on an assumption that it will invest about 1.2 trillion won in the purchase of the entire stake and a capital increase, Shinhan expects Lotte Insurance to contribute more than 120 billion won to group earnings within three years. The estimate takes into account the normalization of Lotte Insurance, reduced losses at Shinhan EZ General Insurance, and the effects of consolidation accounting.

Ultimately, to determine whether the insurer was bought at a low price, it is necessary to examine how much of its net assets would hold up if interest rates fell, as well as how much profit it can generate after the acquisition. Alongside its operating results, the market will also be watching how Shinhan changes Lotte Insurance's investment assets.

This content was produced with the assistance of AI translation services.