Chesnara ticks all the boxes

Chesnara's business model is simple. It buys life insurance funds that are closed to new business and manages the run down. These throw off a lot of cash because reserve requirements diminish over their remaining lives. Of course, the company would eventually wind itself up if it didn't buy in new "closed books". Fortunately it has a history of making such purchases at a decent discount to underlying value - the discount depends on the quality of the book.

At the end of November it completed the acquisition of Direct Line Life Insurance for £39.3m, a hefty 25 per cent discount to the estimated residual embedded value of £52.6m. Debt funded £31m of the purchase, which should magnify the benefit to shareholders if the group can realise its ambitions to unlock value from the book. And the payback could be quick once Chesnara has achieved the economies of scale that come with tucking an acquisition into its existing operation. In fact, the £63.5m acquisition of the Save & Prosper closed book in 2010 has been more than covered by group profits since. The S&P acquisition was made at a 31.7 per cent discount to embedded value and brought with it 174,000 policies.

Chesnara has also benefited from a solid investment performance, and in the nine months to September, pre-tax profits on an embedded value basis jumped from £29.5m to £57.5m, which means that embedded value has climbed 37.4p per cent since the start of the year to 308.2p, which leaves the shares trading at a discount to embedded value.

That's the core business model, and there are indications that the pipeline is likely to contain more bolt-on acquisitions in 2014, which could provide a catalyst for share price rises. However, there is also a 'live' side to the business. This started in 2009 when Chesnara bought Swedish life group Moderna Forsakringar. This was complemented by the purchase of Swedish life and health insurer Aspis Liv, the two eventually rebranded as Movestic.

The path for Movestic has been less than smooth, though, and it took a while to rebuild relationships with independent financial advisers (IFA). However, after a lot of hard work, improving IFA support lifted pensions and savings new business premium income by 55 per cent in the first nine months of 2013, and generated £3.3m of new business profits, up from £1.3m a year earlier. Despite the improved level of IFA sentiment towards Movestic reflected in the rise in new business, policy attrition remains high, and policy transfers and switching, or churning, remains prevalent in the Swedish IFA market. Nevertheless, if recent improvements continue, the shares should benefit.

In the UK business, Chesnara also took a cautious view at the start of the year over lapse assumptions - the amount of premiums that it expected would stop being paid. But lapses in the first nine months were less than expected, leading to a significant positive lapse experience variance of £4.1m.

One of the beauties of Chesnara's business model is that it throws off a lot of cash. Excluding a one-off £7m benefit arising from the deregulation of the S&P business last year, net cash generation in the first nine months of 2013 rose from £28.1m to £30.2m, and pre-tax profits on an IFRS basis rose from £20.1m to £32.8m, which includes a £12.9m release in the provision for S&P policy guarantees - evident the forecast 2013 profit fillip. Needless to say, solvency ratios remain strong. Overall these stood at 240 per cent of the minimum required under the Insurance Group Directive.

Even so, Chesnara has adopted a sensibly cautious approach, because provision releases come primarily as a result of a strong investment performance, and an adverse market performance could easily lead to this situation being reversed.