Earnings at China Life soar 114.4pc SCMP headline, April 18 Very commendable indeed is what you are likely to say in first reaction to this news. But look more closely at the results announcement and you will see a very different story. This big earnings improvement is entirely the result of booking capital gains on holdings of equities, most of them mainland stocks that have gone way up in price with the froth on China's stock markets. What is more, almost all of these gains are unrealised ones. They are paper profits only. Take them out of the figures and my calculations will indicate that pre-tax profits fell 64 per cent from their 2005 level. I cannot work out exactly what the net profit would be as the tax charge and some other items would also be different, but that profit figure would be minimal and I am willing to entertain arguments that it could even be negative. The table illustrates the story with a few items from the company's income statement. Net premiums earned is self-explanatory and I assume that the fixed income portion of net investment income incorporates mostly interest earned on debt instruments. I cannot be absolutely sure, however, that the equity portion of net investment income incorporates only dividends as the figure here rose almost tenfold over the previous year, much more than the increase in holdings of equities. But we shall let this be. I draw your attention instead to the fact that there was a more than two billion yuan improvement in realised gains on financial assets. Effectively, all of it was in equities. And I now draw your attention to the big one. In 'Net fair value gains on assets at fair value through income', (translation: We didn't actually sell these but here is our guess of what we would have made in profits if we did) these accounts show a profit figure of 19.74 billion yuan for equities as opposed to only 172 million yuan the previous year. Take these realised and unrealised trading gains on equities out of the accounts and the result is a pre-tax profit of only 4.27 billion yuan, as opposed to the 25.61 billion yuan actually reported for the year. My figures also show that these adjusted pre-tax profits declined 64 per cent from the previous year. It gets even worse than that. The accounts also feature an entry for 'Policyholder dividends resulting from participation in profits'. The figure here for 2006 is 17.62 billion yuan, up from 5.36 billion yuan in 2005. It seems from this that the company paid out committed cash dividends from paper profits. Will it ask for that dividend money back if the paper profits later turn to paper losses? Would it get any of the money back if it did? You may argue here that China Life can legitimately include trading gains in its profit statements, even unrealised gains, and that it is in fact required to do so under its accounting rules. I accept this, but there are two obvious points to make about the practice. The first is that in this case it disguises a more lacklustre performance in the company's underlying insurance business. The second, and more important, is that the practice may contribute to a fair and true view of company accounts in the United States, but, in China at present, it easily leads to an unwarranted assumption about the sustainability of these gains or even whether they are really gains at all. Share prices on the Shanghai market rose 130 per cent last year with a sudden blooming of retail investment enthusiasm. I now invoke my 20 years of direct experience as an investment analyst to tell you that I think this represents a bubble and that this bubble will inevitably burst. The longer before it happens, the bigger the bang will be. And that bang will have a very severe and direct impact on the profit and loss accounts of any insurance or other company that takes its net profit entirely from unrealised gains in a portfolio of stocks exposed to that bubble. So, when you hear a company like this tell you of its triple-digit-percentage gains in earnings, don't be fooled into believing it.
