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We are upgrading our recommendation on China Life Insurance Co. Ltd. (LFC - Analyst Report) to Neutral from Underperform, based on improving investment income, extensive domestic distribution channel, strong balance sheet, substantial cash flow and stable ratings. However, the company inherently faces substantial interest rate and currency risks, which limit the upside.

China Life has the most extensive distribution and service network among all insurance companies operating in China. The company’s distribution network of exclusive agents, direct sales representatives, banc asurrance outlets, customer service managers and financial advisers is spread throughout the country, making it one of the largest brands with one of the biggest customer base in China.

Moreover, investment income of China life has shown substantial improvement over the past two years. It increased 24% and 26% in 2011 and 2010, respectively, after declining 14% in 2009. Investment income from securities at fair value skyrocketed 285.7% in 2011, due to the combined effect of increased investment in debt securities and higher interest rate.

Investment income from bank deposits also registered a 52.6% and a 51% increase in 2011 and 2010, respectively, after declining 5% in 2009. With the improvement in the economic scenario, investment income is expected to improve further.

China Life’s stable capital, investment and financial leverage position allows it to retain the confidence of the rating agencies.The company holds an insurance financial strength (IFS) rating of “A+” from Fitch Ratings and “AA-” long-term local currency counterparty credit and IFS rating from S&P, with a stable outlook for all the ratings.

Moreover, the subordinated debt issue announced in November last year will further improve China Life’s solvency ratio and be accretive to its supplementary capital, thereby strengthening its balance sheet position.

However, China Life is substantially exposed to market risks. Firstly, a majority of the company’s investments is limited to China, making it highly vulnerable to a downturn in the Chinese economy. Besides, investments outside China are subject to foreign exchange risk in addition to volatility in the concerned market.

Furthermore, China Life faces intense competition from both domestic as well as foreign companies. New entrants in the life insurance market, with access to higher capital and better technology than China Life, are also putting adequate competitive pressure on the company. Despite a strong brand name, significant competition on the domestic front limits earnings growth.

Overall, we expect limited upside for China Life in the near term. China Life’s main competitors are ING Group NV (ING - Snapshot Report), Manulife Financial Corporation (MFC - Analyst Report) and Sun Life Financial Inc. (SLF - Analyst Report).

China Life carries a Zacks #3 Rank, implying a short-term Hold rating.

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