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A life of change

Government and regulatory interference has pounded life-assurance shares in the past few weeks - yet prospects may be better than they seem
April 17, 2014

If investors want evidence of just how hard share prices can be hit by state interference then look no further than the life-assurance sector. Since budget day virtually all life assurers’ shares have suffered - all because of the intervention of either politicians or regulators.

The sector took its first pounding with budget day’s surprise announcement scrapping the compulsory purchase of individual annuities. That hit shares in most life players but, predictably, those of the mono-line annuity providers suffered most - above all Partnership Assurance (PA.) and Just Retirement (JRG). Just nine days later, however, the sector took another punch - this time from the FCA, which announced a probe into closed life funds. Shares again fell, with those of the closed-life specialists - Resolution (RSL), Phoenix (PHNX) and Chesnara (CSN) - tumbling furthest. “There’s a sense of regulatory risk to the sector,” notes analyst Eamonn Flanagan of Shore Capital.

FCA fears

Neither event, however, is obviously as tragic as those initial share price reactions imply. For a start, the volatility unleashed by the FCA significantly reflected the clumsy manner in which the story broke. Specifically, a news report in the Telegraph suggested a review was planned of life and pensions policies sold between 1970 and 2000, covering some 30m customers - driving fears of another large-scale mis-selling scandal. The FCA's subsequent clarification, however, suggested a more benign agenda, focused on fair treatment and service levels. Analysts think cross subsidisation - whereby closed books might be disproportionately charged to support new-business generation - could be a significant focus.

But that’s unlikely to represent a significant threat to the closed-life players. For those such as Phoenix and Chesnara, the issue of subsidising new business with heavy charges on closed books is “not an issue”, as Mr Flanagan points out, because they don’t really write new business. Moreover, while all life companies have back-books that the FCA could look into, the sector sounds confident that there won't be much of a case to answer. The Association of British Insurers has emphasised that companies already take their obligation to treat customers fairly "very seriously". Mr Flanagan thinks the probe could turn out to be a “damp squib”.

Annuity misery

Scrapping compulsory-annuity purchases isn’t terminal, either, as the move doesn’t affect the bulk-annuities market or back-books of individual annuities. As analysts at Barclays explain, those areas are responsible for “the majority of annuity earnings in the medium term for the established UK life names”, suggesting that the biggest players have little to worry about. Indeed, Prudential (PRU), Aviva (AV.) and Legal & General (LGEN) generate just 1-3 per cent of their operating profit from new individual annuity sales.

Nevertheless, Barclays estimates that the individual annuity market could shrink from £12bn to £4bn in 18 months, leaving annuity specialists at risk. Just Retirement and Partnership Assurance generate 75 and 70 per cent of their profits respectively from new annuity sales, and Barclays reckons the reforms have “potentially destroyed their new-business franchises”. Yet even here, prospects may not be so grim. Partnership's management insist that annuities, with their guaranteed income stream, will remain an “important financial solution” for retirees. Chief executive Steve Groves notes Switzerland’s experience: it also axed compulsory annuity purchases, yet “80 per cent of people continued buying annuities”.

Other regulatory changes have also taken a toll. Some companies, such as Just Retirement, experienced a rush from men to buy annuities before gender-neutral pricing was introduced at the end of 2012, as well as from advisers writing business before commissions were banned by the Retail Distribution Review (RDR). That led to a chunk of business being concentrated in 2012 that would have otherwise been written in 2013 - leading to weak sales last year.

 

Opportunities

But change doesn’t only produce losers. The budget-day pension reform also means that those who once had to buy annuities will in future need financial advice - potentially good for those with big advisory functions, such as St James's Place (STJ) and Old Mutual (OML). Moreover, Barclays reckons that lost annuity premiums will instead “go into drawdown/SIPP products and unit-linked savings products”. The fact that the RDR allows advisers to levy an annual management charge for drawdown-type products, but bans commissions from selling annuities, also leaves them incentivised to push such products. That’s potentially very positive for Standard Life (SL.), which is the largest player in both the SIPP and drawdown markets.

Pension auto-enrolment is another reform-driven opportunity and, again, Standard Life looks among the best placed. Its highly automated approach should keep costs sufficiently low to allow for a decent return on this inevitably low-margin product. Legal & General is another big autoenrolment player: by December, it had enrolled half a million such customers into company pension schemes. With the government thinking of capping fees for auto-enrolment business, however, margins look set to get even thinner.

Improving trading

Of course, prospects for the life companies are not driven by rule-makers alone: improving market conditions also matter. Life assurers’ large investment portfolios, for instance, will benefit from today’s healthy equity markets, while an improving economic backdrop should drive consumer demand for saving products. Sales performance in the UK and continental Europe has been encouraging of late. Aviva saw UK new-business sales rise by a solid enough 4 per cent in 2013, and some European operations are bounding ahead; the group's new-business sales in France jumped 39 per cent.

Those with exposure to fast-growth emerging markets also continue to draw ahead. Prudential is by far the biggest UK player in this respect. In Asia, Prudential’s new-business sales jumped 12 per cent last year and operating profit rose 16 per cent to £1.08bn. Management now plans to generate over £1.86bn in operating profit from Asia by 2017. Despite being more mature, its US market is also buoyant. Reflecting demand from retiring baby-boomers, Prudential’s US operating profit jumped 30 per cent in 2013 to £1.3bn.

State intervention has left life-company stocks looking cheap. Even shares in the sector’s biggest hitters trade just a shade above embedded value - net asset value plus the discounted future profit stream from life policies - while shares in those companies most affected by recent events now trade at deep discounts. That derating could yet look too harsh, especially as demand for life products continues to grow with the economic recovery. The fat dividends available in the sector - especially from the highly cash-generative closed-life players - are also hard to ignore. To be sure, there is plenty of risk in life assurance right now. But, for the patient, the value opportunities justify cautious optimism.

FAVOURITES
We’d reiterate our recent buy tips on Standard Life (393.3p, 3 April 2014) and St James’s Place (790p, 27 February 2014), as they look among the best-placed to benefit from pension reforms. Similarly, note our buy tip on closed-life specialist Phoenix (654.5p, 11 April 2014). On reflection, the FCA’s probe doesn’t look that threatening, the group isn’t really affected by the scrapping of compulsory annuity purchases and it’s throwing off huge amounts of cash, making for the fattest yield in the sector. Yet its shares trade at a huge discount to embedded value.

OUTSIDERS
Aviva is a solid performer and isn’t overly at risk from recent regulatory upheaval. But its exposure to fast-growth emerging markets is modest, the yield isn’t great for the sector, and the shares trade at a premium to embedded value. The prospective yield on the shares of enhanced annuity specialist Just Retirement, meanwhile, is the thinnest in the sector; until the long-term implications from annuity changes become clearer, its shares are probably best avoided.

CompanyMarket valuePrice/embedded valueProspective yield†Share price change since budget day
20142015
Prudential (PRU)£33.6bn1.32.4%2.9%-6%
Aviva (AV.)£14.5bn1.13.4%3.7%-6%
Legal & General (LGEN)£12.7bn1.35.3%6.1%-8%
Old Mutual (OML)£9.9bn1.14.5%5.1%+4%
Standard Life (SL.)£9.2bn1.14.5%4.9%+5%
St James's Place (STJ)£4.2bn1.32.8%*3.6%*-8%
Resolution (RSL)£4.1bn0.647.7%7.7%-22%
Phoenix (PHNX)£1.4bn0.598.6%8.9%-16%
Just Retirement (JRG)£746m0.831.6%*2.6%*-45%
Partnership Assurance (PA.)£534m1.03.4%3.4%-59%
Chesnara (CSN)£385m1.05.4%**5.5%**+6%

†Barcalys estimates

*Deutsche Bank estimates

**Panmure Gordon estimates