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Life assurers: where next for growth?

Sector Focus

Life assurers: where next for growth?

Changing regulation is forcing life assurers to find new ways of making money. Pension reforms implemented in April 2015 removed the effective obligation on retirees to purchase an annuity at retirement, denting sales of annuities in the immediate aftermath. Low interest rates were already pushing up the value of companies' long-term liabilities by making the present value of government paper used to back annuities more expensive. That's not to mention the burden on life assurers in preparing for the enactment of the Solvency II regime at the beginning of last year, which increased the capital requirements particularly for insurers writing new annuity business.

It is no surprise then that these companies are looking beyond traditional pastures to win new business. Arguably, the London Stock Exchange's classification of many of these companies as life assurers is no longer accurate. What's more, the change in the mix of business naturally gives good reason for a change in the way these companies should be valued. The question is, which of these markets will offer long-term cash generation growth and not just a short-term bump in earnings?

 

Bigger is not always better

Given the plethora of regulatory reform in recent years, it seems natural that life assurers would club together to try to insulate themselves from some of its worst effects. However, Standard Life's (SL.) £11bn merger with Aberdeen Asset Management (ADN) is the result of a longer-term shift towards asset management and the regular fee-based income that comes with it. Since 2014, the division has accounted for more than half the group's assets. By the end of December assets under management at Standard Life Investments stood at £278bn, more than three-quarters of the group total.

Under the terms of the deal Standard Life shareholders would own a two-thirds stake in the newly enlarged company, with Aberdeen investors holding the remainder. The new group would have around £660bn in assets under management, making it the second-largest active asset manager in Europe. Management at both groups have hailed the cost synergies and diversification benefits of the deal, which has yet to be approved by shareholders.

Scale is becoming more important for active asset managers to ward off increasing price competition from passive investment products. Simplifying and combining investment platforms and reducing third-party service providers are expected to produce around a third of the annual £200m in cost synergies three years after the deal's completion.

However, it's questionable whether this deal is the best way for Standard Life to gain access to the US and Asian investment markets. Investors need only look towards the massive outflows suffered during 2013's taper tantrum, as well as the - admittedly more muted - negative reaction of investors following the election of President Trump, to see the increasingly cyclical nature of emerging market investment. What's more, the fee income generated by asset management may be clearer for shareholders to interpret than the premiums traditionally written by life assurers, but it can also be more volatile when a strategy falls out of favour with investors.

Standard Life is not the only life assurer scaling up to unlock growth. Aviva's (AV.) acquisition of Friends Life in 2015 was a defensive move, aimed at strengthening the UK life and pensions business and balance sheet. The latter helped lift operating profit at Aviva's UK life business by 6 per cent to £1.5bn. Much more important is the cash generation Friends Life brought with it. Last year this business remitted £250m in cash to Aviva, with a further £750m expected by the end of 2018. This is vital for the life assurer to achieve its target dividend payout ratio of 50 per cent of operating earnings per share by the end of this year.

The long-term question is what benefit this added scale will bring once cost synergies and special cash remittances have been accounted for. Critics of the deal have questioned the organic growth opportunities to be gained from acquiring a rival with a similarly UK-focused life business. But head of UK insurance, Andy Briggs, previously told us the benefits of the deal went beyond cash benefits and cost synergies, pointing to the "complementary" nature of the two businesses, given Friends Life's stronger position in the corporate pensions market. He said management expects assets for the UK life business to double over the next 10 years.

 

Eastern promise

However, it would be wrong to say Aviva and its peers aren't trying to expand their focus beyond the UK life and investment markets. A growing middle class, demand for pensions and savings protection and a lack of retirement provision are longstanding trends in Asia, but the majority of the UK-listed life assurers have been slow to expand in this market.

The notable exception is Prudential (PRU). After its initial difficulty in establishing a meaningful presence in the region - namely a failed bid for Asian insurer AIG's life business in 2010 - new business has been growing rapidly. Prudential has used the cash generated in its more mature UK and US businesses to do this. Last year new business profit in Asia grew by more than a fifth to just over £2bn. Growing this business means the group has also retained a reasonably high degree of revenue visibility. Regular premiums on longer-term contracts accounted for around 93 per cent of annual premium equivalent sales during 2016.

For Standard Life, its joint ventures in China and India are the main vehicle for growth in the Asian life markets. Profits are growing strongly, but from a low base - pre-tax operating profits increased by a third to £36m last year. Aviva is further along in its expansion, trying to disrupt the insurance and financial advisory markets. In Singapore, its recently launched financial advisory company has grown its distribution network to 450. Meanwhile, in Hong Kong the group has entered into joint ventures with Tencent and Hillhouse, planning to launch digital insurance products into a market traditionally dominated by agency and bancassurance distribution models, which can be higher cost for customers.

 

Divergent valuations

Following the introduction of the Solvency II regime, many of the UK-listed life assurers have stopped presenting their financial performance on an embedded value basis - calculated as the present value of future profits plus the assurer's net assets. With life assurers moving away from traditional annuity business, this makes sense. Instead, more focus has been placed on the Solvency II coverage ratio - the level of regulatory capital held above that required. This is therefore a good indication of growth since an increase in a group's cash generation tends to push up its Solvency II coverage ratio. One of the main attractions of life assurance stocks is the fat dividends they tend to pay out. Therefore rather than looking at growth in profitability, investors should pay greater attention to cash generation.

 

CompanyShare price (p)1-year share price growthNext 12-months PE5-year historic PE averageDividend yield *Return on capital *
Aviva 50716.3%9.619.94.5%4.5%
Chesnara 36710.6%15.812.85.1%6.4%
JRP Group 121-8.8%8.436.22.7%0.0%
Legal & General Group 2493.5%11.413.45.7%4.1%
Old Mutual 191-1.6%8.919.93.1%5.4%
Phoenix Group Holdings745-14.5%24.896.4%0.3%
Prudential 1,62116.8%11.717.22.6%7.7%
Standard Life 3595.7%12.719.95.4%16.4%
*Last 12 months

 

IC VIEW

Despite the increasing shift by most life assurers away from annuities, it would be inaccurate to forecast the total demise of this type of business. There have been some signs that annuity sales are stabilising. JRP Group (JRP) reported a £321m increase in individual annuity sales, citing a rise in the open market caused by the pension freedom changes. We like the companies that don't put all their eggs in one basket.

 

Favourites

With diversity in mind, we are bullish on Aviva. Admittedly, it does have exposure to the UK life market, but it's also investing in developing its asset management arm, in particular growing third-party inflows into its multi-strategy funds. We also like its improving cash generation and intention to return additional capital to shareholders, as announced by chief executive Mark Wilson at the time of its full-year results in March.

Outsiders

We have also been bullish on Standard Life during the past three years following the success of its investment management business in attracting third-party cash. However, we downgraded the stock on news of the Aberdeen deal. While there may be some economies of scale, it's hard to get excited about a merger that would tie Standard Life to an asset manager suffering a long period of outflows and at the mercy of highly cyclical emerging markets.

The broker's view

The 2016 UK life reporting season featured large, negative, below-the-operating-line exceptional charges. Every company, with the exception of Legal & General (LGEN), reported negative below-the-operating-line costs. On average, weighted 2016 pre-tax profits were 62 per cent of operating profit. While aggregate charges are negative every year, more of the operating profit was lost in 2016 than 2015 (72 per cent), 2014 (89 per cent) and 2013 (73 per cent). This may appear counter-intuitive given the strong equity market in 2016.

L&G was the only insurer not affected by negative charges; Aviva and Prudential reported the largest negatives in 2016. Legal & General stands out as the only UK life insurer to report pre-tax profits above operating profit. Aviva (where pre-tax profits were only 40 per cent of operating profit) and Prudential reported the largest charges. Standard Life (67 per cent), JRP Group (76 per cent) and Old Mutual (OML) (81 per cent) also reported large negatives.

This matters because solvency and cash flow (which continue to be the key drivers of share price performance) move according to bottom line rather than operating metrics. Dividends are paid from actual cash flow rather than operating cash flow. We note that many companies report cash flows but they are vague about what this cash flow is on an operating basis. Often actual cash generation is not reported. Actual cash generation is often hit by exactly the same below-the-line charges that are deducted from operating profit.

The reasons for the charges? As well as the usual charges for economic assumption changes and amortisation, Standard Life and Prudential reported charges for annuity potential redress (although Prudential included this within operating profit). St James's Place (STJ) reported several charges as it invests in the business. The recent change to the Ogden discount rate in the UK resulted in a large negative charge at Aviva. Aviva through the acquisition of Friends Life and JRP Group through the acquisition of Partnership are still seeing large integration costs and losses from amortisation of acquired in-force value. In some cases insurers' hedge programmes cause counterintuitive results. Prudential highlighted the asymmetry between asset and liability accounting in its US business. As equity markets rose in 2016, equity derivatives were marked down immediately, while the IFRS liability reset more slowly causing a negative investment variance.

Gordon Aitken is an analyst at RBC Capital Markets

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By Emma Powell,
20 April 2017

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