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FTSE 350: Why Trumpflation would suit life assurers

Interest rate increases and inflation could mean better returns from the sector in 2017
January 26, 2017

Rock-bottom interest rates have niggled life assurers during the past few years, pushing up their long-term liabilities and reducing the income on their fixed-income investments. Yet the prospect of ‘Trumpflation’ – the belief that US president Donald Trump’s policies will encourage a rise in prices – and the subsequent increase in interest rates by the country’s Federal Reserve have sparked hope for the sector.

The upswing in long-term government bond yields following the US election has sent shares in life assurers, including income Tip of the Year Aviva (AV.) and recent buy tip Standard Life (SL.), steadily up since November (see chart, right). For life assurers with long-term liabilities such as annuities, this increase in market rates is good news for solvency levels. What’s more, members of the Federal Open Market Committee expect rates to increase three times in the course of this year.

At home, life insurers are making progress on offsetting some of the decline in individual annuity sales resulting from 2015’s pension reforms. In response, companies in the sector have worked to diversify their income streams, either by moving further into asset management work or completing more bulk annuity transactions.

Legal & General (LGEN) has particularly large exposure to these deals, which involve taking on the liabilities of a company’s defined-benefit pension scheme in return for a premium: L&G views it as a less capital-intensive way of growing its returns. In May, the insurer bought a £2.9bn back book of annuities from Aegon, which in addition to its own bulk annuity transactions almost trebled sales of this product in the first half of 2016. But it’s worth noting that this business can be lumpy due to the large size of transactions, and the market has not grown as quickly as some had suggested: a bumper year has always been just around the corner.

For Aviva and JRP Group (JRP) – formed via a merger between Just Retirement and Partnership Assurance in April 2016 – consolidating with other big players has bolstered their exposure to the bulk and specialist annuity markets. That said, JRP was one of the few life insurers to buck the trend for declining demand for individual annuities during the first nine months of 2016, with sales up 12 per cent on 2015.

Standard Life has led the way in developing its asset management operations, partly due to the popularity of its Global Absolute Return Strategies (GARS) multi-asset products. Following its 2015 merger with Friends Life, Aviva is trying to get more of the action. This acquisition provided £47bn in assets under management to Aviva Investors. The business also generated £1.7bn in net inflows in its own right during this period. Growing contributions to defined-contribution pensions continues to be another avenue of growth for these companies, thanks to statutory pension auto-enrolment.

However, growth in asset management leaves assurers more exposed to fluctuations in equity markets. As the IC’s Chris Dillow recently argued, if inflation rises as expected during 2017, equity markets could suffer. What’s more, if wage inflation rises and productivity continues to stagnate, inflation expectations could increase at the same time as investors worry about a squeeze on profit margins – hurting equities, Mr Dillow said. This would weigh on assurers’ asset management arms.

One issue that investors have gained greater clarity on is the impact of the Solvency II reform on the life insurance sector. While M&A activity was subdued during 2015, it picked up last year after the dust settled on the implementation of the European legislation. With the new regulatory framework now established, there is every reason to believe this will continue in 2017. This is good news in particular for closed-life insurance book consolidator Phoenix Group (PHNX) as it relies on making acquisitions to grow its cash generation and continue increasing its generous dividend. Last year the group bought Axa Wealth’s pensions and protection business and UK insurance company Abbey Life from Deutsche Bank.

Price (p) Market value (£m)PE (x)Yield (%)1-year change (%)Last IC view
Aviva47919,44238.94.43.4Buy, 478.3p, 05 Jan 2017
JRP Group 1431,3335.21.5-9.6Buy, 114p, 15 Sep 2016
Legal & General24214,43412.15.81.4Buy, 205.9p, 10 Aug 2016
Old Mutual21010,34812.34.338.3Hold, 188p, 17 Nov 2016
Phoenix Group7302,866915.36.21.5Buy, 844p, 19 Sep 2016
Prudential1,55340,08511.92.515.3Buy, 1,402p, 10 Aug 2016
St James's Place1,0525,54926.42.817.0Buy, 957p, 26 Oct 2016
Standard Life3536,9875.15.3-1.8Buy, 341.5p, 01 Dec 2016

Favourites: Aviva is forecast to pay out a yield of above 5 per cent, based on a forecast dividend of 27.7p for the current financial year. But its shares trade at a discount to rivals at nine times forward earnings.

Outsiders: Old Mutual (OML) is in the process of a 'managed separation' of its four constituent businesses. Its shares have risen by more than a third during the past 12 months and now trade at 10 times forecast earnings for 2017. However, the emerging markets business and South African-based Ned Bank have suffered as a result of pressure on the Rand. Meanwhile the US asset management business reported another decline in net client cashflows during the three months to the end of September. We think the prospects for the group are too uncertain at present. Hold.