For an industry characterised by its long-term nature, it is perhaps fitting that by the time all Solvency II rules must be applied in 2030, more than 30 years will have passed since the first moves were made to formulate a single regulatory framework for European insurers. While the Solvency II regime came into force at the start of this year, insurers have a 16-year transition period to comply fully with the rules, which have essentially changed the way capital is assessed for the industry. Taking a risk-based approach to capital, insurers must ensure they have enough capital on their balance sheets to withstand a level of stress that is deemed likely to happen only once every 200 years.
The new regime has caused the biggest headache for life insurance companies offering long-term guarantees, particularly annuities. That is because of the way they must now calculate their liabilities. The Solvency II rules assume an insurance company will continue to write new business and, as such, views risk on a forward-looking basis. A 'risk margin' is added to an insurer's liabilities, which would allow that insurer's liabilities to be transferred to another company's balance sheet, providing additional protection to policyholders.
In addition, insurers must now use market risk-free rates to discount their forecast future liabilities. With these rates held down by Europe's current monetary environment, discount rates are also kept low, pushing up liabilities. The nub of these changes is that life insurers will have to hold more capital against their liabilities and risk margin.
Protecting dividends
Life insurers have historically made good income stocks; bar Prudential (PRU), the dividend yields of the sector's biggest players are forecast to be in excess of 5 per cent this year. Therefore the biggest concern for investors will be the threat that beefed-up capital requirements pose to the ability of companies to continue paying out generous dividends.
The new regime is squeezing cash generation at Phoenix Group Holdings (PHNX). The closed-book life assurance consolidator generated £225m in 2015, but that was roughly half the amount generated in the previous year. That was because Solvency II forced its life assurance businesses to retain more capital. As a result, the full-year dividend was flat on the previous year. Being closed to new business means it is tougher for the likes of Phoenix and Chesnara (CSN) to square dividend growth with stricter requirements on capitalisation. Both insurers are dependent on making acquisitions to grow their cash generation, but the introduction of Solvency II has also undoubtedly made insurers less keen to splash cash on acquisitions.
Cash generation elsewhere in the sector was better. Standard Life (SL.) grew its underlying cash generation from continuing operations by 7 per cent last year, while Legal & General (LGEN) more than doubled that rate. This kept the dividend increases coming for investors in the two life insurers last year. How conservative the life insurers' payout ratios are will also determine the sustainability of dividends under the new regime, particularly in times of economic stress.
How sensitive is the SCR?
The measure introduced to determine an insurer's capital robustness is the solvency capital requirement (SCR); this is an insurer's given capital over the required regulatory minimum. However, it is important to remember that the large insurers in the accompanying table have calculated their SCR according to their own internal model. Head of research at Panmure Gordon, Barrie Cornes, says the SCR should be seen as "a hurdle" for insurers to jump, rather than a like-for-like comparison of solvency.
The sensitivity of this ratio to market stresses is as important as the level of the ratio itself. This will depend on the exposure of the insurer's required capital to different risks; for example, the longevity risk of annuity sales or equity market movements in asset management. An insurer writing more annuities will need to hold more capital against these riskier liabilities. The type of assets held against the liabilities are also important - the riskier the asset, the greater the charge. So risk diversification has become all the more important.
| Share price (p) | Dividend yield (2015) | Coverage ratio (%) | Capital surplus (£bn) | |
|---|---|---|---|---|
| Aviva | 440 | 4.3 | 180 | 2.7 |
| Chesnara | 317 | 5.9 | 146 | 0.1 |
| Legal & General | 244 | 5.8 | 169 | 5.5 |
| Phoenix | 886 | 5.7 | 154 | 1.3 |
| Prudential | 1,428 | 2.9 | 190 | 9.7 |
| Standard Life | 340 | 5.4 | 162 | 2.1 |
Pensions freedom and annuities
Since the introduction of the pension freedom changes in April last year, sales of individual annuities have declined across the sector. For Standard Life, diversification has meant a shift towards asset management via its fund manager, Standard Life Investments. While this has increased the group's exposure to market risk, it has helped to offset the decline in annuities. Yet, even with the rocky market conditions that began during the latter part of last year, Standard Life Investments grew its operating profit by a third, as it has cemented its popularity with institutional investors, including pension scheme managers.
For Legal & General, sales of individual annuities fell by 45 per cent last year. However, the group is the best placed of all the life insurers to increase its bulk annuity business, whereby the insurer takes on the liabilities of a defined-benefit pension scheme. Management views this as a less capital-intensive way of growing its returns. Last year, L&G completed the UK's largest medically underwritten bulk annuity contract. However, this has its own challenges, with long lead times to complete deals and lumpy revenue streams as a consequence.
However, the pressure is more intense for both Aviva (AV.) and Prudential. The insurers have been marked out as two of the nine "global systemically important insurers", according to the International Association of Insurance Supervisors. This means that from 2019 they are expected to have higher capacity to absorb losses than other insurers. This explains Aviva's sector-beating Solvency II coverage ratio of 180 per cent. The group was helped by its acquisition of Friends Life last year, which it expects to boost the cash remitted by the UK life business by around £1bn over the next three years.
Favourites
As expected, Standard Life's UK individual business is shrinking following the government's regulatory changes. However, it has built a strong position in the UK workplace savings segment, helped by strong inflows into its wrap platform and rising auto-enrolment contributions. Indeed, UK pensions and savings assets under management increased to £132bn last year (from £128bn in 2014). However, the jewel in its crown is still the asset management business. Not only is this diversifying risk, but it is offsetting falling annuity sales. Admittedly, this does mean the group is more at the mercy of volatile markets. As a result, shares in the group are 13 per cent below our 2014 buy tip. However, the shares are trading on just 12 times forward earnings and have a prospective yield of 5.9 per cent this year, according to UBS. We think the investment case remains intact. Buy.
Outsiders
Aviva has certainly strengthened its balance sheet - it managed to reduce its combined ratio of claims to income by 1.1 percentage points to its best reading in nine years at 94.6 per cent. The integration of Friends Life is also running a year ahead of schedule and cash remitted by its UK life business last year also rose by more than half. Unfortunately, Aviva has the greatest exposure to European currency volatility within the wider sector. As a consequence, £101m was wiped off operating profits across life, general insurance and health in 2015. Trading this year is also expected to be affected by the dilutive effect of the Friends Life acquisition, slowing organic growth to the mid single digits. The shares are trading on just eight times forward earnings, but we do not expect a re-rating in the near term. Hold.
IC VIEW: It is important to remember all of the large listed life insurers have a solvency coverage ratio well above 100 per cent. Although we need more information on how cash generation is being calculated by companies to determine the effect of Solvency II capital requirements in future years, it's reasonable to claim that cash generation is going in the right direction across the sector. Overall, life insurance stocks retain good income potential and we remain positive on the sector.
