Phoenix dividend gains altitude

Life insurer Phoenix Group (PNHX) is one of the select group of companies to have increased its dividend in the teeth of the pandemic. However, the need to build up its organic cash generation has overshadowed its ability to lift the payout last year. That has meant a prolonged period of share price attrition. The price has fallen 23 per cent over the past 12 months. But the shares now boast a meaty yield, which stands out amongst its listed peers.

Now there are signs that sentiment towards the company could become more positive. This is due to a combination of factors that mean Phoenix is looking more likely to meet its cash-generation target of around £1.5bn this year. Brexit-related changes to regulation could also throw up opportunities for the group. That means investors in Phoenix stand a chance to benefit from a substantial income stream over the next couple of years combined with a strengthening share price.

Bulk buy

Phoenix’s business model isn’t complicated, unlike its balance sheet. There is a clear split between running off closed-end books and the bulk annuities insurance business – and it is the outlook for bulk annuities that offers prospects for growth in organic cash generation.

Bulk annuities are the insurance policies that pension funds take out to cover their pension risk. The market is worth billions annually but there have been some strange trends over the past 12 months. In the first half, the bulk market was unusually quiet, according to sector-watchers. Pension funds are concentrating on getting existing business completed, rather than writing new contracts.

Bulk annuity contracts can take up to a year to be fully implemented, so any slowdown in business writing makes itself felt midway through the annual cycle. At the half-year results, Phoenix had written bulk annuities worth £431m in premiums. Direct comparability with previous periods is difficult as new premiums also reflect contribution from the £3.1bn ReAssure acquisition completed in July last year.  

Analysts at RBC Capital Markets believe that the bottlenecks caused by the pandemic, along with evolving pension regulation and environmental, social and governance (ESG) investing, have combined to slow down the bulk market in the first half. But the broker forecasts are that this should reverse as the year progresses. RBC forecasts that, of the £25bn of bulk business that will be written this year, £17bn will originate in the second half alone.

As an example, in the case of Phoenix, the company completed a £230m bulk buy-in plan with Agfa UK Group Pension to cover 70 per cent of its liabilities earlier in July. RBC also predicts that the bulk market will rise to £38bn next year as underwriting returns to more normal conditions.

Phoenix is also in a far better position to win work now than it was a year ago. It now has the capability to quote for 90 per cent of the deals in that market compared with just 35 per cent of deals in mid-2020. Given Phoenix’s dominant position in the bulk market following the ReAssure acquisition, it is hardly surprising that its shares have matched the rise and fall of written bulk insurance business.

The other thing to note is the correlation of the share price to the tightening of spreads on corporate and government bonds, as happened in the first half. Narrowing spreads restrict an insurer’s ability to match annuities with income-producing assets. This has led to more annuities being matched with illiquid assets such as property or infrastructure. All this has a negative impact on insurers’ profitability.

As this hasn’t been easy this year, the market has discounted the shares of the entire sector. But there is always the possibility for better profits in the future given how narrow spreads are. As soon as spreads begin to widen again, as they must at some point, Phoenix, along with the rest of the sector, is going to receive an instantly higher margin on newly written business.

Brexit bargains

The Brexit aftermath poses an interesting dilemma for EU-based insurers who have legacy life books within the UK regulatory system. This could prove an opportunity for the closed-book run-off business which relies on acquisitions to put more fuel in its tank.

Currently, the consensus is that, without a passporting system in place for financial services, it will be easier for European companies to offload closed books to UK-based entities, rather than try to run them down from within the bloc. EU-based entities running books in the UK have so far benefited in the post-Brexit period from a temporary permission regime. But with no reciprocal arrangement at the EU level beyond agreements on clearing, transfers and listing of securities – although there are some arrangements on a country-by-country basis – the market looks open for buyers, purely on the basis of significant regulatory inconvenience.

That puts Phoenix in a strategically strong position – particularly since acquiring its main rival, ReAssure, makes it the  most likely beneficiary from a sell-off. And if the company can hit its full-year cash generation targets this year, then it will have generated 60 per cent of the £6.5bn it promised between 2019 and 2023. That will put it in a strong position to do deals that would underpin growth in cash generation.

It is also worth noting that Phoenix’s directors have been backing promises with hard cash. For instance, chief executive, Andrew Briggs bought over £430,000-worth of shares in August and September alone, alongside regular bundles bought by non-executive directors. Some of this may be options vesting, but it is interesting that management has chosen to get into the game at this point in the cycle.

The downside with Phoenix is that, having already bought its biggest rival, it will be hard for it to find a large enough deal to really move the needle in terms of cash generation. In addition, buying up closed books requires capital upfront. Much of its organic cash generation potential depends on how active management is prepared to be in chasing new business.

Phoenix’s share price, along with the rest of the UK life insurance sector, has underperformed both the FTSE All-Share and the European insurers index ever since the main players disclosed the quiet state of the bulk annuities market through the first part of the year. Phoenix, with its much larger exposure to the bulk market via the ReAssure acquisition, has seen its shares suffer more than most. That has pushed the dividend yield for 2022 to over 7.3 per cent, based on Berenberg’s forecasts, compared with a 5.8 per cent average for the sector. But with the potential for sentiment to improve in the coming months, that looks like a decent entry point for investors looking for income, as well the possibility of being in the right place when the annuities market picks up. Buy.