Jamie Clark

Annuity trends boost life insurers – largest component of ‘Population Ageing’ theme

Jamie Clark

We have a sizable overweight position in life insurers. These businesses are the substance of our Population Ageing theme, which seeks to exploit the commercial opportunities that spring from rising life expectancy and the need for individuals to save more as the state and corporates retreat from increasingly expensive pension commitments.

August’s spate of interim updates offers an excellent opportunity to assess the operational performance of our life insurers and evidence in confirmation of the broader, thematic investment case.

At 6% of AUM, Legal & General is the largest position in both the theme and the Macro Equity Income Fund. The holding is roughly 10x market weight, illustrating the extent of our conviction and the degree to which share price movements may impact Fund performance. In this way, earnings updates can prove important catalysts, with very real consequences for the portfolio.

Happily, Legal & General’s half-year numbers brought vindication of our outlook. Operating profit from divisions (excluding mortality releases) rose 7% on the interim period, contributing to an impressive 10% compound annual growth rate from 2011 to date (see chart). This is consistent with management guidance of 10% growth in earnings per share through to 2020 and suggests the company’s share price of less than 10x 2018 expected earnings is too modest.

Jamie Clark: Annuity trends boost life insurers – largest component of ‘Population Ageing’ theme -

Source: Legal & General https://www.legalandgeneralgroup.com/media/2635/2018-hy-slides-final.pdf

The fruits of this success were clear on two counts. In keeping with its intent to progress dividends (and the mechanical link with between final and interim dividend), Legal & General raised the half-year payout by 7% from 4.3p to 4.6p. At the same time, the company’s Solvency II position, a regulatory measure of capital adequacy, was strengthened; rising from 186% to 193% of liabilities.

Dig deeper and you’ll see that this was driven by two operating divisions.

Legal & General Capital (LGC) increased profits by 21% to £172m from £142m. This reflects a strong showing from its £2bn portfolio of direct investments, with a key contribution from the now fully-owned CALA Homes housebuilding business.

For us, this speaks of LGC’s unique merits. In LGC, the group has an operating division with the capacity to manufacture high-return, long-life assets across housing, infrastructure and SME finance. These are attractive to both third parties and the group’s other businesses; Legal & General Retirement (LGR), for example, in search of long-life assets that better match its annuity liabilities. Meeting such needs is lucrative. 

LGR too made a meaningful contribution to H1 results. Headline earnings rose 9% to £480m, with growth seen in International Pension Risk Transfer (+98%) and New Lifetime Mortgages (+23%).

Detractors have cited the steep fall in UK institutional annuity premiums vis a vis H1 ‘17. But this is remiss, to the extent that it ignores the inherent lumpiness of institutional pension risk transfers and the variability of sales between single reporting periods.

Equally, such criticism seems to miss the clear and positive guidance given for H2 annuity sales. The company talked of quoting on over £20bn of UK pension risk transfer deals, with £7bn of transactions expected to close in H2.

Staggeringly, this would equate to growth of more than 100% on 2017 which we think gives strong confirmation of our argument that annuity writers, like Legal & General, will thrive as corporates de-risk balance sheets by transferring onerous defined-benefit pension liabilities.

Further evidence to this effect was seen in Aviva’s interim statement. The company reported a five-fold increase in institutional pension risk transfer volumes, inclusive of a record £925m deal with the Marks & Spencer Pension Scheme. This heralds a step up from Aviva’s historic focus on small and mid-sized pension risk transfer deals and gives clear idea of how large the market opportunity is. Margins disappointed, but this likely reflects the temporary process of sourcing sufficient higher yielding assets to back new annuity business.

Earnings from Aviva’s UK Life operations rose by a credible 14%, whilst headline earnings per share increased by a comparatively muted 4%; a number impacted by weather-related losses in Canada and the UK.

As with Legal & General, the interim distribution increased by 10% to 9.25p. For us, this kind of gesture imparts real financial substance to management’s confidence in the business’ prospects and gives credibility to our thematic read on the sector.

Lastly, Prudential’s interims were something of a curate’s egg. IFRS operating profit rose 2%, as US weakness was offset by UK one-offs and higher profits in Asia, albeit on lower sales as the company focused on higher margin protection and health products.

That said, Prudential is what we’d term a special situation and concentrating too closely on periodic earnings updates can risk obscuring this.

Prudential’s substantial Asian exposure offers a direct means of playing the growing wealth of the Asian consumer, their increasing financial sophistication and the associated demand for financial products. This plays out in the long-sweep.

Further, the forthcoming split of the business into UK and Asian/US operations holds the tantalising prospect of value creation, as investors are forced to focus on the sum of the parts valuation.

In summary, August’s interims gave no cause to doubt our conviction in life insurers. With particular reference to pension risk transfer, we found both abundant evidence of operational progress and clear confirmation of our thematic analysis.

In combination with the attractive ‘value’ ratings of such businesses and their positive gearing to higher rates, this gives us great confidence in our exposure to life insurers.

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Friday, August 17, 2018, 10:24 AM