The key takeaway from Legal & General’s interim update is that operating profit is comfortably above market expectations, keeping it on track to easily meet full-year forecasts.
Bulked-up annuities
The decline of the shares on Wednesday morning however shows investors remain wary over the strategic direction of the group and continuing weakness in its British insurance arm. L&G has strongly focused on the bulk annuities market over the last year or so, partly in a bid to forestall the potential economic impact of Britain leaving the European Union on its UK insurance business. L&G’s new bulk annuity business more than doubled to £1.6bn in H1 and it said that it is in the early stages of further potential deals worth another £12bn.
Investors are concerned that rapid expansion of bulk annuities— essentially taking on the risk of companies’ defined benefit, or final salary pension schemes—may increase L&G’s exposure to business of varying quality. In turn, regulatory capital ratios may weaken. If these deteriorate too much, regulators can force insurers to improve capital, with a consequent reduction on profitability. Legal & General (LON:LGEN) is far away from such a scenario, though investors tend to differentiate between insurance companies on the quality of their capital ratios. Credit rating agency S&P downgraded its outlook rating on L&G in July, from ‘stable’ to ‘negative’, indicating a higher risk of a rating downgrade. It cited rapid growth in L&G’s investment and bulk annuities businesses.
UK insurance arm
As Legal & General has one of the highest exposures to UK revenues amongst close rivals, it has also been scrutinised for any potential Brexit-related economic impact. As widely expected, Legal & General Insurance delivered the group’s weakest divisional performance in H1 2016, driven by a 12.6% fall in UK operating profit, though that was somewhat offset by a modest rise in the US. The UK business saw a general decline in margins with gross premiums up 6% to £1.3bn whilst new Retail Protection business was flat compared to H1 2016 at £16m, Group Protection annual premium equivalent fell to £224m from £233m and Group Protection new business was down by £8m to £28m. All this drove an operating profit fall of 13% to £90m in L&G’s UK insurance arm. The group points to a previously anticipated “adverse experience” of £26m from a relatively small number of income protection schemes. It expects “some adverse experience to continue emerging” albeit at a reduced level in the second half.
UK sensitivity
After a quick comeback from the Brexit vote shock, Legal & General shares ended 2016 more than 30% higher. They’ve risen by a more modest 9% so far this year. That seems to reflect investor wariness about increasing pressure on L&G’s UK-facing businesses from declining real incomes, inflation and hesitant business investment. The fact that L&G stock was trading 2% lower at the time of writing after it reported a 27% rise in operating profits and an improved solvency ratio also points to continued sensitivity of its stock to Britain’s economy.
Should signs of weak economic growth begin to abate, the rapid expansion of L&G’s bulk annuities market share and overall operating strength could certainly have a positive impact on the stock. Without a return of resilience to UK growth however, L&G shares seem set to drift without much further gain into the end of the year.
Disclaimer: The information and opinions in this report are for general information use only and are not intended as an offer or solicitation with respect to the purchase or sale of any currency or CFD contract. All opinions and information contained in this report are subject to change without notice. This report has been prepared without regard to the specific investment objectives, financial situation and needs of any particular recipient.
Any references to historical price movements or levels is informational based on our analysis and we do not represent or warrant that any such movements or levels are likely to reoccur in the future. While the information contained herein was obtained from sources believed to be reliable, the author does not guarantee its accuracy or completeness, nor does the author assume any liability for any direct, indirect or consequential loss that may result from the reliance by any person upon any such information or opinions.