Back in December, the first half of 2016 looked relatively straightforward for the UK’s large life insurers.
The EU’s Solvency II regulations were due to come into force at the start of January, but early news from continental rivals such as Axa and Allianz suggested that the sector’s largest companies were coping well. All that was left was for the UK insurers to report their own solvency positions over the first quarter of the year.
But just six weeks in, the outlook has changed. Since the start of the year, the FTSE 350 life insurance index has fallen by about a fifth (at one stage it was down by a quarter). That performance puts it on a par with the downtrodden banks. The FTSE 350 overall is only down 7 per cent.
Suddenly the upcoming results season, which starts with Standard Life on Friday, has taken on a new importance. “Four weeks ago, the focus would have been Solvency II and capital generation. The focus now will be on how the Solvency II numbers have moved,” says Alan Devlin, analyst at Barclays.
Although falling stock markets will have hurt the life insurers’ balance sheets, they typically do not own a lot of shares. Usually they allocate well under 10 per cent of their assets to equities. The bigger concern is the strength of their corporate bond portfolios, which are much larger.
Some insurers have moved to soothe market nerves ahead of the results season. Prudential released its solvency position, along with other balance sheet details, in January although that had been planned for some time. Legal & General, meanwhile, unexpectedly released details of its bond portfolio last week. The company was at pains to stress how little exposure it had to subinvestment grade credit in the oil and gas and basic resources sectors.
The Solvency II rules help to damp the impact of widening credit spreads. “A lot of disclosures so far have shown that solvency ratios are not very sensitive to market movements,” says James Shuck, analyst at UBS. However, he points out that much depends on whether recent moves in bond prices are down to liquidity problems or — as he believes — mounting risks of default.
The former have little impact on the insurers as they hold bonds to maturity. But defaults can be painful even if, as Mr Devlin points out, the likes of Legal & General, Prudential and Aviva have already put aside reserves against the risk of defaults on corporate bonds. He says that Legal & General, for example, has £2.3bn of reserves against its £43bn portfolio.
The health — or otherwise — of the insurers’ solvency ratios will have a bearing on their dividend plans. Dividends are one of the sector’s big attractions for investors. The recent fall in share prices has left Legal & General yielding 6.3 per cent, with Standard Life at 5.3 per cent and Aviva at 4.9 per cent. Prudential’s dividend yield is 3.4 per cent.
Mr Devlin expects 2015 dividends at Legal & General and Aviva to grow strongly — the former by 18 per cent and the latter by 15 per cent — but he says their growth rates will diverge. “From after this year Legal & General will grow its dividend in line with the business, but Aviva is just starting the journey of increasing its payout,” he says.
As for Prudential: “They generally increase the dividend by 5 per cent per year and every now and again they have a reset. They want a dividend they never have to cut.”
But Mr Shuck warns against being too confident on the outlook for dividends. “You need to be careful about assuming that future dividends and the potential for capital returns are as clear as they seem.” He points out that transitional measures under Solvency II, which benefit solvency positions in the early years of the new regime but are gradually removed, could limit the extent to which the capital is generated in future years.
The other concern the insurers may address is the impact of volatile capital markets on new business. Many life insurers have changed their business models so that they no longer offer the same investment guarantees that they used to, but there is a fear that choppy markets dissuade customers from putting more money in. That could affect the so-called unit-linked business that many life insurers have put at the heart of their new business plans.