Legal & General Group Plc (OTCPK:LGGNF) Q2 2022 Earnings Conference Call August 9, 2022 5:30 AM ET
Nigel Wilson – Group Chief Executive
Jeff Davies – Chief Financial Officer
Michelle Scrimgeour – Chief Executive Officer, Legal & General Investment Management
Andrew Kail – Chief Executive Officer, Legal & General Retirement Institutional
Kerrigan Procter – President of Asia-Pacific
Conference Call Participants
Andy Sinclair – Bank of America Merrill Lynch
Ashik Musaddi – Morgan Stanley
Nasib Ahmed – UBS
Larissa Van Deventer – Barclays
Alan Devlin – Goldman Sachs
Dom O’Mahony – BNP Paribas Exane
Oliver Steel – Deutsche Bank
Mandeep Jagpal – RBC Capital Markets
Barrie Cornes – Panmure Gordon
Good morning, everyone. It’s really, really thrilling to see everyone today here at Legal & General. And welcome to our results presentation for the First Half of 2022. Please silence mobile phones and the usual disclaimers about forward-looking statements apply.
Consistent strength and growth are very apparent in today’s numbers. Strength in our balance sheet, which consistently proves itself highly resilient in the face of external economic and political shocks and profitable growth delivered by all our businesses. We are performing ahead of our five-year plan for cash and capital generation, delivering unique synergies across divisions and we have a terrific collaborative management team. I’d like to thank all of our people for today’s results, while still encouraging them to be even more ambitious.
Here are the headline numbers. Operating profit from divisions up 7% to GBP1.35 billion, EPS of GBP0.1928 pence, that’s up 8% as well. This is more than the GBP0.1816 pence we achieved in the whole of 2015 and share price was the same as it is today. The ROE of 21.3% and a Solvency II ratio of 212%. Solvency II operational surplus generation GBP0.9 billion, that’s up 14% and an interim dividend of GBP0.0544, up by 5%.
Our four business divisions delivered balanced, high-quality earnings. Across LGC, LGIM, LGRI and Retail, we cover alternative asset origination, asset management, global pension risk transfer and U.K. retail retirement and protection. We are market leader in at least 10 of the market segments, where we participate. Indeed, we participate in scale markets, where we have leadership and growth markets, where we can both lead and can deliver scale. Our strategy is very clear and our focus is relentless. These businesses work together to deliver the synergies, which underpin our consistent 20% ROE.
This should be a familiar slide, but the extent of the positive interplay between the divisions is a unique feature for Legal & General. Asset origination in LGC enables us to win business and optimize the annuity back book. Retail is a source of capital and further assets through the lifetime mortgages. Our principal balance sheet in LGRI is a source of business for LGIM and LGIM brings investment management scale and access to 3,000 institutional clients. A potential source of third-party capital for LGC.
Our four divisions each contribute LGRI GBP560 million, up by 7%; LGC GBP263 million, up by 5%; LGIM GBP200 million, down only 2% despite the market shocks of recent months and Retail of GBP332 million, up 14%. The six strategic growth drivers to which we align our businesses have not changed. In fact, they are more relevant today than they have ever been and the market opportunities they drive are immense.
Demographics is now trending. The world continues to get older, driving demand for pension de-risking and retirement solutions. A global $57 trillion opportunity. Only 10% available DB schemes have completed buyouts. So we’ve just scratched the surface. Asset Management continues to globalize and consolidate. The tough space is in the middle, but LGIM is in the global top dozen and internationalizing fast in this $129 trillion global marketplace.
Real economy investment is supported politically. We are likely to see positive change in this area. On the market favors alternative assets. We have a unique capability to deliver and a trusted track record, constraint government spending and economic insecurity drive welfare reform and the need for personal provision. Technology is advancing faster than at any point since the 1860s. We have invested directly and indirectly in over 500 start-ups. Climate change or possibly climate catastrophe creates a $20 trillion liability and with it, for us, a series of huge investment opportunities. There’s a great deal more to do as we tackle the planet’s most pressing crisis.
Turning to the current economic and market environment. This slide captures the three current trends of normalizing interest rates, widening credit spreads and rising inflation, and their respective impacts on Legal & General. First, normalizing interest rates, this is a net positive for us as a Group. You see the positive effects on the Solvency II ratio. This gives us greater capital optionality and creates more favorable conditions for PRT transactions. Normalizing rates also help EPS as they drive positive insurance investment variances. Against this, you see the higher rate reducing LGIM fixed-income revenue. However, the shape and balance of our Group is such that normalizing interest rates are a net tailwind.
Widening credit spreads similarly support the PRT market by reducing DB scheme deficits and improving bulk annuity pricing with positive consequential effects for both volumes and margins. Our credit portfolio has seen no defaults since 2028. Concerns about the impact of widening spreads are simply not borne out by the facts, as Jeff will explain in some detail.
Inflation, which is a challenge for so many people across the U.K. is for us a minimum second order impact. In short, L&G’s mix of business and its resilient balance sheet, again, put us in a very strong position to manage headwinds from the broader economy. We are on track to achieve or indeed beat our cumulative cash and capital ambitions for the five-year period 2020 to 2024. Here you see 0%, 5% and 10% growth assumptions for both cash and capital. The key takeaway is that even if we have zero growth in cash and capital from here, through to 2024, we will achieve our target. This is a good underpin, but we will not rest on our laurels. We are confident that we can grow cash and capital faster than our dividend commitment. Widening jaws over the dividend creates positive optionality for us.
We expect our annuity portfolio to be self-sustaining again in 2022, as it was in 2020 and 2021. The driver is growing operational surplus or capital generation, which we expect to see at GBP1.8 billion in 2022. This grows year-on-year as the annuity portfolio grows and we exercise consistent discipline around new business strain.
Our newly created retail division has multiple growth opportunities. In Retail Retirement, we have strong market shares in growing markets, in workplace savings, in retirement income and home finance. We also have strong positions in U.K. protection and a smaller market share in the larger U.S. protection market, where we are bringing to bear our digital expertise, disrupting the markets and gaining market share. And in Fintech, we have made nine strategic investments in growing exciting businesses that complement or are adjacent to our own business.
L&G has always been a purpose-led company. We think this is entirely consistent with the delivering value for our shareholders. Aligning purpose and profit makes purpose scalable. We believe in applying the principles of ESHG. We include health as a socially beneficial impact, tackling health and equality is explicitly part of our leveling up policy. We have started already through our partnership with Sir Michael Marmot to narrow the widening inequalities in health outcomes.
ESHG, in a commitment to sustainability, strengthens our business for the long-term, attracting new customers and existing customers and also motivating our employees. Inclusive capitalism, that is investing our capital and our customer savings to benefit society, as well as delivering good returns is a purpose we have been leaning into for over a decade, including our 20 U.K. cities and now the GBP4 billion investment in the West Midlands, the GBP2.2 billion deal with British Steel Pension, a $4 billion deal with Ancora in the United States.
To sum up, our strategic drivers are more valid than ever. We have made a strong start to 2022. LGIM experienced GBP65 billion of inflows. The market environment is accelerating global demand for PRT. LGC is on track for our 2025 ambitions to deliver at least GBP600 million to GBP700 million of operating profit and attract GBP25 billion to GBP30 billion of external capital.
These are strong half-year results and the outlook for the full year is positive. I’ll now hand over to Jeff to take you through the numbers in more detail. Jeff?
Good morning, everyone. I hope you’re keeping well. It’s not a little warm. In the first half of 2022, Legal & General continued to prove its resilience by delivering another set of strong results. The year-to-date operating performance is in line with our expectations, notwithstanding market volatility with operating profit up 8% to GBP1.2 billion. Investment variance was positive, reflecting the impact of increase in interest rates on protection reserves and strong performance in the annuity portfolio. This was partially offset by volatile global equity markets, impact in LGC’s traded equities.
As Nigel mentioned earlier, we are well positioned to navigate prevailing market conditions and our diversified business model allows us to continue to deliver dependable and consistent value generation to our shareholders. In the first half, profit before tax was up on the prior year at GBP1.4 billion, but the earnings per share at GBP0.1928, up 8% and our ROE was once again above 20%. Solvency II operational surplus generation was GBP0.9 billion, up 14%. And finally, the coverage ratio at 212%. This very strong ratio demonstrates the strength of our balance sheet and provides the Group with optionality for future growth opportunities.
So, turning to our divisions. In the first half, LGRI delivered operating profit of GBP560 million. This performance was driven by the ongoing predictable delivery of prudential margin releases from our growing back book and effective ongoing asset strategy is increasing the total yield on our portfolio, and new business surplus generated from robust volumes of PRT business. Investment variance was positive, reflecting the continued strength of LGRI’s defensively-managed and well-diversified asset portfolio.
The H1 2021 results included positive variances driven by COVID-related deaths, which have not been repeated at the same scale in this period. In the first half LGRI were up GBP4.4 billion of global PRT across 25 transactions. These volumes were written at attractive margins and capital strain levels were below 4%; the result of good asset origination and favorable reinsurance pricing. We were pleased to announce a follow-on transaction of over GBP2 billion with British Steel Pension Scheme in the U.K., executed under an umbrella agreement. In the U.S., we wrote our biggest ever transaction that’s over $550 million. We continue to be excited by our growth prospects in the U.S. PRT market. We wrote another Canadian deal for $230 million, building on our strategic partnerships in that market.
Market volumes in 2022 are expected to be higher than in ’21, and our pipeline is strong. We’re confident in delivering against our five year ambition of GBP40 billion to GBP50 billion of U.K. PRT and $10 billion of International PRT. As always, we will remain disciplined in our pricing to ensure we achieve our target financial metrics.
Moving to the annuity asset portfolio. As usual, we’d provide an overview of our A-rated annuity portfolio. The diversified GBP73.2 billion bond portfolio down in value because of rising interest rates is defensively positioned and actively managed to optimize performance and mitigate downgrades. We’ve maintained high credit quality with two-thirds of our bond portfolio rated A or better with 14% in sovereign-like assets.
Our portfolio is geographically diverse and we have minimal lower rated cyclical exposures. During the first half, we originated GBP1.6 billion of new direct investments. The DI portfolio now stands at GBP20.5 billion, approximately 26% of total assets. 100% of scheduled cash flows were paid in the period and around two-thirds of our DI portfolio exposure is from counterparties rated A or above, often secured making it very resilient to market stresses. We provided our top 10 BBB exposures in the appendix and includes names such as National Grid and Bayer. Our ambition is to continue to strengthen our asset sourcing capabilities with a strong ESG focus. Working alongside LGIM and LGC, our ability to self-manufacture attractive long-term assets to back annuities, for example, affordable housing, build to rent and urban regeneration is a differentiating feature of our annuity business and remains a key competitive advantage.
Investment grade credit, which very rarely defaults represents 99% of our annuity bond portfolio. Even so, we adopt a prudent annual IFRS default allowance of 43 basis points, based on assumptions that have been broadly unchanged for almost a decade. This is equivalent to the GBP2.7 billion default reserve held on the Group’s balance sheet.
To illustrate the level of prudence in this assumption, the IFRS base default assumption for the portfolio is just 18 basis points, which in itself has proven to be conservative. Our actual default experience has been much lower with an annualized default rate since 2007 of less than 1 basis point. Whilst we are of course proud of our track record of low defaults, the key point is that we adopt prudent default assumptions that we expect to be significantly greater than our experience over time, and which provide us with optionality as margins unwind to rebalance the portfolio, if and as required.
The outcome of our careful approach to managing credit risk can be seen clearly on this slide. Since 2007, the annuity book has more than quadrupled in size. Actual default losses in the book have been just GBP25 million and the majority of these were back in 2008. The difference between the base default assumption and our actual default experience is reported through investment variance, together with other trading profits. Year-on-year, this variance has been positive, even after allowing for the cost of selectively trading out of any assets.
To further demonstrate the resilience of our balance sheet, we’ve run a severe potential credit stress scenario, broadly consistent with 2001, ’02 credit rent; the worst period in 30-years for downgrades and defaults. In this scenario, we have seen 1% of our credit assets default pre-recoveries with 1.4% of BBB assets defaulted and 7% of sub-investment grade assets defaulting. We assume an immediate big letter downgrade on 20% of all assets and haven’t recognized any benefit from widening credit spreads. In this scenario, the primary impact on our solvency ratio is from downgrades. We would expect downgrades to reduce the ratio by around 29% without taking any management action.
However, experience shows we could take action to rebalance the portfolio. We would add around 10 percentage points from a partial rebalancing of sub-investment-grade assets, which in itself is prudent, compared to our standard sensitivity. We could, therefore, reasonably expect the solvency ratio to be around 190% shortly after this scenario given the current starting point. This demonstrates that our balance sheet is well-positioned to absorb a significant credit event, should it occur.
Moving on to LGC, operating profit was up 5% to GBP263 million, this reflects increased profits from our alternative asset portfolio and strong trading performances in CALA and Affordable Homes, as well as valuation increases in our VC portfolio and in Pemberton, which was driven by strong growth in revenues and committed AUM. The alternatives portfolio now stands at GBP3.7 billion. We also now have GBP15.6 billion of third-party capital, which positions us well to exceed our ambition and managing over GBP30 billion of alternative assets by 2025 and delivering at least GBP600 million to GBP700 million of operating profit.
As part of LGC’s growth strategy, we recently announced our first U.S. investment, a 50-50 partnership with the U.S. real estate developer, Ancora, delivering life science and research facilities in this fast-growing market. This is a first step in replicating the synergistic model we have in the U.K. and will produce investment opportunities for both third-parties, as well as the annuity portfolio.
Moving on to our Investment Management division. In LGIM, operating profit was down 2% to GBP200 million; a resilient result in tough market conditions where interest rates, inflation and equities impacted asset values across the portfolio. Second-half revenues will be challenged if these conditions continue. Expenses were up, reflecting ongoing investment in the business and inflation offset by careful cost management resulting in a stable cost-income ratio of 59%.
Total AUM was down slightly at GBP1.3 trillion, with international assets accounting for approximately 36% or GBP468 billion. We remain a market leader in U.K. DC, where our strong customer focus has helped grow AUM to GBP129 billion, covering over 4.7 million workplace members. And our wholesale business continues to make good progress with AUM reaching GBP46 billion. We continue to make strategic progress to modernize, diversify and internationalize the business. For example, we are expanding our ESG product range. This includes ongoing preparations for the launch of a new renewable infrastructure equity offering in partnership with NTR.
In Europe, we’ve expanded our product range through the development of thematic equity and fixed income ETF products and extended our distribution reach. And in the U.S., we expanded our product proposition through the launch of five new mutual funds, which provide the building blocks for our U.S. DC retirement income solution. We also added to our U.S. real estate investment capability.
Despite market volatility, we delivered record external net flows of GBP65.6 billion, equivalent to 10% of open and external AUM on an annualized basis. The flows were diversified across the business and driven by strong international growth, reflecting deep relationships with our clients. International net flows represented over half of Belgium’s total. U.K. TV flows were also strong as clients seek to de-risking volatile markets with ongoing demand for LDI solutions.
U.K. DC also produced solid results, where we had 22 scheme wins, many of which is our multi-asset or Target Date funds as their default strategy. And our ETF business has shown a resilient performance against a challenging market backdrop, contributing to overall growth in LGM’s annualized net new revenue of GBP13 million, up 14%, compared to the first half of last year.
Now moving on to our Retail division. Operating profit increased 14% to GBP332 million, driven by ongoing releases from our growing protection and individual annuity portfolios. We also experienced valuation uplifts in two of our retail Fintech businesses, where there was external funding and strong business growth.
In the U.S., we continue to experience adverse mortality, consistent with the broader market. COVID-related claims were concentrated in Q1 and in line with the GBP57 million provision set up at the year-end. Solvency II new business value generated was down on the prior year at GBP124 million, reflecting some margin pressure and lower retail protection volumes, compared to the very strong market we saw in the first half of 2021.
Moving on to capital. Our balance sheet remains well-capitalized with the Group’s Solvency II surplus of GBP9.2 billion. As at the end of June, the coverage ratio was 212% as we’ve said, following positive market movements, partially offset by payment of the 2021 final dividend. Operational surplus generation from the growing back book was up 14%, demonstrating the predictable nature of our capital generation.
After allowing for efficient new business strain of just GBP0.1 billion, net surplus generation was GBP0.8 billion. Market movements were GBP1.2 billion, predominantly driven by the higher interest rates. As a reminder, we hedge inflation and so we’re not materially exposed to this risk, as can be seen by our sensitivities. A 50 bps increase in future inflation expectations reduces the solvency ratio by just 3 percentage points.
So, to conclude, we have delivered another strong set of financial results with operating profit up 8% and an ROE of 21.3%. Our carefully managed annuity portfolio continues to perform as expected with no defaults, and we are well-positioned to absorb a significant credit event, should it occur. As noted and assuming no change in market conditions in the second-half, we expect LGIM revenues to be down year-on-year, due to the reduced level of AUM.
However, given our diversified businesses, we still expect the Group to deliver full-year operating profit growth in line with the first half. Our unique business model drives predictable levels of cash and capital and funds our progressive dividend. As guided previously, we expect to deliver GBP1.8 billion of capital generation at the full-year. We continue to make significant progress on our five-year ambition and our Solvency position is stronger than ever, allowing us to capitalize on the significant growth opportunities across our businesses.
Thank you. Nigel?
Thanks, Jeff. The investment case for Legal & General can be summarized in these six points. A track record of growth, which has been consistent through changing economic environments, driven by a proven synergistic business model, delivering 20% ROE, delivering predictable value across the long-term, a resilient balance sheet and a clear purpose. This is a standout proposition in a challenging economic and political environment. We have delivered a gain in H1 2022 and are positive and ambitious in our outlook for the second half of the year and beyond.
Thank you. And we are now very happy to take questions. Before each question, can people state their name and the organization they are representing. And why don’t we start with Andy?
Q – Andy Sinclair
Thanks. It’s Andy Sinclair from Bank of America. Three for me, please. Firstly was just on LGC, just wonder if you could give us an idea of the actual cash generated within LGC, and if possible, just give an idea of that by mature businesses, disposal proceeds and margins on third-party capital? That’s question one.
Second question was just on the bond portfolio. I think, for the first time, correct me if I’m wrong, under 50% of the portfolio is now in the U.K. with over 50% international. Just wondered are you looking to further internationalize that portfolio? And does the average credit rating differ by geography?
And thirdly, was just on the, on LGIM, just with the slightly lower AUM base, just if you could, give us an update on outlook for costs and cost-income ratio for the rest of the year and beyond? Thanks.
Jeff, do you want to take the first one? I’ll do the second one. And Michelle, you are happy with the third one.
Sure, yes. The cash on LGC for the first half was roundabout profit. I think, you’d said before sometimes, it will be less than our profits, some will be more, some will be significantly more as it was last year with sale of MediaCity, for example. So, there were no large transactions as such in the first half. So it was good steady cash emergence roundabout just higher than your profit number.
Yes, it was very observant of you on the bond portfolio, because that was in the appendix in one of these slides. So well done, Andy, it is indeed the case that we’ve invested more of the assets in outside the U.K. than in the U.K., 51-49. And that’s one of the arguments we’ve been having with both the government and the regulator, because clearly, ideally, we’d like to invest more of those in the U.K. So, giving us a mandate where we have more opportunities and more asset classes in the U.K. would undoubtedly result in a better outcome for the U.K.
Unfortunately, I mean, America is very open for businesses, as my colleagues will tell you. And therefore, we are getting some pull from America, and in one sense, the attractiveness of America is going up a bit and the U.K. is going down a bit, and under the current politically and regulatory environment over here. We’d like to reverse that we’re hoping one of the things that the new Prime Minister does is indeed reverse that to give us more opportunities to invest here in the U.K. Plus, ironically, they’ve got a bit ahead of us in things like retrofitting of housing and offices already produces a matching adjustment asset class. But, we’d like the U.K. to at least keep up with the U.S. and indeed Europe. Michelle?
Yes. On costs, I mean, just to say, clearly, it’s a challenging time. I’m not going to lie about that. But in terms of what we said at the Capital Markets Day in November 2020 was that we would expect to see the cost-income ratio go up towards the mid to high-50s, given that we’re going to invest in the business. That hasn’t changed. What’s happened and as Jeff has also indicated is that we would expect that to probably drift up a little bit actually in the next year or so, but that’s not going be the norm, it will normalize once markets settle. I would expect that to come down again over time.
Thank you, Michelle. We do three there then we’ll —
Yes. Hi, thank you. Ashik Musaddi from Morgan Stanley. First of all, great set of results and pretty clean this time. So really appreciate that. Not many one-offs, so that’s a good news. Just three questions. One, I saw somewhere in the table at the end of the presentation, the credit default reserve was GBP3.4 billion last year, it’s GBP2.7 billion this year. I mean, can we just get the mechanics? I think it is to do with the level of assets, but would be good to get a bit of mechanics as to how you decide on this number, would be good. Thank you.
The second one is around solvency ratio. Now, 212% is a number, which looks pretty good. I guess, you would agree that there is a lot of buffer to absorb shocks here. But how are you viewing this? I mean, would you like to capitalize on this through some extra capital return or some accelerated growth? Are you looking to do that or you’re just waiting for markets to settle and then take a call at that point?
And the third one is, I mean, one of the sensitivities that you have is around interest rates and a bit of benefit that has gone through in insolvency ratios rates. Is there any way you can hedge that out at a reasonable cost. So that the solvency ratio doesn’t go down even if interest rate drops again. Thank you.
Jeff, you want to take the first and the third question. I’ll go on the second one.
Sure. Yes, the first one is reasonably straightforward. It is just the discount. And so the methodology is still the same, it’s the 43 basis points supply to the same assets as it was before, basically. But I think Tim send me an email I forgot, discount rates have gone up by something like 170 basis points. So it’s literally just discounting at a higher rate for the same cash flows gives you a much smaller number. So, if we put it back to the old, it would be virtually the same. So there is no big change there.
On the third one, do you —
Yes, sure. Rates hedging, we constantly look at this. It is a big question we have asked smartest people on earth all the time to think we tried to balance solvency versus IFRS and the cost whether or not change coming in IFRS, we’re looking at what’s possible there. You shouldn’t confuse solvency ratio movements with whether we’re matched or not, a bit like inflation, cash flow matched, rates matched on the annuity portfolio. It is the fact that you’ve got an SCR, which has got a big stress, which gets — brings in more duration to that.
So we constantly look at it, we balance using derivatives to do that, spend some money or use the liquidity in a stress up by putting more derivatives on, but we’re pretty happy. We wouldn’t want — we don’t want to get higher, we try and balance the two, but we will be making changes as we go into IFRS 17 and we’ll see try and optimize between the different metrics.
We want an investment-led recovery here in the U.K., in fact, everywhere. We fundamentally believe that’s the right thing to do. We would like to be given a bigger mandate to allow to invest. And so, the fact that the Solvency II ratio is well over 200 is very comforting, and it does bring into the question of buybacks, which though we made a comment on last — in the R&S. Our preference, if we can still deliver a 20%-odd return on equity is to continue investing in a very attractive high growth businesses and just relentlessly pursue that.
We’ve got — we’ve hired some great new people into our organization, who globally dispersed looking at investment opportunities everywhere. We’ve got a great track record and pretty much all of the businesses right now. And these 500 startups, our activity in new attractive sectors like renewables give us lots and lots of opportunities to invest and to grow the business, and in fact, accelerate the growth of the business. And one of the things, we’re looking forward to is explaining why we’re accelerating growth in 2023, 2024 and beyond that. We’re not going to go along the zero percent line that I had in my slide.
Okay. Next questions. Could you just pass the microphone and just [indiscernible]
Hi. Thanks. Nasib Ahmed from UBS. Thanks for taking my question. So, first one, on your capital generation target for 2022 of GBP1.8 billion. If I double the 1H number, I get to GBP1.9 billion and you’ve got management actions coming in the second-half, presumably. So are there any offsets that bring you down to GBP1.8 billion? And then, on the GBP25 billion of pipeline, what percentage are you exclusive on? I didn’t see that in the release. Apologies, if I missed that?
And then, on the credit migration sensitivity, it was a little bit higher. What’s driving that and what’s the difference between the minus 19% on the slide and minus 14% in the press release? Thanks.
Jeff, do you want to take the first and third question? Andrew, do you want to take the pipeline and the opportunities and why you’re so confident that we’re going to outperform?
Yes, no problem. The capital generation, I mean, there’s not a lot going in there. It’s pretty much the same, it just doubles up is a bit around then 0.9 and 1.8, but there isn’t much there. We expect double-digit growth in the OSG, it’s obviously dependent what was in the previous period when you’re only looking at the half-year, what’s in the full-year, but we expect that 1.8 roundabout double-digit growth in OSG. So there is nothing major going on within that.
I’ll do the last one, if you like, I mean, again, a lot of it is math. The credit migration one is very simple and we saw this in the pandemic in our numbers. It’s very simply, because the sub-investment grade spreads have widened. So when we formulaically model our stress, we say, well, BBB is downgrade and then we sell them and we go back. So we make a bigger loss at the point we sell them in our model, because the spreads are wider that they migrate into. So we saw exactly that in the pandemic, it’s just the math of having wider spreads as a starting point. So there is nothing — we haven’t strengthened it or anything, it’s just the market conditions, the way flow through.
And on the 19% to 14%, yes, we showed 19% was the net impact of 20% downgrade. We show 14% in our sensitivities. As I said, we’ve taken the slide more prudent view. So we’ve only rebalanced sub-investment grade and not quite all of it, partially, it’s let’s call it 75% or so of the sub-investment grade. If we rebalanced all the sub-investment grade, that would give you another couple of percent. And if we rebalanced the investment grade, which we also haven’t done in the slide that would give you another 3%, which closes the gap on the 5%. So we’ve just taken a more prudent view on what we would rebalance to show in the sensitivity on the slide.
Good morning, everybody. So, on the GBP25 billion, we haven’t disclosed the number of exclusive, that’s a relatively small number at this stage of the GBP25 billion would cover the transactions that we’re in active conversations through to pricing across the U.K., U.S. and Canadian markets. So as Nigel said and Jeff said very buoyant markets, both in the U.K. and the U.S. as with other compensators we’d expect 2022 to be a high level of transacted volumes than we saw in the previous year and we are in the final stages of some very significant pricing conversations, but we’re not exclusive at that stage.
Yes. I think, we can — it’s fair to say, we’ve got more active conversations than we’ve ever had in the history of 35-years that we’ve been doing this business. So the sales teams are very busy at the moment pricing up various things and people pulling forward deals that they might have been thinking about doing three, four or even five years’ time, because rates have moved up, deficits have gone. And Chairman and trustees are pretty anxious now that they’ve got a window of opportunity to do things. And so they are kind of getting on.
I think the other thing, Jeff, about our portfolio, we don’t have very much BBB- in our portfolio as well, which I think is a good thing. And Chris is sitting at the back there, and he is always commenting on the fact that we’ve got so little cyclical BBB- as well. And so the team, clever team constructed the portfolio, spend a lot of time figuring out what’s the right portfolio for us to have as a business.
If you just put the mic there and you guys just — sorry.
Larissa Van Deventer
Larissa van Deventer from Barclays. Congratulations on a good set of results. Two questions please. The first one on LDC, how should we think about growth and the sustainability of growth to the end of your five-year plan. And specifically, which areas do you see expect most aggressive growth and what would put that at risk? And then with respect to bulk annuities, you mentioned the active discussions on margin. What are those margins most sensitive too and what could the biggest risk be to the margin compressing? Thank you.
Laura unfortunately is not here. We don’t have all of the executive team here today, so [indiscernible] gone LGC, and if you take the second question that will be great.
And I think we were very fortunate now, we created a lots of optionality for ourselves across the whole of the LGC business, and we really started that in 2013-2014, and lots of those businesses, which were tiny in those days have really become quite substantial businesses already, and are structurally growing in markets. I think, GBP600 million to GBP700 million target of General you think is very conservative, I will agree with that myself and the fact I certainly agree with it myself. But that’s kind of the targets we’ve set at the moment. I think if you talk to the management team and Gareth is here, who is the CFO, just stand up, Gareth, so people know who you are.
If you catch Gareth afterwards, you can go through some of the more detail about it and why we’re very excited about. The American opportunity, which has really opened up for us and the renewables opportunity. And again, Simon is — glad he’s sitting at the front, and he can go through some of the more of the detail around one of the opportunities. We’ve done sort of tactical equity and a small amount of debt investment so far. But the universe of opportunities is this why which is goes back to this point about Solvency II. There’s a lot of that we have to do outside the Solvency II buckets at the moment. We’d like to push a lot more of that into Solvency II and get rid of the fixed cash flows and come around to highly predictable cash flows, and hopefully our regulator and the treasury can see eye to eye on that just makes a huge amount of sense here in the UK and indeed elsewhere.
If you just — Jeff?
Larissa Van Deventer
And the second question was on margins.
Yes, sure. Another PRT margins. I mean, you will see first-half last year pretty consistent sums to new business margin. We absolutely will only deploy capital if we believe the margin is there. The big thing that drives that for us I talked about, it is obviously the asset manufacturer that gives us a big competitive advantage. Spreads widening also make it easier to achieve those margins with traded credit, which gives us a bit more optionality in the investment and we are able to get very good reinsurance terms. We then make a decision about how much capital, how much to reinsure pending Solvency II discussions and everything else, capital headroom, how much do we want to maintain.
But we have a model that works extremely well to deliver that margin with a really good team that can deliver the hedging required on day one and source the assets and we’re very careful to make sure we’ve got a site on those assets, what are the spreads, what are we going to achieve, and that’s the main thing drives the margin in conjunction with the reinsurance.
Larissa Van Deventer
Nigel, thanks. Alan Devlin, Goldman Sachs. Two questions. First of all on capital. How are you thinking about capital given your strong solvency ratio and the comments with the jaws of capital generation, increasing above the dividend. I think in your press release, you included for the first time that you wouldn’t set an excess capital and that was in the best interest of trying to shareholders. But then obviously given the very strong book annuity volumes in your comments that things you’re expecting to see in three or four years coming through potentially earlier would you use that excess capital to take advantage of that market if you could?
And then secondly, a related question, just given the big move in interest rates in credit spreads you’ve seen both in the U.S. and U.K., and you’ve talked about the investment portfolio. Does that change your kind of view on bulk annuity markets, that’s incrementally more attractive to invest capital for Legals as you obviously both markets got more attractive, but in relative terms has been any change? Thanks.
Andrew, do you want to take the second one? And Jeff, do you want to take the first question?
Sure. Yes, I mean, we did include some of them. We had lots of questions over the last few months. So, well, ratios are higher. What does that mean? As you know, we don’t set a range of solvency ratio, because we like to look at economically what’s really going on within that. So you hit on the right point. It’s the jaws, the sort of what is real economic capital projection and generation that we are producing. And as those open, that’s real generation. So if rates go back down and we’ve created that capital and we either put it to work or we sitting and that’s when we have a discussion, not just because rates move around, that gives us great optionality, as Nigel said at the start to invest, and it’s not just capital for PRT.
I mean, that’s pretty efficient, but it’s also capital whether it’s LGC, LGIM to grow those businesses create assets for the third-parties, create assets for other parts of the business. We, luckily, don’t need too much capital for retail, it’s a very efficient business. So we’d balance the two all the time, but it’s that real economic capital growth is important for us.
And just on the U.K., U.S. markets, obviously we have a very different market profile in the U.S. to the U.K. We’re typically competing on $500 million and below schemes and planned termination. And we do see a difference in margin in the U.K. and U.S. So I won’t repeat Jeff’s comments, but we’re very disciplined around how we deploy capital and making sure we achieved the right margins, recognizing our US business is in scale up and just like I said on the U.K., the U.S. business volumes and the market opportunities there are significant.
So, we’re very active in the U.K., but we’re not disciplined on how we deploy capital, particularly given the different scale of balance sheets and a different capital regime we have in the U.S., there are some technical differences around yields and margins in the U.K. and U.S., particularly around duration and local U.S. stat. But I think on economic basis, we’re very disciplined in how we deploy capital.
And the exciting thing is U.S., we quoting on over $500 million deals and winning them. So that’s a big plus for us. So the brand recognition has gone up immeasurably in the United States.
Hi. Just three questions from me please. I think, in the appendix, you’ve got your top quality BBB. So what’s actually — do you have examples for the BBB-, because that’s also 12% of your total BBB?
And second question is your 35% exposure in BBB, that’s obviously not much higher than your peers on the mid-teens. And that’s a increase from your 2008 acquisition, which I believe was around 20%. And is there any action or any plans you could do sort of going forward on the new business side, as well as the existing book to maybe like bring down that 35% hedge?
And third question is the widening jaws between the capital and dividend. You’ve talked about optionality. Could you give a little bit more examples of what sort of investment in growth you could do. Also, would you consider any excess return to shareholders? Thank you.
I think, that was about six questions around that. On the credit portfolio, I’ll just make a few general comments. I think, we’re all feeling very relaxed about the composition that we have of it — we decided not to people want BBB. So we give them BBB and then they come back and say, well, can you give us a BBB- one. We’ve had no defaults in the portfolio. So it’s not — it’s discussed more by you guys than by our rating agencies and our regulators.
So, the more sensitive Group, hence, we’ve given you a lot of information try and get you over the hurdle that effect. This isn’t a high-risk portfolio and then more names to give you seems to be somebody else you want to get access to. So we’re very comfortable at 35%. Chris crisis is the CRO. If you want to catch up with him afterwards and have a longer discussion about the risk in the portfolio. He’d be very happy to do that. Jeff?
Yes. I mean, some of the change there will be that it will be FX, because there’s a much more active BBB market in the U.S. And so with the movement in FX, it proportionally looks a bit bigger. You’ll notice the AAA also proportionally has gone up. So no one says that though we’ve seen it. It is just moving around little. It isn’t, but it’s very active. Some of it also is to do with early-stage direct investments when you develop in some of those, and a lot of those don’t get reviewed and upgraded later. And don’t forget the BBB- will include some of the sub-IG that we’ve had as upgrades over the last 12 months or so after coming out of the pandemic.
Yes, there is a formulaic thing that we do on assets under construction, which gets upgraded once the stop being under construction, so this mechanics in there. So there is part of the reason that we’ve got a 35% and not a lower percentage they were actually building assets in different parts of the country and things like affordable housing, and so far, you guys can get a lower rating, but then get upgraded once the development is finished and producing over a long period of time, but we’re very comfortable with the portfolio, but not complacent. Next question, yes.
I have the mic. Just firstly on going back to [indiscernible] question and Alan’s question. I mean, I think one of the EBC is saying that next year is going to be a record year for bulk volumes. So given your composition. Would you consider going over the 40 to 50 and the 10, because it’s great value business and would you also consider asset reinsurance to really to white-label and to grow in that space?
Question two is, the direct allocation of the back book. Presumably, given LGC and given the opportunities you have, you’re looking to expand that. Can you give some more idea about that? And lastly, on mortality, where are you in the journey to thinking about what is a sustainable kind of picture for mortality improvements, mortality rates and protection, given what just happened? Are there — is there any movement there? Thank you.
Yes. I think, the answer to the first question is yes and yes. I mean, if you can make — if our capital is very strong and there are lot of opportunities, then clearly, these were guidelines, they’re not necessarily — if the market is poor, then will be below targets, if the market is very attractive, then we may be a lot of targets. I don’t think it’s one EVC thinking the market is going to be larger next — I think all of them thinking that it’s going to be very large next year. And that’s part of reason the rules change for Solvency II is to give us a wider university of DI. So we’re capable of dealing this issue when it comes our way. Jeff?
Yes. I mean, in terms of back book DI, it is back book and obviously putting the better assets against new business and you can see different examples of that. The part of it positive investment variance in LGR is put in assets to the back book and seeing that come through in returns, but also in the release from operations is some of that is the assets that we’ve started applying to new business, some of which we’ll also be putting to the back book going forward is prudent allowance for those assets coming through. And so the majority of that increase actually comes from what we’ve done with assets, whether that’s build to rent, et cetera.
And we have very prudent assumptions around those and those therefore unwind, and the IFRS and you see that in the release from operations and economically we think absolutely it makes sense. We have — whenever you want to — however you want to measure GBP10 billion, GBP13 billion, GBP15 billion of headroom to put these assets against. We believe we can produce more than we need for new business, even with these large volumes, and at the same time we can direct some to the back book. We have still significant guilt holdings in the back book we don’t believe we need those all the time. And so, we’re currently managing the flow and how much we can put to the back book and it goes back to what we use asset reinsurance as well, et cetera, to optimize the economics of the whole thing.
Yes. On assets, I mean we’d like to do more for affordable housing and social housing. There’s — the housing list in the U.K. is — waiting list over million houses, there were 90,000 children in London in temporary accommodation last night. These are some shocking statistics for a modern economy and all the capital is available, all the land is available, all the people are available to produce a massive change in that. And again, that’s something we think between the government and the regulator, they’ve got to get these things sorted out, so that it sounds like ours can step up. We’re really excited about the life science projects not just here, but in the United States, because pretty much everything we’ve done in cities and towns over here, there’s a mirror image somewhere in America of a town or city it looks a lot like what we’re doing in the U.K.
And the universities themselves have realized they all need to modernize and compete even the mighty Oxford University is in that position, but we have great partnerships with about 10 or 12 of the U.K. Universities right now and they are all recognizing the world’s changing, online teaching is changing, the customer proposition for the students is changing. How much research and how much commercialization you can do in the U.K. is changing. So there’s — everywhere there’s change in disruption going on and we are sitting at the heart of the debate and discussion more of those things. Yes, we will deploy capital to help you go on this transitional journey with us. And I know if the renewables team are here that they’ve got a very long list of new opportunities that are coming our way that we want to invest our capital in, in part to produce returns for normal service, but also to back annuity liabilities if growing annuity liabilities.
I have a very quick answer on the mortality rates, because it basically it’s too early to tell is the quick answer. But we look at that we think it will be any probably slightly negative impacts going forward probably impact the annuity portfolio the older-age is more than, say, the retain book in the U.S. But it is too early, I mean, you will have some form of endemic COVID, but of course, you got vaccines and medical treatment improving, and we’ve been monitoring Australia where you have had a flu season again, but we haven’t had, there has been some hospitalization, but you haven’t had a huge number of test, but you can definitely say flu is back. So we will have both endemic COVID and a flu season. What will the impact be on that it’s quite subjective at the moment and that doesn’t change our long-term view.
So at the moment we remain prudent on that and we would assume we’ll see again releases coming through in the P&L year-on-year at the moment unless we make changes to the assumptions.
Thanks, Dom O’Mahony, BNP Paribas Exane. I’ve got two detailed questions and then one border. The first is just on the Fintech revaluations. I couldn’t see a value or an impact on the profit. If you could just share that, it will be very helpful and clarify would that have been in the operating surplus generation or would it have been in the variances within the capital movement? Secondly, in the operating surplus generation, what the management actions in the — I couldn’t see that in the release, but if there will be helpful to understand how much?
So then the border question is Solvency II reform. We’ve now had quite a lot of detailed insight into how the PRA’s thinking about this, some scenarios around fundamental spread, but the ABI has been quite clear that actually this isn’t the reforms is post don’t seem to achieve some of the outcomes of the government certainly seem to have thought they might get. Could you give us a sense of where you think the impact on your business would be given those reform as they were laid out both sort of the stock and the sort of the new business dynamics. I don’t really have a sense of whether this is a big thing or a small thing or positive or negative at the moment? Thank you.
Do you want to the first one Jeff and I’ll do the second one.
Yes, sure. The Fintech, number of you had a stab at it already. I’d say it was sort of in the tens of millions, people have had stabbed at 30 to 60, so that’s pretty closer than the range there. Obviously, we have to be sensitive, it looks, third-parties investing in these businesses, if it isn’t public et cetera, but equally, we don’t make these numbers up, there is either external funding that goes through a rigorous process of how they achieve in the business plan, salary finance is really moving forward. The U.S. is accelerating, I must note that [indiscernible] she’s on the board. You can ask her afterward if you like, they’re really doing well, dealing very well with the economic environment and then continuing to invest. So we look at are they achieving plan is the funding.
This is rather the model we said we would be invested in Fintech. Nigel mentioned the nine of them, they will come through. So yes, I mean, the IFRS is the base balance sheet for Solvency II, so that will be coming through within it. And so, yes, it would be in the surplus generation. Management actions, I mean very little, so there was a negative investment variance, that’s more about reinsurance type management actions, and so we haven’t executed same as ever, we haven’t put in place the what used to be called the XXX funding for the term life in the U.S., that’s not there. So that will be gone by the second-half. So, very little in the way of management actions, it continues the theme of clean numbers.
Yes. On Solvency II, to leave all of this PRA recommendations were implemented our ratio would go down a little bit. And so that’s not something that we think represents Brexit dividend for the U.K. I think, it would force us to look at more asset reinsurance rather longevity in reinsurance, given the amount of volume that’s out in the marketplace right now. It would encourage us to invest in non-U.K. assets as well. So, we think those are not good outcomes for the U.K., but putting in rules that make us less competitive as an industry doesn’t seem like the right thing to do, particularly when we think we haven’t — there is a great need for investment-led recovery and with the largest investor in the U.K. and set of rules which discourages from investing in the U.K. doesn’t seem the right policy outcome, it’s not like this room is full of rash and reckless people and bet on read in spread betting all day. This is one of the most conservative prudent people we have and that’s one of the reasons I can sleep well at night. There are so many people worrying about these sorts of things across our firm, but it’s not a worry for me.
And we’ve given you more data as much data as we can. We have to ask for everybody’s name, and we have to ask permission of S&P to get all this data to you guys. So you can do a better job analyzing what’s really going on in our credit portfolio. And we always want to do the right thing for the right reasons deliver the right outcomes that we not suddenly going to go change our spots and actually go around and do all sorts of reckless things, because we take our prudent principles very seriously. And Tim and I have worked very unsuccessfully together for six years on trying to get reform and Solvency II. He is reassuring me that at some point in the next n years that we will resolve it. But if you really want to draw any details on the lack of success that Tim said than I have had, then you can talk to Tim afterwards. That’s okay.
Oliver Steel, Deutsche Bank.
You got a quick grab there. [Multiple Speakers] you don’t have the light.
[Multiple Speakers] to ask any questions, but nice judgement. So, two questions, the first is the gross release from operations in LGRI and LGRR pushed up very, very strongly 23%, I think, on the first of that. I appreciate that some of that came from increased direct investments and increased yields on direct investments. But I think some of it was also caused by inflation. So I’m wondering is there any element of that, that is not sustainable and where we’ll find out next year that actually the numbers are coming back down again. So that’s question one.
Question two is, if you hit the top end of your targets on capital generation and cash. Is it axiomatic that you should then be at the top end of your targets on dividend growth?
Alan got the second question. Jeff can go —
Yes. I mean, that’s what I was referring to earlier so of your 23%, 60%-plus from the assets that we applied to the book last year, and those are fully repeatable, it is just the prudent assumptions, it just unwinds in the same way as a prudence in the default assumption. Some of that is helped by inflation, if it’s rental assumptions on build-to-rent, then those will factor through in the model. But those are fully repeatable, it’s just unwinds over time and it’s just a very prudent assumption.
People like Chris and the PRA make sure we’re very prudent on that and it completely makes sense. We don’t anticipate lots of future increases for 25 to 40 years if they would inflate way too much and wouldn’t give a fair view of that.
Part of the problem is that we are soo prudent that you end up with being so far behind. You’ve got to have —
Yes, you have to catch up, which is why you got the big increase, so, over half of that, 60% or so of the 40% half of that is then just from having a bigger book. So that’s fully repeatable and the other half is just noise to be bits of going through, there’s always in a massive portfolio there’s always stuff that come through. But, so we wouldn’t see it dramatically going backwards or anything.
Yes, we’re clearly ahead of plan and the plan had 5% dividends and we actually haven’t had to pay anything other than that right now, Oliver. So, and if we continued on the trajectory and the jaws open up, then there will be debates at the Board about what’s the right dividend policy and what should we do about share buybacks. So I’m hoping at the moment our colleagues — or my colleagues, our colleagues will go with even more investment ideas on a go-forward basis. So we can continue to kind of get sort of results that you guys all like and we like. And you still haven’t got [indiscernible] you are not a man of influence.
Good morning. Mandeep Jagpal, RBC Capital Markets. Just one question left for me on the credit portfolio again. I think, late this year, we’re going to see the unprecedented event of the Bank of England settling back tens of billions of pounds of corporate bonds back to the market, and at the same time, we’re expecting potentially record volumes of bulk annuities for the next 12 months. And given the high proportion of corporate bonds used by insurers to back these transactions, do you foresee any risk or opportunity as a result of these bonds being sold back and could it potentially have a positive impact on margins or pricing.
That’s very insightful question that one. I’m going to pass it to Jeff.
I mean, any liquidity in the market clearly helps. I mean there is a reason why we go to the U.S. dollar market for a lot of our corporates, because it’s just way more liquidity. So if there sterling bonds been sold back in — we, of course, don’t really invest heavily in financial services, which is a lot of the sterling bond market that you’ll be talking about. So it’s very hard to tell what it does to marginal spreads and these spreads move around anyway that gets reflected in price. And if you look back up, margins have been pretty consistent since Solvency II have come in. So we wouldn’t be looking at this and hoping that it fundamentally changes things. But, yeah, it’s a good question. Anything to help liquidity, definitely it’s been so that we may be at the point where we want spreads to come in a bit suspect as soon as.
Barrie Cornes at Panmure Gordon at last. Most people have asked my question to be honest, but I’ll take it from a different angle. Obviously you have great opportunities going forward to get that and high ROEs, but you also talk about optionality. What needs to occur for you to start seriously considering returning capital to shareholders. You’ve skirted around it, but what should we be thinking needs to what sort of hurdle rate, what we should be looking at before we think it might be on the agenda?
I don’t think we’ve ever never really had a serious discussion at the Board, I think about what’s the right parameters around it. It’s relatively new that were over 200% solvency ratio that we’ve been through yet another test as it were and everybody is happy with it. I think, we were — the only financial service company with a market cap over GBP10 billion, GBP12 billion who paid a dividend during COVID, so there’s lots of attractive features that we have and how resilient the model is. We don’t have a parameterizztion right now if X, Y, Z happens and obviously, we do, but we actually don’t.
Are there any more questions? Kerrigan, do you want to say a couple of things about Asia since you’re — he’s busy nothing quarantined at the moment.
Really good to see you all. It’s been three years since I’ve seen a lot of you. So, thanks, Nigel, for giving me the opportunity to say couple of words. I think when we look at Asia, the opportunities there and you think about our skill sets incredible skill sets capabilities that we have in pensions and investment on the strategic growth drivers that we talk about, I’m very enthused about the opportunities we have in Asia all the way from long-term savings, pensions, addressing climate change and alternative assets more broadly. So, all of those things we’re exploring actively investigating. I very much hope that we’ll have more to say on progress on those in the near future. Thank you.
There are a number of questions have come through from Andrew Crane and Greg and others on the back. But they tend to, I think, overall overlap with questions that we’ve asked answered here. If Andrew or Greg, I think that’s not the case or anybody else who submitted a question if they then just call us and we will answer the questions obviously and Ed or Nim, either Jeff or I will make ourselves available afterwards for it.
And I’d like to say thank you to everyone. And whilst it was a really good set of results, I think, we have to remember the ongoing struggle. There is a real cost of living crisis out there. People are living in extraordinary times, unable to pay their food bills, fuel bills, energy pricing, et cetera, et cetera. And I know that we as a corporates and MSA here having a job for us, want to make a difference both from our investment-led strategy, but actually looking after our people and our customers during these really difficult and challenging times, which is going to be here for a while until we get some good resolution on those things.
I don’t want to leave on a downbeat node. So I’ll like to say it again, we are very confident about 2022, 2023 and beyond, we’ve got a great team, tremendous collaboration huge investment appetite and the huge investment capabilities. We’re very motivated to continue to deliver great outcomes for our shareholders and our customers and indeed for you guys as well. So thank you.