Legal & General Group Plc (LON:LGEN) has noted the Chancellor’s references in yesterday’s Autumn Statement to Solvency II reform. We believe the proposals represent a positive step forward. We also provide an update on PRT (Pension Risk Transfer) new business written year to date and further detail on LDI (Liability Driven Investing). Finally, the Group reiterates its ambition to deliver full year operating profit growth and capital generation in line with the guidance given at the interim results.
Solvency II: a strong position bolstered by positive proposed reforms
The Group welcomes the Chancellor’s references in yesterday’s Autumn Statement to Solvency II reform. We believe the proposals, as outlined in the corresponding policy document[1], represent positive progress and will allow us greater flexibility to make appropriate investments, including ones which: develop new infrastructure, contribute to the UK Government’s levelling-up agenda, and support positive climate outcomes. We welcome the primary proposals to: reduce the risk margin for long-term life insurance business by 65%, maintain the existing methodology and calibration of the fundamental spread, and broaden the matching adjustment eligibility criteria to include assets with highly predictable (as opposed to fixed) cashflows. We welcome the inclusion of these reforms as part of the Government’s reform programme to financial services regulation, through the Financial Services & Markets Bill process, which we anticipate will be during the first half of 2023.
The Group estimates its Solvency coverage ratio as at 11th November 2022 to be between 225-230%, principally reflecting the contribution from higher interest rates and strong ongoing operational surplus generation (FY21: 187%). We expect the reform to the risk margin to increase the Group’s solvency ratio by 3-4 percentage points. Currently, approximately half of the assets backing our annuity portfolio are bonds issued by companies that are not based in the UK. We would expect the percentage of UK-based assets backing our UK annuity portfolio to increase following the implementation of these reforms.
PRT: continuing to perform strongly in an attractive and growing global market
Our global PRT business has continued to perform strongly, securing new business wins in each of the UK, US and Canada in the last few weeks. Year-to-date, LGRI (Legal & General Retirement Institutional) has transacted or is in exclusive negotiations on £9.3bn of global PRT business (UK: £7.1bn and International: $2.6bn), which already exceeds the £7.2bn of global PRT secured in 2021.
There has been a step-up in the number of pension schemes approaching the insurance market and the global pipeline into 2023 is the busiest we have seen. Indeed, LCP anticipate £100-200bn of UK PRT demand over the next three years.[2]
We are on track to deliver another strong PRT result this year and a record year for our international PRT business. We have continued to source high quality assets at attractive yields throughout the second half of the year. These assets have been used both to increase the overall yield on our backbook as well as to secure the recent new business. PRT volumes have been secured at margins and capital strain that are in line with our long-term average.
Our UK annuity portfolio has continued to be highly resilient to market moves and has not experienced any difficulty in meeting collateral calls. Positioning remains defensive with approximately 10% of the portfolio held in cash and high-quality government bonds, with no material changes to the investment or liquidity management strategy anticipated in the near future. We expect the portfolio to be self-sustaining again in 2022.
LDI: a liquidity challenge in the UK prompted by a rapid increase in interest rates
Legal & General Investment Management (LGIM) has for many years supported pension funds with a variety of solutions, including LDI, and continues to do so.[3] We earn on average 2-4bps fee margin on LDI assets under management. We implement LDI business for clients in the UK, US and Europe. UK LDI is expected to be around c2% of our Group divisional operating profit in 2022 as it was in 2021.[4]
LDI enables pension funds to match movements in pension assets with liabilities, whilst freeing up capital to invest in growth assets. LDI has played a critical role in helping Defined Benefit (DB) pension funds to reduce their pension deficits. As the UK Pensions Regulator noted recently: “Over the past twenty years, as long-term interest rates fell to historically low levels and through market events seen through the COVID-19 pandemic, LDI has meant that the assets in DB schemes increased. During that period, LDI also played a significant role in helping to manage the affordability of DB schemes for employers.”[5]
LGIM has worked closely with its LDI clients to support them through the recent period of severe market volatility, which catalysed a sharp and extreme rise in interest rates. Interest rates had been increasing throughout 2022 in most major western markets. In the UK, between the beginning of the year and 16th September (just prior to the mini-Budget) 30-year gilt rates increased by 230 basis points. This had not caused significant disruption for UK LDI clients. However, in the week of and following the mini-Budget, 30-year gilt rates increased rapidly by a further 150 basis points before the Bank of England stepped in to provide support to the gilt market.[6] This sharp and extreme increase in gilt yields, which materially increased the collateral required by banks from LDI funds, was more than twice the level seen over any week in the last 25 years. This caused liquidity problems for some LDI clients who had assets available but could not access them in time to provide cash collateral.
The extreme volatility in the UK gilt market following the mini-Budget has highlighted the need for technical changes to ensure the smooth functioning of both LDI and the government’s financing of its debt. Clients who have implemented LDI have now significantly increased collateralisation levels. In addition, LDI providers are working closely with banks to further enhance and diversify sources of collateral.
Recent events have highlighted to DB pension funds the value of holding additional scheme assets with their LDI provider, enabling easier access to liquidity. We are well positioned to benefit from any potential consolidation of pension scheme assets, given our range of investment capabilities. LGIM acts as an agent between our LDI clients, their trustees, advisers, and market counterparties (banks) and therefore has no balance sheet exposure.
We have experienced positive flows into LDI over the course of 2022. However, DB flow-related revenue has decreased as higher fee products have been sold to meet collateral requests. We expect DB flow-related annual revenue and profits to reduce by around £10m in 2022 as a result. More generally, and as we signalled at the interim results, rising interest rates have reduced LGIM’s assets under management in fixed income and solutions strategies, with a consequent reduction in revenue.
As noted by market commentators, a positive consequence of rising interest rates is that many UK DB clients are now in a position where they have, or are very close to having, a surplus in their pension schemes.[7] Consequently, Legal & General is actively engaging with many of these schemes on PRT. We are seeing similar trends in international PRT markets.
Accelerating international growth
In addition to our success in International PRT, we recently announced our first two US real estate asset origination projects through our newly formed joint venture, Ancora L&G. We have a well-established model of investing in Science & Technology-focused real estate in the UK through our Bruntwood Scitech Joint Venture (JV). This partnership has an extensive portfolio, including 2m sq ft already built, and with another 5m sq ft in development, with universities including Manchester and Birmingham. We also have a £4bn JV with the University of Oxford. We are now replicating our successful UK SciTech model in the US.
Marking the first acquisition for the new partnership, Ancora L&G has acquired 387 Technology Circle NW, a 128,000 sq ft Class A life science/lab building in the Science Square Innovation District adjacent to Georgia Institute of Technology’s (GeorgiaTech) campus in Atlanta, Georgia.
Ancora L&G has also been selected as the preferred developer by the State of Rhode Island to develop a new Rhode Island Department of Health Public State Lab in downtown Providence. The 80,000 sq ft state-of-the-art laboratory will sit within a building totalling 210,000 sq ft. Brown University has signed a letter of intent to lease 20,000 sq ft of the remaining private laboratory space.
Expectations for FY22 operating profit and capital generation unchanged
Consistent with the guidance provided at HY22, we expect to deliver resilient FY22 operating profit growth in line with the 8% delivered in H1 (£1.16bn vs £1.08bn) and FY22 capital generation of £1.8bn.
[1] HM Treasury: Review of Solvency II: Consultation – Response
[2] Lane Clark & Peacock: “Insurance enters a new phase: a skyrocketing market”, October 2022.
[3] PMC (the entity which primarily manages the LDI business) is regulated by the PRA; LGIMH (the Holdco) is regulated by the FCA. 79% of LDI assets under management are segregated; 21% pooled (as at end-Oct 2022).
[4] Group divisional operating profit in 2021 £2.66bn, H1 2022 £1.36bn.
[5] Managing investment and liquidity risk in the current economic climate | The Pensions Regulator
[6] This Bank of England speech by Andrew Hauser provides a helpful account of recent events: Thirteen days in October
[7] The UK DB scheme buy-out funding ratio, which has averaged 63% for the last 15 years, has increased significantly in 2022. Source: Payment Protection Fund, Purple Book, 2021. Lane Clark & Peacock (LCP) estimates the average scheme is 88% funded against their buy-out measure at 30 Sep 2022 (“Insurance enters a new phase: a skyrocketing market”, October 2022); PWC estimates UK DB pension schemes have already moved into a surplus position on a buyout basis at a 113% funding ratio (PWC Buyout Index, October 2022).
