UK's Legal & General Group ( OTCPK:LGGNY) (OTCPK:LGGNF) (LGEN on LSE) yields close to ~8.5% at the time of writing. The company is committed to raising its dividend by 5% in both 2023 (the final part is payable in May 2024) and 2024. Is this trend sustainable in the longer term? And can we count on capital appreciation in addition to the generous dividend? These are the two main topics of this post.
Three months ago, I published ("previous post"). It is time to update since LGEN has recently reported its 2023 results.
Legal & General brief description
The company has experienced many transformations during its long history and currently consists of 4 divisions/segments:
- L&G Retirement Institutional (LGRI) is by far the biggest division doing exclusively Pension Risk Transfers (PR) aka group (or institutional) annuities. A company with a defined benefits (DB) plan can offload pension obligations by transferring related assets and liabilities to LGRI. LGEN is a PRT market leader in the UK with a ~25% market share. It also expands into the US, Canada, and the Netherlands - the countries with the biggest DB plans.
- Retail is the division writing individual annuities and life insurance policies that is also engaged in other financial services - primarily issuing rather unique mortgages to people in or close to retirement. It also controls several Fintechs. Retail is doing business mostly in the UK but also the US.
- L&G Investment Management (LGIM) is the UK's biggest asset manager with ~ £1.2T AUM with a third of them being international. Most assets are DB and defined contributions (DC) pension plans split between traditional (active and passive) stock and bond funds and ETFs. It also manages LGEN's insurance portfolios.
- L&G Capital (LGC) is involved in alternative investing such as various forms of real estate (it owns one of the bigger UK builders and several other real estate businesses), renewables, private credit, etc. The division grows quickly and helps the other three divisions by manufacturing alternative assets for internal customers (alts are on LGRI and Retail balance sheets) and third parties.
2023 results
We will start with the overall picture on the slide below:
LGEN has to report traditional metrics such as profit before tax and EPS but they are not the most important metrics for life insurers. Life insurers' accounting is incredibly complex and requires multiple assumptions. In each particular year, the experience deviates from these assumptions and causes big variances (the line item just below Operating Profit on the slide). Over many years, these variances are expected (though not guaranteed) to net out. Consequently, annual operating profit is a better gauge of short-term progress and it was in line with 2022.
The paragraph above relates only to IFRS accounting. For international insurers, a separate accounting regime called Solvency II (SII) is at least as important as IFRS. SII exists for regulatory purposes (similar to Statutory Accounting Principles (SAP) in the US) and measures the balance sheet strength. Regulators developed both SAP and Solvency II to make sure that insurers will remain solvent, i.e. have enough capital to pay claims even at the time of stress. However, while SAP is relatively rarely mentioned in investment posts, it is impossible to cover a European insurer without referring to SII.
In my previous post, I presented an oversimplified review of SII, and will not repeat it here.
SII operational surplus generation on the slide above is the first (but not the only) important metric measuring the ability to pay dividends. For dividend sustainability, SII operational surplus generation less new business strain (i.e. immediate costs of new insurance contracts such as commissions, additional reserves, etc.) should generally exceed the dividends paid out as illustrated below:
On the diagram of SII surplus changes on the right side, temporary and/or non-recurring items such as market movements, operating variances, and M&A are far less important than operating results such as operational surplus generation, new business strain, and dividends. Excluding these fluctuating items, LGEN increased its ability to pay dividends as £1.8B of new surplus less £0.4B of new business exceeds £1.2B of dividends paid.
LGEN's operating profit from divisions on our first slide can become more meaningful when represented on a per-division basis:
The two top lines represent LGEN's insurance capital-heavy business that deserves detailed consideration.
LGEN's insurance business
LGEN is an insurance company. Non-insurance segments (LGC and LGIM) exist mostly to support the insurance business. For example, LGC manufactures alt assets that are used to increase insurance investment income. LGIM directly manages LGEN's insurance portfolios. Since LGIM also manages DB plans of many UK third parties it provides valuable insights for the PRT business and helps LGRI to source PRT deals.
LGRI is much bigger than Retail which also houses some non-insurance businesses. Any review of LGEN should be focused on LGRI first. Not only does it provide ~43% of operating profit from divisions today but also stores predictable future profits. At the same time, this segment is at the center of debates about the future of LGEN. We will start by presenting LGRI's 2023 results.
The schedule above may look truly foreign to many US investors and I have to digress into IFRS accounting to explain.
At the inception of a new group annuity contract (as a reminder: group annuities aka PRT is the only LGRI's business!), LGRI receives cash to invest against a promise to provide specified retirement income to group members. It hopes to harvest a spread between the investment interest (and/or profit) and what it will pay out to retirees.
This hope is subject to two risks: a) a financial risk since the company may not be able to generate returns higher than are required to pay retirement income; b) an insurance risk that actual claims might exceed expectations due to, say, elevated longevity. Both risks require adequate compensation and expected future profits correspondingly consist of two parts.
New IFRS 17 (applicable for only 2022 and 2023) specifies rules to calculate both parts of the expected future profits. A so-called Contractual Service Margin (CSM) represents the difference between the present values of the contract's future investment inflows and future cash outflows to retirees when claims develop as expected. Risk Adjustment (RA) represents the present value of compensation for taking insurance risks.
At the PRT inception, both CSM and RA are accounting liabilities that are gradually released into profits throughout the contract duration. We can consider both of them as a store of future profits. Out of the two, CSM is much bigger and more predictable.
The table above appears quite transparent now. CSM release is the biggest item that grows very nicely. At the end of 2023, CSM was £8.9B out of which 6.6% was released into profit. The current CSM should be sufficient to provide the same profits approximately for the next 100/6.6~15 years.
RA release adds to the profit but is more volatile due to the nature of insurance risks. Both CSM and RA keep growing supported by profitable new business written. In 2023, more than £1B of new business future profits (CSM+RA) was added vs £693M in 2022.
When calculating CSM and RA, insurers are conservative in both discount and expected investment rates. In reality, they may do better than expected by, say, using alts or optimizing investments depending on the current macro environment. The difference between the conservative forecast and what is achieved is entered as the expected investment margin in the table. This entry also includes a return on surplus assets, i.e. those assets that are owned by LGRI without related insurance liabilities.
Experience variances consist of actuarial adjustments and unrealized mark-to-market items. Finally, non-attributable expenses represent overhead.
The current healthy state of the LGRI business manifests itself in the growth of both operating profits and annuity assets. However, this business appears controversial as it depends on the supply of DB pension plans that the companies will eventually offload to insurers. Most employers have either switched to DC retirement plans or are about to do so. DB plan assets can be considered as a melting ice cube and this risk is hanging over the company's stock price.
Due to several reasons, this risk does not seem to me as scary as some people depict it. First, the existing DB supply is quite high. Between the four main markets (the UK, the US, Canada, and the Netherlands with LGEN active in all of them), the supply of DB liabilities is estimated at £6T with only 10% transacted so far. In the UK alone (where LGRI is a leader with ~25% market share), the expected PRT demand is ~£350B over the next 5 years. This supply should be sufficient to support LGRI's business in the medium term even under conservative assumptions. LGEN forecasts healthy PRT business in 2024 and expects to write £8-10B per typical year further down the road (in 2023, it wrote almost £14B but only £10.5B was retained after reinsurance).
Once the supply of DB plans starts shrinking, the annual PRT volume is unlikely to drop drastically. Probably, it will be a gradual process with plenty of time to react. The drop in the PRT volume will release substantial capital that can be used in writing individual policies in the Retail segment and applied to buybacks or M&A. Our IFRS 17 review also shows that LGRI will keep releasing substantial CSM and RA for many years after it stops writing new group policies.
The risk of the limited DB plans supply should be also weighed against the unique benefit that group annuities provide. For life insurers, the biggest risk is policy surrenders. But group annuities are not surrenderable at all! As long as PRT assets dominate LGEN's book, the company is almost free from the biggest industry risk.
Valuations
In my previous post, I valued LGEN using the discount dividend model and SOTP. Both methods produce similar intrinsic values of 290-300p. per share vs the current stock price of 240-250p. The 2023 full-year results have not changed these estimates.
This means only that investors are not overpaying for LGEN today but does not guarantee quick stock appreciation. It is well-known that UK stocks are currently much cheaper than both US and European stocks. Besides LGEN, several other insurers are yielding high. For example, Phoenix Group (PHNX on LSE) boasts a 10%+ yield. Without going into details, Phoenix's dividend does not appear as secure as LGEN's.
Very recently, JPMorgan (JPM) published a list of European stocks with a high and sustainable dividend. LGEN was the only UK insurer on this list.
Travails of the UK stock market are probably caused by various macro reasons such as Brexit, political neglect, high inflation, etc. It may change for the better. Historically, insurers and pension plans owned about half of the UK stock market. This figure is only about 4% today. Perhaps, the situation can hardly become worse. If the UK stock market improves, LGEN should rise with the tide, and investors will harvest enviable total returns.
But what will happen otherwise? LGEN is committed to paying a dividend of 21.36p in 2024 which provides an almost 9% forward yield sustainable in the long run. Even without further growth, it is very close to a historical 10% of the US stock market return. In my opinion, this is high enough to consider buying the stock without relying on likely capital appreciation.
Conclusion
In my previous post, I mentioned that LGEN reminds me of Apollo's (APO) Athene with certain differences. But Apollo seems much more ambitious, particularly on the asset management side. LGEN's asset manager LGIM is very big (more than £1T in AUM) but involved primarily in low-margin business. In H2 2023, LGIM margins improved but there is a lot of space to cover. In 2024, LGIM may turn around due to declining interest rates and related growth in AUM. Cooperation at scale, in some form, with aggressive US alt managers may represent a very promising opportunity for LGIM and LGEN as a whole.
Ditto about the LGC division which invests in alternatives. Its growth, though visible, is slow by US standards. Its profit in 2023 was almost equal to 2022 which is explained by alts volatility. But importantly, third-party managed capital grew by only 9% vs 2022. I would like to see higher numbers for this metric. LGC may represent another opportunity within LGEN.
In 2024, LGEN appointed a new CEO with a banking background. So far, he has not announced any change in direction but it is too early for that. We may hear something new at LGEN's Capital Markets Events on 12 June.
I will finish with simple practical considerations for US investors:
- I suggest buying LGEN on LSE instead of US pink slips. The liquidity is much better without hidden expenses. You will pay 0.5% British stamp duty which will be added to the commission.
- Use Interactive Brokers (IB) if you have an account. Your international commissions will be lower.
- BP/USD exchange rate is an important consideration. Currently, it is 1.29 which is close to the average over the last five years. Today or in the future, you might be interested in hedging against BP depreciation. For that purpose, you can hold your LGEN position on margin. It is practical to use low IB margin rates, particularly for Pro accounts. The cost of hedging today is 2% (IB Pro BP margin rates are below 7% vs 5% yield of US T-bills). This cost may become lower in the future.
- The UK does not have withholding tax and you will receive your dividends intact. LGEN's dividends seem to be qualified for US tax purposes though I am not 100% confident: my requests for information have remained unanswered and my holding period is too short to receive a 1099 form with LGEN's dividends.
Editor's Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.
Alexander Steinberg
Ph. D. and MBA. I worked in executive/management positions for big US companies, then ran my own business for about 15 years, and upon exiting, turned to full-time investing. I primarily manage my own funds and consult a limited number of friends and clients.
Analyst’s Disclosure: I/we have a beneficial long position in the shares of LGEN either through stock ownership, options, or other derivatives. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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