Insurer Legal & General (LGEN) is one of the few companies on the stock market which benefits from rising interest rates. The current upward trend in rates has helped to strengthen the company’s capital position.

The company has also benefited from pension asset managers transferring liability risk from defined benefit pensions to Legal & General.

With an 8% dividend yield on offer, it’s no wonder this is one of the most popular stocks among retail investors.

THE LEGAL & GENERAL STORY

In June 1836 six lawyers founded Legal & General. During the 1940s the group entered the US market acquiring the pensions business of Metropolitan Life Insurance Company of New York.

Legal & General was listed on the London Stock Exchange during the 1970s and this coincided with the creation of Legal & General Investments. A decade later the company became a founder member of the newly established FTSE 100 index.

Today Legal & General’s pension business supports more than 629,000 people in the UK and US, helping them save for retirement

HOW IT MAKES MONEY

Life insurance companies like Legal & General make money from the profit they make on premium payments (the money paid to a life insurance company in exchange for life insurance coverage) by investing this income.

These premiums are invested primarily in fixed income products such as bonds, but also in stocks and real estate. In 2020, investment income represented $186 billion of revenue from the life insurance industry compared to $143 billion from life insurance premiums.

Legal and General’s asset management business charges fees to cover its costs which include administrative and trading fees and staff salaries.

Asset managers apply various fees to their products. The ongoing charge is based on a percentage of the total assets. Performance fees are another way income is generated. These are invariably a percentage that is charged on top of the ongoing management fee but only when the fund outperforms its target.

Funds may also apply initial and exit charges when investors deposit or withdraw money. These are usually a percentage of the amount put in or taken out.

Legal & General's five divisions

Legal & General Retirement Institutional is Britain’s longest-serving active pension risk transfer pricing provider. This division takes on pension scheme liabilities from corporate schemes in both the UK and the US. This ‘pensions de-risking’ gives companies greater certainty over their liabilities while providing guaranteed payments to individuals within their schemes.

Legal & General Investment Management is one of the world’s leading asset managers. The division manages £1.3 trillion in assets and is at the forefront of global index fund management and investment solutions for defined benefit and defined contribution pension schemes.

Legal & General Capital is an alternative asset platform specialising in residential property, specialist commercial real estate, clean energy, and alternative credit.

Legal & General Insurance is the market-leading provider of life insurance and income protection.

Legal & General Retail Retirement covers the savings, protection, mortgage and retirement needs of about 12 million retail policyholders and workplace members.

RATE HIKES TO BOOST PENSION RISK TRANSFER GROWTH

Rising interest rates reduce the funding gap between income and liabilities on annuities held in defined benefit pension schemes.

This reduction in the funding gap has encouraged pension asset managers to transfer defined benefit liability pension risk to specialists like Legal & General because it is more affordable for them to do so. The incentive for companies is they no longer bear the financial risks associated with maintaining a defined benefit scheme.

As ratings agency Fitch explains: ‘Companies transfer pension risks to insurers under buy-ins (where, in return for an upfront premium, the insurer makes payments to the scheme to cover future pension amounts) and buy-outs (where the insurer makes all pension payments directly to scheme members).’

Legal & General is perfectly placed to take advantage of this with its coherent strategy, and with subsidiaries Legal & General Investment Management and Legal & General Capital giving it a unique offering in this line of business.

It is worth noting the pension risk transfer market is also growing outside the UK and Legal & General is the only UK life insurer with a significant footprint in this space overseas.

In the US, there are approximately $3.4 trillion of defined benefit assets as estimated by the Investment Company Institute. However, according to data from the Secure Retirement Institute, since 2011, under 6% (approximately $192 million) has been passed on to insurers. An SRI survey saw just over 40% of plans with $1.3 trillion in assets indicate they are interested in a transfer.

Competition is strong. However, even assuming only 40% of the defined benefit market ever moves into the insurance space, there is still plenty of opportunity to grow.

For the UK life companies, the US is an additional opportunity because, as Legal & General has demonstrated, the skills needed to transact in the UK are readily transferable to the US. To date only Legal & General has seemingly been growing a presence there, having been active in the market for several years.

CAPITAL DIVISION POTENTIAL TO SURPRISE ON THE UPSIDE

The Legal & General Capital division has developed investment expertise in housing, financing for small and medium-sized companies, specialist commercial real estate and clean energy.

Continued growth in these ‘alternative’ areas is supported by long-term trends including increasing investment from defined benefit and defined contribution pensions.

The net asset value for these areas has more than tripled since 2016, and now constitutes over 40% of the division’s net asset value. This is up from less than 20% in 2016.

The alternative asset allocation is targeted to reach 60% by the end of 2025 to capitalise on the higher returns available.

The current 8% to 10% annual returns are expected to increase to 10% to 12% by 2025, and total Legal & General Capital operating profit to £600 million to £700 million.

A DEPENDABLE DIVIDEND

Legal & General expects to achieve £1.8 billion of capital generation in 2022, and aims to generate between £8 billion and £9 billion of cumulative cash between 2020 and 2024.

Cash and capital generation are expected to significantly exceed dividend growth, which is targeted to be in the region of 3% to 6% per year over this period.

The group is on track to generate a 20% return on equity and its 215% Solvency 2 ratio, a key measure of an insurer’s financial strength, provides a strong capital buffer.

According to estimates from broker Berenberg, Legal & General is forecast to grow earnings by 4.5% between 2022 and 2023, and by 5.5% between 2023 and 2024.

On their estimates, the stock is trading on a current 2022 price to earnings ratio of 6.6 times, falling to 6.3 times in 2023. The current 2022 dividend yield is 8%, rising to 8.4% in 2023.

‘We believe that Legal & General’s strengths are its solid franchises in each of its chosen markets, which are enhanced by the group’s coherent nature that allows each operating division to leverage off the strengths of the others,’ says Berenberg analyst Kathryn Fear. ‘As such, it is very well placed to benefit from the structural growth inherent in the UK life market.’

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