Legal and General shares dragged by UK insurance arm

The key takeaway from Legal & General’s interim update is that operating profit is comfortably above market expectations, keeping it on track to easily meet full-year forecasts.

Bulked-up annuities

The decline of the shares on Wednesday morning however shows investors remain wary over the strategic direction of the group and continuing weakness in its British insurance arm. L&G has strongly focused on the bulk annuities market over the last year or so, partly in a bid to forestall the potential economic impact of Britain leaving the European Union on its UK insurance business. L&G’s new bulk annuity business more than doubled to £1.6bn in H1 and it said that it is in the early stages of further potential deals worth another £12bn. Investors are concerned that rapid expansion of bulk annuities— essentially taking on the risk of companies’ defined benefit, or final salary pension schemes—may increase L&G’s exposure to business of varying quality. In turn, regulatory capital ratios may weaken. If these deteriorate too much, regulators can force 1insurers to improve capital, with a consequent reduction on profitability. Legal & General is far away from such a scenario, though investors tend to differentiate between insurance companies on the quality of their capital ratios. Credit rating agency S&P downgraded its outlook rating on L&G in July, from ‘stable’ to ‘negative’, indicating a higher risk of a rating downgrade. It cited rapid growth in L&G’s investment and bulk annuities businesses.

UK insurance arm

As Legal & General has one of the highest exposures to UK revenues amongst close rivals, it has also been scrutinised for any potential Brexit-related economic impact. As widely expected, Legal & General Insurance delivered the group’s weakest divisional performance in H1 2016, driven by a 12.6% fall in UK operating profit, though that was somewhat offset by a modest rise in the U.S.  The UK business saw a general decline in margins with gross premiums up 6% to £1.3bn whilst new Retail Protection business was flat compared to H1 2016 at £16m, Group Protection annual premium equivalent fell to £224m from £233m and Group Protection new business was down by £8m to £28m. All this drove an operating profit fall of 13% to £90m in L&G’s UK insurance arm. The group points to a previously anticipated “adverse experience” of £26m from a relatively small number of income protection schemes. It expects “some adverse experience to continue emerging” albeit at a reduced level in the second half.

UK sensitivity

After a quick comeback from the Brexit vote shock, Legal & General shares ended 2016 more than 30% higher. They’ve risen by a more modest 9% so far this year. That seems to reflect investor wariness about increasing pressure on L&G’s UK-facing businesses from declining real incomes, inflation and hesitant business investment. The fact that L&G stock was trading 2% lower at the time of writing after it reported a 27% rise in operating profits and an improved solvency ratio also points to continued sensitivity of its stock to Britain’s economy. Should signs of weak economic growth begin to abate, the rapid expansion of L&G’s bulk annuities market share and overall operating strength could certainly have a positive impact on the stock. Without a return of resilience to UK growth however, L&G shares seem set to drift without much further gain into the end of the year.

• Technically speaking, the long uptrend in L&G's share price continues abated, after a consolidation of around 15 months that bottomed at the post-Brexit vote lows close to 160p 
• In fact the stock has now erased 50% of its March 2015 to end-June 2016 decline and is currently eyeing the critical 61.8% Fibonacci marker of that move at 289.90p
• Usual price behaviour at the 61.8% interval is likely--the stock could reverse to a degree at the price. That would not necessarily preclude the eventual continuation of LGEN's rising trend in due course
• Before that however, buyers would be wise to see whether the shares return above c.275p, that being effective resistance in August and December 2015 and again following the release of Legal & General's interim results for 2017
• Further support might be possible at the end-April 2016 high (248.79p) and slightly below at 38.2% of the March 2015 to end-June 2016 move (240.48p)
• Should these also fail, a more serious pull back could be in the offing--bringing in a potential A/B/C/D scenario. 'A' would be March 2015's all-time high (296p) or initial establishment of 275.45p resistance in August of that year. The pattern could call for a decline at least back to LGEN's post-Brexit vote lows