L&G capitalises on bank retrenchment

Legal & General wins Insurance Risk's 2014 award for insurer of the year for the firms advanced thinking on liquidity risk and bold push into direct lending

Awards 2014: Legal & General
Insurer of the year

The reshaping of the financial services industry has presented both opportunities and threats for Legal & General (L&G), and the firm has dealt astutely with both.

On one hand, the firm has faced challenges such as the announcement in March of changes to UK rules on compulsory annuitisation for pensions, which came as a bombshell to the industry and caused L&G's share price to fall 8% in a single day. On the other, the company has benefited from the retrenchment of banks, resulting from their own regulatory pressures, to become more active in direct lending.

The shock in March turned out to be less bad than initially feared. By the summer, L&G's share price had recovered to levels before the rule changes were announced. And, although sales of individual annuities have collapsed in the UK, L&G has fared much better than others. A principal reason is that only about a third of L&G's volumes are accounted for by individual annuities and the company has deftly switched much of its attention to an already strong bulk purchase annuity business.

So, for example, the company's most recent half-year results show a 386% increase in bulk annuity new business premium. Highlighting the scale of its capability and the potential of the business, in early 2014 the firm executed the biggest UK bulk purchase annuity deal , for ICI's pension fund.

Looking forward, L&G has identified five macro drivers as central to its strategy. Key among them is the retrenchment of banks, creating opportunities for others to step into areas of business that banks traditionally dominated. L&G has been one of the most ambitious insurers to do so, making £1 billion of direct investments during the first half of 2014 in areas such as social housing and lending to small and medium-sized businesses.

"The crisis affected both insurers and banks," says Sumit Mehta, investments manager at Legal & General Capital, part of L&G Group, in London. "The impact on banks is also a fundamental reason for insurers to look again at opportunities in the asset space."

A deal to co-invest with Pemberton Asset Management, announced in July, is intended to help L&G further establish the firm in direct lending. And in March the insurer bought a portfolio of low-cost housing from Places for People for £252 million - the largest direct investment by an institutional investor in the affordable housing sector. The company has also been vocal in its support for government initiatives to boost infrastructure investment.

The pace of progress has been swift. L&G direct investments grew from £600 million in 2011 to £4.6 billion in the first half of 2014. However, the company's direct investments are more than just an exercise in chasing yield. The firm sees direct investments as a means to diversify its asset portfolio and also a cost effective way to hedge rates and inflation risks.

Bank retrenchment is affecting the cost of hedging in the capital markets, while regulatory change such as the European Market Infrastructure Regulation (Emir) threatens additional costs for trading over-the-counter swaps. L&G includes in its pricing of direct investments a calculation for the liquidity benefit of holding a matched asset against its long-term liabilities, rather than a derivative that would incur collateral requirements.

Says Mehta: "We are one of the first firms to consider seriously the lifetime liquidity impacts from various derivatives such as inflation swaps and cross-currency swaps, and are building models to quantify [that impact] and incorporate it into our liabilities pricing. Our collaboration with our in-house asset manager LGIM is a significant source of competitive advantage to our liquidity risk management in light of a changing portfolio mix and regulatory change." Standard & Poor's rates the firm's liquidity monitoring and management as exceptional.

Organisational change at the firm has also helped engender a performance culture in the management of the balance sheet, with the creation of Legal & General Capital (LGC) to increase risk-adjusted returns on the group's £60 billion principal balance sheet. This includes shareholder funds, debt and liquidity, as well as the annuities and with-profits funds.

Paul Stanworth, managing director and head of LGC, based in London, says: "If we really wanted to achieve our focus of filling some of the spaces left by banks, and of lending directly to the economy in place of banks that have closed down funding lines - if we were to do that, we needed to change the way we run our investment function. We needed a more focused investment group."