Shares in focus: Can Resolution ride out the storm?

The insurer’s shares have taken a battering, but they’re currently too cheap, says Phil Oakley.

It’s been a rough couple of weeks for insurance company Resolution – soon to be renamed Friends Life. First, George Osborne announced a radical shake-up of pensions, which means that in future people could cash in their retirement savings in one go rather than buying an annuity.

Then there were rumours that the Financial Conduct Authority (FCA) was going to look into whether insurance companies selling products such as endowments, pensions and life insurance had treated their customers fairly on policies going back to the 1970s.

These two announcements have got analysts worrying about how much money a company like Resolution might be able to make in the future. Its share price fell by nearly a quarter in just over a week, which would seem to imply that profits will be a lot less than they are now.

That said, the stock market often overreacts to news. Resolution’s shares have recovered some of their lost ground after the FCA said that any investigation would be a lot narrower than had been previously feared.

What is clear is that Resolution, which makes meaningful amounts of money from pensions and annuities, does have a cloud hanging over it. What does this mean for the shares?

The outlook

In the case of annuities, the firm is managing a number of policies that are already in payment. However, any profits from these annuities will gradually go down as the policies come to the end of their lives. Whether the FCA probe has any impact remains to be seen.

Critics point to the fat profit margins that annuity providers are currently making, but that doesn’t automatically show that they have treated customers unfairly. Equally, the scale of the political embarrassment caused by the FCA’s poor handling of the announcement has put the regulator on the back foot for now.

Of more concern is what happens to the pensions that are still being built up. Friends Life is a big player in the provision of defined contribution (money purchase) pension schemes for private individuals and companies. Many of the policyholders would have bought an annuity on retirement; they might not do so in future.

Yet things might not turn out as bad as people think. Annuities have come in for a lot of criticism for paying low rates, but it is very hard for pensioners to get a higher guaranteed income for life from other investing strategies.

Some analysts are predicting that the annuity market in the UK could decline by up to two thirds, yet annuities still remain popular in markets such as Switzerland, where the compulsory purchase of them has also been axed.

There’s also the possibility that Friends Life’s pensions business gets a boost from people saving more to take advantage of the decent tax benefits. The introduction of auto enrolment for company pensions is also likely to be helpful.

But Resolution needs to keep winning new business to maintain and grow its profits. At the moment, the bulk of its profits (and, importantly, its cash flow) come from a closed book of insurance policies where the focus is on boosting returns by cutting the costs of running the policies.

But the expectations built into the firm’s share price seem to be quite low. The dividend yield is currently 7% and looks safe for now. It probably will not grow until the business can generate a cash surplus of £400m, compared to £331m in 2013, but might be worth tucking away.

The other thing to note is that at 300p a share, the company is valued at just under £4.3bn. This compares with an embedded value – a measure used to value insurance companies based on their net asset value and the present value of future cash flows from contracts already written – of £6bn.

Embedded value is not the easiest of things for the man in the street to understand, but the near-30% discount suggests that Resolution shares could be too cheap.

Verdict: a buy for the brave

Resolution (LSE: RSL)

Resolution share price chartShare price: 300p
Market cap: £4.27bn
Net assets (August 2013): £5.54bn
P/e (prospective): 11.0 times
Yield (prospective): 7.0%
Price to book value: 0.77 times
ROE: 6.9%
Dividend cover: 1.3 times

Resolution dividends per share chartWhat the analysts say

Buy: 7
Hold: 13
Sell: 2
Target price: 350p

Directors’ shareholdings

A Briggs (CEO): 400,695
T Tookey (CFO): 339,134
M Williamson (Chair): 18,185