Prudential Plc (NYSE:PUK) Q2 2016 Earnings Conference Call August 10, 2016 6:30 AM ET
Mike Wells - Group Chief Executive
Nic Nicandrou - Chief Financial Officer
Barry Stowe - Executive Director
Tony Wilkey - Executive Director
John Foley - Executive Director
Chad Myers - EVP and CFO, Jackson
Guy Strapp - CEO, Eastspring
Jon Hocking - Morgan Stanley
Andy Hughes - Macquarie
Lance Burbidge - Autonomous
Oliver Steel - Deutsche Bank
Blair Stewart - Bank of America
Nick Holmes - SocGen
Ladies and gentlemen, welcome to the Prudential Plc, 2016 Half Year Results Presentation. We’re now going live into the presentation room, where you’ll have silence or background noise until the call begins. [Operator Instructions]
Hi everybody, if you don’t mind we’ll go ahead and get started. Good morning - Mike Wells, Nic and everybody in the room. We’re going to follow the same format as the last presentation, where you’re going to have me go through some high level comments, Nic to a very detailed drill down on the financials. I’m going to come back up and give you some comments on outlook in general and then we’ll bring a variety of the senior management team up here to answer Q&A for you. And we have some other of our key associates in the audience as well. So we’ll get to any level of detail you’d like in the conversation.
So that said, let’s go ahead with delivery. I think we - I was commenting with our collogues before, and it was an interesting first half of the year. I mean question, lots of different challenges globally. I’m very pleased with our success in delivering both cash and growth. IFRS up 6, free surplus generation of 10, the dividend as you know is mechanical but up 5, solvency ratio of 175, which again we’ve said; I think it’s a good number. We never consider this subsequently a good fit for us, given about a quarter of our business or less is actually in the original target in solvency structure the local regulators use. They don’t capital regimes [ph], but again I think from a headline point of view, until this number matures in the industry, it’s important we have a strong number and we think that’s the strong number. So thought it was good clear results in a fairly tumultuous period.
What I want to focus on the opening today is what I think are going to be three of your key questions. One is the resilience and the relevance of our growth. Second being the positioning for us in markets, whether relatively increased interest rates or equities and this competitively in general. And then the third and final piece that comes a lot is Brexit and its impact on the group or a little impact on the group as the case maybe and then I’ll get to more general comments on the business. But I think what you saw on the first half on growth, the structural model we have, the strategic decision of going with the uninsured middle class, still seeing two thirds of our Asian clients not having owned the product before, that’s the catch for markets. But you don’t have a high correlation between those transactions and their view on interest rate equity. So that’s turning out to be a very, very good piece of our business.
In the U.S. and the UK, more and more is about our ability to gather assets effectively, perform well for the clients and price and distribute effectively again. So those are slightly more opportunistic, but given the general demographics in those markets as you saw from the first half results, even in a climate like this, consumers are looking to de-risk their more and more responsible per solutions, so again it’s giving us very predictable and robust growth. And then the last piece which I’ll get into a little more detail later is we’re continuing to invest for scale. One of the questions I think is fair is that our continuing size, each year we get bigger, bigger, bigger, can we continue to grow. And I’m not sure we spend enough time on all those things for doing to invest for that growth, but we think we’ve got plenty going to continue to grow at the rates we’ve seen historically.
So moving to markets, again the 16% of the business is now - the revenue is now coming from spread based products. We moved away from these 10 years ago, with the start, it’s taken time. This can be anything from deemphasizing fix in the U.S., moving away from bulks in the UK and moving away from evolved Asian markets. There is an implication of top-line that our competitor can hold up and get up and say, we have them beaten this part of this market. I would ask you to consider, when you see those sorts of comments, does Pru have the ability to manufacture that product and the answer is the usually yes and we probably already had it systems wise and capability wise and then second, do have the ability to distribute it and the answer again I think is generally resounding, yes.
So it’s a conscious decision for us to participate and in the case of interest sense that our products not participate in markets because we have better uses of the capital. If they can or can’t make money depends on the company and my role is not to tell you which have them can or can’t make money, but I can tell you for us we have higher uses of capital and I’ll show you some of those returns as we’ll see them and the lenses we’re using now. But I want to challenge the thesis of someone has is it, but we can’t capture that market share if it shows to, if we give the U.S. and the UK and toning the highest priced product in each market, we would be out of capital in about two hours of the distribution power we have and we clearly not going to do that. But I think that’s a key element in this discussion, as we chose the growth we want, we chose the market and we chose the value of those earnings over the volume.
The balance sheet itself extremely defensive, we have not stretched for yield, we are not into aggressive asset classes, we have been talking for the last four years if you will about going up in asset class, managing duration carefully, up in quality. Nic will get into detail on this, but just proportionately what we own is investment grade. You’ll see that in the shocks and spread. We don’t think this is what our core business proposition is and nor do we think it is the right time in cycle for taking tremendous investment risk. So we have an extremely conservative portfolio, and actively manage balance sheet, you saw that in the first half of the year. And I think, Nic would give some detail there, but very pleased with the quality product portfolio, quality of the hedging in the U.S., and quality of underlying assets on the balance sheet and the Group.
A proactive approach to value across the cycle, and it’s something we were talking before about some of this, that’s a pro-cyclical regime. We are arguably a countercyclical player to look at what we do best, certainly some of the results you see here. And that is a byproduct of our conservatives from different points in the cycle. So I think that’s a - these sorts of time, these stresses will show what we can do, we certainly can do more than this. Again I will come back to that in the second half, but I think it shows the nature of the business and what we want to do, but our intent at this size, we have a great growing stable earnings base, 90% of our IFRS earnings now come from existing clients, and if you think those terms our stability. So the incremental things we will do from here, we should be more countercyclical. You should expect that we should get paid more for that, we should get better pricing, we should be able to create more unique solutions for consumers from that.
And finally on Brexit, our UK participation has been selective and the key takeaway there. 10% of the M&G assets roughly are in Europe. Poland, if you remember is the rep office for our UK business. So we are not a European facing insurer by any means, and we are certainly not the asset management business. We will see what solutions come for those plans to be serviced effectively, and transact effectively with M&G, it’s little early in that, but obviously M&G has contingency plans in place and continues to work those. We want to maintain a seamless relationship with those consumers, and it’s clear as Brexit evolves at least you might - you’ll see clients as you did, when we saw one up in our bond fund sales, the one own pound denominated products that London successfully continues as a financial center, as a rule of law currency all the various things that have succeeded over a very long period of time.
So we will make sure that variable declines as they need in the jurisdictions they want to buy them, in the forms they want to buy them, so that’s an evolving process, so as the rule evolve and we are fully capable of managing that, so the Brexit in general for us, minimal strategic and certainly minimal financial impact to the Group.
Go to Asia. So where the confidence comes from in the growth, it’s the quality of the growth, it’s bring it back to the recurring premium versus single premium, the quality of what’s sold, the health and protection focus, and then absolutely critically the pan regional model. And I understand that there have been a few questions about this. So let me go through a couple of these. So the long-term focus and the blue shadow box in the your far right end of the screen shows as it should that the first half of the year, regardless of what was going on, it was a lot like history of this business. There is no material change in the shape of the business, continued focus on health and protection, continued long-term focus on relationships with the clients as it should be, okay. Why does the pan regional model matter?
Well seven of the 11 markets were up double-digits in terms of earnings. We can’t predict which markets in a portfolio that big, will have a political turmoil, will have a rate movement, will have other options, will have a new rational competitor; all those things are the nature of including our Western markets, but certainly our Asian markets. So the footprint we have given the stability to be disciplined. It allows us to back off on our product segment, market and the country if we needed to, and to accelerate if we see the opportunity there being unique. So I think you see that in this half’s results, so it was an interesting period of time, lot’s going on, very broad Asian results, and getting the clients we want, with the products we want, with the earnings we want, and value over volume because we have choices. We are not defined by our limited licenses, limited distribution options, limited product or system’s capability and that’s where I think you will see a continued succeed across the breadth of economic environments in Asia.
We have tremendous optionality there, and it’s again it’s an attributed scale. Should translate the earnings for you? It does. Yeah in the earnings base, strongly driven by existing clients, not that new business profits in the sales, the clients are important, we want to keep adding cohorts of profitable clients to the business year after year after year, as we do with the U.S. business, as we do in the UK business, as we do in M&G. That is the long term stability of the earnings of the Group comes from that. But again not a particularly unique shape in the first half of the year, the historic shape of the business, and good year-over-year numbers in an interesting period of time. So very, very pleased with the execution of the team, and extension of what they have been doing for a long time, reasonable expectation that should turn into both growth and cash.
So cash and free surplus generation if you will both, excuse me, our earnings and free surplus generation both up 15%, a good number. Again as I mentioned, seven in 11 countries in double-digit earnings including Indonesia, and markets where we are seeing rational competition were accelerating other parts in the business, getting good earnings growth out of it and good profitability out of it. Again you see the breadth of the portfolio producing very, very good outcomes for our investors. And time in the region, which you also see is, the footprint allows us to recruit very talented people, we not only brought a new CEO in Indonesia, an incredible add to the staff, people in the business units and move from one country to another as both their interest and ambitions and skills evolve, so it allows us to recruit talent, it allows regulators to look across the region and say, how do they behave for consumers, are they good partner for the social solutions that we bring to the market, there’s tremendous leverage in our footprint in the region and it’s not simply earnings base.
The learning’s we have for one market, we apply to another. I thought the most interesting one of these is personally it’s not material in your models yet, will be someday. They are spending some time with the Cambodia team, you see our learning’s from multiple markets, in that effectively start-up, I think it’s important from our size considerably do start-ups, you see us doing in Africa, Laos, Cambodia, other markets, but what you also see is a very familiar business plan coming from other phases, and very, very good execution, very early on in the life of those business plans. The other place you see it is in the bank relationships, as I mentioned some of you before, the bank relationships are not linear, there is a learning curve, there is a relationship development phase, there is a product development phase, and we are pretty good at accelerating that just given the shear experience we have and Standard Chartered is still being the standout bank relationship with I think any insurance in that region and others we have are maturing nicely.
So what does this produce? Pretty consistent delivery, 2017 targets, the objectives we put out, double earnings still look in line and on target, and then of course if you back into that that implies a tenfold increase in the 11 years. So again these are strong growth rates. Other subjective comrades on the ground, I know a number of you’ve been there, the business is pure materially different than they did a year ago, three years ago, five years ago, 10 years ago, I mean we are maturing into - these are companies, these are portfolios of standalone companies, one with similar sense of purpose, similar sense of value, similar risk management, they are maturing very, very evenly and very effectively, and it’s quite impressive to spend time with these teams.
Okay, jumping to the west. Let’s go the U.S., the main event in the U.S., we have done with the last year’s deal well. Couple of deals out, we have April next year implementation, we said you at the time this is going to be a sales event, not an earnings event. As you see there, earnings were up 9%, it’s actually pretty much captured all of the net flows in the U.S. VA industry in the first half of the year, that’s mostly going to the perspective to product reflects your product as you can imagine lead access without a guarantee in this sort of climate is not as popular with client as a produce with a guarantee, so I think that’s - and you also still seeing some of the broker dealers looking at it that should be on their qualified platforms. Jackson has put a number of products and processes in place with distributors going into DoL fee based products base as it turns out the final interpretation that is little broader and little better for the broker dealers, SO most of them are looking that is a - they can in fact charge commissions or will have a tutorial process for this, a traditional product approach and a fee based product approach.
There is a part of the industry that believes that the rules would get better, that is upside we are fine with the rules as they are, if they get better, we are more fine with that and certainly could be A little clear but that said we can function with them as written and the value of the consumer will see if that plays out over time, but we think we can build good products for consumers, both in the fee based structure and we know we have a good product for consumers in the traditional structure VA products. We also in the U.S. are continuing to look opportunistically on bolt-on’s [ph] and hopefully at this point in the stake holders, there is something we can do, but again nothing to report at this time. I mentioned net flows are excellent hedges for holding up well. At this point as the rules and DoL stabilize, Jackson should see more opportunity.
The UK is probably one of the most interesting stories I think for us. This defines our group’s versatility at this point. So sales now in the life company post RDR, post pension reform, post Solvency II, post annuity review are now higher than they have ever been. Not surprising the width to offer its [ph] product and it is various forms. The distribution team has done a great job of getting this in front of consumers who are now responsible for funding their own pension. Living here, coming into to my second year, lots and lots of conversations with people all around the city about what they are doing with their money, where are they putting in their eyes in different things [ph] and I am shocked at the number of them that are cash candidly, hope they look more at investments, but lot of the bank sold substance to be cash centric and we are getting a lot of it. And that is a great thing, so this product provides asset diversification, good smoothing for the client, it is a good long term hold, really appropriate product for a long term retirement savings and the more volatility we receive, the more demand we receive for the product. So the team has shifted nicely to a capital life model as requested and is market driven. John continues out his team, will show you more of that in November given few folks aren’t officially on board with us yet, but I think you would be pleased at the level of talent is brought to bear on that business and again this is a good example of our ability to pivot.
M&G controlling cost, the earnings again at the guidance level that gave you at the full year, clearly there is some challenges and outflows for UK fund managers in general but M&G continues to work on not only the current climate we are in, the second half was better than first half, but also what they need to see in the next 10 years. And again I am going to ask your indulgence or Anne and their team that have been working on since January, but we’re going to let Anne and the team, so she’s just joined. Have a good portion of the November industrial meeting and show you where we are going at that point in time. So obviously answer direct questions for you and where they are at this point in time. But again very pleased with what they are doing, good combination, the two entities give us great capability in market.
We have talked about this before, I think it is been a bit more important in this first half, the diversification by the type of earnings, diversification by currency, diversification by types of exposures we have and of course the earnings and profits following that model. So we like the foot print, we continue to de-emphasis spread. This gives us resilience, it gives us good cushion against some of the rate movement and we think, it positions the group extremely well for this climate. So I’m going to stop there, last comment I guess will turn to Nic. We think having watched what has been going on the industry, these are good result on a relative business and absolute basis. I think you guys know my bias is to comparing to ourselves and I think we are consistent with what we have been able to do in the past as far as client acquisition, profitability, flexibility of the firm, its ability to adjust the challenges.
So I’ll come back after Nic and I will give you some comments on outlook, but I could ask Nic to come up please.
Thank you, Mike. Good morning, everyone. So in my presentation, I will take you through the half-year results, highlighting the key drivers of our performance in the period and then I will cover the Group’s capital position.
So, starting with the financial headlines, Prudential has delivered another strong performance across our main growth and cash measures, despite the effect of lower rates and the expected reductions from U.S. spread, PUK annuities and M&G retail which I talked to you back in March. Our progress in the face of these headwinds was achieved by making the most out of our stock source advantages in the countries that we operate by executing with discipline and focus.
On a constant currency basis IFRS operating profit increased by 6% to 2059 million. New business profit was up 8% at 1260 million and free surplus generation was 10% higher at 1609 million. Currency FX was positive adding between three and five points to our underlying performance.
This performance is entirely driven by the outcome of commercial transactions and did not benefit from any changes to our reserve in Prudent. Furthermore no aggressive actions were taken in any of our businesses to stimulate short term sales as we continue to prioritize long term value creation of our volume. These results demonstrate the benefit of our earning diversity by geography, currency, and source and the power of our Asian platform which continues to compound strongly supported by largely uncorrelated structured drivers.
Our ability to deliver growing levels of profit and cash also provide meaningful protection at times of extreme market volatility. Therefore even though interest rates fell to unprecedented levels, our solvency to capital at 30, June was trim back by only 0.6 billion at 9.1 billion.
In contract to our embedded value, which is a fairer measure of economic value as it has no artificial restrictions and it is not subject to excessive regulatory Prudence was up 9% in the first half to 1356 pence per share.
The first half performance takes us another step closer to the 2017 objective. Our Asia IFRS operating profit and free surplus generation continue to compound nicely towards the 2017 target levels, demonstrating the ability of the PCI team to successfully execute again, the secular opportunity in the region.
The market cyclicality that we have experienced so far in 2016 confirms why targets or other businesses are not tangible [ph]. Here the focus is on remaining disciplined and on balancing the trades between rate, value and capital. Cash generation is the best way of measuring how effectively we are doing this, which is why we have a cumulative free surplus generation target. As you can see we are also on track to deliver this goal.
The actions we have taken over the years to improve the quality of our earnings and to manage risk provide us with meaningful protection as Mike has already said against low rates Therefore before turning to the results I would like to take a few minutes to remind you what underpins our resilience to the current market environment.
So starting with earnings in the slide, we have spoken many times of our strategic focus on insurance and fee income as these sources are less sensitive to the interest rate cycle. In today’s environment, this is a significant strength.
Compared to 2011, which was the last time that we saw a material drop in rates, we have more than doubled the size of insurance and fee income and increased its share of the total to 76%. We can also draw more comfort now from the greater diversity in our earnings with the amount of profit coming from our overseas markets being 2.3 times higher than in 2011, representing nearly 70% of the total.
At the same time, our business growth has not detracted from our careful management of costs, which have grown at a slower rate than revenues. In most of our operations our flexible and scalable platforms will continue to generate unique efficiencies, which will in turn help absorb the impact of natural business technicality.
Moving to capital, our ability to generate sizable Solvency II operational capital and a healthy start to the year position have enabled us to absorb the effective markets on this metric, and we reported surplus 9.1 billion at 30 June.
Our financial resources remained strong, and provide ample buffers to absorb further downward move from here. By taking actions, we have also significantly reduced the sensitivity of our capital ratio. The sensitivity shown here reflects protection currently in place and incorporate the effective action, which have already been taken well within our control, more can be done if required.
As I have said before, given our predominant non-EU business footprint, Solvency II is an imperfect fit for Prudential, it therefore underplays the strength of the Group as it excludes sources of real economic value such as the shareholder share of the state surplus of 0.4 billion, 1.4 billion.
With further surplus in [indiscernible] with UK profit funds of 3.1 billion, the unrealized gains on Jackson’s interest rate swaps of 0.8 billion, the deduction of 1.6 billion of Asian surplus due to regulatory improvement, and 2 billion of economic diversification benefits between Jackson and the rest of the Group. If we were to incorporate all these items then our solvency would materially improve to a level that more closely reflect the true capital strength of the Group.
We continue to manage our balance sheet cautiously. At June 30, the proportion of investment grade holdings in both our U.S. and UK credit portfolios was up 98%. These portfolios are well diversified and subject to strict concentration limit. We continue to prioritize quality of the yield, an approach that has been in place for many years and is consistent with our overall philosophy on risk. In fact, the fact that both portfolios are higher quality, more diversified, and with smaller individual exposures means that we are in a better position now than at any point in our recent history to weather credit event.
The balance sheet exposure to product risk is also well managed. Invariable annuities would protect the downside risk with extensive hedges, which continue to perform well. We have updated the chart that show the un-hedged VA cash flows at June 30, and have included them in the Appendix slides. These charts compare the net present value of future guaranteed fees, with a value of future policyholder benefits, which would un-stress under its down rate, and a down equity scenario.
The output which is summarized on the right, shows that the base position is unaffected by the fall in rates seen so far this year. The down rates scenario from here does not alter this picture, the down equity scenario produces our overall negative values, but again this is not markedly different with the position at the start of the year. In this scenario of course, gains on existing hedges will turn the number into a positive. These cash flow projections confirm the ongoing health of Jackson’s VA backlog, and the [indiscernible] has remained both unchanged in this yearend at around 9%.
So in summary, our confidence and our ability to successfully navigate the current market environment reflects the fact that our earnings are high quality and resilient in the cycles. Our capital and economic financial results have remained healthy and our focused risk management continues to be robust.
So returning to our half year results, IFRS operating profit was up 6% to 2059 million, equivalent to an annualized return on equity of 24%. I flagged in March that our 2016 earnings would be adversely impacted in the UK, reflecting our reduced appetite for annuities in the U.S. from the impact of lower yields on spread margins, and in M&G as a result of net outflows. These affects outcomes was as expected reducing IFRS profit by a combined 112 million and will continue to be a feature in the second half.
Our profit improvement in the period was predominantly led by Asia, where earnings were 15% higher, reflecting increased income from insurance business, and by Jackson’s fee business which benefitted from stable margins, and growth in the large base of variable annuity assets.
The half year results also benefitted from an extra contribution to profit of 74 million, reflecting the effect of actions taken to improve the UK solvency, which I’ll come back shortly.
While there are a number of moving parts, this first half highlights that our business has the scale, positioning and flexibility to successfully manage through the current cyclical challenge, and I want to turn to each business in turn.
Asia has delivered another excellent set of results, improving all of its growth and cash measures by 15% or more. Our focus on quality delivered a 21% increase in regular premium new business, representing 94% of APE. The result was underpinned by another strong performance from agency, where sales were up 22% driven by improved productivity.
The strong growth in Hong Kong, Vietnam, Malaysia and China continues to afford us the flexibility to make strategic decisions to a country level. We strike the right balance between protecting our overall long term economics and short term sales headline.
New business profit increased at approximate rate of 20%, boosted by favorable changes in countries and product. The NBP improvement is supported by a 26% increase with the contribution from health and protection business which accounts for two-thirds of Asia’s NBP.
IFRS operating profit and free surplus generation were both up 15%, driven by ongoing growth in the scale of the business and the strong bias towards insurance. At a country level, as Mike had said, we have seen double-digit earnings growth in seven markets led by Hong Kong, Indonesia and Malaysia. Eastspring increased assets managed.
However, a shift in asset mix meant that revenues were broadly unchanged. Cost controlled improved margin by two points to deliver operating profit of 61 million, just ahead of last year. Finally, underlying cash remittances were high at 258 million, tracking the growth of the book of business.
Now, as Mike said, all of the quality drivers which underpin Asia’s momentum are impact, which bodes well for our future earnings prospect in the region. Our strategic preference to new regular premium business with high protection content provides an in-force premium base that is both large and growing.
Together with our focus on customer retention, this produces a higher liability base, up 22% compared to a year ago, which includes a sizable insurance risk component. This forms a stable and highly valuable source of predictable income both in good times and bad, underpinning the positive performance outlook for our business in the region.
Jackson’s results continue to reflect specifically the disciplined value based approach to managing the business. Sales in the first half were impacted by volatile markets, and by the uncertainty which surrounded the Department of Labor really. As a result, total VA sales were down 27%, broadly in line with observed market trend.
Elite Access sales were similarly impacted but were also affected by lower demands from qualified accounts. This product remains the leading investment on the VA in the market, and drives the 28% non-living benefit mix of our sales. New business profit shelved due to lower sales and the declining rates. Nevertheless the overall margins remain very attractive.
Despite these cyclical headwinds, Jackson maintained the IFRS operating profit at 2015 levels. The contribution from the big fee business proved resilient, of course upset by the anticipated effect of lower yield on that business.
Spread margins fell by 27.217 basis points, and if rates remain at current levels, we expect this margin to now drift towards the 150 basis points level by 2020. Jackson remitted another sizable dividend to the Group by 339 million. This was lower than 2015 when capital formation was stronger reflecting the more benign market conditions at the time.
Fee income on variable annuity business remains the dominant component of Jackson’s earnings. This is driven by separate account asset values, which has continued to benefit from net inflows despite the reduction in gross sales in the period. Combined with a small gain for market movements the separate account balance increased to 138.9 billion having traded below the start of the year value for most of the first quarter, as a result fee income was flat compared to last year.
We have extended our analysis of Jackson's sources of earnings to now share the profit contribution for each product. This shows that after deducting direct and allocated costs, profit from fee business increased by 9% benefiting from lower strain. The increase also confirms what we have previously said that DoL is a gross sales not an earnings event.
At a time when half of yields were declining and consumers are becoming more self-reliant, our UK proposition in retail rich managed products is becoming more popular. Retail sales were 51% higher with PruFunds attracting the lion's share of the sales.
As a result of the onerous solvency to capital requirements, we have stopped writing Bulks annuity business. Indeed in the current rate environment the highest solvency to trade has reduced the attractiveness of retailer annuities and we have taken steps starting in July to scale down our presence in this market.
Our core to profit in-force annuity business has delivered stable profits of 306 million in line with 2015. During the first half of the year, we took actions to support the solvency position of the UK These actions delivered 66 million profit from longevity reinsurance transactions and 74 million profit reflecting the effect of a repositioning the asset portfolio.
Our longevity reinsurance program now covers 10.7 billion of annuity liabilities, which is about the third of the book. While the value tradeoff is appropriate in our in minds, these actions will reduce future annual earnings by between 10 million and 15 million on top of the previous guidance of 25 million. Finally in line with our normal practice, remittances from the UK in the first half reflected the 2015 with profit transfer.
The effect of a market wide retrenchment from equities in the first half combined with continued withdrawals from optimal income lead to a 6.1 billion return on their outflows from M&G in the first half. I indicated in March that retail business accounted for two-thirds of M&G’s total revenue. So the 14% decline in retail AUM was the main driver of the 10% drop in fee income to 440 million. Actions on cost mitigated the overall impact on margin, to deliver operating profit of 2 million to 5 million, down 10%.
Absent of meaningful recovery in net flows the first half revenue trends will persist for the rest of the year, which together with the usual seasonality on costs will see the cost income ratio move to around 60% for the full year.
Moving on to cash generation free surplus after investment in the new business increased by 10% to 1609 million, the life in-force result grew by 14% and was underpinned by the sizable expected returns of 1437 million augmented by positive experience of 374 million. The former was dampened by the effective rate while the latter benefited from UK management actions that I covered earlier.
As you can see in the top right, Asia's in-force momentum provides important support to this metric and act as a buffer for the cyclical impacts elsewhere. New business strain is higher at 502 million; in Asia strain has grown at a slower rate themselves due to changes in business mix. The U.S. increase is also mix related driven by higher gig [ph] and lower elite access sales.
It also reflects the higher proportion of new VA premiums directed to the fixed account, which was up four points to 22%. In both Asia and the U.S. the investment in new growth opportunities remains highly capital efficient with returns well in excess of 20% and short payback period.
The new business strain in the UK for 2016 is on the more onerous solvency II basis. The increase here is driven by retail annuities, which despite the modest sales levels, consumed 69 million of free surplus, equivalent to 24% of premium.
Mindful of the many moving parts this time around this next slide provides you with some additional detail on the movement of the three surplus generation between two periods. And I would leave you to stay at your ledger, but I will draw out a few points.
As you move from left to right, you can see the negative want to 8 million interest rate effect on this metric, which mostly relates to Jackson, about 70 million relates to Jackson. You can also see the positive 138 million offset provided by the UKs actions and the additional 147 million from our ongoing focus to grow and manage the business for [indiscernible], which represent the underlying growth driver of free surplus.
You can also see the effect of Solvency II on UK free surplus generation were in line with our guidance the expected return from in-force after amortizing the transitional were 22 million higher in the top row and where I shift in focus to capital life product contained the more onerous strain effect of this regime to only 31 million. The negative interest rate effect does not detract from our ability to continue to grow this measure and as I said at the start we remain on track to exceed the 10 billion cumulative free surplus target for 2017.
The next slide shows how the annual free surplus generation has impacted stock on the left and cash on the right. I would remind you that from this year the UK insurance contribution to free surplus stock and flow is based on Solvency II. For the rest of the group free surplus continues to be based on local measures as these remain the biting constraint.
Stock has increased overall driven by the resilient operating performance. Market effects were more adverse this time reflecting for the most part higher negatives in the UK given the more market sensitive nature of the new regime. After remittances, free surplus stock finished higher as I mentioned central cash was also up at 2.5 billion.
Completing the overall earnings picture for the period, items outside the operating results have made an overall net positive contribution on EEV and have largely effect on IFRS. In the IFRS table the negative investment variance of 0.9 billion was primarily driven by the asset and liability accounting asymmetry in the U.S. This is further accentuated this year as Jackson opted to achieve economic protection against frozen rates by increasing allocations to long data treasuries instead of buying more traditional instruments.
Unrealized gains on these treasuries are included within the 1.1 billion positive shown on the next line alongside the gains on other fixed income securities. Otherwise there was no change to Jackson's hedging approach, which remains economically effective.
The net negative investment variance under EEV, which coincidentally is also 0.9 billion mostly reflects the effect of the lower assumed future investment returns on the VA amenities as under our methodology these future returns are activities left.
Given the group’s sizable non-sterling assets, currency movements contributed positively in the first half under both reporting basis. The effect of adopting Solvency II trimmed 473 million of our UK life EEV reflecting the extra cost of holding higher capital.
The fact that both IFRS and EEV shareholders fund increased in the period by 13% and 9% respectively is testament to the consistency of our operational delivery and the natural offsets, which exists across our business.
As summarized on the slide, the movement in the Solvency II surplus during the first half of 2016, our operating performance remains an important and reliable source of capital contributing 1.2 billion to the surplus in the first half. Market effects were negative 2.4 billion, around a third of the total relates to Asia, reflecting the higher Solvency II risk margin at the lower rates.
Now unlike the UK and European domicile businesses, transitional relief is not available to us to cushion this effect. Just over a third of the market effect relates to Jackson, but the instruments we use to hedge against frozen rates are broken at book value, which means that the sizable gains of 11.8 billion made this year have been excluded.
And finally, about a quarter arises in the UK where lower rates increased the annuity FCR, and reduced the contribution from a profit transfer. At 0.9 billion, currency also provided a meaningful false positive on the solvency measure.
As I have already mentioned, we took action in the course of the year to mitigate the adverse effects of lower rates and to improve the sensitivity of our surplus to sell the market shocks. These included longevity and other liability actions, asset switches, asset duration lengthening and additional hedging within businesses and our group.
So in summary, we remain comfortable with the overall capital level. We have the operational and financial growth to mitigate legacy’s market effects, and we are protected from six months ago against the real shocks from here. I have provided on this next slide a capital update for our main businesses. The contribution of our Asia operations to the Group’s Solvency II surplus has been maintained at 5.1 billion, as operating capital generation and currency positive have offset the higher risk margin effect. However, it is the locally driven fee surplus of 1.8 billion that remains a relevant measure for cash and capital which is extremely stable.
The U.S. local stock basis capital has been impacted by the falling rates. The affirmative tax is currently in place, means that the offsetting gains of the hedge instruments that we use to protect against holding rates are not voting to account. Unwinding the committed taxes which is up for renewal next month would recapture $1 billion of post-tax, our hedge gains and restore excessive capital to the responsible [ph] levels. In the UK, shareholder solvency to surplus of 2.9 billion has benefitted from the actions that we have taken, with a ratio 138% solvency remains within our target range. The UK profit solvency surplus has improved to 3.5 billion equivalent to a ratio of 176%.
I’ll conclude my presentation by reiterating two key points. The first is our belief that the most important source of capital is the consistent delivery of a growing level of high quality earnings. This is precisely what we have achieved so far this year, delivering higher IFRS operating profits, and improving operating free surplus and solvency to capital generation. The second point is the resilience that comes from having a large economically effective and well diversified balance sheet, which is both secure and growing in scale. While we are not immune to the economic and market cycles, we’re in a strong position to take profitably through any environment.
And with this I will hand it back to Mike.
Thanks Nic, I appreciate that. So just a little bit on outlook, we are obviously - we are pretty good about where the Group is, and its ability to capitalize on the market and what’s going on in the sort of this next stage of the cycle. Couple of fundamental reasons, one being strategic, the behavior of the growing age in middle class, the behavior of someone referred to as the graying middle class and the western markets is one getting greyer, I took that slightly personally, but there is a consistency of their behavior which is this de-risking of their financial assets of various concerns, and directly towards products and services that we provide. So the footprint we have, the capabilities we have, the services we have seem to be fitting the major demographic trends and mobile, sure we are getting more investors have started [ph] it’s harder to live on or asset returns on lower levels and more concerning, the more valuable of our solutions consistently seem to be for clients across the globe.
There has been a lot of discussion in the industry about cutting, and I want to address this very clearly. This has two issues for us, one we manage expenses very tightly all the time. Can we get better? Always. Is that a challenge to the team up here? Always. But we are actually investing, investing pretty heavily in this company, and we are investing in sort of three levels. Things we do that will improve the relationship we have with existing clients, the service, the technology, their access to lot of products we have, just anything that grows and develops that relationships gets to more likely to buy something to stay with us longer. Again to protect the long term operating results. The second area is on scalability, we are investing things that we see to improve our marginal cost, improve our capabilities, it allows us to do things that competitors can’t do. That could be on risk that could be on our asset management platforms, in the Life businesses. It’s a key element to us, because as we get bigger we should produce higher return for our shareholders, and we should produce a better product for our consumers. And we are doing both of those again at scale in multiple countries.
And the last piece of things we do for innovation, for new opportunities, for new relationships, and that could be anything from a bank relationship to entering a new market in Africa or Asia to recruiting a portfolio team for one of the asset managers, be it Eastspring or M&G, all those sorts of things that take us into businesses that we didn’t have our capabilities, we didn’t have quickly, M&A in the U.S. and bolt-ons, all of those sorts of things are in that category. And when we look at what money we put behind with capital deployed beyond the products, right, the lens is as it’s always been on, it’s on cash payback, it’s IFRS centric, it’s on the cash flow signatures, it’s on the strain, it’s on the interest rate sensitivity. And we are very clear, we can get more efficient as a Group, and we will continue to work on that, but our earnings growth isn’t based on us coming up with a material reduction and what we already have in cutting our way, profitability. It’s based on growing from here, and again I want to reiterate, we have more options for capital than we have capital. We could grow - we could invest more, do more, grew more, if we chose to, and understand the balance required to our shareholders on those metrics.
So what does that look like? How we are using that? Yeah, what’s the discipline of that? Well, we know there is an expectation on the growth, as we do this investment to do on an ongoing basis, not one-offs, not - we are going to stop to do this for a while, and come back to profitability. We are trying to give you a very high rate of return of growth, trying to do that at very attractive returns. The bottom grey box is return on a better value, I maybe defensive on the half year, because it bugs me at 14, 1% of that is interest rate, and 1% of that just to remind you is front-end loading of expenses in our business model. So it’s a little stronger than it looks. But we think these are competitive returns in this market, given where our risk free rates are and alternatives, and again we think they give us - they demonstrate a bit of our scale and the ability to grow at scale.
The other thing I want to hit on just for a minute is the lot of questions in the meetings after full year results on dividend. Why do we think it’s sustainable? Why is it a better dividend if we are not growing at five plus incremental as we did? Where does the confidence come from that? Well, first off, it comes from the fact that in our view, dividend should be aligned with earnings growth. Post-crisis you have seen a lot of our competitors knock earnings per share and grow dividend per share, and that is not what this management team is going to do, to be very clear. This is a long term growth business growing earnings first and dividends second, and we are doing both as we are growing the value of the company, so all three of those metrics are moving at pretty effective rates.
But the other model guys, I don’t believe is sustainable. If you are growing dividend faster than you are growing earnings, there is only couple ways that can end, you can have a lot of capital to start with, or later re-capitalize that, we don’t believe either of those necessary for us. We are growing earnings at a very strong predictable manner, like I backed to one of my favorite slides, from Jackson days and certainly from this role. Our earnings in the first half, looks like they have for the last decade, okay, this is how you should hold this up. We have the responsibility to lower few quarter-after-quarter, but the context to that should be against our own performance, and the context to that should be how that gross look, how does that profitability look, how does that cash generation look over the cycle. The relationships we have with consumers are decades long if we do them correctly. We should get the benefit of that as a shareholder.
So I think this is one of the most effective way to look at this, there is lot of good slides in the deck, lot of good slides in appendix, but if I got one that this would be the one I’d use. I also like the cash for testing in the U.S. that's my second favorite slide, but there's - do you think this is a business where short-term things we can do can increase one of these lines and that's not our objective, grow growth, grow value, grow dividend.
So let me just finish with a couple of final comments. So all this is what we've been doing, all this is the team has been doing it, all this is the markets we've been in all the things that you knew before coming in. Again I think the results are absolute and in a relative level are pretty good. Is there upside, what else could happen? Well, given the Asia numbers and the pace at which they are doubling, anymore normalcy in Asia is clearly upside for them; in the Western markets given our success at gathering assets and managing them, any improvement in market performance, any lighter version of DoL if that in fact comes to play is better. A broader capture of assets under that more RA assets coming to Jackson on that side, they're not factored into how we're looking at the business, but clearly part of its capabilities. The improvements we are making to our UK businesses scalability, capital light positioning them for where that market is going, we see upside there. And again the general climate for consumers, the blend between the new expectations of what returns are and what expertise they need is driving them towards the things we're good at in the markets we're good at. So we know this is a challenging time, we're not suggesting it's not, but we think we're very well positioned to succeed - what for lot of firms seems to be a very difficult time and we're growing cash, growing earnings and growing dividend.
So I want to stop there and open it up for questions and if could ask some of my colleagues to join us and we’ve got a few more in the audience, this is the biggest stage we could find. We will hand them a microphone, if they have a specific question.
A - Mike Wells
I’m just going to wait for the team to settle down, but before you ask a question, please do state the name of your firm and your name before firing away. Could I start with Jon, please?
Good afternoon everybody. Jon Hocking from Morgan Stanley I’ve got three questions please, two on the U.S. and then one on the group capital sensitivities. The first question the U.S. just in terms of some deflation you’ve seen in the VA product in the first half, I appreciate we didn’t get the rules on day balance like beginning of the second quarter and got a re-launch I guess in 3Q. How should we think about this side look for flows for the second half of the year because if we don't already have so normal run rate, and also we didn’t get Q1 update, it is first question. Second question the gigs and size of price you are raising, gigs are getting size in the U.S. What are the sort of [indiscernible] capital of that product and is this just an expense bill and what about the general account just depleting second question and then just finally on the Solvency II rates down, sensitivities just the 2.4 billion that Nic run through, it sounded like a long leverage rates and risk margin, but the rate sensitivity give 50-50 diagonal on the right hand side of that slide looks recently smallish, well if you can still talk through how much of that is asset versus liabilities and how much of it is of the risk margin related. Thank you.
So Barry do you want to take the two U.S. comments and Nic, the Solvency II.
The slowdown I mean - it is correct that we did not actually get the rule change until April, but it was it was highly anticipated and because there was uncertainty around grandfathering and we ultimately ended up with an element of grandfathering, which help was not it not for grandfathering, but because there was uncertainty around grandfathering the slowdown and production of new business actually started much earlier back in the second half of the 15. So that’s the reason for the flows. In terms of the through the gigs, we feel it’s opportunistic something we do periodically. I mean. Chad you want to talk about the specific detail or?
Sure, so that's our returns, generally speaking we target about 12% on leverage and on those types of products. So if that that I think that's generally speaking we saw - keep in mind that this used to be a material portion of our overall balance sheet, the ability to actually earn spread that has not been before, I guess financial papers been relatively pricey post-crisis and that's finally start of the go away. So we're actually seeing good opportunity now to lever off of our AA rating and actually bill well against that turn of good spread.
Just coming back on the gigs question because in the start I think you said that you sort of reinvest to make it sort of greater 20% ROI across new business, is that 12% unleveraged return, is not a return on capital rather than on ROI [ph] metric or is the two aren’t the same number?
Return on capital, AA statutory capital.
Sure I means there other advantages suppose if you are maintaining a stable general account level has a lot of benefits across the business, certainly helps with liquidity as well. So we take everything into consideration. Okay on the sensitivities look we - I mean you have to appreciate that Solvency II is only very new, the sensitivities we gave reflect the product with the balance sheet that we had at the time. The balance sheet was not optimal at that time, since we found those sensitivities. We have taken both liability and asset side actions, as referenced one of the liability actions in relation to the longevity, which we've started doing that in any event in the course of last year.
On the asset side, there's a key thing here that across our UK business, but also across certainly some of Asian countries, which contribute to the overall Solvency II surplus, we match our assets to the best estimate flows. We don't match the asset for the one in 200 cash flows, but when interest rates fall as they did immediately in the aftermath of the of the first of January and again. You have a mismatch effectively that comes or having shorter assets than the liabilities on the FCR. So what we've done in the course of the year as we look to optimize the position I said both in the UK and elsewhere, we traded a lot of our excess assets if you like and increase the duration. So where did we do that - we did that with some of the excess assets that we have backing - our excess capital in the UK. So we switched 2 billion of them - extended duration by something like 15 years.
Opportunistically there was another 2.8 billion that we did elsewhere in the group across the piece, which also gives us economic protection for that. Other areas is the matching adjustment was quite efficient. We entered the year with 95% efficiency. At the end of - so there was some ineligible asset. Now you get to the law diminishing returns, but we effectively sold 400 million ineligible assets, which gave us some further protection against that. With it some general asset trading within the matching adjustment constraint to improve the risk and liabilities of the risk versus yield position that was another 1.2 billion of that. And of course we did some more equity hedging as said elsewhere in the group. So there's a whole host of actions that in effect by 30, June has shifted our matching to not just be affected [ph] in the liabilities, but be best asset and liabilities but not all the way to the 1 and 200 cash flows we don't think that sensible, but enough to bring the sensitivity back.
Hi Andy Hughes from Macquarie. I have a first question, 24% strength of single premium for individuals annuities, but the [indiscernible] would be even bigger and presumably I know you are outsourcing some of the new initiatives [indiscernible] just you probably outsourced to Mars instead. That's a huge trend is some improved specific about; these are expensive over a variety of number or is that -
No, there is no expense Andy. The people that we are transferring are to administer the sizable back book. It's what the numbers show, it is what the numbers show, up 17% or so is the FCR, the rest is risk margin. The 18% to 20% depending on where you were, what the interest rates were in the quarter risk is with margin. We dialed up prices as we enter the year. So you come to a point where you run against the constraint or value for money from a customer perspective. So we moved the pricing as much as we can without giving our false presence to the FBA. Of course, it’s without the benefit of any insurance, we - that’s the numbers that we have given you, without even the numbers, it’s on the numbers, if you assume, you reinsure 80% of that and you at a full percent of fee, which is a typical fees, for these type of insurance, and you save a little on the string when you remove the risk margin components, but you are still moving around the teens, right. And you said some capital, but you did give away enough of the returns, to give you a small higher up pickup of the sales, at the adjusted cost of capital, which is why we said we will, we have taken actions to withdraw. We voted down 27 million of APs, 270 million of single premiums, about a quarter of that comes from open market sales, and sales with partnerships that we announced in June that we are selling for the open market, and we have given notice to our partners effective on July, but we will not take any annuities. About half of it comes from the profit fund, because it was effectively which was arranged short on to the shareholder account. We have stopped doing that again from July 1, and that leads us to the guaranteed annuity which we are trying to find a solution. So it is almost and that’s why we still fight, and this is in this recent frustrating environment, you see us pull back.
Okay and my second question is about USBAs, and Mike I know you personally love [indiscernible], obviously there is so many compared to lots of problems in those products, so it’s like an impact, the competitive landscape for the second half of the year, you are going to see the products from GM being pulled. And obviously on net rates, like the investigation there, it’s not tracing your business comes down, and this side is probably positive based on your cash flow disclosures, and so the rates is not posted, right.
Yeah I think just a general comment, you have number of experts in the room. There is a lot like one U.S. competitor rode of 2.1 billion, added 1 billion. So yeah there is an element, we look at our assumption at the year ends, we don’t have - while we don’t have the GMI, the exposures you know that the structures you are talking about, we for lot of years we sit up here and said that was the wrong product, wouldn’t waste our money, let’s say I think the thing the bigger issue in the market would be well, firms need, so you go from this, a regulatory standard historically that was suitable to your product, or you assign a client a product, that will be a good reason, sell it’s a pretty good reason for a buyer, that we just buy in the U.S. pretty well. It’s up now to, it was basically the same as the reasons why that we are here - we are the best product, it’s difficult, but you are signing off, but this is basically the right product, it is much more specific, much more liability, if you are wrong, it’s got a different recourse to it. We think the quality of the VA product if they buy or sell gets even more important. So the performance matters, the flexibility matters and one of the other topics, and we didn’t bring up, we didn’t like what was the ball control, and I will leave you doing your own homework, go back and look at those funds versus the funds we have for our consumers. You know just never been a fan of that model, and if you are paying for that, and paying for guarantee, it’s always been a question on mind. So I think Jackson has got a very good product set to where the market is going and I think snowing with some of the broker dealers, they could see that, we are likely to see more concentration with the broker dealers, because there is more technical support, morality support, the platforms and things. So it’s a good question that travels for the heads of the broker dealers, which products that they would want to invest and how long their platforms, and I think quality will be a major cut, and I think we are in good shape on that.
Let’s go to Lance please.
Good morning, it’s Lance Burbidge from Autonomous. I have got couple of questions on Jackson as well. So in terms of launching the fee based versus what I wondered, Barry if you could talk about, presumably this is attractive for a sales person to sell, because they get the recurring fee, which is applied to the recognition of the product. How does that play with the consumers, that presumably would be worst off, which is you know what I was [indiscernible] first place. And second one is, Mike was talking about in the past, which is that interest rates pull, is there a point where this product from a guaranteed perspective becomes unattractive from yours perspective or from the customer’s perspective, sort of maybe just talk about that as well. And just on the sensitivity, you like other companies to put negative rates into your sensitivity, I just want to look, if you looked at what that sells, there is nothing in that.
The fee based product will be introduced, the perspective of [indiscernible] will be introduced in September, what it really does I think as much as anything else, as it does, it gives an alternative to the broker, to the advisor that does not want to be advised in the equity portfolio. They doesn’t want to deal with the regulatory complexity of operating end of it, so it gives them an alternative that I think from a compliance perspective, a little easier. For a sale that’s made that has long duration, there is a prospect that the agent gets paid more, the customer, typically what companies like ours do in order to suspend if you will the upfront commissions as you build of that 100 basis points in for distribution. So if you except that the standard fees is going to be about 100 basis points, the customers really not going to see an imperial difference, which we talked before the session.
There is the prospect that as you move towards more fee based than let’s say 100 basis points gets locked in, it’s the typical fee level that over time, there will be pressure on that to pushed down to 75 basis point or 50 basis points, and that could certainly happen. But I don’t think that it’s going to be, it’s going to disadvantage the consumer in any way, but what it is going to do is they will give a choice to the financial advisor, which is really important. And talking with both the dealers, and talking with the buyer house is what we are hearing overwhelmingly is that they will operate under the hit, they except that they have gotten their heads around that. Some of them view it as a long term proposition, others view it as a bridge, and maybe you know within three to five years, they plan to have transition completely off of commission they sell, and be totally on fee based.
So there is no doubt that there is going to be an evolution around distribution in the industry, and that in fact is what I think regulators are trying to get at, because we spend a lot of time also talking to political leaders, regulatory leaders, people within the Department of Labor, SEC, and what comes through overwhelmingly is, they think the product is complicated for consumers. The reality is the industry has complicated, it’s really not a terribly complicated product for consumer to understand, that we need to change the way we talk about it, and use different simpler language, which the regulators, they welcome that. But they love the product itself, they love the idea of product that provides upside, their only equity markets are going to be able to gear for the foreseeable future combined with some level, it’s a modest level, but some level of guaranteed income for life around which, someone approaching retirement, or entering retirement plans. So there have really lots of products, so there is calls of real optimism for organizations who have a track record being flexible, investible and sort of get on the cutting edge, and I think that’s where I think Jackson is. Does that answer your question?
Lance, he sounds like an American, is that clear? I think on the interest rate fees, we have got a couple of issues, we have to build the adjusted guarantees down, as you have seen us do, the systems have the flexibility to do that. And on the accounting point of view, [indiscernible] it’s sort of, because we are market consistent element in the drift rate, the discount rate is defined by the current rate, in the equity some performance have declined, right. So you can get quite a ways, the accounting as [indiscernible] quite a ways from what’s a reasonable economics sort of assumptions. So that’s one of the challenges and that’s a discussion as a management team and with the guys, our investors, I will review that, but at the lower levels the drift rate assumptions feel kind of ridiculous that, but a portfolio with every asset class available basically on the globe can produce 100 basis point returns sort of thing is good over 20 years is a bit of a strategy. If you actually believe that you probably would offer different product. So that’s where I think you’ll see the noise, but again the we are looking at - and we do have the flexibility if we believe that the true economics of lowering the guarantees then we have done that on withdrawal rate.
Mike? Can I ask the question on the floor? So you're referring to - our internal model, which lowers interest rates pull shocks at zero.
I'm sorry [indiscernible]
That's okay so we start - just to be clear, so we start with swap cuts into various markets that we operate with and apply the one in 200 shock. In all cases above zero and then we apply the 50-basis points from that, the only place where that drops to below zero is in year one in Singapore, and our cash flows in Asia pretty much across the average 10 years plus average, so immaterial impact. The other place where we dropped to below zero is in the UK between year naught years today and year five back in the minus 50. Our cash flows in the UK are even longer. So they go out 20 years plus. So that impact of them is immaterial.
Thanks you. [indiscernible]. UBS. Two questions, first on Solvency II capital movements, just firstly thank you for your detailed disclosure on page 76 on the movements there. 1 billion of underlying organic capital in generation represents about 10% of your opening SCR, which in-life the 20, which is the top end of your peer range. Is it relatively stable compared to the 2 billion in 2015, so just looking for comment on can we use that as a starting point to build for that is nothing toward in that number. Second question is on Asia in two parts, firstly on Hong Kong obviously there is strong growth has continued there. There's obviously concern around posting ability of growth and also some regulatory tail risk.. Tony if you can give some comments around, the gross side and also in particular on the tail risk the initiatives from the Hong Kong regulator, which I think will help manage all of it. On the non-Hong Kong side, we saw obviously some negative growth in this half, that's partly driven be a strong switch to a premium, best management initiatives in Indonesia, the stock something universal life in Singapore some just curious all the different actions where do you think, are we close to [indiscernible] underlying economic growth headwinds, are we seeing some light in terms of where you see that stabilizing and picking up again?
Nick, do you want to take all these two piece and Tony the
I thank you and I think your analysis is correct. Clearly there are some management actions in there that benefit you accounted for them. Look we have a business that generates capital, when you consider the effects of U.S. comes in on a local basis and we've seen a very strong capital formation in the U.S. that was reported year after year as the business has grown, there is no reason to believe that its contribution to that number is going to do anything other than what it's done in the past the last. Of course the UK is under Solvency II and we gave you the Solvency II risk monetization profile at the year and. On an underlying level we saw 300 or so million come through with 600 million for the year. We have to trim a little of that, as we have withdrawn from, what works against that in new business strength, which will eliminate as we go into the second half and beyond and of course we have a positive experience that contribute. So we were confident in the family as we are against all the metrics that we asked you to judge us again we're confident that we can continue to have a positive slope.
Asia, Hong Kong growth continued strong up 58% at the half again continued driven by mainland Chinese and correlated quite well with the growth in the agency force, which I think is now close to 16,000 in the first half. In Hong Kong we've recruited about 700 to 800 new agents every month and so that feed into nicely. In terms of the actions from regulators and they’ve seen a lot of activity in the first half. I think the most interesting ones are declaration put out by the China regulator CIRC I think towards the end of Q1, early Q2 that they actually put out I guess to the Chinese citizens on their website that was stated if you're going to buy product in Hong Kong These are a couple of things you'd need to be to be aware of. I view this as good news, honestly in part codification of the process, it’s okay for the business to continue on this certain controls. We did as we've always done; we immediately took those CIRC statements and put them in an additional disclosure at point of sale that the agency and customers have had to sign.
Now what the Hong Kong regulator OCI has done is taken those standards and created a formal form - disclosure form that effective September 1, all mainland customers purchase in Hong Kong will have to execute. So based on everything we've seen so far not materially concerned about the impact and again and as usual we're ahead of the curve in terms of implementing those standards. In terms of - the rest of Asia, I think you might have answered the question. Yeah, there have been to be economic headwinds most probably most notably in Indonesia where GDP has struggled for an extended period of time. And that for us, I think we talked about this in the past that have flown through into on the cold face the Consumer Sentiment Index, which has been, which has been depressed. Remember in Indonesia we sell to the middle market, the mass market not the mass affluent household disposable income were sensitive that it might be in some of the upper segment, which is typically the people who are actually buying product through bank assurance, not agency.
So we have felt some impact but we continue to grow the business and if you look at the business even though the comparable is not great; if you look at the business we averaged about 370 billion Rupee per month of new businesses in first half, that’s £21 million of new business margins staying in line and almost £200 million of IFRS profit coming through. We also added on average 700,000 new agents every month in the first half and I think we acquired 160,000 plus new customers, so 800 new customers a day. I'm a little disappointed that that's not per hour, but we'll get there. If you look at the leading indicators - the drivers for direction Q2 over Q1 grew by 11%, that's great news. If you look at Q2 over Q1 last year was flat and the growth coming through APE per active, so agents are actually starting to have a lot more success at point of sales. I think if you - add on the final macro of the [indiscernible] new cabinet especially with his new Minister of Finance, I think we feel pretty good about maybe the economy - probably [indiscernible], but it feels like it might have bottomed out, currency stable, JCI is up 20% year-to-date looks little bit better as the economy recovers our business will recover.
So, Oliver Steel.
Oliver Steel, Deutsche Bank. Three questions. First one right back to U.S., you were able to give us a sort of indication of how much sales from qualifying accounts actually fell in the first half and mitigation what happened on the non-qualifying accounts and how you see particularly on the qualifying accounts, how that will develop that next, one to three years if you can. Secondly the flows M&G and [indiscernible] my expectations. Each spring can you tell us what's happening there because they were remarkably good this year but they were remarkably good last year, but less than the first half M&G, perhaps an update on particular funds and how much is left in each of these and then third question left field is you talk about raising the dividend in line with earnings but obviously your earnings are beneficial, you got lot form Sterling currency weakness and your dividend is paid in Sterling, how are you thinking about Sterling relative to your dividend decision?
So, Barry Stowe comment on the qualified accounts first.
Lead access [indiscernible] - the lead access sales from qualified accounts have and basically have dropped to essentially zero almost, I mean they’ve fallen precipitously, because as Mike alluded to I think earlier, like in the presentation, most of the broker dealers are now not allowing advisors to sell EEA into qualified, because they feel like the fee in return for the advantage that you get from the tax wrapper, which obviously you don’t get with the whole [indiscernible] on the new advantage. So that’s been hit very hard. Overall sales, do we have that number at our fingertips? Of qualified, how much qualified is down versus not all?
We don’t have the number, it’s just the percentage down below, what I would say is that the mix is about the same as it was last year. So you’re looking at roughly 65-ish percent is qualified and the 98 -
In the 98, so EA has been hit very hard. In terms of how we expect it to develop, broadly we think that a recovery is afoot. It’s not like it’s going to come roaring back in the third quarter or the fourth quarter, I think it’s a gradual thing over series of orders to return to the historic levels of flows across the industry, but I do think that there is based on some of the comments I made earlier about, it’s the way regulators actually are embracing, the product’s concept, and just want to look at distribution I think as we’re successful in evolving distribution I think there is strong prospect that we will see growth and flows they need to be. When you look at the number of baby boomers that are retiring, the assets that are going to be looking for a home the fact that interest rates oriented - our parents and grandparents retired on CDs, which were paying 10% or12% interest, but that’s not an option. So there’s really - there are few alternatives to people that are going into equities and the prospect of a guarantee with the equity upside just I think is becoming increasingly appealing. So don’t look for instantaneous change in sales levels, but over time, I think there’s a real cause for optimism.
If you think of the problem you are solving for the consumer, it doesn’t materially change with the new product structure. We’re going to have some assets already and qualified plans rolling over. They’re going to have supplemental savings for retirement. So they may go fee, they may go commission, but the fundamental problem we are solving is the same regardless of DoL. I wouldn’t just probably I was guessing. I wouldn’t think it’s an immaterial shift in qualified and non-qualified banks in the U.S. The inception of that, that may be in a fee-based lead access you get into a different, [indiscernible] aloud. Now it should be the same problem we are solving with effectively the same tools, it is different optionality, other structure, but if you get the same outcome.
Let’s go, we just happen to have the CEO of Eastspring. Guy, do you want to comment on flows?
So if we just [indiscernible] slightly, second half of last year flows started to slow out after China had been hit by currency and the stock market. So since been in Asia started to shift after a very strong ‘14 and for us very strong first half of ‘15, you translated into ‘16 and investor appetite for equity product is that right is largely it’s money market, pockets of high yield. All countries that we look - all 10 countries that we run money in Asia, except two and possibly flows through the first half. So it was confined to Japan where we saw outflow mainly through dividend distributions in Asia equity income product and a very short duration product, which almost money market plus product in China, which management decided to close down, with the two reason, with the only two countries - were an outflow in the first half. So I know the two countries would possibly flow.
And on M&G please.
Penelope Jane James
Yeah so I think of a couple of things to comment on two main reasons, I think what flows have been under pressure for the last 18 months or so first with obviously it’s related to the four month, and I think the second big driver was around Brexit, on stuff with Brexit ahead of that. So we will be touching on performance. There are challenges over the past 18 months, so but if you look back over the last six months, over 60% of funds in the retail range are now above median. So there is a bit of work to do to repair some of the slightly longer term relative performance, but you can see the direction of travel is right and in particular optimal income which is the single biggest funds there, they were not seeing against the European sector, which is the most important sector that funds the European share costs, so we are now [indiscernible], year-to-date one year and five years again we really rebuilt that fair track record and over three years again we’re in second quartile. So direction of travel is very much right, in the right direction there. And if you look at the broader context of flow, actually what is quite encouraging is, it seems that we have got net inflows across quite a few different strategies both on the retail side and importantly on the institutional side as well and quite a range of different things. Real estate, some of the private debt markets and so forth, global macro multi asset. There’s a lot of work to do to turn net outflows into net inflows, but we have some of the building blocks already in place there. I think the Brexit vote, obviously has relevance and particularly the 25 billion or so of asset quality management that we managed across the European client, and I think we still don’t have perfect foresight in terms of how that is likely to progress going forward. So that’s the area where we’re looking at focusing really on client service as we wait to hopefully get a little bit more unraveling and visibility on the extent to which for example we’ll still have European passports and I guess the Brexit negotiation would analyze, but in the line, that’s the picture.
And Nic do you want to comment on dividend of FX 2015?
Yes, is it a factor? Yes, it’s the fact, is it more important when we scrap the dividend to the impact on shocks, no. Is it more important than when we weigh up the growth opportunities, no. And we take the rough with the smooth. Now that being said, we have always maintained that currency and the half of the world that we were exposed to, it’s a tailwind for this business, at the end of the day, over the medium to longer term currency shoots will go into GDP, and if you’re operating in countries where GDP. Is going fast, but well the country in which you are reporting, then over time that will come through into traditional learning. So day-in day-out because of the fact that that’s significant longer term, I think it’s a right tailwind for us.
Now we have historically hedged dividend, not as [indiscernible], but so there is some control over, we were trying to dampen some of that.
Thank you very much. It’s Blair Stewart from Bank of America, three questions please. Nic, you talked about the implemented practice in the U.S., just wondering if you could expand on that, is that something you are looking to explore and could you give us what the RBC in the U.S. actually was, I am thinking if that’s a route to getting more capital and cash over the U.S., it would be the results in presentation, but me complaining about cash coming out of the U.S. Second question on the [indiscernible] 08:15, announced that profit growth has slowed to 12% growth, is that simply a function to investing in the business during a period of time when sales are coming down on a sort of - that it in fact it does. And thirdly on back to management actions, Mike I was wondering what more can be done especially to capture some of that surplus that’s disallowed and particularly on the West profits stay, [indiscernible]. Thank you.
Maybe I will say one or two things and then I’ll pass on to Chad. I mean it was, it’s the practice, it’s something that we carried, put in place after the last financial crisis at the time. And like the balance of the book, it was more on the general account where interest rates up with the predominant risk. The balance of the book is gradually shifting into given where interest rates are, the point at which it becomes the permitted practice is a benefit to us is the further away. That being said, we’ve strong capital formation. We even with this in place over the years, but it’s something that we’re looking at. Chad would do, you want to add anything for that?
I think it’s - the bulk of the answers are there. So with the permitted practice, so we view that as something where, interest rates were low enough and we’re deep enough in the money if you will that there’s a pretty good offset up and down with reserves now so there’s logical reason why you might take a permitted practice off, now before the conversation we had with state. The thing would be you’d still, the reason we’ve had around to begin with is where you have rates move up significantly and there’s going to be an asymmetry between the mark on the slot book and the reserves because the reserves will floor out on the stack and so there's still that kind of tail winds if you will - if you had a big inflation environment or something like that, or we start moving back up rapidly. We'd have a disconnect I think it would be harder for us to get that back on having taken it off, but we wouldn't do so lightly, but it's certainly an active discussion just given the fact what we're seeing now kind of a one sided mark against us even though the economic hedges in place.
Hi, [indiscernible] we use more of treasuries as part of the hedging strategy is considered more efficient, less volatile, but they're also under stat trading book, so you're getting a quite an understatement of the financial strength, it's action. We haven't ever given RBC [ph] other than what we've published year end. But it's still in a very acceptable range for us.
Okay, so it 12% growth in Indonesia
Yeah, I mean Blair you're absolutely right we have been investing in the business we've learnt - Mike often talked about the counter cyclical opportunities we continue to invest; we've expanded new branches; we've hired more agents; we've upgraded our people and we've invested quite heavily in technology to make the whole process more efficient on the back end and the front end. So obviously that has some impact. I don't know Nic if you want to expand on it any further.
Sorry, I’m extremely frustrated that I can’t include there were profit on savings into the ratio. Not least because we've seen we are the only business now that has a sizable amount. Nevertheless we have that debate and the rules have been interpreted in the way in, which they've been interrupted and we excluded. How can we get, how can we access it, we could distribute it but that wouldn’t be, only one we can do, it is the thing that is underpinning, providing the working capital and the risk coverage to obtain best in the way that we do in the deposit fund which is now attracting the phenomenal flows that we're getting. We could - these things you can do from this point, but to get more credit up front, you could monetize the shift, you could hedge the shift further, but you're giving out the upside that that will do if needed to within reason, but on that profit side more difficult to bring more credit on to the ratio.
Mike here please. Thank you very much. Nick Holmes of SocGen, couple questions on the variable annuity book again, just wanted to follow up on the policyholder behavior assumption. Wonder if you could - I know this is an incredibly difficult to take area, but I wonder if you could try to give us a sense of your level of confidence about your assumptions not just laps, but also guarantee utilization perhaps looking backwards what did the last review tell you and what were you pleased about, what are you worried about and then the second question is on notice the very large unrealized lot of the operating line now this we all know is a familiar feature of insurance accounting, but I think in your case quite a lot of it is to do with the hedge program and I just wondered want is you thinking about communicating the performance of the hedging of your variable annuities. Are you total inclined to start reporting an economic type of, I know that subjective in itself, but that is one very large your peer company that does this and puts it in its operating earnings. Now is this something that you would be interested in doing in the future because my sense is that it would be very helpful for people to understand the true performance of the variable annuity guarantees and hedging, thank you.
I'll start with both and leaving it to the few U.S. for help on it. On the hedging, I think this two elements, if you remember the New York meeting a number of you were out we sort of gave you 11.5 hours or you want to know about Jackson one of the things that we did there, we showed you some of the internal we did work with you on cash flow testing. Because of the industry's varying descriptions of metrics, the choices management teams have to define hedging, define risk, part of the reason on those, we've always looked at that remember un-hedged and then we can tell you what the hedge looks like and that shock in terms of value at given point in time. But we are not doing a debate of what type of hedge or how is it structured and is that better than [indiscernible] Lincolns etc. We'd tend to keep it at the various best and will keep showing you those sorts of issues. I think personally that's the single best way to look at a VA block and how it's going to perform. If you remember back that being one of the things we said is it is not just the PV, which again that's one of the that the easy one for us to summarize for you, but it's also as a given your shocked look at versus your capital, insurers fail for cash at the end of the day.
So those stresses are important and our intents to keep showing you that I think that gets you a better look at our hedging than anything up our non-hedged liabilities. There was a question that came out of one of the meetings about like net amount at risk versus in the money. There amount at risk is a shock event, that's not our liabilities are structure. It's the sort of everybody goes at once sort of model to [indiscernible] that's an incredibly inefficient way of looking at our liabilities, it may fit a life company with pure mortality [indiscernible] concentrated in one region, you start to get that viable book for us with the fact that the guarantee plays out over decades. Shocking it to one day can even structurally occur, they all can't collect. So that’s not particular good metrics. I do think the cash flow metrics assuming very efficient utilization is the best way to say do you like to look at what's there. The actual value the hedges we can mark to market in any given day you see some of that below. Some of the blow on this time as interest rate as well, the severity of the rate movement in the U.S. and your other question on policy holders reviews.
There's multiple levels in the U.S. policy holder review, there's an ongoing intellectual challenge of [indiscernible] there is a team that gets together and says look for any inefficiency; look for any behavior that's change; look for any anything that would suggest that our models are wrong; look for new combinations anybody in that committee can bring up any combination of variables they want to be run and tested and it's quite detailed and then we have our formal processes that we follow as all U.S. carriers to review our assumptions setting and we typically do those in the second half of the year. The challenge you guys have I appreciate this investors is you have firms in the U.S. that have different structures of liabilities and VA, they have different assumptions you can. There's a lot of assumptions to your earlier point inside our policy holder behavior it's not just one number and so when you look at that you got to say do you agree with all the things you're seeing in the marketplace.
We've got this discussion with external consultants, how valid for Jackson is marketplace data that GMIB based or they've gone back and raised the fees or they've gone back and put forth allocation or draw a control line versus our clients. It is directionally of some value, but - what we wouldn't build pricing based on it. So - I appreciate the it's beyond or it's got just opaque, it's a confusing space - but I think Jackson you'll see us disclose sensitivities, we’ve shown before. What we think of lapse rates, what we think of what our stress look like in the trans implications will continue to give you those.
Can I comment on the reporting as well? I'm aware of what other companies do in this regard and we thought long and hard [indiscernible] our position on accounting disclosure. We thought long and hard, but have we best project, but you hit on two of the key points. The first challenge you run into is what is economic. Is it real world well or is it market consistent and there can be different judgments that are applied in that regard or something in between. Then you hit the other challenge is to say to you depart from your [indiscernible] and bring in the entire guarantees fees, the calculation of the way you think of the reserves or the element that you brought in on day one, which is when you're locked them in, they produces zero profit on day one. The more you depart it took the view that the more you depart and make judgments from the base U.S. accounting, the less comfortable your numbers are with the way everyone else does it and in the end we decided that it's better to take that volatility and be more comparable and answer your question rather than make judgments that put us out of kilter with the way the rest of the industry is reporting. So yes we will - so what would you be then refer you back to the cash flow on the one side and the other thing is the embedded value because ultimately that does capture all the fees and does factor in the way you move forward how you're hedging program will react them. There are stochastic elements that are all within that to capture some of the ability of some of the assumptions. No, we look at it, but we just thought if we move it would be just not beneficial.
One of the things I want to point out on the interest in Q2 is, around the policy holder behavior and the ability of the assumptions and as Mike has said, we are constantly going to the process of reviewing and we’re - we occasionally tweak as a result of that announcement, but historically that our assumptions had hailed very, very well. And I would argue that given that we’ve provided this is where the probably the most stable consumer experience to beat anyone in the industry around this product. And given the scale of our book, I would say that historical data that we produce on our book is probably the most credible data available in the industry.
Thanks, Alan Devlin from Barclays. Just one question, you mentioned of a bolt-on you referenced to the U.S., can you give some color on what kind of things you’re considering as Department of Labor forcing you declares potentially out of the market. Thanks.
That’s the bolt-ons, we wouldn’t buy - we’re not looking for the A blocks for example, we’ve been pretty clear that that’s not something we have an appetite for. What we look for is life, so life falls, technical revenue, further diversification, just that’s got a nice - there’s coverage benefits, there’s a lot of things we get. The last 24 months you’ve had some interesting new players in the market, private equities, some of the Japanese friends and things that bid things up. Typically what you see is at this point in the cycle, a little more rational pricing. But you got some new players; you got some pension funds, multiple pension funds and vehicles now. Actually very reliability for pension funds, you think about it the cash flow signature that allows the - like the cash flow signature of the underling life time premiums. So there’s competition still, but we’re looking we continue to look for all the years I sit up here, we’re always looking [indiscernible]. But if we see something like we would do it and we’re not in, there’s no obligation or capital allocated specifically for that, it will be opportunistic as it’s always been. But you do own a very low cost platform in the U.S., that can integrate those and produce a return in addition to the return the existing owner is getting, so there’s value there.
One last one Andy.
Thanks so much. A couple of more questions, I think Nic we just pointed of it Africa is [indiscernible] so is Indonesia just to double check the persistency and lapses are okay because that will be our main concern. I guess there is not much EEV hit from lapses in the numbers, so obviously just double check that. And the second point on Asia, obviously sticking with your growth solvency, but obviously Indonesia adds a lot more to the IFRS earnings than it is and then Hong Kong, so is that kind of - the mix going to be a bit of head wind in terms of growth going forward. The third question is on VAs, on regulatory change, so actually looking at holding back some cash with the potential changes in the U.S. VA rule just may or may not happen, obviously they have a big capital and you don’t, but there was something like the - do you expect the rules to come more economic which might lead to high capital requirements. Could you comment on that? Thanks.
No, lapses you’re right. You can see the numbers does not come through. The persistency pretty much across actually the portfolio on the protection side is strong. From time to time you’ll see some spike with effective markets not performing, you’ll see some partial withdrawals, maybe people taking money out, but we’ve seen nothing different this time around to what we’ve seen before. On the impact of Indonesia on the growth rates, I think the answer is that the strength of the platform. Don’t underestimate the growth in Hong Kong. Yes, a little bit comes from the success of our [indiscernible] but the growth within that our health and protection which has a very attractive IFRS signature is not to be underestimated. We’re building some nice momentum in Hong Kong on the back of layering more protection business to what was previously there. Hong Kong was under rated in our earnings before and it’s now gradually drifting up to its appropriate weight. Yeah, there’s some pluses and minuses. In terms of your regulatory question, Andy, there’s - I mean there’s always the prospect of regulations evolve overtime, but we have always had and continue to enjoy a very positive productive relationship with Jackson’s lead regulator which is the State of Michigan. And they’re literally multiple weekly meetings between Jackson and the state and I think they’re comfortable with the existing regulatory regime under which Jackson operates and even more so happy with the manner in which we have complied with that regime. And so I don’t see a huge risk such as you describe.
I just want to thank everybody for a very long session and appreciate the time and the questions and we’re maybe around for a few minutes, if anybody wanted to do one on one. Thank you.
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