The A2 issuer rating for M&G is supported by: (1) the Group's strong name and leading position in the UK with-profits savings; (2) a growing footprint in Europe and in the global asset management industry; and (3) solid and stable operating profitability. The strengths are offset by the group material longevity risk exposure and the still material amount of equities in the with-profits fund, albeit partially mitigated by the flexibility of the product design. Whilst pro-forma financial leverage, adjusted on a Moody's basis to reflect the capital surplus in the with-profit fund, is commensurate with an Aa-rating, financial flexibility is somewhat constrained by an absence of a well-established stand-alone track record in the capital markets and relatively high leverage on a Solvency II balance sheet basis. The group also faces long-term pressure on bottom-line profitability given increasing competition and margin compression across the asset management sector.
Moody's believes that M&G, a savings and asset manager with a closed annuity book, is well placed to capitalize on a number of structural trends within the UK and globally, including Pension Freedom reforms introduced in the UK in April 2015. The Group's long-established expertise in retirement savings, excellent brand name, good product offering to both retail and institutional investors and innovative product design capabilities, are reflected in the significant 31% growth in its 'savings and asset management' assets under management between 2015 and 2018. However, M&G's share of the UK life insurance market has been declining, reflecting management's decision to withdraw from certain capital intensive lines of business. For example M&G's annuity business is now closed to new customers.
The Group's product diversification, with a focus on PruFund savings products, is relatively narrow compared with similarly-rated UK life insurance peers. However, Moody's views PruFund, the Group's "new generation" with-profits savings business launched in 2006, as a key differentiator for M&G. PruFund, which offers smoothed returns, protecting customers from market fluctuations, is one of a small number of remaining with-profits savings policies available in the UK, which coupled with the fund's excellent capital surplus and track record in terms of performance is a significant growth opportunity in the UK and potentially also in Europe.
Moody's views the expanding asset management product base and footprint, with around one third of third party assets under management now generated outside the UK, as positive as it diversifies earnings and, together with the natural run-off of the group's annuity business, reduces product risk. However, as the asset management business continues to grow, M&G's revenue and earnings will become more correlated to market movements, and therefore more volatile than those from long-term insurance operations.
M&G generated GBP1.6 billion of operating profit for year-ended 2018, and Moody's view M&G's overall profitability as strong and consistent with that expected of an Aa-rated entity. M&G will continue to benefit from the material stable earnings generated by the traditional with-profits and annuities book, known internally as the Heritage business, which are running off gradually. The rating agency estimates the Group's pro-forma return on capital (calculated on a Moody's basis) to be around 7%, with operating earnings falling short of the 2018 result, which benefited from an above-average longevity release of GBP441 million as well as other material non-recurring gains. Equity market volatility and pressure on asset management fees will also continue to adversely impact the Group's asset management's operations, as seen in H1 2019. Furthermore, after the demerger, M&G will have to bear its own central costs (in the range of GBP80 to GBP100 million), as well as interest payments of around GBP190 million.
Moody's commented that M&G's proforma regulatory Solvency II ratio of 139% (170% on a shareholder view) as at 30 June 2019 is relatively low in relation to the rating level, and reflects the limited fungibility of the group's large with-profits fund. Furthermore, the quality of capital will weaken post demerger, with around GBP3.2 billion of retained earnings being replaced with Tier 2 subordinated debt. More positively, the with-profits fund's Solvency II ratio is very strong at 249% and the group's dividend policy is relatively conservative, with a base annual payment of GBP465 million, which Moody's expects to equate to around a 50 percent pay-out ratio and rise only in line with growth in operating capital generation. Furthermore, the previously announced annuity reinsurance deal with Rothesay Life Plc reduced the Group's longevity and credit risk, although M&G's solvency surpluses remains vulnerable to market movement, with the key sensitivity being credit rating downgrades.
Moody's estimates M&G's pro-forma financial and total leverage (which includes 50 percent of the excess returns within the with-profits fund), at around 19% and 25%, respectively, with pro-forma earnings coverage of around 7x. These ratios are commensurate with an Aa-rating with limited refinancing risk. However, financial leverage is materially higher at around 34% on a Solvency II balance sheet basis, and the group's financial flexibility is somewhat constrained by the absence of a well-established stand-alone track record in the capital markets.
ISSUER AND DEBT RATINGS
Moody's A2 issuer rating on M&G is derived from the Aa3 IFSR of PAC. The notching differential between the Aa3 IFSR and A2 issuer rating is two notches, reflecting Moody's standard practice for an insurance group domiciled and operating in jurisdictions where group regulation is in effect.
We do not expect the A3(hyb) subordinated debt ratings on instruments (listed below), which will be transferred to M&G Plc from Prudential Public Limited Company, to be affected by the demerger transaction. However, post demerger, the ratings on these instruments will reflect solely the financial strength of M&G and Moody's standard notching practice, as described above.
The outlook is stable, reflecting Moody's assumption that M&G will maintain a shareholder view solvency ratio at above 150% on a sustainable basis, and financial leverage below 25% while continue to grow its savings and asset management operating profit, offsetting short-term profit pressures post-demerger.
A caveat to the stable outlook, Moody's says that in the event of a "no-deal Brexit," UK life insurers, including M&G, would face increased risk of capital, revenue and profit deterioration, a credit negative.
WHAT COULD CHANGE THE RATINGS UP/DOWN
Whilst considered unlikely at this time, M&G's ratings could be upgraded in the event of: (1) a meaningful increase in profitability as evidenced by a return on capital consistently above 10%; (2) financial leverage below 15% with earnings coverage of interest consistently above 10x; (3) sustained material improvements in capitalisation; and (4) meaningfully increased business diversification without compromising profitability.
Conversely, negative rating pressure could arise on M&G if: (1) there is a meaningful deterioration in profitability, with return on capital consistently below 6%; (2) financial leverage exceeds 25% with earnings coverage consistently less than 5x; and/or (3) there is a decline in capitalisation, resulting for example in a solvency II ratio (shareholders' view) consistently below 150%.
The following ratings actions have been taken:
Issuer: M&G Plc
....Long-term issuer rating, assigned A2
Outlook assigned Stable
Issuer: Prudential Assurance Company Ltd
….Insurance financial strength rating, affirmed Aa3
Outlook remains Stable
Issuer: Scottish Amicable Insurance Fund
….Insurance financial strength rating, affirmed Aa3
Outlook remains Stable
We expect the following instrument to be transferred to M&G Plc from Prudential Public Limited Company on 18 October 2019 with no change in ratings:
....GBP750 million Subordinate Regular Bond/Debenture, maturing October 2051, ISIN: XS1888920276, A3(hyb)
....GBP700 million Subordinate Regular Bond/Debenture, maturing December 2063, ISIN: XS1003373047, A3(hyb)
....GBP600 million Subordinate Regular Bond/Debenture, maturing July 2055, ISIN: XS1243995302 A3(hyb)
....GBP300 million Subordinate Regular Bond/Debenture, maturing July 2049, ISIN: XS2025521886, A3(hyb)
....GBP500 million Subordinate Regular Bond/Debenture, maturing October 2068, ISIN: XS1888925747, A3(hyb)
....USD500 million Subordinate Regular Bond/Debenture, maturing October 2048, ISIN: XS1888930150, A3(hyb)
The primary methodology used in these ratings was Life Insurers published in May 2018. Please see the Rating Methodologies page on www.moodys.com for a copy of this methodology.