Aviva Research Report

This UK listed insurer currently trades at a discount to its book value and at an attractive multiple of its average cash flows of the last 15 years. Recent market volatility and the impact of divestments have clouded the numbers despite continuing strong performance from its business operations. This has created an opportunity for investors willing to look through negative sentiment and purchase a market leading company at a discount price.

Executive summary

Aviva is a UK headquartered insurance company with a history extending back over three centuries. It is listed on the main market of the London stock exchange and a member of the FTSE 100 index, with a market capitalization of c.£12bn.

The company’s main business segments are: UK & Ireland Life, which produced 73% of the total cash remittances in 2021; UK & Ireland General Insurance, which produced 15.7%; Canada General Insurance, which produced 9.4%; and Aviva Investors, which manages £268bn of assets, with £216bn managed on behalf of Aviva Group. In many of its business lines the company is the market leader, and for much of the rest it is a top three provider.

Aviva had a number of other international subsidiaries which it divested in 2020 and 2021 for total proceeds of £7.5bn. The case for this divestment was to focus the company on its core markets where it holds substantial market share and is most profitable. £1.9bn of the proceeds was used to repay debts, bringing the debt leverage ratio down to 27%. A further £4.75bn was returned to shareholders through a £1bn share buyback program and a £3.75bn direct cash payment. In order to maintain the share price, a share consolidation was undertaken, reducing the share count by 25%.

As an insurance company, Aviva is subject to the Solvency II regulations. These include the Solvency Capital Requirement (SCR), which is the amount of capital Aviva is required to hold on its balance sheet to cover its insurance liabilities in a 1 in 200 year catastrophic event. This figure is influenced by both the size of the insurance liabilities and the current level of interest rates (i.e. expected return on assets). As of 30 Jun 2022, the SCR stood at £7.7bn - a decrease from £9.1bn at 31 Dec 2021 reflecting the increase in interest rates during this period.

Another important metric is the shareholder coverage ratio, which is calculated by dividing the shareholder’s equity by the SCR value. After accounting for an acquisition and debt repayment which occurred during H2, the shareholder coverage ratio stands at c.213%. The management of Aviva has stated that they aim to target a shareholder coverage ratio of 180%, and any capital above this will be available for investment or return to shareholders.

The company has announced its intention to pay dividends of £870m and £915m in 2022 and 2023 respectively. This equates to 31.5p and 33p per share, or a yield of 7.3% and 7.6% respectively, and reverses the dividend cut that occurred during the pandemic. Subsequent mid single digit dividend growth is expected from 2024 onwards in line with growth in profits/cash flows.

The company’s shares currently trade below its book value, which as of 30 Jun 2022, stood at £13,653m or 480p per share. This provides some downside protection in the unlikely case that the company were liquidated.

The average free cash flow of the past 15 years was c.£2bn, thus offering a return on equity of c.14.6%, or with the current market cap of c.£12bn, a free cash flow yield of c.16.7%. This yield provides a considerable margin of safety against negative events, and given the management’s positive stance on returning excess capital to shareholders, plenty of scope for increased earnings/dividends per share and capital appreciation from share buybacks.

Company overview

Aviva is a UK headquartered insurance company with a history extending back over three centuries. It is listed on the main market of the London stock exchange and a member of the FTSE 100 index, with a market capitalization of c.£12bn.

Aviva’s main business segments are: UK & Ireland Life; UK & Ireland General Insurance; Canada General Insurance; and Aviva Investors. The figures used in the following breakdown of these business segments are taken from the latest annual report for the year ending 31 Dec 2021.

The largest segment is UK & Ireland Life, which generated cash remittances of £1.22bn in 2021 out of a total of £1.66bn from continuing operations, or 73%. Aviva is the UK’s largest life insurer with a 25% share of the UK market, equating to 11m customers. Within UK & Ireland life are the following product categories:

• Savings & retirement
  • Workplace pensions: largest workplace pensions provider in the UK with 23,000 corporate clients and 4m members. These pension schemes are largely sold through intermediaries.
  • Retail pensions: primarily sold through external advisory firms, but also internally by Aviva Financial Advisers.
• Annuities & equity release
  • Bulk purchase annuities: currently the second largest provider (behind L&G) in the UK market estimated to be worth £2tn, of which only 10% has been captured.
  • Individual annuities: largest UK provider with over 1m customers.
  • Equity release: manages the UK’s largest book of equity release mortgages, some of which have been securitised and sold on.
• Protection & health
  • Individual protection (life insurance): second largest provider in the UK. Sold through intermediaries such as financial advisers, and directly to customers.
  • Group protection: second largest provider in the UK. Services include life cover, income protection, and critical illness cover.
  • Health insurance: third largest UK provider with over 1m policy holders.

UK & Ireland General Insurance generated £261m in cash remittances in 2021, or 15.7% of total remittances. Aviva is the largest general insurer in the UK and third largest in Ireland, with a combined c.6m customers. The Combined Operating Ratio (COR) for UK & Ireland general insurance was 94.3% in 2021 (2020: 98.2%). It’s products can be divided into the following categories:

• Personal lines
  • Core offerings include home, motor and travel insurance.
  • Multi-channel distribution: direct to customers through MyAviva portal; listing on Price Comparison Websites (PCWs); and through intermediary relationships with brokers, and several UK banks.
  • 3.5m customers.
• Commercial lines
  • Divided between SME business and Global Corporate business (GCS), with both growing at double digit rates in 2021.

Aviva is the third largest Property & Casualty (general insurance) provider in Canada - a market itself the 8th largest in the world with estimated Gross Written Premiums (GWP) of $CAD69bn. Aviva holds an 8% market share. Cash remittances were £156m in 2021, or 9.4% of total remittances, and its COR was 90.7% (2020: 94.7%). Aviva Canada’s products can also be divided into personal and commercial lines as follows:

• Personal lines
  • 63% of overall business mix.
  • Predominantly sold by brokers and RBC Insurance (a position they’re trying to change through investment in digital sales channels to increase direct customer sales).
• Commercial lines
  • SME makes up 19.2% of the overall business mix.
  • GCS makes up 18.1% of the overall business mix.
  • 2021 growth across commercial lines was c.9.7%.

Aviva Investors manages £268bn of assets, with £216bn managed on behalf of Aviva Group. It generated cash remittances of £15m in 2021 and profits before tax of £41m. The products and customers it serves can be divided into the following categories:

• Aviva client distribution channels
  • Savings & retirement: offers products to Aviva’s defined contribution pension and savings customers.
  • Aviva shareholders: provides investment solutions for bulk purchase annuity and individual annuity funds.
• External client distribution channels
  • Large asset owners: insurance companies; consultants; pension funds; sovereign wealth funds.
  • Global financial institutions e.g. large private banks.
  • UK wholesale intermediaries to retail customers e.g. independent financial advisers and wealth managers.

Something to note is that the cash remittances from subsidiaries cancel out on consolidation and hence are not directly reconcilable to the Group’s IFRS consolidated statement of cash flows. In effect this means that cash payments might be paid to the parent company even if the group as a whole has had net cash outflows from operations. This was the case in both 2021 and 2020, where the cash flows from operations were both negative.

Aviva had a number of other international subsidiaries which it divested in 2020 and 2021 for total proceeds of £7.5bn. The case for this divestment was to focus the company on its core markets where it holds substantial market share and is most profitable. £1.9bn of the proceeds was used to repay debts, bringing the debt leverage ratio down to 27%. A further £4.75bn was returned to shareholders through a £1bn share buyback program and a £3.75bn direct cash payment. In order to maintain the share price, a share consolidation was undertaken, reducing the share count by 25%.

The management aims to maintain centre liquidity of c.£1.5bn in normal circumstances. This represents a year’s worth of centre costs, debt interest and dividend payments. Excess liquidity beyond this is available for investment or return to shareholders through dividends and share buybacks.

As an insurance company, Aviva is subject to the Solvency II regulations. These include the Solvency Capital Requirement (SCR), which is the amount of capital Aviva is required to hold on its balance sheet to cover its insurance liabilities in a 1 in 200 year catastrophic event. This figure is influenced by both the size of the insurance liabilities and the current level of interest rates (i.e. expected return on assets). As of 31 Dec 2021, the SCR stood at £9.1bn - a decrease of £3.7bn on the previous year, reflecting the business divestments and an increase in interest rates.

Another important metric is the shareholder coverage ratio, which is calculated by dividing the shareholder’s equity by the SCR value. The management of Aviva has stated that they aim to target a shareholder coverage ratio of 180%, and any capital above this will be available for investment or return to shareholders.

Aviva is making the following investments over the next couple of years:

• c.£100m per annum between 2022 and 2024 in internal growth investments, expected to boost operating profits by £100m from 2025 onwards.
• £200m investment in cost savings, expected to yield £250m per annum cost savings from 2024 onwards.
• Acquisitions, including the now completed purchase of Succession Wealth (a UK based wealth management and financial advice firm) for £385m. This acquisition is expected to yield a double digit return in the medium term as the financial advice services are offered to Aviva’s 6m pension and savings customers in the UK.

The company has announced its intention to pay dividends of £870m and £915m in 2022 and 2023 respectively. This equates to 31.5p and 33p per share and reverses the dividend cut that occurred during the pandemic. Subsequent mid single digit dividend growth is expected from 2024 onwards in line with growth in profits/cash flows.

Balance sheet

In the consolidated statement of financial position from the 2021 annual report, total assets were listed as £358,474m, set against total liabilities of £339,020m, leaving total equity of £19,454m. As previously mentioned, a substantial chunk of this equity has since been returned to shareholders.

The largest items on the asset side of the balance sheet were Financial Investments (£264,961m), Loans (£38,624m) and Reinsurance Assets (£15,032m). Current assets totalled £26,624m, of which £12,485m were cash and cash equivalents.

On the liability side, the two largest items were Gross Insurance Liabilities (£122,250m) and Gross Liabilities for Investment Contracts (£172,452m). Current liabilities totalled £22,945m.

Overall the assets and liabilities seem to be well matched by duration, with sufficient liquidity to cover near-term liabilities.

Income

After tax, the profit for continuing operations was £336m (2020: £1,466m). Adding the profit for the year from discontinued operations and the profit made on their disposal gave a profit for the year figure of £2,036m (2020: £2,910m).

We’re also given an adjusted operating profit figure, which strips out short-term fluctuations due to changes in economic assumptions. The group adjusted operating profit before tax from continuing operations was £1,634m compared with £1,806m for 2020. The variance between these two figures can be seen to be much smaller than the net profit from continuing operations.

Cash flows

The following table shows the cash flow from operations over the last 15 years:

The cash flows for 2020 and 2021 have been skewed by the investment of the proceeds from the disposal of discontinued operations (£7.5bn) into financial investments. For accounting purposes this is treated as a net payment to the operating businesses causing the cash flow from operations to appear substantially negative. As you’ll see later on, this had the reverse effect in H1 2022 as these funds were disinvested prior to the return of capital to shareholders, serving to positively boost the cash flows from operations.

As can be seen, the cash flows vary quite considerably from year to year, but the average over this period was £3,351m. If you exclude the last two years that could be considered to be exceptional, the average figure is £4,227m.

While the recent divestments could be expected to result in lower cash flows from operations in the near-term, the average figure for the last 15 years may still be representative of expected cash flows moving forwards. This is because the business has made both acquisitions and divestments throughout the last 15 years and so has varied in size over this period. The remaining operations also represent the core of the business and the principal profit centre.

To get a better picture of the cash flows attributable to shareholders, it is instructive to subtract financing costs, such as interest expense, and tax from the operating cash flows. This leaves us with the following free cash flows:

Total free cash flow for the last 15 years was £28,509m and the average for a single year was £1,901m. Excluding the last two years brings these figures to £35,684m and £2,744m, respectively.

A brief note on the H1 2022 results

Group adjusted operating profit was £829m, an improvement on H1 2021 where the comparative operating profits from continuing operations were £725m. However, an overall loss was reported for the period of (£633m). This disparity came substantially from short-term fluctuations in the return on investment for non-life business of (£1,080m) and investment variances and economic assumption changes for the life business of (£537m). While this loss does not reflect the underlying profitability of the business operations, or the cash flows they generate, it does reduce the equity attributable to shareholders.

As of 30 Jun 2022, total equity came to £14,401m, down from £19,454m at 31 Dec 2021, principally due to the return of capital to shareholders during this period. Of this total £252m belongs to non-controlling interests, and £496m is attributable to the owners of the 6.875% fixed rate reset perpetual restricted tier 1 contingent convertible notes issued during the period. These notes convert to ordinary shares on the occurrence of a trigger event, which relates to own funds falling below the SCR by a given amount or for a certain period of time. While these notes are in all other respects no different to the rest of the company’s subordinated debt, their convertibility means they are treated as equity.

SCR decreased from £9.1bn to £7.7bn between 31 Dec 2021 and 30 Jun 22. This coincided with a reduction in own funds from £22.2bn to £19.0bn, meaning the shareholder cover ratio dropped from 244% to 234%. There is expected to be a further reduction in own funds of (£1.6bn) when accounting for planned debt repayment and the acquisition of Succession Wealth. This would bring the shareholder cover ratio down to 213%.

This is still significantly above the 180% target, leaving room for further investment and return of capital to shareholders. The board has stated that they anticipate commencing a new share buyback program in 2023 following the publication of the 2022 full year results.

Cash flows from operating activities before tax were £6,148m, compared with £517m for H1 2021 and (£2,554m) for FY 2021. This dramatic difference is helpfully explained in a footnote, which also goes some way to explaining why 2021 and 2020 both had negative cash flows from operations. It reads as follows:

Cash flows from operating activities in the 12 month period ended 31 December 2021 and in the six month period ended 30 June 2022, include impacts from the investment of proceeds from the disposal of discontinued operations into financial investments during 2021, and subsequent disinvestment from those financial investments in the six month period ended 30 June 2022 ahead of the return of capital to ordinary shareholders. This activity is reflected as an increase in cash generated from operating activities in the six month period ended 30 June 2022 (2021: reduction).

So as mentioned before, the operating cash flows were substantially reduced on paper by the investment of the disposal proceeds, and then boosted by their subsequent disinvestment.

Cash remittances from operations for the period were £798m. This is down on the same period the previous year (H1 2021: £1,052m), primarily due to cash being held in operations in 2020 during the uncertainty around Covid, and then released in 2021.

Centre liquidity reduced to £2,735m following the capital return and share buyback (and loss for the period).

Finally, IFRS net asset value (NAV) was 480p per share as of 30 Jun 2022. This is calculated by dividing the equity attributable to shareholders (£13,653m) by the number of ordinary shares outstanding (2.8bn).

Management

The few years prior to 2020 were quite turbulent for management, with a number of executive team changes after relatively short tenures. Since mid-2020 this situation has stabilised somewhat with the exception of the departure of Jason Windsor, the CFO since 26 Sep 2019, in July 2022. Charlotte Jones, the previous CFO of RSA Insurance plc, is being brought in to replace Jason with effect from 5 Sep 2022.

The current CEO, Amanda Blanc, was appointed to the board as a non-executive director on 2 Jan 2020 and then CEO on 6 Jul 2020. Amanda has spent much of her career working in the insurance industry. She started as a graduate at one of Aviva’s legacy companies - Commercial Union plc - and has since progressed through a variety of roles, including a number of senior executive positions at companies such as Axa and Zurich Insurance Group.

George Culmer, the current Chair of the board, was appointed to the board as a non-executive director on 25 Sep 2019 and became Chair on 27 May 2020. George has a wealth of experience gained from holding senior executive positions in a number of banking and insurance companies, including, Lloyds Banking Group plc, RSA Insurance Group plc, and Zurich Financial Services.

I think the board and executive team have done a good job of steering the company through the pandemic while simultaneously carrying out significant divestments. They have also made significant capital management decisions that have been well aligned to the interests of shareholders. This has included the return of £4.75bn of capital to shareholders, from the proceeds of the business disposals, through share buybacks and direct cash distributions.

It is worth noting that there may have been some influence from activist investors on the size of the return of capital. Cevian Capital, which built up a 5% stake in 2021, was an outspoken proponent for a return of capital following the business disposals.

Valuation and investment case

There are two main ways I would approach valuing Aviva, the first is by looking at its book value or equity attributable to ordinary shareholders. As of 30 June 2022 this stood at £13,653m, or 480p per share. This theoretically represents the cash shareholders would receive were the business to be liquidated. While this gives you some idea of your downside protection, it is subject to short-term fluctuations in the value of assets and liabilities as we saw with the (£633m) loss for H1 2022. It also doesn’t reflect the value generated by the business operations. For this I think cash flows offer a better avenue for valuation.

Cash remittances are important as they represent the funds available for paying dividends and reinvesting in the business. However, like profits they are somewhat arbitrary as they depend on management decisions around reserve requirements as we saw from the artificial boost in 2021 as reserves held in 2020 were released.

For a better picture of the cash generated/(used) by the business operations, we need to look at cash flows from operations, which after taking into account financing costs and taxes, gives us the cash flows available to shareholders. As we’ve seen in the figures from 2020, 2021 and H1 2022, the cash flows from operations can vary considerably from year to year and be skewed by exceptional items such as business disposals. Therefore, it serves us to average this figure over an extended period as I did above with data going back to 2007.

From this analysis, I arrived at an average figure of £1,901m including 2020 and 2021, and £2,744m when excluding these years. Given that 2022 is likely to be reversely skewed to 2020 and 2021, and thus cancel out their negative impact, it seems reasonable to say that the average should be a little higher. However, to be prudent (and to make it a nice round number), let’s say the business is generating cash flows for shareholders of c.£2bn each year. With shareholder equity of £13.65bn, this cash flow figure represents a return on equity of c.14.6%, or with the current market cap of c.£12bn, a free cash flow yield of c.16.7%.

This yield provides a considerable margin of safety against negative events, and given the management’s positive stance on returning excess capital to shareholders, plenty of scope for increased earnings/dividends per share and capital appreciation from share buybacks.

There is also plenty of room for organic business growth through reinvestment, and inorganic business growth through targeted acquisitions, like that of Succession Wealth. So we shouldn’t only expect this cash flow figure to remain static or decline.

Risks

As an insurer, Aviva is in the business of assuming and managing risk on behalf of their customers.

Each business segment is exposed to its own set of risks, some of which are common across the company, and others that are specific to that business segment. This provides some diversification within the Group’s overall risk exposure.

Life insurance, which is the largest business segment, is exposed to two principal specific risks: longevity risk and mortality risk. The former affects the annuity business as it means customers are living longer than expected and so receiving payments for longer than originally accounted. While this risk has a big impact on the business, longevity is closely monitored and tends not to change significantly in the short-term. Mortality risk is the opposite of longevity risk and affects the life protection business. Any increase in mortality and subsequent increase in life protection payouts, would at least partially be offset by gains from the annuity business (assuming there was some crossover between the demographic groups for each product).

General insurance similarly has its own specific risks. These relate primarily to loss events (fire, flooding, etc) and inflation. The former adds an element of cyclicality to Aviva’s profits, as there may be spikes in the number of events in some years and then quiet periods in others. The key to mitigating this risk is to hold sufficient capital to cover extreme periods with increased loss events. Capital requirements are specified by the regulators, and Aviva has a substantial surplus above these required levels. If loss events appear to be occurring with increasing frequency, premiums can be adjusted accordingly. This is a benefit of policies typically renewing on an annual basis.

The inflation risk comes from periods where the price of fulfilling a claim (repairing a car, house, etc) rises rapidly, possibly to the point that the aggregate cost of the claims exceeds the initial premiums. This is something that can again be mitigated by holding sufficient liquid capital. Ultimately the premium prices will be adjusted to reflect these increased costs, but there may be a lag period where losses are incurred. This will be limited by the relatively short duration of general insurance policies.

Health insurance is exposed to morbidity risk and medical expense inflation. Morbidity relates to the proportion of customers falling sick and is generally mitigated by close monitoring of disease frequencies amongst the population and carefully worded policies. Medical expense inflation carries the same risks and warrants the same mitigation strategies as general insurance expense inflation.

Risks common to all business segments and the Group at large include: credit risk; liquidity risk; market risk; operational risk; and conduct risk.

Aviva is exposed to credit risk on its portfolio of corporate bonds and other debt instruments. Defaults above a certain level would jeopardise the company’s ability to cover its liabilities and thus the solvency of the business. The company mitigates this risk primarily through diversification, which limits its exposure to any one company or industry. It also weights the majority of its debt holdings towards investment grade securities, further decreasing the risk of loss.

As touched on in the segment specific risks, the company protects itself from liquidity risk by ensuring it has sufficient capital in the form of cash and liquid assets to meet expenses under extreme conditions. This is an area that is heavily regulated and so there is little scope for imprudence on the part of the management.

As the majority of the company’s assets are publicly listed, they are exposed to the fluctuations of the market. These fluctuations constitute the company’s market risk and can affect its ability to cover its liabilities as they become due. Some of these fluctuations in asset values are offset by similar movements in the value of liabilities. This is the case, for example, with investment contract liabilities that don’t have guaranteed returns.

Where a decrease in asset values has been caused by a rise in interest rates, this also has the positive effect of decreasing the value of long-term insurance liabilities, the present value of which is calculated using a discount rate based on the market rate.

There is still the potential for asset values to be adversely affected beyond the extent of offsetting movements in the value of liabilities. To manage this risk, the company endeavours to match the duration of fixed assets with their corresponding liabilities, thus removing the need to sell the assets before they mature. In addition, the company also employs hedging strategies aimed at further reducing exposure to market risks. To similar effect, the company makes use of reinsurance to remove certain liabilities from its balance sheet. Reinsurance also helps to protect against the other risks mentioned, and is used where the company does not see sufficient reward for the risk it is taking onto its balance sheet.

While I’m discussing risk, it is worth mentioning some of the recent events we’ve seen in the UK gilt market and the subsequent effects this had on the UK pension industry. Markets took flight after the publication in September of a fiscal statement by the UK government that was deemed to contain spending commitments that would require unsustainable levels of additional borrowing. I won’t dwell on the fiscal statement itself, or the political fallout, but the economic effect was to cause a drop in the value of the pound and a sharp rise in the yield on UK government debt. It was this sharp rise in gilt yields (and corresponding fall in gilt prices) that triggered a crisis in the UK pension industry.

The decreasing interest rates of the last few decades left many UK pension funds unable to meet their liabilities with the reduced yield available on fixed assets. Some addressed this deficit by moving a portion of their funds into higher yielding but higher risk assets such as stocks, lower grade debt, and alternative assets such as real estate and infrastructure. Many more stuck with government and investment grade corporate bonds, but applied leverage through LDIs and other instruments to synthetically boost their yield. When the price of UK gilts - which were being used as collateral - fell sharply, the pension funds received margin calls and became forced sellers of the same gilts as they struggled to find sufficient cash to cover their positions.

Ultimately, the Bank of England stepped in and started buying these bonds on the market, stabilising their price and preventing a downward spiral taking hold. Had it not done so, a large number of UK pension funds would have become insolvent, with many British people losing some or all of their pension.

Aviva uses derivatives to protect against movements in foreign exchange, interest rates, and the value of equities. They recognised derivative assets of £5,734m and derivative liabilities of £5,763m in the financial statements for the year ending 31 Dec 2021. The net liability from derivatives is lower than this (c.£1bn) after accounting for collateral pledged. You can see from this that the company has balanced its derivative assets and derivative liabilities so the net exposure is minimal. As noted above, the group has substantial liquid capital which should be sufficient to cover any increases in collateral requirements.

As a large life insurer, Aviva has the resources to manage these risks where smaller corporate pension managers may not. This recent market volatility could provide a tailwind for Aviva’s bulk purchase annuity business, as companies look to remove pension liabilities from their balance sheets, and therefore prove to be a net benefit to Aviva.

Conclusion

In conclusion, Aviva trades at a discount to its book value and an attractive multiple of its average cash flows of the last 15 years. It is well equipped to withstand short-term market volatility which has produced paper losses that belie the continued strong performance of its business operations. This creates an opportunity for investors willing to look through negative sentiment and purchase a market leading company at a discount price.