U.K.

Annuity Volumes Will Suffer Until Greater Clarity Emerges On Policyholder Response To Budget
Primary Credit Analyst: Oliver Herbert, London (44) 20-7176-7054; oliver.herbert@standardandpoors.com Secondary Contacts: Simon Ashworth, London (44) 20-7176-7243; simon.ashworth@standardandpoors.com Sanjay Joshi, London (44) 20-7176-7087; sanjay.joshi@standardandpoors.com Mark Button, London (44) 20-7176-7045; mark.button@standardandpoors.com Miroslav Petkov, London (44) 20-7176-7043; miroslav.petkov@standardandpoors.com

LONDON (Standard & Poor's) March 25, 2014--The U.K. government recently announced plans to reform the savings and pensions market over the next year. Standard & Poor's Ratings Services does not anticipate that the reforms will trigger any immediate rating changes. Individual annuities represent less than 10%, or 12 billion, of U.K. life insurance premiums. Furthermore, the sector manages over 200 billion in annuity reserves--these will remain a source of earnings for insurers. We anticipate that the reforms will reduce market growth prospects for some players, particularly those with narrow product profiles, and affect the competitive landscape. However, they are unlikely to have an immediate or material effect on the credit strength of our rated insurers. The U.K. life insurance sector has frequently had to adapt to changes in regulation and tax rules. Broadly, the reforms proposed on March 19, 2014, will introduce: Greater flexibility at retirement from April 2015, enabling all policyholders to choose whether or not to purchase an annuity (a guaranteed lifetime income); Greater ability to draw down pension savings at age 55 or to convert

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savings into cash; and An obligation for insurers to provide free advice for all at retirement. The budget also announced some related reforms, including: An increase in the Individual Savings Account (ISA; a tax-free savings vehicle) allowance to 15,000 a year from July 1, 2014; and From January 2015, the opportunity to invest up to 20,000 in new government-backed savings bonds, for those aged over 65 years. The longer-term implications of the reforms on the business and financial risk profiles of the insurers we rate will emerge gradually and will depend on consumer behavior and on insurers' ability to innovate. The reforms may affect all the major components of our analysis, but we expect any negative effects will likely be mitigated by the sector's product diversity and balance-sheet strength. INSURANCE SECTOR IS PARTICULARLY EXPOSED TO REGULATORY RISK Some of the reforms are subject to consultation until June 2014 and may change before the final legislation passes. However, in our view, the government clearly wants to increase the flexibility associated with pensions and savings products. These reforms add to an already packed regulatory agenda for U.K. insurers and serve to increase the operational uncertainty and strategic challenges that they face. Where we consider the regulatory and political framework to be detrimental to the market in which an insurer operates, we may take a more negative view via our insurance industry and country risk assessment. In particular, we may assess U.K. life industry risk as higher if we expect the reforms to materially weaken market growth prospects, lower potential returns, or elevate product risks. That said, this is not our base-case assumption. TOO EARLY TO PREDICT MARKET PARTICIPANT BEHAVIOR We will monitor the impact of the reforms on policyholder behavior and insurers' strategic responses in assessing the effect on our ratings. At a sector level, variables will include: Opt-out rates for workplace pension schemes and the implications for net savings flows into the sector; Consumers' propensity to access pension savings for consumption; The proportion of individuals who choose to buy annuities, and when they do so; The extent of policyholder demand for alternative products and their willingness to shop around; and Insurers' desire to write capital-intensive business that includes income and investment guarantees. We cannot take the evolution of these variables for granted. Although it has been supported by legislation, the U.K. has a cultural tradition of purchasing an annuity at retirement. Consumer inertia and risk aversion may help to

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maintain some volumes. Policyholders may also be unwilling to engage with alternative, more-complex products, or assume the risk of outliving their savings. Although the government proposes that policyholders should receive free investment advice at retirement, the cost implications of this are very uncertain. More-flexible products may require policyholders to have ongoing guidance, rather than a single session with an advisor. The provision of advice to customers is a long-standing challenge for the sector. For example, banks have mostly withdrawn from providing individual savings and investment advice in recent years; we associate this with their inability to deliver advice in a cost-effective way. The proposed reforms do not affect the tax-efficient nature of a pension as a long-term savings product. Increased flexibility in retirement may improve incentives to invest in a pension. In our view, it is also unlikely that policyholders who have sacrificed disposable income during their working lives would choose to draw down all their savings as soon as they reach age 55 for immediate consumption. This is especially the case for those with larger pension pots, given the adverse tax implications. That said, we do anticipate higher lapse rates among those with smaller pension pots, which are typically less profitable to insurers. An increase in lapse rates triggered by the reforms could weaken earnings if combined with other regulatory initiatives, such as the ongoing debate surrounding charges that can be levied on pensions. This may reduce our assessments of capital and earnings and weaken debt servicing metrics, and may have possible rating consequences. At present, capital strength is generally supportive of ratings in the U.K. life insurance market. INDIVIDUAL ANNUITY SALES ARE ALREADY SLOWING Individual annuity sales were already down to 11.9 billion over 2013 (15% drop in premium terms). The decline reflects disruption from previous regulatory change and the decision by many policyholders to defer purchasing an annuity. Some policyholders have already opted to make use of income drawdown products or delay retirement to avoid locking into low annuity rates while interest rates are so low. We expect to see a further hiatus in sales as policyholders digest the implications of the proposed changes and insurer strategies become clear. We anticipate that insurers will develop new products in response to these reforms. Those insurers that already have a broad product range and presently benefit from strong competitive positions will remain well placed. They can already offer alternatives to policyholders. Those that have more-concentrated business profiles may find their competitive positions and future earnings weaken unless they can innovate and revise their business models. Policyholders may embrace greater flexibility in their choice of retirement income, but may still wish to maintain some guarantees as to their future

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income. Insurers' enterprise risk management capabilities will be tested by the need to launch new products that may carry higher risks--because they include guarantees or innovative features--in a highly uncertain policyholder environment. ANNUITIES POSSESS VALUABLE PRODUCT FEATURES A continuing fall in individual annuity volumes remains a significant risk to margins, over and above those caused by initiatives already set in motion by the Financial Conduct Authority and the Association of British Insurers. Nonetheless, we expect the product to remain relevant. Annuities are a "hedge and forget" solution: protecting policyholders financially against an uncertain lifespan and from having to actively manage their savings assets to generate income. In addition, a material proportion of existing pension savings benefit from valuable guaranteed annuity options. The potential market for individual annuities remains very large. The U.K. insurance sector has a stock of about 600 billion in defined contribution pension assets. It has already passed legislation that will automatically enroll employees into workplace schemes (making the system opt out, rather than opt in). The increase in participation should cause annual pension savings to rise by around a third by 2018 (11 billion a year). This should provide considerable momentum to the build-up of available savings assets that could be used to purchase retirement income products. CORPORATES REMAIN KEEN TO EXTINGUISH THEIR PENSION LIABILITIES In 2013, the total annuity market was worth 21 billion. About 45% of this consisted of bulk-annuity transactions purchased by companies seeking to transfer the risks and responsibilities of managing their defined-benefit schemes to insurers. These volumes are inherently large, but uneven, and the effect of the reforms on these schemes is particularly unclear. However, we consider that there is scope for the bulk annuity market to continue growing. U.K. corporate balance sheets still hold over 1 trillion in defined-benefit pension scheme liabilities. We may see some new business margin pressure on the bulk annuity sector as competitors increase their focus on this segment. However, this may also be offset by natural growth momentum, as well as the barriers to entry and the higher risk profile associated with managing this sort of business. INFRASTRUCTURE ILLIQUIDTY PREMIUM REMAINS ATTRACTIVE Insurers have responded to low interest rates by investing in long-dated assets which are less frequently traded than assets such as government bonds. These illiquid securities, such as infrastructure projects, typically attract higher returns and are used to match annuity liabilities. Certain insurance players agreed with the government in December 2013 that they would invest 25 billion in U.K. infrastructure over the next five years. However, this is a small proportion of the total stock of annuity assets, which presently stands

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at over 200 billion. Where insurers can benefit from higher returns by investing in illiquid assets, with limited extra credit risk, we believe they will continue to do so. Further, insurers will continue to reposition their existing assets backing annuities following the greater clarity on the EU's Solvency II directive (see "Underwriting The Recovery: Insurers' Role As Investors Expected To Be Preserved," published on Jan. 14, 2014). A fall in the volume of new annuities being purchased will likely curtail insurers' long-term capacity for investing in illiquid assets. However, if the total size of the annuity market shrinks, it will increase the need to be competitive and the need for yield. RATINGS IMPLICATIONS UNLIKELY TO BE MATERIAL At this stage, we consider the reforms unlikely to have any material rating implications. However, we may see a period of elevated industry risk and changes to the competitive landscape. The reforms will predominantly affect new business sales, which are small in relation to the size of the existing stock of insurance liabilities. Financial and business risk profile assessments could be affected by changes in policyholder behavior and insurers' strategic responses. However, the change in liability and risk profiles will be gradual. RELATED CRITERIA AND RESEARCH Underwriting The Recovery: Insurers' Role As Investors Expected To Be Preserved, Jan. 14, 2014 U.K. Life Insurance Sector Carries A Low Industry And Country Risk Assessment, Nov. 6, 2013 Under Standard & Poor's policies, only a Rating Committee can determine a Credit Rating Action (including a Credit Rating change, affirmation or withdrawal, Rating Outlook change, or CreditWatch action). This commentary and its subject matter have not been the subject of Rating Committee action and should not be interpreted as a change to, or affirmation of, a Credit Rating or Rating Outlook.
Additional Contact: Insurance Ratings Europe; InsuranceInteractive_Europe@standardandpoors.com

Standard & Poor's Ratings Services, part of McGraw Hill Financial (NYSE: MHFI), is the world's leading provider of independent credit risk research and benchmarks. We publish more than a million credit ratings on debt issued by sovereign, municipal, corporate and financial sector entities. With over 1,400 credit analysts in 23 countries, and more than 150 years' experience of assessing credit risk, we offer a unique combination of global coverage and local insight. Our research and opinions about relative credit risk provide

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