The recent rise in UK gilt yields has mixed implications for life insurers, but the overall impact is negative for valuations, according to analysts at RBC Capital Markets.
Yields have been rising across the curve but more at the long end, with the 30-year gilt yield topping 5.7%, the highest level since 1998.
RBC's financials team noted that higher long-term rates narrow the spread between sector dividend yields and gilts, making payouts look less attractive in relative terms.
"Some investors compare the dividend yield of UK life insurance sector companies to UK gilt yields, using the spread between the two as a proxy for credit risk (offset by dividend per share and book value growth).
"As long-term rates rise, UK life insurers’ dividend yields appear relatively expensive compared to gilt yields, which tends to exert downward pressure on share prices.
"However, this trend has recently reversed, without any apparent cause, leading to a narrowing of the spread between the sector's dividend yield and gilt yields."
The analysts also highlighted negative implications for balance sheets, with equity positions falling as rates climb.
"This is a key area of focus," particularly for Phoenix Group Holdings PLC (LSE:PHNX) and Legal & General Group PLC (LSE:LGEN), "given the recent declines in IFRS shareholders’ equity."
By contrast, Solvency II ratios improve as higher discount rates reduce capital requirements, while annuity and pension risk transfer demand may benefit over time, albeit with smaller deal sizes.
RBC set out its preference order for the sector, "in the context of rising rates exposure", as Chesnara PLC (LSE:CSN), rated 'outperform'; M&G PLC (LSE:MNG), rated 'sector perform', Legal & General at 'underperform' and Phoenix Group Holdings PLC (LSE:PHNX) at 'outperform'.