Macquarie Research has assigned an underperform recommendation to Legal & General citing that its annuity business is more challenging post Solvency II.

With Solvency II becoming effective from 1 January 2016, Macquarie Research said this has a large impact on the annuity businessparticularly due to the stress on both credit risk and longevity risk applying for the long outstanding term of the contract.

It explained that companies such as Prudential have decided UK bulk annuities are non-core, following Aviva’s lead in 2014. The main challenge seems to be the higher level of capital needed for the Solvency II risk margin.

According to Macquarie Research, the annuity business drives the earnings of L&G, even without the capital which has been reallocated to LGC (Legal and General Capital division), and the business is still 25% of 1H 2015 operational cash and 19% of IFRS operating profit.

The research provider noted that L&G is moving to a model similar to peer Rothesay (reinsuring longevity risk and investing in infrastructure) which gives much lower ongoing earnings.

In a note to investors, Macquarie Research said: "The back book has benefited from a very benign credit cycle, to which annuity profits are leveraged. The business is now much more dependent on sales growth (and continuing longevity reinsurance) to maintain existing earnings."

The note added: "The business model is, in our opinion, rather limited focussing on annuities (L&G Retirement), Asset Management (LGIM) and Insurance (Protection and a small general insurer).

"The focus on cashflow has also lead to dividend growth well above peers, most recently at the interim results the dividend was increased by 19%. Given the low interest rates, we expect consistent dividend growth is a key attraction for investors."

Macquarie Research concludes that Legal & General’s annuity business remains a leveraged return on credit investments and constitutes a large proportion of the value of L&G.

It stated: "We believe L&G will underperform in challenged debt markets and under the stricter solvency II rules for annuities."