DEALWATCH: Capital Volatility May Force Aviva U-Turn On US Operations

The volatility of Aviva PLC's (AV.LN) level of capital surplus and the uncertainty surrounding the upcoming Solvency II capital regime could force the large U.K. insurer to make a U-turn and consider selling its important U.S. life insurance operations, analysts said Thursday.

The comments come after newspaper reports said Aviva is considering the sale and could fetch around GBP1 billion from it, which is only about half the price Aviva paid for the business, including debt, in 2006.

The reports surprised the market and run counter to Aviva's oft-repeated strategy of focusing on 12 key markets around the world. These 12 are the U.K., Ireland, France, Spain, Italy, Poland, Russia, the U.S., Canada, Turkey, China and India.

"This seems at odds to previous indications that the U.S. was one of the group's 12 core divisions, albeit that it accounted for 8% of continuing IFRS profits in 2011," said Shore Capital analyst Eamonn Flanagan.

Oriel Securities analyst Marcus Barnard said: "This would in our opinion be a U-turn and change of strategy."

Aviva has set requirements that its businesses must meet to be considered "core market," including that they should generate an annual operating profit of $100 million and a 12% return on capital. The U.S. business meets these requirements. Last year, it grew its life insurance operating profit by 13% to GBP197 million, with a return rate of 14%.

"The U.S. business, being spread-based, has volatile capital requirements under Solvency II. We feel this has similarities to complaints from Prudential (PRU.LN) that said its capital position under Solvency II would be difficult to manage," Barnard said.

"The capital surplus at Aviva fell during the third quarter only to recover during the fourth quarter. Selling the U.S. business would reduce this capital volatility," Barnard said.

An Aviva spokesman declined to comment on the reported plan to sell the U.S. business.

Last month, Aviva Chief Executive Andrew Moss said the company was "very experienced" in managing its capital surplus, which acts as an extra buffer of cash to cover liabilities.

"We know that it's volatile--between GBP4 billion to GBP3 billion and then to GBP2 billion--but we also know the way calculations work, and because of the hedges we've got in place, it's far less volatile when you get down to about GBP2 billion," he said.

Aviva's surplus capital at the end of 2011 was GBP2.2 billion, down from GBP3.8 billion at the end of 2010, and down from GBP4.5 billion at end-2009.

That figure had risen to GBP3.3 billion by the end of February as stock markets rose.

"The requirement is to have one solitary pound in excess, if we take it to the extreme. I don't want to sound complacent but we're very experienced in managing this number," Moss said.

Another reason why Aviva would sell its U.S. life business, analysts say, is the uncertainty over Solvency II, more specifically, its provision on so-called "equivalence."

This provision answers whether or not other countries like the U.S. would be deemed by the European Commission as having a capital regime which is as stringent as Solvency II.

Lawmakers are still debating the draft law but it is currently scheduled to be implemented by European insurers in 2014.

If the U.S. capital regime isn't deemed equivalent to Solvency II, European insurers fear they may be forced to set aside billions of euros worth of capital as added buffers for their U.S. operations.

"Do we think it (Solvency II) is the right way to treat our U.S. business for capital purposes? No, we don't, just like the Pru. But it's a lesser issue for us because our U.S. business is broadly half their size," Moss said.

Prudential last month said it is looking at whether it should move its headquarters away from the U.K. due to the uncertainties surrounding Solvency II.

However, Moss said the issue of equivalence could be resolved amicably.

"I'm pretty confident that some sort of solution will be reached. Because, politically, how can it make sense for the U.S. subsidiaries of large European insurance companies to be massively commercially disadvantaged relative to their American competitors? It doesn't make any sense," he said last month.

Shore Capital's Flanagan said a U.S. disposal would remove "a capital intensive business from Aviva's stable, a positive move in the group's focus on improving its return on equity, particularly as Solvency II approaches."

This would also "bring Aviva's focus firmly back to the U.K. and Continental Europe," he said.

"The question, however, is who might be a buyer?," Flanagan said.

Panmure Gordon analyst Barrie Cornes said: "Whilst there may be a strong rationale for such a sale including the consequent capital boost, Solvency II concerns and the European strategic focus, we do not think that current prices for U.S. life businesses make a disposal sensible at the current time."

"Whilst obviously Aviva would consider any serious offer for any part of the business, in our view a suitable offer is unlikely in the short to medium term," Cornes said.

-By Vladimir Guevarra, Dow Jones Newswires: [phone], [e-mail]