Aviva plc (AV) Ratings Affirmed by Moody's Following Move to Merge with Friends Life

Moody's Investors Service has affirmed the insurance financial strength rating (IFSR) of Aviva Life & Pensions UK Limited (ALP) at A1 (negative) and the debt ratings of Aviva Plc (NYSE: AV) (Aviva; (P)A3 senior debt, stable). Moody's also placed on review for upgrade the A3 IFSR of Friends Life Limited and the debt ratings of Friends Life Holdings plc (Baa2(hyb) guaranteed senior subordinated debt). Moody's has also affirmed the A1 IFSRs of Aviva Insurance Limited (AIL) and Aviva International Insurance Limited (AII), both with a stable outlook.

Today's rating actions follow Aviva's publication of further details on its proposed all-share acquisition of Friends Life Group Limited (Friends). Moody's says that the Aviva affirmation captures the potential for improvements in Aviva's financial profile, post transaction, but notes that whilst this transaction will help Aviva achieve some of its stated financial targets, in Moody's opinion the transaction increases Aviva's exposure to the challenging UK life insurance market. Any transaction remains subject to both regulatory approval as well as shareholders' approval, with the transaction expected to complete in the second quarter of 2015.

According to Aviva's statement, Aviva would acquire the entire share capital of Friends, in exchange for a consideration of 0.74 Aviva ordinary shares for each Friends ordinary share. The total consideration payable (based on the 21 November 2014 closing share price) would be around GBP5.6 billion.

See below for a full list of the affected ratings.

RATINGS RATIONALE

--- AFFIRMATION OF AVIVA'S RATINGS

The affirmation of Aviva's ratings reflects a combination of (1) improvement in pro-forma financial leverage following the transaction, with Aviva's pro-forma 2013 leverage likely to improve to the high-20's (Aviva's standalone at year-end 2013: 32.3%); (2) an improved market position in Aviva's core UK market, post-transaction; and (3) modest improvement in capitalisation expected post-consolidation, with Aviva's economic capital coverage ratio of 180% as at H1 2014 likely to modestly increase. In particular, Moody's considers the all-share nature of the transaction to be credit positive for bondholders and will improve leverage to levels consistent with a low Aa score.

However, the affirmation also reflects Moody's views on the political and regulatory headwinds currently affecting the UK life insurance market, with Aviva's exposure to this market to increase following the acquisition of Friends (Aviva has a market share of 10% and Friends of 6% based on 2013 Annual Premiums Equivalent). In particular, Friends' key product strengths include corporate pensions and, to a lesser extent, annuities. Both of these segments remain under pressure as a result of the pension fund charge caps and the March 2014 Budget reforms on annuities.

Furthermore, Moody's believes that whilst this transaction will help Aviva achieve a number of its stated financial targets (particularly around capital/cash generation and deleveraging), this transaction is, in Moody's opinion, a deviation from our understanding of Aviva's strategic roadmap. In particular, we previously believed that future growth for the Aviva group would mainly occur from General Insurance and/or Emerging Markets, neither of which this transaction addresses (albeit that Aviva notes that the transaction would enable investment in its growth businesses).

Positively, the transaction has the potential to increase flows and assets under management into Aviva Investors (AUM of approximately GBP240 billion as at year-end 2013, of which approximately 80% are in-house assets). Aviva estimates that up to another approximate GBP70 billion of assets could become Aviva Investors AUM over time, but the timing and profitability of these flows remains uncertain.

Finally, Moody's expects that Aviva's future earnings coverage will be partially suppressed as a result of this acquisition, at least in the near-term. Whilst Aviva's historical earnings coverage has been weak (2009-13, five-year average: 2.7x), 2013 witnessed an improvement to 6.2x, reflecting improvements in underlying profitability. Conversely, Friends Life's earnings coverage metrics have been very weak in recent years (2013: 1.1x), albeit this is driven by the inclusion of significant non-cash items such as amortisation charges and impairments of the acquired in-force business and other intangible assets (2013: GBP483 million).

--- NEGATIVE OUTLOOK ON AVIVA LIFE & PENSIONS

The continued negative outlook reflects ALP's current and expected future exposure following the transaction to both the individual annuity and corporate pensions markets, both of which Moody's considers to be under pressure. This transaction does not fundamentally change Moody's view that Aviva faces challenges within the UK life insurance market, with Aviva still needing to react to changes in the individual annuity market, a line of business for which Aviva has traditionally been the market leader and which is seeing significant volume reductions.

--- STABLE OUTLOOK ON AVIVA PLC

Aviva Plc's ratings were affirmed with a stable outlook. The stable outlook on the group's ratings reflects a combination of the recent improvements in Aviva's underlying profitability, notwithstanding the pressures within the UK life insurance market, together with the equity financing nature of this transaction.

The affirmation with a stable outlook on Aviva Insurance Limited (AIL) and Aviva International Insurance Limited (AII) reflects Moody's view that these two entities will be largely unaffected by the transaction. AIL focuses on the UK general insurance market and AII continues to act as the internal reinsurance mixer for the Aviva group.

--- REVIEW FOR UPGRADE FOR FRIENDS LIFE

The review for upgrade on Friends' ratings reflects Moody's view that Friends will benefit from Aviva's very strong positions in both UK life and non-life insurance, post-transaction. Overall, positive rating implications are likely for Friends, because of (1) Moody's higher ratings on Aviva (implying higher creditworthiness for Friends, post-transaction); and (2) the transaction envisages that Aviva will acquire the whole of Friends business.

If the transaction goes ahead, Moody's review will focus on the integration plans for Friends' business and legal entities, including any implications for Friends Life debt. If an acquisition occurs, Friends Life's ratings could be upgraded by at least one notch.

LIST OF AFFECTED RATINGS

The following ratings were affirmed with a stable outlook:

Aviva Plc: guaranteed senior unsecured debt at A2

Aviva Plc: senior unsecured MTN at (P)A3

Aviva Plc: subordinated debt at Baa1(hyb)

Aviva Plc: junior subordinated debt at Baa1(hyb)

Aviva Plc: senior subordinated MTN at (P) Baa1

Aviva Plc: subordinated MTN at (P)Baa1

Aviva Plc: preferred securities at Baa2(hyb)

Aviva Plc: junior subordinated MTN at (P)Baa2

Aviva Insurance Limited: insurance financial strength rating at A1

Aviva International Insurance Limited: insurance financial strength rating at A1

The following ratings were affirmed:

Aviva Plc: guaranteed commercial paper at P-1

Aviva Plc: commercial paper at P-2

The following ratings were affirmed with a negative outlook:

Aviva Life & Pensions UK Limited: insurance financial strength rating at A1

The following ratings were placed on review for upgrade:

Friends Life Limited: insurance financial strength rating at A3

Friends Life Holdings plc: guaranteed senior subordinated debt at Baa2(hyb)

Friends Life Holdings plc: guaranteed junior subordinated debt at Baa3(hyb)

PRINCIPAL METHODOLOGIES

The principal methodology used in rating Friends Life Holdings plc, Friends Life Limited and Aviva Life & Pensions UK Limited was Global Life Insurers published in August 2014. The principal methodology used in rating Aviva Insurance Limited was Global Property and Casualty Insurers published in August 2014. The principal methodologies used in rating Aviva Plc and Aviva International Insurance Limited were Global Property and Casualty Insurers published in August 2014, and Global Life Insurers published in August 2014. Please see the Credit Policy page on www.moodys.com for a copy of these methodologies.

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