UK Insurance - Pearl assumptions overtaken by events as FSA delays takeover of Resolution

The UK Financial Services Authority's (FSA) concern that Pearl's aggressive approach to modelling Resolution's future cashflows could negatively impact the interests of policyholders, has led to a delay in the takeover of the closed fund specialist as the regulator reviews the plans.

In a joint release, the companies said that Pearl's original change of control application to the FSA was based on the information available concerning Resolution's recommendation of its offer on November 16, 2007.

However, "In the light of the exceptional recent volatility of financial markets on the company, Pearl has sought further detailed and updated information on Resolution's financial position."

According to a source familiar with Resolution's financial situation, the FSA has asked Pearl to re-examine the assumptions and stress testing used by Pearl in its plans to release the surplus capital from the balance sheet of the company headed by Clive Cowdery. According to Resolution's 2006 annual report, surplus capital stood at £2 billion against liabilities of £50 billion.

As a closed book matures, less capital is required to back it, which can then be fed back into the parent company. But according to the source, the FSA was concerned at how recent market volatility might make Pearl's capital release plans over ambitious. "The FSA needs to be confident that there will be enough capital to support policyholders, and they might be required to inject more," said the source.

The FSA declined to comment, citing the confidentiality of the change of control process which it said could take up to three months to assess, but in reality, "Will occur much quicker." Another source familiar with the details of the takeover said that the FSA moves were part of a wider drive to ensure that life offices are well-capitalised, and was simply, "Part of the political climate post Northern Rock. They want to demonstrate they have properly assessed this deal."

According to Peter Elliot, analyst at MF Global, even if the FSA decides Pearl's plans for Resolution are overly aggressive and that it will need to inject capital to shore up Resolution's balance sheet, this is unlikely to derail the takeover process.

"Pearl has invested too much time and money in Resolution simply to walk away at this point," said Elliot. "It owns 25% of Resolution, which if the deal fell through would be worth significantly less than was paid for it. Pearl's credibility would be damaged also - who would want to conduct takeover deals with it in the future? And even if the future cashflows are smaller than expected, Pearl still needs them."

The source familiar with details of the takeover, however, rejected the idea that Pearl would even face the scenario of increasing the amount of capital it would need to put up against Resolution. "The FSA has put a lot of time into introducing the individual capital assessment, realistic balance sheets and ensuring that stress testing is done correctly - and on a consistent basis.

"Both Resolution and Pearl have constructed their capital positions under existing FSA regulations, and it would seem absurd to suggest that when they merge they should be subject to more onerous capital requirements than their competitors. Particularly when they are both closed book companies and are exposed to less risk that their open book peers."

The third partner in this deal is Royal London Mutual, which originally was going to take on the legal entity of Resolution's Scottish Provident business in exchange for providing Pearl with £1.3 billion of funding for the deal. Royal London is obtaining its cash from the £2 billion unallocated divisible surplus - the mutual equivalent of the inherited estate in publicly limited insurers - sitting in its with-profits fund.

A spokesman for the insurer was at pains to point out that this move would not lead to a decimation of the funds used to support Royal London's with-profits policyholders. "If you calculate the total level of assets and liabilities that we will receive as part of the Resolution deal, the net cost is a reduction in our estate of about £50 million. Instead of using surplus assets to invest in riskier assets, we are benefiting policyholders by increasing the size of the total fund." Lazard & Co, and Citigroup are advising Resolution, while Pearl's advisers are Deutsche Bank, Morgan Stanley and ABN Amro.