In need of reassurance

The knock-on effects of the crisis in equities has hit the insurance sector particularly hard – so much so that UK regulatory body the FSA has been forced to step in and allow certain insurers to breach mimimum solvency ratios. Oliver Holtaway asks how this might affect bondholders

Unless you have recently returned from a long holiday in Antarctica, you will probably have noticed that the insurance sector is going through what analysts might euphemistically term a ‘rough patch’. The turmoil in global stock markets – since 2000, the Dow has fallen 30% and the FTSE is down 51% – has left insurance companies with greatly reduced assets to meet their liabilities.

Equity troubles have affected insurance companies across the board: both life assurers and non-life companies from the US, UK and Europe.

Rating agencies, which for the past two years have maintained that the pressure on insurance companies’ battered creditworthiness would be alleviated by cyclical trends, have finally reacted. In December, Moody’s downgraded Prudential, Legal & General, Standard Life and Friends Provident, with most other insurers still on review. Standard & Poor’s has placed most insurers on negative outlook.

But UK life assurers have felt the most pressure as they were more heavily exposed to equities than their non-life and European counterparts. In 2000, UK insurers’ investment portfolios contained an average equity component of 55%, compared with second-place France’s 30%.

What’s more, insurance debt is also a larger component of the UK bond market than in Europe or the US. The sector accounts for 6.4%, or a notional value of $16 billion, of the Merrill Lynch sterling corporate bond index – compared with 2.7% ($44 billion) in the dollar market and 3.5% ($30 billion) in euro market. Spreads in these indices have widened dramatically over the last 12 months, to 91bp from 55bp in the euro market and to 194bp from 114bp in the sterling market.

In response to the downward pressure on equities, the UK’s financial regulator, the Financial Services Authority (FSA), has relaxed the insurers’ required minimum solvency rates. Like most European regulators, the FSA requires UK insurers to maintain a statutory minimum solvency ratio. At the end of January the FSA announced that, as some insurers were coming close to breaching that minimum, it would allow insurers to apply for a waiver to their regulatory commitments. As recently as four years ago it was de rigueur for insurers’ capital to cover the minimum solvency ratio up to nine times over.

The FSA has decided to relax the regulatory requirements because falls in the equity market were forcing insurers to sell their equity holdings and creating a vicious circle – regulations demand UK insurers are able to meet the statutory minimum even if the value of their equity holdings falls by 25%.

But these solvency rates are also crucial for bondholders because they express insurance companies’ ability to meet their liabilities to policyholders. Senior insurance debt holders are deeply subordinated to policyholders in this sector, leaving subordinated debt holders subordinated twice over.

But the FSA’s decision has hardly prompted sighs of relief from bondholders, who complain that the move has merely added more confusion to the situation. Alok Basu, credit analyst at Gartmore Investment Management, is not reassured. “It’s tantamount to a bank regulator waiving the need for risk weighting – moving the goalposts to suit a losing team,” he says. While the decision triggered a minor rally in the equity markets, the ramifications for bondholders are less clear.

“The real problem,” adds Basu, “is that the FSA’s decision tells you nothing about the real position of these firms. What if equity keeps falling, what happens then?”

Pilar Gomez-Bravo, insurance analyst at Lehman Brothers, is less perturbed by the FSA’s act of leniency, given that the statutory solvency requirements barely relate to actual financial solvency. “It is fine, as long as it is a temporary measure,” says Gomez-Bravo. “The requirements are quite conservative, and I doubt you’ll see many insurers taking the FSA up on their offer of a waiver – none of the larger companies anyway.”

Nevertheless the move does pose bond investors new questions. The waiver does not technically absolve insurers of their obligation to meet the minimum, but rather allows them greater scope in the way in which they calculate their solvency ratios. For instance, placing implicit items on the balance sheet (for example, future projected profits) helps insurers nominally meet statutory targets, and makes balance sheets look healthier.

But merely reorganising the balance sheet will not inspire investor confidence, and given that the practice of recognising future profits is likely to be prohibited in Europe by 2009, it is hardly a forward-thinking solution. This is symptomatic of a core problem in investing in insurance debt: insurance companies are notoriously opaque. To make matters worse for bondholders examining any repercussions of the FSA’s move, insurance accounts are intrinsically complicated compared with most other sectors.

Says Gartmore’s Basu: “There’s no reason for this opacity. It reminds me of banks in the late 1980s. The technical solvency figures are available to regulators on a daily basis – investors have the right to know where they stand.”

In addition to complicated accounts, the insurance sector is a relative newcomer to bond issuance, and consequently dedicated insurance analysts are a relatively new phenomenon. “It is a new area for issuers, and I am surprised by the demand for experienced insurance industry insight,” says Christian Dinesen, insurance analyst at Merrill Lynch, and previously the head of Heddington Insurance. “In the past, most insurance analysts tended to be bank analysts who had been asked to do more work.”

And even if the sector was not new, the stunning decimation of the FTSE and other stock markets over the past three years makes it difficult to claim that anyone truly has experience in dealing with the market conditions the insurance sector faces today. Bondholders are left wondering whether there is any value to be had in the market, or whether it is just better to walk away and invest in sectors that are easier to understand.

“There are the believers and the non-believers,” says Damien Régent, insurance analyst at UBS Warburg. “Some will simply stay away from the market, but there is some value there.” Dinesen agrees: “All the insurance companies have been under pressure, but now we see some companies have reached a credit plateau, while there are some still under pressure. Value has become name specific.”

Fiona Thompson, insurance analyst at Morgan Stanley, says: “We need to look at who will be the long-term winners in this situation. The large issuers of debt are undervalued, in my view. Prudential, Legal & General, Aviva, Standard Life, Generale and ING should be fine, but a lot of mid-tier players could be in trouble.”

“The most important factor is financial flexibility, having easy access to capital markets,” says Lehman’s Gomez-Bravo. Larger insurers are better placed to extract more cash from their shareholders – through rights issues, for example – and bond investors should seek out the insurers who are prepared to do so. “Look at recent capital-raising actions,” says UBS Warburg’s Régent. “Legal & General has launched an £800 million rights issue – that’s a positive, confident signal. Friends Provident issued convertible debt, another confident move.”

Gomez-Bravo recognises, however, that the ability to raise sheer volumes of capital is not enough to preserve or repair credit quality. “The problem is not capital per se,” she says, “it is asset-liability management. Liabilities are the game – that’s where the surprises are.” Financial flexibility may be important, but bolstering the asset side of the balance sheet is not that useful if the insurer cannot control the liability side.

When it comes to the management of liabilities, bondholders’ coupons are in direct competition with policyholders’ benefits. While it may sound harsh, investors are thus well advised to seek out insurers who are not squeamish about trimming policyholder benefits, and those who are changing their product mix to adapt to their circumstances. Put simply, do not buy bonds and life assurance from the same company. UK life assurers have an advantage in this respect, in that their ability to reduce and restructure policyholder benefits is less constrained by regulation than is the case in Europe.

Merrill Lynch’s Dinesen insists that this ability to manage capital is what investors should be looking for, and he disagrees with the notion that investors should take refuge in larger names. By Dinesen’s reckoning, small insurers, more experienced in intensive capital management, are like mammals to the large insurers’ dinosaurs: leaner and more adaptable.

“It’s frankly lazy to assume that big is beautiful,” says Dinesen. “Simply having a huge amount of capital is not enough to maintain credit quality. If a lot of capital was enough, you wouldn’t have seen all these triple-A names getting downgraded. Yes, size can be important for outright survival and has greater potential for recovery from stress, but when you’re looking for relative value, effective management of capital is key.”

“For example,” adds Dinesen, “I prefer Legal & General to Prudential – they have a more proactive approach to asset allocation. I believe Legal & General is more like mid double-A and Prudential more like high single-A.”

Dinesen argues that for the life assurance sector, good capital management means recognising the capital costs of product design. Insurance company products typically offer either guaranteed income to policyholders or equity-linked products that essentially transfer risk to the policyholder. When investment income is volatile, investors should favour insurance companies that shift the emphasis in their product range towards equity-linked products. These may not be as popular with consumers, but show that the insurer is taking a realistic approach to product design.

In the non-life universe, bond investors should look to those insurers that keep their capital constraints in mind when underwriting business. During the period of overcapitalisation three or four years ago, non-life insurers focused on increasing volumes and increasing market share. Insurers were prepared to accept a technical loss (that is, a loss in terms of premiums charged to policyholders minus claims paid out to policyholders), as they could reliably count on investment income to make up the difference. This reliability, Dinesen and other analysts argue, no longer exists. The best bets for bond investors are the non-life insurers who have taken this on board, charging realistic, or higher, premiums and underwriting realistic, or lower, volumes of business.

Life assurers that continue to sell guaranteed income products as interest rates and equity markets fall, and non-life insurers who continue to underwrite large volumes of business should be red flags to investors: these companies are so focused on preserving or increasing market share that they are prepared to accept technical losses and remain hostage to volatile investment income.

While there is agreement that realistic capital management is vital to debt performance, Dinesen’s preference for smaller insurers puts him in a minority. “The small companies are used to having to fight for every penny, but they are nevertheless more vulnerable to a massive structural change in the sector,” explains Gomez-Bravo. “A £100 million hit is a £100 million hit – a £1 billion company can weather it but a smaller one, no matter how skilled at active management, will be wiped out.”

Either way, analysts accept that prospects for sector-wide recovery depend very much on what happens to the equity markets in 2003. “Recovery of the insurance sector is hostage to recovery in the equity markets,” insists Gartmore’s Basu. “Insurers have made themselves less vulnerable, but where does their true solvency stand?”

“I believe there will be ongoing volatility for spreads because there will continue to be seepage of equity market sentiment into bond spreads,” says Morgan Stanley’s Thompson. Still, she believes that the beleaguered industry has turned a corner. “I see 2002 as the credit bottom, the stabilisation of credit deterioration in this sector. Based on our equity strategists’ view of the equity markets in 2003, we believe insurers may begin a gradual repair process – but this may not be felt until even the last quarter of the year,” she says.

Lehman’s Gomez-Bravo agrees: “Has the sector bottomed out? 2003 will be another challenging year. We can expect 2002 results to be awful, but at the same time we will hear sighs of relief. In terms of capital health and solvency, we will start to see reassuring signs.”