Bangers and the crash

Editor's Letter

One of the most surprising aspects of the recent period of economic turbulence has been the transformation of the humble second-hand car. Eighteen months ago, as environmental standards tightened, and petrol prices soared, the owner of a 10-year-old gas-guzzling family car looking to upgrade was facing a double cost - buying a new car and paying someone to get rid of the old one.

But as politicians around Europe have latched on to the idea of offering consumers big incentives to scrap their old rustbucket in return for a cash grant towards the purchase of a new car, the value of a decade-old jalopy has soared.

The German scheme puts EUR2,500 in the hands of car buyers, while similar schemes in Italy, France and now the UK have been credited for driving up car sales by as much as 40%. Using the fig leaf of environmentalism, governments have created the win-win situation of boosting their domestic economies and pleasing their car-owning constituents.

Overnight - and as a direct consequence of the economic conditions - the value of old cars has rocketed from being a liability of a couple of hundred pounds to becoming an asset that brings its owner a lot closer to that shiny new BMW they have had their eye on for some time.

However, just as the impact of the credit crunch has been a spike in the value of old cars, it has tanked the value of marquee names of the European insurance sector. Allianz, for example, has seen its share price plummet from EUR130 at the start of 2008 to about EUR70 by the middle of April last year; at the same time, Axa's share price has quartered to EUR6 over the past 12 months.

The pressure on insurers' share prices has racheted up as they report their results using market-consistent embedded value (MCEV) and with risk-free rates reaching record lows at the long end of curve in 2008 the resulting valuations were not pretty.

Aviva's decision to publish under MCEV was bold, given its heavy exposure to the type of long-dated liabilities that fare badly under the metric. And when the market saw its IFRS losses after tax of £855 million transformed into a £7.7 billion MCEV loss, its shares fell 33% on the day, and 40% in the space of 48 hours.

As the spreads on the long-term assets used to back Aviva were squeezed, the value of its liabilities shot-up. In a mirror image of Europe's used car market, their value had radically changed overnight due to the impact of external events.

Market consistency ideologues will simply retort that the market price is the market price. But given the failure of economists of the calibre of Jevons, Smith and Ricardo to answer the question, "what is a universal store of value?", intuition suggests the task of finding universal value of an insurance company may be equally fraught.

Does this mean the MCEV metric has suffered the ironic fate of becoming valueless? Storebrand's chief financial officer (CFO) Frederic Ottesen says no - it merely needs tweaking, and on page 16 he outlines a liability valuation approach for Solvency II that is already in use to provide the Norwegian company's MCEV figures.

Aviva's CFO Philip Scott offers a relaxed take - MCEV is distorted by current market conditions, and it will return to usefulness as those conditions calm. The ultimate outcome of this debate over how long-term liabilities are valued is central to not just MCEV but also Solvency II. Getting the correct answer is vital. With the car-scrapping scheme, European governments have demonstrated how to create value from nothing - it is important that Solvency II, or MCEV do not do the opposite.