Kiss of death for the life industry

Prudential, Legal & General, Axa, Swiss Life - life insurance companies were queuing last week to reassure us that despite plunging stock markets and rising corporate collapses they are resilient, financially strong and committed to investing in shares.

It would be more surprising if they were saying anything else. An insurance company which needs to sell shares to meet regulatory requirements is hardly going to be broadcasting that to the market; nor is it likely to give advance warning about cuts in bonus rates or the need for a rescue rights issue to keep its business on track. In truth, almost the entire industry is contemplating these actions.

'Companies can reassure as much as they like,' said Roger Doig, insurance analyst with JP Morgan. 'But implicit within their arguments is the notion that the market rebounds.'

If the stock market stays flat - which would trigger a toughening of the Financial Services Agency's resilience test - or, as the doom-mongers warn, falls a further 1,000 points, then even the strongest companies could be starting to squeal.

The problem is that, like everyone from the cab driver to the top investment banker, the insurance industry was seduced by the cult of the equity. Even such companies as Prudential, which has been cutting its holdings of shares over the last three years, still has more than half its assets invested in the stock market, higher than most of its European counterparts.

At Standard Life, 75 per cent of its life fund is invested in equities, and the impact of the stock market fall will have been severe.

Ned Cazalet, an independent insurance analyst, estimates that its surplus capital - effectively, its protection against disasters - has fallen from £11 billion at the end of 1999 to just £2bn now - and it could be lower than that. For the industry as a whole, he thinks the £130bn surplus two-and-a-half years ago could have all but gone.

The industry needs that surplus both to allow it to invest in shares and to grow the business. The lower the surplus gets, the greater the risk it will have to take action either by raising more capital from investors and in the debt market or by cutting policyholders' bonuses.

Standard Life points out that credit rating agencies have just reaffirmed its AAA credit rating, given only to the most robust companies.

All three solutions are already being tried. Aviva, as CGNU is now known, is cutting its dividend to conserve capital; Legal & General has raised debt finance; Abbey National has put extra funds into its Scottish Mutual life insurance subsidiary.

And last week Norwich Union said it would cut future payouts on its with-profits policies by 5 per cent. Scottish Widows has already announced a 7 per cent cut and others are likely to follow.

Even these cuts may not be sharp enough if the stock market continues to fall. And again the problem can be blamed on the cult of the equity.

With-profits policies are intended to smooth out the peaks and troughs of the market for investors. In good years, bonuses will be lower than the rise of the stock market and, in bad years, the excess will be clawed back to bump up the bonus rates.

The trouble is that the actuaries, whose job it is to set bonus rates based on their estimate of future returns, started to believe that the heady returns of the Eighties and Nineties would go on forever. Now it is clear they have not, bonus rates have had to come tumbling down.

But some of the optimism remains. Cazalet points out that Norwich Union's bonus cut partly reflects its forecast that stock markets would rise by 7.25 per cent; in fact, they fell by 9 per cent.

Optimism is also behind Standard Life's determination to keep its equity allocation high. But Cazalet warns that its strategy can actually be damaging to its customers. Unlike most other life companies, it does not impose what is called a market value adjustment when investors surrender their policies, cutting the amount paid out to reflect turbulent stock market conditions.

It has also maintained its bonus rates so that returns, particularly on newer policies, are far higher than would be expected given the falling stock markets. The difference has to be funded and the only place it can be found is in the capital which should be available for the remaining policy-holders.

Likewise, Standard Life and Norwich Union both promised to pay mortgage endowments in full, meeting any shortfall themselves, provided they could earn an average return of 6 per cent a year. Since then the stock market has fallen by about 30 per cent, so a lot of catching up is needed to meet that guarantee. So far, however, neither has reneged on that promise. Standard Life says only a few policies required the guarantee, so the cost of meeting them has been negligible'.

Cazalet says the industry's conviction that rising share prices are just around the corner makes them like gambling addicts. 'It is the geezer in the casino who thinks he is James Bond. He bets more than he should, then has to eat into the housekeeping to bail him out, then into the money that was earmarked for his daughter's wedding. But still he can't let go, so he starts to borrow from his friends - in the insurance industry's case, the with-profits fund. And each time the bets have to double so that the reward can be big enough to bail him out.'

Even if the equity die-hards had a sudden change of heart, now is hardly the best time to sell. They would suffer huge losses, and it could be difficult to get back in quickly enough if the markets do recover.

In the longer term, the effects on the industry are likely to be profound, although not just because of falling share prices. Margins are under pressure from such things as the introduction of stakeholder products and fierce competition; if the recommendations on disclosure and product design in the Sandler report are accepted, they will become tighter.

That is likely to mean a big reduction in the number of life companies that survive; some will get taken over, others could close to new business. The strongest - Prudential and Legal & General are undoubtedly among them - are likely to prosper. But there are more than 150 life companies now. By the end of the decade, that number is likely to have shrunk a lot.