Capital, but no punishment

The insurance industry’s capital level is under close scrutiny. Investors have become concerned that insurers, like banks, will be forced into massive recapitalisation programmes as falling equity markets and widening corporate bond spreads have eaten away at insurers’ capital base. Citigroup says the major European insurance groups have, in aggregate, no surplus capital benchmarked against the level required for an A rating.

Although capital levels are being squeezed, the industry is not facing the same threat of meltdown as the banking sector did a few months ago. It is important to distinguish between insurance companies and banks when judging the health of the sector:

• The banks’ problems were caused in part by a crisis of liquidity – ie, the ability of a bank or business to convert its assets into ready cash. Banks’ highest quality assets suddenly became impossible to sell in the markets, even though their default risks had not gone up at all. Liquidity is not an issue for insurers; claims, for instance, cannot be accelerated.

• Insurers are also unlikely to face the vicious circle of declining confidence and inability to raise money that caused some major banks to implode. The question of confidence is far less important to insurers than it is for banks. Insurers’ need to access short-term lending facilities is limited too. As Citigroup notes, this means it is much more difficult for investors to “force” a recapitalisation.

• The insurance industry is in a much better position now than it was in 2002/2003, the last time the sector had to undergo significant capital raising. Then it was generating a very low return on capital from operating earnings and there were material deficiencies in general insurance reserves.

• Insurers are still operating at a fair margin above regulatory capital levels. Aviva, for instance, had a regulatory surplus of £1.3bn at 24 October, despite £600m being wiped off that figure in the preceding three weeks. RSA’s insurance group directive surplus increased between 30 September and 5 November.

Where does this leave the insurance industry? A major recapitalisation of the sector is unlikely. Insurers, particularly the pure-play general insurers, will be able to trade through the current financial difficulties, but some companies will undoubtedly have to raise fresh capital. Credit Suisse said recently: “Despite recent market falls, [European insurers’] capital levels remain robust, with no particular player standing out as particularly exposed relative to the peer group as of today.”

The Lloyd’s insurers appear to be in a particularly strong position. They have largely avoided exposure to toxic assets and are awash with cash. And while weak equity and bond markets have hit investment performance, much of the pain has related to mark-to-market adjustments on short duration bond portfolios, which will reverse over the next year to two years as the bonds redeem at par. “This leaves the sector with no requirement for new capital and potentially able to return surplus capital to shareholders,” according to analysis by investment bank Noble Group.

The FSA and ratings agencies are likely to give the sector some slack in terms of stress testing capital models. Insurers will need to consider how they will rebuild their capital in the next 18 months if they can avoid having to issue new equity. Share buyback programmes are likely to be postponed until 2010 and more reinsurance is likely to be purchased to provide a solvency boost.

michael.faulkner@instimes.co.uk