Life assurers are in trouble - don't invest in them
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Associate Editor
David Stevenson Feb 19, 2009
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In a financial crisis, it never just rains. It pours.
As the economic picture worsens, more and more weak links are revealed. Banks are going bust, new scams are being uncovered every other day – even whole countries are tottering on the brink of insolvency.
And it seems the life insurance sector is next in line to feel the pain. Potential carnage in corporate bonds is forcing these companies to make big loss provisions.
Not only is that very bad news for these firms' shareholders, but the overall fallout could be quite shattering. Here's why...
Why life assurers are like bookmakers
Life assurers are a bit like bookmakers. Rather like taking money on a horse race, they sell policies which offer protection against death or serious injury. For that they collect premiums. If your horse loses, the bookie wins. Likewise if a policyholder doesn't claim, the life assurer keeps the money.
Assuming the actuary gets his sums right, the life assurer makes a profit. But this cash has to be invested somewhere. And the last bear market from 2000 to 2003 taught Britain's life assurance companies some harsh lessons on this front, when stock markets dropped sharply and hammered their asset bases.
So the assurers reacted by unloading what they thought were some of their riskier assets - some £100bn-worth of equities, according to insurance analyst Ned Cazalet. Then, in 2004, the industry's solvency rules changed. That meant life companies were required to hold more capital than they had previously.
Analysts then assumed that these businesses would now be better protected against the next bear market.
After getting burned in equities, the life assurers made a biggish bet on corporate bonds, which are basically company-issued IOUs paying a fixed rate of interest. At the end of last year, these securities comprised between 20% and 30% of their investment portfolios, said Citywire's Edward Lander, making the life assurance sector the biggest single investor in the sterling non-gilt bond market.
Fears are rising that bond issuers won't make their repayments
And here's where the problem arises. While good quality corporate debt looks good value now (see Find your way round the bond market), anyone who has been holding lots of it over the last three years will now be carrying some big capital losses. What's more, fears of default risk, i.e. the chance that bond issuers won't be able to make their repayments, have been climbing again.
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This has caused the latest problem for the life assurers. Legal & General has had to move in line with Standard Life, Prudential and Aviva by vastly raising its 'non-payment' provisioning. L&G's "default allowance" for its £17bn corporate bond fund has been upped by a staggering four times. "The planned additional reserves... follow a thorough sector-by-sector review of our portfolio, and default experiences from the 1930s and subsequent recessions", said the firm.
This means that life assurers are now factoring in corporate bond defaults hitting post-Great Depression levels - the peak was in 1935. Yet as The Times' David Wighton points out, this may not be gloomy enough. "The market thinks it's going to be even worse. Bond prices currently assume that as many as two in every 100 top-rated companies will fail to make their debt repayments, far higher than after the 1929 crash". In other words, the market is now reckoning that 2% of the best businesses will effectively go bust.
As for the riskier companies, Moody's reckons that nearly 20% of all European 'speculative grade' companies will fold in 2009.
This could be seriously bad news for investors in life assurers. For example, L&G shareholders have already seen their investment plummet in value by some 80% over the last 10 years. If the group has to make even bigger provisions, it'll surely be forced into either a dividend cut, or a large rights issue to raise more money from shareholders – or maybe both. And either would knock the share price for six, as I mentioned earlier this week (Beware! Rights issues could lose you money).
Why this time could be worse than the Great Depression
But surely the idea that things will be worse than the Great Depression is overly gloomy? Well, perhaps not. For one thing, we associate the Depression with pictures of skint and suicidal stockbrokers in the US. But the truth is that in Britain, the Depression wasn't anywhere near as bad – so to compare today's crash with the 1930s isn't as hyperbolic as it seems.
And the Bank of England's deputy governor already admitted this week that in Britain, "the slump could be even worse than the 1930s", says The Telegraph.
One thing's for sure - the economic damage unleashed by the debt default levels expected by Moody's and the bond markets would be utterly devastating. Despite all the politicians' bailout antics, job losses and insolvencies would likely climb to levels higher than even the most gloomy current forecasts.
Let's just hope that both Legal & General, and also the corporate bond market's uber-bears, are wrong. But I'm not sure that they are – so for now, I certainly wouldn't be buying into life assurers, even at these beaten-down levels.
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