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In a week when the Government has proposed tougher capital requirements for banks, it is instructive to see the effect of a similar directive applied elsewhere.
When the banking crisis broke, and it was widely assumed they would all go bust, people looked to see who were the big holders of banking bonds and therefore likely to face large losses. They found their answer in the life assurance industry, and as a result fears about bank insolvency transferred wholesale to the insurance sector. The shares were duly trashed.
Enter the Financial Services Authority, unnerved by the signals from the market but determined no insurance company would be deemed insolvent in its watch. So capital requirements were toughened, just as the Government now proposes to increase the capital requirements of banks. Insurance firms that did not have, or chose not to deploy, additional capital, in effect withdrew from the market.
Thus Paternoster, the pension buyout company, no longer does deals, Prudential under Mark Tucker scaled back its annuity business and Legal & General's Tim Breedon directed his group to focus on capital-lite products, although these are much lower margin. Customers pay more for less, companies do more for less. Lower risk means lower rewards. Extra capital tied up inside the companies provides comfort for the regulators but inhibits their growth, distorts the market and provides lower returns for shareholders.
There is worse to come. The credit crunch means nothing unless it implies more expensive capital, which will also be in short supply, and the financial services industry as a major consumer of capital is therefore faced with a huge challenge. But life offices have a further nightmare because a paper from the FSA that was originally scheduled for April and is now expected in the autumn goes to the heart of how bonds that form the bulk of their investments are valued, and therefore what they are worth.
Its sounds difficult but it is not that complex. The shorthand way to value a bond is to talk about the spread, that is, the difference between the return on that bond compared with the return from a risk-free equivalent Government bond. That spread has two elements, the risk of default and the illiquidity premium, which recognises the fact that you may not get full value for it if you try to sell it before it matures.
There is no issue over default risk — it is a fact of life — but there is a battle looming over illiquidity. The insurance industry argues that this illiquidity element does not matter as it does not intend, or need to sell, because it bought the bonds specifically to hold to maturity when the funds will be used to pay out on maturing policies.
The FSA, having long accepted this view, is about to change its mind on the basis that if Armageddon comes between now and then, the industry may be a forced seller. The result will be significantly to change for the worse the valuation of the bond portfolio, and that in turn will bring a need for replacement capital from somewhere else.
Even that is not the end of the story because the European Union plans changes on similar lines that go even further and will be even more painful for companies writing UK-style annuity business, but interestingly not for their Continental cousins who run their books in a different way. The law is not passed yet but there is no great sympathy from elsewhere for what is seen as a UK problem.
The silver lining in this is that it will make investors pose the question they have been far too slow to ask in the past, which is “what is an insurance company for?”
Traditionally, they provided a tax-free wrapper within which people could accumulate savings which they would then manage, with a bit of insurance on the side. But today those wrappers are available from any independent financial adviser, and with a much greater choice of underlying investments.
That is bad enough, but the industry makes no money from much of what it does sell because it can't hold on to its customers. It boasts about new business and, if its customers stayed loyal for a decade or more, companies might make money from them. But mostly they leave within five years, having cost the company money. Everybody knows this, but no one is willing to face up to it.
That is about to change. Late last year, Clive Cowdery's Resolution Group raised £600 million with further billions on standby to sort out the industry. Point man John Tiner has been pitching to the City that the insurance company of the future should focus on term insurance — covering the risk of early death, annuities and guaranteed savings products that derive from their expertise running life funds.
Over the next 18 months, he plans to buy three or four of the big ones, merge and restructure them along these lines, allowing existing shareholders to stay in for the ride and then bring them back to the market. A traditionally dull sector promises soon to become almost too exciting.
