Are hedge funds banking on insurance killing?

Date: Friday, March 6, 2009
Author: David Wighton: Business Editor\'s Commentary,

Are life insurance companies the new banks? They seem to think so. Aviva, the largest British insurer, was blaming bear raids by short-sellers yesterday for the astonishing 33 per cent plunge in its share price. Investors seem inclined to agree, for other reasons, predicting that some of the big household name insurers, including Aviva, Legal & General and Prudential, will have to raise bucketloads of money from their shareholders.

They brush aside the assurances from executives that big investment losses are not on the cards and rights issues not in the plans. The market continues to predict the worst is yet to come. Some of the big guns of the hedge fund world, including Odey Asset Management and Lansdowne Partners, are known to have targeted insurance companies as likely to be at the centre of the next credit markets blow-up. Having had good sport with the banks, they smell new blood.

There were some inaccurate rumours circulating in yesterday’s febrile market and trading was volatile even by recent standards. Aviva’s losses sparked selling across the sector, with Legal & General, which lost almost a third of its value yesterday, falling 10 per cent in the last few minutes of trading.

On the surface, Aviva’s figures looked rather encouraging. Operating profits rose 4 per cent, thanks to a good performance from established life policies and the general insurance business. At the end of the year, it had a £2 billion cushion above its regulatory capital requirement of £13.5 billion. And it is maintaining its dividend.

But for insurers, and their regulator, the big worry has been their exposure to the increased risk of defaults in their corporate bond holdings. At the heart of Aviva’s £7.71 billion reported loss yesterday was a £12.4 billion unrealised loss against potential defaults in its huge £151 billion bonds portfolio.

Aviva has not sustained these losses. Actual defaults last year, on holdings of Lehman Brothers, AIG and the like, were just £140 million. But Aviva has had to calculate what the losses would be if the investments were cashed in now under a new European accounting standard known as market consistent embedded value (MCEV).

Under the old IFRS approach, insurers would mark to market their investment holdings in bonds, property and equities.

But they would then discount much of the impact of falling stock prices and ballooning credit spreads by using their own assumptions about the performance of their holdings over their lifetime.

At least for Aviva, this is no longer an option. Under MCEV, and the watchful eye of the Financial Services Authority, it must use the market’s projections at the time about how many companies will fail to make debt repayments in the coming years.

The problem is that the market is predicting Armageddon, assuming default rates among investment-grade companies of almost 5 per cent, way above the highest ever recorded. As one analyst said yesterday, applying Aviva’s assumptions to the FTSE 100 would mean roughly 30 of its member companies collapsing within the next five years.

The new accounting standard was designed to make insurers’ notoriously complex results more transparent. But it has left them exposed to the vagaries of a market that many believe is on another planet.