Bank of England report and falling share prices stoke fears that insurance sector will be hit hard.

Leading industry analysts this week said the insurance sector would be drawn into the contagion of the credit crisis following a stark warning from the Bank of England.

A Bank report published this week said insurance had emerged as an area of potential concern and indicated that the FSA was scrutinising the health of the sector closely.

The report said: “As long-term investors, insurance companies tend to hold a significant proportion of their assets in equities and corporate bonds. The marked decline in the value of these securities in 2008 has generated capital losses for some UK insurance companies.

The report added that risks could arise if the value of insurer investments fell below regulatory capital requirements.

Andrew Moss, chief executive of Aviva, moved to reassure the market on Tuesday as the insurer released its third-quarter results. Its share price bounced back after almost halving in the past two weeks (see page 2).

However, Keith Nicholson, senior UK insurance partner at KPMG, warned that a number of general insurers had invested in hedge funds and structured products to improve returns, but that those along with corporate bonds had been hit by the crisis.

“Depending on how the credit crisis plays out, [insurers] will continue to be hit by that. What it does reflect is if insurers understood the risk of the assets into which they were investing when they were trying to seek enhanced returns,” he said.

“In the fourth quarter this year or next year we could see an impact on results. What people should be looking at is to see whether insurers have exposure to those companies that are seeing claims from the US.”

Nicholson added that there was a question over whether insurers would have to raise new capital to protect their credit ratings. “In this environment it will not be easy to do so,” he said.

“I am not convinced the government would want to support some of these general insurers. An alternative would be to find ways in which companies can be brought together, that’s a possibility.”

Citigroup analysts said the insurance sector was robust enough to deal with material falls in equity markets and the valuation of other asset classes.

Risks concentrations had been reduced, risk management had improved and underlying profitability meant free capital generation was far stronger than in the last equity bear market, it said.

However it warned that declining equities and widening corporate bond spreads since the end of June could leave the major European insurers with little spare capital.

In a note Citigroup said: “If companies, regulators and rating agencies hold their nerve then there is no reason to panic."

The Bank of England report added that risks could arise for insurers if the value of investments were to fall below regulatory capital requirements. It said: “This was an issue in the bear market of 2003, but regulatory reforms introduced in 2004 have reduced the likelihood of this risk by using a more risk-based capital requirement with countercyclical resilience testing.”

Click on the link on the right to obtain a pdf of the full Bank of England report