The banks are in serious difficulties. But analysts say insurers are sound – despite depleted capital levels. Michael Faulkner looks at how the industry will stay above the waves

The credit crunch and worst financial crisis for 70 years have claimed the scalps of some of the world’s major banks, including Bear Stearns and Lehman Brothers.

While the sector has been saved by the injection of hundreds of billions of dollars, the world economy continues to career towards recession with the spotlight now focusing on the insurance industry. Investors have become spooked about the solvency of some insurers, particularly those with life assurance businesses, as capital has been eroded by plunging equity markets and widening corporate bonds spreads.

The share price of some have plunged. Aviva’s stock fell more than 30% in October; the value of Legal and General’s shares plunged by more than a quarter and Prudential’s stock was down more than 40%.

Even the pure-play general insurers have taken a battering. RSA’s stock fell over 16% in October, while Admiral and Beazley have had more than 10% wiped off their share price.

Yet analysts say the sector is sound, despite capital levels becoming depleted. “The story of the insurance sector since the start of the credit crisis is mainly one of what has not happened,” says Citigroup in a recent report. “So far, not one European insurer has come to the market to raise capital, has cut its dividend, or has abandoned a share buyback as a result of solvency pressures. The fabric of the businesses is very much intact.”

Credit Suisse echoes this: “Despite the recent market falls, industry capital levels remain robust. This resilience has largely come about as a result of the sharp reductions in equities in the industry over the past five years, and as a result of the apparent astute management actions of the first half of the year, when equity exposures were further reduced and significant hedge programmes were implemented at many of the more exposed companies.”

It adds: “By and large, companies appear to have avoided the worst of the ‘toxic’ asset classes that have so bedevilled the banks, despite the pessimistic expectations of some observers.”

The insurance sector’s capital levels are under pressure, nonetheless, with little head room. Citigroup’s analysis suggests that the top 10 European insurance groups have no surplus capital, benchmarked against the level required for A rating.

“The insurance sector looks to be heading back to the ‘capital crisis’ levels of the equity market downturn of 2002/03,” says Credit Suisse. “Furthermore, the sector is clearly not in particularly good shape to absorb any material level of further investment losses from current levels.”

Yet, Citigroup argues that the insurance industry will be able to trade through the difficulties, provided that the market stabilises. It warns that further destruction of capital adequacy could arise from declining equity markets, or from natural catastrophes. “While our sense is that regulators will start to relax capital requirements if equity markets continue to decline, this could change if other external problems were to emerge. A €50bn loss earthquake or winter storm would cause serious problems.”

It also says the rating agencies will not look to add “fuel to the fire” in Europe through downgrades.

The view from analysts is that the insurance sector as a whole will not have to raise new capital, although some companies may have to issue new equity. Nonetheless, insurers will need to demonstrate a plan to rebuild capital strength in the medium term.

Putting to one side issues of capital, one positive impact of the crunch is that it is likely to accelerate the turn in the market cycle. A number of factors will influence this, including deteriorating underlying accident year results at industry level, in many places to cost-of-capital levels.

Credit Suisse says: “While published earnings have remained strong for the majority of P&C [property and casualty] players, supported by reserve releases that are now likely to have peaked, the true underlying picture has steadily deteriorated in many lines of business.”

The UK motor market is an example. Capital stands at 15% of group equity as a result of market falls, which will accelerate the turn in the cycle. The high level of large losses in the past year is also a factor, with estimates for large losses at about $30bn for the industry as a whole.

“We see a more benign environment for property and casualty pricing emerging globally,” says Credit Suisse. “We see all major P&C players as beneficiaries of this; however, RSA, Admiral, ZFS and the Lloyd’s companies, together with the major reinsurers, appear to be the biggest beneficiaries.”

Meanwhile, the economic slowdown is likely to have an effect on demand for cover, with a concurrent impact on business volumes and a slowdown in growth. There is likely to be an impact on claims costs too.

Analysts also expect an increase in the amount of reinsurance cover purchased by insurers. “The most obvious example of this is in higher demand for reinsurance, both in terms of solvency relief cover and in extreme event protection,” says Citigroup.

The major reinsurers are expected to be the beneficiaries of this extra demand, the bank says, as there is unlikely to be new capital entering the sector.

What the analysts say

• Aviva
The insurer's general insurance business is expected to be positive in 2009. Although claims frequencies could increase as the economy slows, a turn in the pricing cycle would be beneficial. The economics of the general insurance business are being closely examined and, although volumes may fall before expenses come down, the benefits should be seen next year.

• Admiral
The motor specialist has outperformed the sector by 49% since the half year. The company's reinsurance arrangements, whereby it retains only 27.5% of the risk, has made it an attractive proposition. It is on track for a record year in 2008. The income it derives from the sale of ancillary products to consumers (which is expected to amount to 43% of income in 2009) could be hit by the economic downturn, although Admiral insists sales will hold up as consumers will become more risk averse. The continued climb of motor rates will benefit the company.

The European insurance giant has been spared the worst of the financial markets downturn in 2008, with solvency indices holding up well. The stock has performed well, trading at a premium to its peers. The insurer's general insurance businesses are expected to benefit out of any improvement in the pricing cycle.

The company has delivered a consistently good performance, particularly in the UK, since the disposal of its US business. As a pure non-life company, it does not suffer from the accounting confusion that is currently troubling the UK life insurers. The major risks are seen as a big catastrophe loss or the UK downturn accelerating claims costs beyond management's control. Any turn in the pricing cycle will also benefit the business.

• Zurich Financial Services
Recent efficiency measures mean Zurich enters the potential upturn in pricing over the next year from a position of strength. Reserves continue to look comfortable, while underlying claims ratios have steady improved thanks to tighter risk selection and claims leakage. It is likely to be one of the biggest beneficiaries from any loss of business from AIG, given its position as a top-three player in the global risks market and a major player in the UK.