The crisis will restrict financial re-engineering, says Andy Baldwin of Ernst & Young.

"This is worse than a divorce, I’ve lost 50% of my net worth and I’ve still got a wife!” This quote from a trader in the Financial Times recently is one of the few things that has made me laugh over the past few weeks. We have journeyed beyond the use of normal superlatives.

A year ago, what would have been the odds on the FTSE losing 20% in five days, the UK government nationalising four major banks, and anti-terrorist laws being used against the UK arms of two Icelandic banks?

The impact of the market turmoil on the industry has been largely insurer-specific, reflecting the underwriting strategy, exposure to collateralised debt obligations and the business mix of individual insurers. But there are a number of broader themes emerging that will influence the outlook for UK insurance.

At the start of the crisis last year, the UK looked as if it might escape the worst of the fall-out. Now it looks like it could be faring worse than the US. Heading towards year end and despite government intervention, liquidity concerns are increasing rather than dissipating. Insurers’ ability to hold assets into a recovery period that keeps moving further away is likely to force more realised losses affecting profit and loss accounts. Asset values have also continued to decline, with equity markets across the globe falling; the FTSE has dropped 35% since January.

Many insurers learnt the lessons of 2001 to 2004 and moved out of equities, but the ability to determine fair values continues to be difficult, and companies that have liquidated higher valued securities may be facing more unrealised losses as they scrutinise year-end numbers.

In addition, the principles-based approach to capital adequacy as proposed by Solvency II regulations requires much more dynamic processes. But while models are important, management must take the lead, demonstrating an increased willingness to believe in the possibility of considering a sequence of “one in 100-year events” all in the same week.

Although credit spreads have widened substantially, the impact is principally on new cash flows. Insurers’ investment income will be lower than in 2007 and cannot be relied on to shore up earnings. And the risks of certain securities are difficult to evaluate. This is likely to drive changes in risk appetite and underwriting strategy, contributing to an acceleration of market hardening.

Foreign exchange risk and volatility has also increased in 2008, particularly relative to the dollar. European company operations are exposed not only in the US but also in the Middle East and Asia, where currencies are pegged to the dollar.

Solvency II has already caused companies to evaluate legacy businesses and develop restructuring and disposition strategies to redeploy capital. Run-off business acquisitions and divestitures have been common and will continue to be so.

We are likely to see insurers retrenching in the UK and focusing on the fundamentals of underwriting, risk management and operational efficiency to drive profit, rather than wholesale financial re-engineering. However, the UK insurance industry is well placed to meet the challenge.

Traditionally seen by investors as a sector characterised by steady rather than spectacular returns, we expect interest to increase as investors seek to capitalise on the hardening market. After the past few weeks, predictability and reliability are just what many institutional investors want.

Andy Baldwin is EMEIA financial services accounts, business development and markets managing partner at Ernst & Young.