Lowdown: Life assurers FOR 30 JAN

24th January 2009

Insurance companies are fiendishly complicated animals, with documents relating to full-year accounts frequently running to over 100 pages, much of which is too specialised to be of great interest to most investors. One of the reasons why life insurance companies are cloaked in mystery is the diversity of their business model. Some life insurance companies are also known as composite insurers, and this is because they operate a non-life insurance business such as car insurance or household contents.

But the life side is complex enough on its own, and covers simple life insurance, life insurance attached to a policy that pays out a lump sum even if you don't die, pensions, self-invested pension plans, (Sipps), individual saving accounts (Isas), annuities, and so the list goes on. The other complication comes from the way that life assurers present their accounts. Non-life companies have been busy in the past few years swapping over to a new reporting standard called International Financial Reporting Standards or IFRS. However, life assurers also use a system known as European Embedded Value. In short, this allows the insurance company to include profits that it has yet to make. For example, if an insurance company sells a life policy that runs for 30 years, EEV includes the expected premium income for that period. Up to a point, this provides an idea of how much income a company can look forward to receiving.

However, more recently EEV has come in for mounting criticism. This is because many insurance policies are sold on behalf of insurance companies by independent financial advisers (IFAs), who receive an upfront commission payment for policies sold. So initial premium income is offset by the commission costs. Now, if the policy holder decides to change to a more attractive policy after a year or so, projected premium income is lost but the commission is not reclaimed, and some policies will struggle to make the insurer any money at all. So there is always a danger that one company's new business is another company's lost business, and therefore not 'new' new business. Insurance companies have also been badly mauled because they are the largest investors in equity markets although, as long-term investors, future liabilities will decline as equity markets recover - which they will at some point.

Looking at where the insurance companies do business is another important point. In broad terms, markets in highly industrialised countries such as the UK are more mature. In other words, most people will already have some form of insurance, unlike fast-developing countries such as India where, with a population of 1.2bn, there are enormous opportunities to develop new business because very few people have insurance policies. Companies with the biggest exposure to markets in developing countries include Aviva, with a solid presence in the Asia Pacific region, and Prudential.

One of the key indicators used to assess a life assurer is the relationship between the share price and the company's embedded value. This is calculated as the share price as a percentage of the total equity figure as calculated on an EEV basis. So, if this is, say, 200p and the share price is 187p, the shares are said to be trading at a discount to EV. In normal circumstances, this would imply potential for a higher share price. However, in today's stricken markets, it suggests that embedded value is too high. This is not good news. As well as being battered by falling equity values, life assurers are also counting the cost of consumers battening down the hatches on discretionary spending. Some might argue as to whether life insurance is discretionary or non-discretionary, but there is no doubt that life business has been hit by a collapse in the housing market, with mortgage protection and mortgage-related life insurance falling sharply.

And with little sign of equity markets touching the bottom of the cycle, life assurers look set to take further punishment. There are also worries that further equity losses will put pressure on reserve ratios, which dictate the amount of spare cash life assurers have to have tucked away. In the longer term, life assurers look to be steady enough, but there is mounting evidence that conditions will become a lot worse before they improve.

JARGON BUSTERS

PVNBP:

Present value of new business premiums. A measure of sales that forms part of the EEV accounting principles, calculated by adding the value of single premiums to the present value of regular premium streams.

With profits policy:

An insurance policy that provides not only cover in the event of death but also a payout at maturity.

Churning:

Insurance policies issued by one life assurer, cancelled by the policy holder, and then renewed with another insurer.

Bulk annuities:

Companies worried about liabilities in their pension funds sometimes pay insurers to take over the scheme. This is known as a bulk annuity purchase.

Longevity:

Various calculations are used to assess how much a pension scheme is likely to pay out based on how long people are expected to live. Life expectancy is known as longevity.

Source: http://www.investorschronicle.co.uk/