Insurers’ exposure is much lower

Oct 29 2008 by Andrew Miller for The Journal

WITH the financial markets in continuing crisis, one concern has been the capital strength of insurers.

Unfounded rumours have suggested some insurers are either seeking new capital, or some leniency from the regulators. So is the sector heading for its own perfect storm?

Insurance companies are major holders of financial assets. Fluctuations in the value of these assets affect insurers’ balance sheets, and the value of shareholders’ equity. One worry is that an extreme fall in the assets’ value could also affect the ability of insurers to meet claims – although we are a long way off this point.

In general, insurers’ equity exposure is much lower than it was at the start of the decade. Insurers also tend to be better placed than other bondholders to hold bonds to maturity.

Analysis is further complicated by the differing ways in which the financial risks of an insurance company can be presented in its capital accounts. There is no firm consensus on measuring capital strength. Potential investors need to understand the concept of “Embedded Value” , currently the preferred approach in the UK and Europe.

So far, the direct hit from sub-prime and of other pressurised asset classes has been relatively small. Another positive factor is that insurance companies are clearly not facing the liquidity problems that banks are.

Moreover, the unique cash flow nature of the industry should prove helpful in these cash-hungry times. Customers are also likely to be more reluctant to withdraw money precipitately from insurers than from banks, due both to their longer term expectations and also significant tax and redemption penalties.

A slowing world economy will undoubtedly affect sales. Areas linked to the housing market, such as mortgage protection insurance, will decline. Asset management divisions will be hurt by lower fee income, and by investors withdrawing funds. But certain product lines, such as car and buildings insurance could be seen as non-discretionary in nature: customers need to have them.

In summary, any investment appraisal of individual insurers needs first to assess how firms’ individual markets are likely to be affected. But you need to look at balance sheet issues, too. So while we continue to believe many insurers look attractive investments at current prices, and won’t suffer the severe financial distress of the banks, some caution is advised.