Life insurer under pressure

Life insurance companies are difficult to understand because they produce two sets of accounts. One is based on the conventional accounting standards used by almost all big companies. But insurance-industry people think they need something more specialist and so pay more attention to accounts using so-called embedded values. They think this is better because profit and net-asset-value calculations include an estimate of the present value of income from policies that have already been sold but for which future premiums are still due. It's a bit like expecting payments every month for the next 40 years and popping that income into this year's accounts.

However, the wisdom of doing this is increasingly open to question. One danger is the emphasis it places on generating new business. So, for example, despite the weak economic climate, Legal & General announced a 5 per cent rise in worldwide new business sales in the first nine months of the year and that helped boost its embedded value because of all the assumed income from premiums due, but it did nothing to boost cash flows today.

Meanwhile, money is being paid out up-front in commissions to independent financial advisers (IFAs) who have sold the policies. This means that some policies can take over 10 years to break even. And it gets worse - if an IFA can persuade a customer to switch to a more attractive policy after a couple of years, then profitability will be pushed back even further.

Using embedded-value accounting, when a life assurer's share price traded well below net asset value that used to indicate that the shares were cheap. Increasingly, however, a steep discount just suggests that the embedded-value calculation is too optimistic.

The importance of this can be highlighted by looking at L&G's first-half results. These showed embedded-value operating profit of £626m, but on a conventional accounting basis L&G made operating profits of just £391m. True, the embedded-value figures had to bear a bigger write-down on investments, even so they produced a £65m pre-tax profit for L&G compared with a £44m loss using conventional accounting.

L&G faces the added problem of deriving 80 per cent of its profits from the UK, a market that will clearly struggle to provide any meaningful growth over the next year. By comparison, Aviva, another leading insurer, makes just 39 per cent of its profits from the UK.

And breaking down L&G's revenue stream into its component parts provides further grim reading. Sales of mortgage-protection policies were down by 13 per cent in the first nine months of the year compared with the same period a year earlier. And this trend may accelerate as the UK's mortgage market remains frozen, although sales of non-mortgage-related products have held up reasonably well. Even so, overall new business for protection policies fell by 6 per cent. And unit-linked bond sales have also been hit, reflecting reduced investor interest following changes to capital gains tax - gross sales volumes in the first nine months slid 49 per cent to £101m. Sales of annuities and with-profits saving products were also lower, but bulk annuity business has continued to expand as employers increasingly seek to offload their pension schemes. Sales of retail investment products, such as unit trusts and ISAs, have also risen, thanks to a distribution deal with Nationwide Building Society.

Meanwhile, the tough trading climate has raised questions about L&G's financial strength. Analysts at investment bank JP Morgan believe that L&G is not conforming with the latest guidance on risk and capital values from the UK's finance-industry regulator, the Financial Services Authority (FSA). According to the FSA, the latest guidance includes putting in place the governance, controls and processes to respond to sharp changes in market conditions, such as a sharp fall in equity values or a counterparty failure. It also covers the valuation of illiquid assets, including asset-backed securities, and the effect of widening corporate bond spreads on the valuation of liabilities. In short, the FSA wants insurance companies to be more aware of their potential exposure to poor investments.

L&G's default assumptions are more relaxed than at rival life assurers, and JP Morgan believes that that the impact of bringing default assumptions into line with, say, Prudential would be around £864m, a significant sum when compared with 2007's operating profit of £626m. L&G's bosses think that no action is required until the second quarter of next year, thanks to a six-month cooling-off period following the FSA's September directive. However, L&G's assumptions could still fall foul of the regulator because trading conditions could be even worse in six months from now, while the company's default assumptions have not been changed since 1999.

And there are implications from all this for the insurer's profitable bulk annuity business. If L&G's lower level of default assumptions were brought into line with other insurers, it would have to increase its reserves, thus making bulk annuity business less attractive.

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