FTSE 350 Review: Big payouts remain life insurers’ biggest strength

Initially, the market did not draw any real distinction between pension schemes reliant on liability-driven investing (LDI) that were frantically struggling to meet margin calls on interest rate derivatives and the life insurers who act as derivatives agents to the LDI industry. In the event, both groups turned out okay: the thought of half the working population losing their retirement savings was enough to prompt swift Bank of England intervention. 

The irony of the LDI affair, which must surely count as a one-in-a-100-year event, is that it knocked the life insurance sector’s share valuations just as the sector has generally been on an improving path, certainly when compared with the under-pressure and inflation-hit general insurers.

When compared with their motor brethren, the rise in interest rates has a larger beneficial impact on life insurers, not least because it helps improve their capital reserve position for solvency purposes. A rising rate environment also helps boost pension schemes’ funding positions, increasing the likelihood that they will offload liabilities to insurers. The consensus is that the LDI episode will also persuade more pension scheme trustees to move their defined-benefit schemes onto life insurance balance sheets, too. That should be a boon for larger providers such as Phoenix (PHNX), as well smaller niche players such as Just (JUST).

Regulatory uncertainty and corporate bond risk

But the big news for the life industry this year is how the government’s proposed changes to the Solvency II regime will play out. This is part of a package of individual financial services reforms that seeks to distinguish the UK regulatory regime from European rules. The package recently passed the first reading stage in Parliament, but it is clear from debates that regulators are worried that the divergence may increase financial instability. At recent parliamentary hearings on the topic, the Bank of England’s top prudential officials warned that a planned relaxation of solvency rules opens the possibility that insurance companies could run out of capital to back up their promises. The debate also involves 'call-in' powers – the idea being that the government would be able to challenge regulatory decisions. There is some suggestion that the Bank of England accepted a more radical overhaul of solvency in return for the government dropping the ‘call-in’ powers idea, although the central bank denies this.

A potential negative for life insurers in 2023 is whether the market will accept their large exposure to corporate bonds, which tend to suffer in a higher interest rate environment, and whether this will lead to an unwinding of these positions. These positions are a hangover from a decade of historically low yields, when insurers had to take on a greater diversity of assets to generate decent income. Fundamentally, there is little incentive to take on too much corporate debt when gilts are delivering steady returns. Despite this, Berenberg expects the industry to allocate more spare capital to market investment than in previous years, particularly as life insurance rates have been on an upward curve that has blunted the short-term impact of inflation. Overall, the sector looks far more stable than other insurers.