Jeremy Warner: L&G attempts to reassure on bonds

Outlook Tim Breedon, chief executive of Legal & General, hopes to put the lid on negative talk of rights issues and dividend cuts with yesterday’s statement on the group’s capital position. Has he succeeded? Precedent from the banking sector, where attempts to reassure have repeatedly been overtaken by events, would suggest not. With the mood in markets deeply bearish, analysts and investors seem unwilling to listen to the positive.

Yet there are plenty of reasons for thinking life insurance isn’t about to go the same way as the banking sector. The most important is life insurance involves liabilities of typically very long maturity. Short-term movements in markets therefore don’t matter nearly as much as they do in banking, where deposits and wholesale funding can be withdrawn at will, and the value of assets therefore needs to pretty much match that of liabilities at all times.

With life insurance, provided the assets match liabilities at maturity, there should in practice be no solvency or liquidity problem. Nonetheless, markets, encouraged to some extent by what might be depicted as the ultra-purist “provisional wing” of the Financial Services Authority, have tended to ignore this reassuring truism, and instead concentrated on the depressed current value of assets. If markets were to go lower still, life funds would on this matrix go sharply into deficit.

There is little sign of the FSA learning from the damage this line of “mark-to-market” analysis has inflicted on confidence in the banking sector. Instead, the FSA has in a move which seems to run counter to recognition of the need for “counter-cyclical” capital requirements for banks, recently required life insurers to stress-test their capital positions against a further extreme deterioration in markets.

This seems perversely designed to demonstrate life insurers need more capital. It won’t be just shareholders who lose out if such an approach to capital is imposed. Life insurers required to hold more capital against their pensions and savings policies will deliver lower returns all round.

In any case, L&G has revalued its corporate bonds portfolio against the assumption that defaults will rise to levels more extreme than those seen even during the Great Depression. The assumed rate of default over the next four years has as a consequence been raised from 30 basis points per annum, which was quite a bit lower than peers, to 130 basis points, which is far higher.

This requires provisions of £650m, which in turn reduces the capital buffer to £1.6bn. Even assuming all of this provision eventually becomes recognised losses, the capital position looks sufficient without need for a rights issue to allow the continued payment of dividends. That’s not to say the dividend won’t be cut, but it is unlikely to be axed entirely.

As I say, this crisis has a habit of trashing all reassuring analysis. Perhaps it is right that markets will continue to fall into the abyss, never to return. It may also be right that the FSA decides to condemn the sector to death by imposing much harsher capital requirements. But absent of these two outcomes, the situation doesn’t look quite as scary as the markets have been painting it.

I’ve tried to highlight the differences between banks and insurers, but one feature of the crisis is common to both. In both, “value at risk” analysis has acted in an excessively pro-cyclical manner, requiring perversely that more capital is held when assets are at depressed prices than when they are at unsustainably high prices. This accentuates the boom and the bust.

Who’s to say that markets are any more right about the risks of default now with spreads high than they were two years ago when spreads were exceptionally low? In fact, over time, the risk is the same, yet regulators require less capital to be held when spreads are low, thus encouraging the extremes of the boom, than they do when in the depths of a bust. All this has to change.