Black box blues

tauringhuang.

Jul 24th 2008
From The Economist print edition

Insurers have largely avoided the worst of the credit crunch. Why are their shares suffering?

Illustration by Satoshi Kambayashi
AFTER watching bank shares drop by almost a third this year, most European investors probably consider the idea of buying insurance stocks a sick joke. Banks’ balance-sheets may be difficult to understand but insurers can be mind-bogglingly complex.

Insurers also have a track record of fouling up when the economic environment worsens. In the downturn in 2002 they got things badly wrong. The big European life insurers owned far too many equities. When stockmarkets fell, their capital positions were whacked, forcing many to issue new shares. “Once bitten, twice shy” is the market’s motto today. The share prices of Europe’s insurers have dropped by almost a quarter this year and trade on the lowest multiple of earnings of any sector, battered banks included. Is that fair?

Insurance companies are certainly not immune to economic slowdown. People buy fewer equity-linked savings products in difficult times, for example. But concerns about what lurked on insurers’ balance-sheets have probably been overdone. Most of the big companies will report results over the next few weeks. So far the damage from the credit crunch has been limited: the days when insurance companies could be relied on to be the dumbest guys in the room seem to be over.

Admittedly, America’s AIG got into serious trouble after expanding into the business of insuring mortgage bonds, but Swiss Re was the only other company to dabble in this dangerous niche. By and large only those insurers which own banks, such as Germany’s Allianz and ING of the Netherlands, have revealed big exposures to toxic credit. And the industry’s disclosure about such assets has tended to be far superior to that of the banks. ING’s last quarterly report was 96 pages long, with a 190-page statistical supplement chucked in.

If the sector has a secret it may be a pleasant one. Most industry executives and specialists think it has been transformed for the better since its near-death experience in 2002. Equities now make up only 10% of the invested assets of Europe’s ten biggest insurance firms; the rest is largely in government and high-quality corporate bonds. Andy Rear of Oliver Wyman, a consultancy, says risk management has improved dramatically. Capital positions have been rebuilt.

Why then are investors so sceptical? Andrew Crean, an analyst at Citigroup, thinks that weird accounting is partly to blame. Investors have two options to choose from when dissecting the books, neither of them good. International Financial Reporting Standards (IFRS) try to smooth the immediate costs of writing new business across several years. Unfortunately, earnings are still a bad proxy for the cashflow available to shareholders. Worse, IFRS are inconsistently applied across Europe. Standard setters hope to reach a definitive set of rules only by 2011.

The alternative is the industry’s home-grown accounting standard, Embedded Value (EV). A life company’s EV represents its shareholders’ funds plus the value of future profits it expects to generate from its existing book of business, after adjusting for risk. This is a concept most investors can get their heads around. But individual companies can pick their own assumptions on things like investment returns. Furthermore, diversified firms often report EV only for their life divisions, making it harder still to compare companies on a consistent basis. The result is that many investors view EV as just another type of black-box reporting.

The good news is that the industry is taking note. In June, a forum of Europe’s biggest insurers agreed to implement new Market Consistent Embedded Value (MCEV) rules in 2009. These require companies to make uniform assumptions about investment returns and apply the reporting standard across the entire company. In addition it will no longer be possible to book at once the profit expected from holding risky assets. Mr Crean argues that MCEV standards make it easier to see how much cash is being generated by the “back book” of existing business and how much of this is being reinvested in new business, rather than being handed to shareholders as dividends.

Have insurers found their holy grail: a language that makes them comprehensible to outsiders? MCEV represents progress, but most generalist investors will still feel like an Italian being spoken to in Spanish rather than Cantonese. The only way to double-check the calculations will be to hire an expert. Bruno Paulson, an analyst at Sanford Bernstein, points out that measurement of critical non-market risks, such as how long customers will keep their policies, is inevitably still pretty crude and largely up to the companies themselves. And MCEV has no direct link to capital adequacy. The introduction of new solvency rules by 2012 should change this, but until then those keen to know how far markets would have to fall before insurers had to raise new capital are still partly in the dark.

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