The Safety Of Insurers And With-Profits Policies

How financially stable are our insurance companies and could they be the next victims of the global liquidity crisis?

Over the last month, the banking crisis has dominated headlines around the globe. But this week, the strength of British insurance companies has been called into question. 

The Financial Stability Report, issued by the Bank of England this week, reveals the credit default swap (CDS) spreads of UK insurers are rising.

This is a bad sign. In simple terms, CDSs measure the financial health of a company. (Read more about CDSs and what they mean here.)

Share prices act as a similar measure. And right now, insurance company sector share prices are falling. 

Will British insurers be the next victims?

This begs the question: will UK insurers be next to seek a bailout from the British government? 

It's already happened overseas. Last month, US insurance giant, AIG, was saved from the brink of collapse with a huge $85 billion rescue loan from the Federal Reserve.

And this week, AEGON -- which employs 3,000 people in the UK through AEGON Scottish Equitable -- announced it has secured _3 billion of additional capital from the Dutch government. Although unlike AIG, AEGON hasn't been nationalised, and the Dutch government hasn't taken an equity stake in the company.

Falling asset prices

The good news is, insurers in the UK don't tend to be highly-leveraged businesses. This means financial liquidity issues which sparked the banking crisis should be less of a problem for insurers. Instead, insurers rely on solid returns from the assets they invest in on their policyholders' behalf.

Then again, in falling markets, this business model starts to look shaky.

The sharp declines we have seen in asset prices -- predominantly shares, commercial property and corporate bonds (company debt) -- poses a serious risk to insurers' financial well-being.

Some are already posting capital losses this year. Indeed, the Bank of England's report warned that insurers risk their capital reserves falling below regulatory solvency requirements if the value of their investments continues to drop.

Likewise, the City regulator, the Financial Services Authority (FSA), is keeping a watchful eye over British insurers and their exposure to corporate bonds. The FSA believes insurers aren't giving sufficient consideration to the higher risk of corporate bond defaults (that is, where a company is unable to meet its debt obligations to its investors.)

In a nutshell, I think it's fair to say that, while British insurers don't face the same challenges as UK banks, they too are unlikely to come through this financial crisis unscathed.

What does this mean for insurance company policyholders?

If you hold an insurance company endowment policy, pension or investment bond, falling investment returns will undoubtedly have taken their toll on the value of your investment. But it's the value of with-profits investments which are particularly contentious right now.

Several insurers have announced exit penalties will be reintroduced on some with-profits policy withdrawals. This is an obvious indication that falling asset prices are having a detrimental effect on the performance of with-profits funds.

Market value reductions

Last week, leading insurers Norwich Union and Friends Provident announced exit penalties -- known as market value reductions (MVRs) -- will be applied on many with-profits plans where policyholders want to sell some, or all, of their investment.

MVRs ensure that policyholders leaving the with-profits fund don't take more than their fair share of the returns at the expense of those policyholders who remain. MVRs are normally only exercised in exceptional market conditions. And I think we would all agree we have entered a phase where market conditions are exceptional.

Norwich Union say  the recent investment climate and financial uncertainty are responsible for the reappearance of MVRs. The penalty will be applied to unitised policies in the CGNU, NULAP and CULAC with-profits funds. The reduction will be heavy at 13% to 22% depending on when the plan was first taken out. Meanwhile, Friends Provident will dish out MVRs on a policy-by-policy basis.

But NU and Friends Provident aren't the only insurers to feel the effects of deteriorating asset prices. Legal and General has also cut final bonus rates, meaning that payouts from with-profits policies will fall between 5% and 9%. 

And, today, Standard Life announce final bonus rates on its with-profits policies will be cut immediately leading to a 13.5% drop in the cash-in value of bonds taken out five years ago. Worse still, MVRs have also been increased and extended across more plans. 

However, British insurers are keen to gives reassurance over their financial strength. Earlier this month, Norwich Union said it had sufficient surplus capital that a 40% fall in stock markets would only reduce it from £1.9 billion to £1.2 billion. 

However, the insurer's interim results -- announced yesterday -- reveal its surplus has already dropped to £1.3 billion (estimate as of 24 October) and an additional 20% drop in equities would actually reduce it by a further £0.4 billion. Meanwhile, Friends Provident claims its strong capital position means a 30% fall in share prices would have no impact on its surplus.

What should you do if you want to cash-in your with-profits policy?

If this news means you're anxious to get out of with-profits, do check whether an MVR will apply before you cash-in the plan. Don't forget, not all policyholders will be affected. You may be one of the lucky ones.

Fortunately, there are specific circumstances when you might be able to escape the penalty. These are:

• Where the policy has a specific maturity date (such as an endowment policy). An MVR shouldn't be deducted if you don't cash the plan in until you reach this date.
• MVRs won't normally be applied to with-profits pensions where you take benefits at your pre-selected retirement date.
• Some policies offer specific MVR-free dates. These usually fall on the 5^th or 10^th anniversary of the plan.
• Smaller withdrawals may be allowed which won't incur an MVR. Check the terms and conditions of your policy.

MVRs are usually only temporary until investment conditions improve, although it could take some time for asset prices to recover. If you're unsure what do to, speak to a good independent financial adviser. And for further help read this article: Should You Ditch Your Endowment?

More: An Investment So Safe It's Lost Money | Should You Sell Your Endowment Policy?