Jeremy Warner: Insurers get the banking treatment

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Outlook Has the stock market got it completely wrong about Aviva and other insurers, or are chief executives being too optimistic about their ability to ride out the storm in asset prices and the economy? Yesterday's stomach-churning 33 per cent plunge in the Aviva share price looks an extreme over-reaction to a results statement which wasn't any different in substance to the guidance given last month. The chief executive, Andrew Moss, found it almost incomprehensible. The capital surplus is as reported back then at £2bn, profits are in line with expectations, and the dividend is left untouched as promised. What's there to be bearish about?

It didn't help that Aviva reported its results on another terrible day for stock markets all round. A negative circular on the UK insurance sector from the credit rating agency Standard & Poor's further added to the bearish sentiment. What's more, it's one of those endearing characteristics of chief executives that there's a blind spot when it comes to a bombing share price. They cannot understand why the market price dares to be so far out of sync with what they see as the more upbeat fundamentals. It's like a personal slight. Regrettably, the markets have a nasty habit of ultimately being proved more correct than the chief executive.

Even so, Mr Moss seems to have a point in insisting that Aviva shares have lost touch with underlying realities. With all companies, it is always possible to construct a "nightmare" scenario of double defaults that would drive the enterprise into insolvency. This is especially true with financials, which are complicated beasts at the best of times, with multiple different risk profiles that any amount of transparency will never fully expose.

In a bear market, this kind of doomsday analysis runs riot, and as we have seen repeatedly in this crisis, it is frequently capable of becoming a self-fullfilling prophecy. So you shouldn't assume the market is going to be proved wrong about Aviva and other life assurers. None the less, it would require some very extreme outcomes indeed to drive the company to the wall, and for the time being, there appears to be no need for a rights issue. Much confusion surrounds the IGD capital surplus. The £2bn referred to is only a financial buffer over and above minimum regulatory capital requirements. Add these in and the total capital surplus is actually £15.5bn. Even if Aviva were to burn through its entire IGD surplus, it wouldn't be bust, though it would be required to have intense conversations with the regulator about how to repair it.

Payment of the dividend will use up around £500m of the surplus, but this is compensated by capital replace-ment from earnings and sale of Aviva's health insurance business. Mr Moss admits that a further 40 per cent fall in equity markets would reduce the surplus to £1.2bn, but he claims to be well hedged and to have fully marked to market his £150bn bond portfolio.

In marking to market, Aviva has applied an 8 per cent "unrealised" impairment charge, which according to Mr Moss would require a worse default rate than the 1930s to come to fruition. In other words, his capital position already discounts credit default of historically unprecedented proportions. If these default rates aren't realised, the capital position will soar. A particular area of concern for investors has been exposure to bank bonds, which could potentially be wiped out in wholesale nationalisation. In fact, the total exposure to bank bonds worldwide at Aviva is "just" £1.2bn.

All that said, we heard similarly reassuring analysis from the banks during the early stages of the credit crunch. The deepening crisis made mincemeat out of all such complacency. But for insurers, it honestly doesn't look as bad as stock prices are painting it. There is a proviso. Almost any financial services company can be broken eventually, and the bears seem mighty determined to achieve their purpose.