Jeremy Warner's Outlook: Takeover fever grips the insurance sector. The Prudential thing to do is not to merge

Inflation: muesli is out, iPods are in
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The Independent Online

Will two and two be made to equal five? As regular readers know, I'm sceptical verging on the outright hostile when it comes to the supposed benefits of big league takeovers, and I see little reason to change this view as far as Aviva's assault on Prudential is concerned.

On this occasion, the stock market seems rather to agree. After yesterday's surge in the share price, Prudential is already out of Aviva's reach. Instead, it reflects the prospects of someone else, possibly one of the big European insurers, coming in as an interloper. Of course, this is only the beginning, and there is plenty of time for things to change, but as things stand, Aviva's Richard Harvey faces an uphill struggle in convincing the City of the merits of his proposal.

Problem number one is that, like all insurers, he's capital constrained. Aviva may have some limited capacity to top up its offer with cash, but admits that it would much rather devote any available surplus capital to growth. Any increase in the all-paper terms of yesterday's proposal risks hitting the law of diminishing returns.

The more shares Mr Harvey gives to the Pru, the less value there is in the deal for his own investors. The £320m in annual cost savings and synergies Aviva expects to derive from the deal scarcely justifies the 10 per cent premium already offered. Anything more, and Mr Harvey will be diluting his own shareholders. Few of them would back such a proposal, even for the sake of creating a "national champion" to stand up to the Axa's and Allianz's of this world.

As it is, the £320m of cost savings, achieved at a cost of some £480m, looks heroically optimistic. The only decent argument for this deal is that Aviva's strong presence in Europe is a good geographic fit with Prudential's much greater presence in Asia and the US, yet this also limits the scope for cost savings, virtually all of which have to come from the UK market. Given that about 50 per cent of an insurer's costs are in commissions to third parties, even here the scope is not as great as you might think.

As for administrative costs, the bulk of these are in the with-profits business, where 90 per cent of any savings derived have to go to the policyholders. There may also be some diseconomies of scale involved here. Overall, the two companies combined would have less than 20 per cent of the savings market, which in itself is not enough to justify regulatory intervention.

But in with-profits and individual annuities, the latter of which is one of the insurance world's most profitable products, the combined share would be dominant and almost certainly require a degree of divestment to win regulatory approval.

All this might seem reason enough to wonder what the purpose of this merger proposal really is beyond that of merely bulking up. Aviva points to the better valuations enjoyed by larger European counterparts as evidence that greater reach and diversity of capital in insurance is in itself capable of commanding a higher rating. I wonder. These higher valuations may just reflect the benefits of monopoly.

The near perfect geographical fit may look attractive from Aviva's point of view; it looks much less attractive from that of Prudential shareholders who, as things stand, seem considerably better exposed through Asia and America to high margin, growth markets.

Aviva, by contrast, is still largely confined to low growth Europe. As so often happens in takeover bids, Aviva may only have succeeded in focusing attention on its own weaknesses by making its offer. On the face of it, Aviva needs Prudential's growth opportunities rather more than Prudential needs either Aviva's capital or its higher dividend.

Big mergers are in any case riddled with execution risk. More fail than succeed in their purpose of generating shareholder value, even in some cases where they deliver on the promised cost cuts. Only now, six years after the event, is the merger of Glaxo Wellcome with SmithKline Beecham beginning to work as intended.

The share price meanwhile remains some distance adrift of its turn of the century peak, and there is no real way of knowing the damage done by crunching two such culturally different companies together, or what value might have been created had they remained apart.

It's hard to believe it could have been any less. There are some truly spectacular examples of mergers gone wrong in insurance, most notably at Royal & SunAlliance, which ended up in something close to meltdown. Aviva's experience in merging first Commercial Union and General Accident into one, then merging again with Norwich Union, seems to have been a more successful one, though whether these mergers created any value or not is now utterly lost in the mists of time.

The high degree of overlap between the share registers of Aviva and Prudential means that more so than usual, it will be the big institutions who make or break the marriage. The calculation they must make is whether bolstering their investment in Aviva is worth more to them than surrendering their exposure to the Prudential growth story.

Even if this is what they do eventually decide, they will face some difficulty in foisting the deal on to a board which seems implacably opposed. Mark Tucker, one of the insurance industry's most highly rated players, is still less than a year into the job as chief executive at Prudential. He's not about to give up his new train set, willingly at least.

Mr Harvey might have stood more chance had be pounced earlier, when the Pru was still writhing on the canvass after launching a badly explained rights issue. Yet there were capital issues with all the main insurers at that time as they sought to recover from the ravages of the bear market, and I doubt if Aviva would have got away with it even back then. Today the boat has long since departed.

Mr Harvey's initiative has at least succeeded in putting a rocket under the insurance sector, but this is one of those deals not destined to fly. We Brits just don't seem to have the same appetite for the creation of national champions as our Continental counterparts, and I suspect we are the richer for it.

Inflation: muesli is out, iPods are in

Out goes muesli, frozen boneless chicken thighs, baseball caps, lambrusco and dishcloths. In come iPods, flat panel TVs and music downloads. Yes, it's the annual farce which is the updated shopping basket used to compile the official rate of inflation, otherwise know as the consumer price index. Out with the old, in with the new in what sometimes seems only a publicity stunt to help grey suited national statisticians seem up with the times.

To be fair, these changes are based on surveys of people's real spending patterns, so in theory, they should make the CPI a better indicator of the cost of living than it used to be. In practice, however, this is very far from being the case. The annual inflation rate at just 1.9 per cent as measured by the CPI bears very little relation to most people's reality.

This is in the main because it completely misses out a great swathe of public services which are paid for by taxes. The cost of many of these, it scarcely needs saying, is inflating away with impunity. Even the TV licence fee, another tax which is rising at above the general rate of inflation, has been removed from the index in the latest adjustments.

As for the biggest inflater of the lot, house prices, still no news on when the Europeans might agree a common mechanism for containing these in the index. Houses are, of course, not an everyday cost of living. Once bought, they only matter in terms of how much it costs to service the mortgage, or in the degree to which they make people feel wealthier.

Yet unless you happen to be exiting the housing market altogether - maybe to emigrate or go into a home - most people have as little real interest in rising house prices as in general price inflation. For first time buyers and for those trading up, rising house prices merely makes bricks and mortar seem ever less affordable.

The irony is that it is price deflation in goods - for which thank the emerging economies of Asia - which allows the targeted rate of inflation to remain so low and through consequentially low interest rates helps create the bubble in houses and other assets. If people don't have to pay more for their goods, they can afford to spend it on other things instead. For the past 10 years, this has proved a boon for the UK economy, but what happens when it comes to an end?

j.warner@independent.co.uk

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