Insurers head for altar

A wave of bidding activity in the insurance sector - starting with an attempt by Prudential to take over Friends Provident - is expected in the wake of the announcement that Royal and Sun Alliance are to merge.

Friends Provident was thought to be the target of Sun Alliance until the pounds 6.3bn merger with Royal Insurance was announced on Friday.

Guardian Royal Exchange - the subject of perennial takeover rumours - is also tipped in the City as a likely target as the industry rushes to consolidate.

The big question could be which of the other two big composite insurers, Commercial Union and General Accident, will be left without a partner. "They could be panicked into making a move," said one industry insider.

A flurry of mergers, takeovers and flotations is also expected among the mutual life assurers, although policyholders are unlikely to see the kind of windfall bonuses being paid to building society borrowers and savers.

The merger, described as a "sea change" by a City analyst, is likely to result in a re-rating of the sector, currently the most undervalued of the financial services. Shares in composite insurers jumped by at least 25p after the announcement.

Insurance companies are expected to move quickly, partly to ensure that they are not left out, and partly because they do not wish to embarrass the Government with job-slashing announcements immediately before the next election.

Some industry insiders suggest that Royal Sun Alliance is already showing restraint by pegging cost-cutting at pounds 175m, with 5,000 jobs lost. "That's at the conservative end of the range," one said. "They're probably downplaying it so as not to scare the horses."

Domestic consolidation is widely seen as the easiest way to increase shareholder value. Foreign acquisitions offer the potential for future growth but few immediate cost savings, and the premiums demanded for goodwill can actually reduce value in the short term.

Commercial Union is thought to have paid an extra 30 per cent when it picked up Groupe Victoire from Compagnie de Suez for Fr12.5bn (pounds 1.46bn) two years ago. On the other hand, argued SBC Warburg in a briefing paper published in October, a domestic merger generating a 15 per cent cut in costs would increase profitability by 40 per cent.

Consolidation is also a way of defending against possible foreign takeovers, a threat that Michael Heseltine warned about while he was President of theBoard of Trade. "You should be taking steps now to protect yourselves, in the same way that your competitors are already protected," he told the Association of British Insurers.

Stephen Bird, an insurance analyst at Merrill Lynch, described the Royal- Sun Alliance merger as "a defensive move". He explained: "Looking two or three years out, they would be vulnerable to an overseas bite and they're pre-empting it."