Aviva leads plunge in insurance shares on capital fears

UK's biggest insurer sees its stock drop by a third after holding annual dividend

Aviva maintained its full-year dividend yesterday but the insurer's shares plunged on fears that the decision left its capital position exposed to big investment losses.

Aviva held its annual dividend at 33p as it announced pre-tax operating profits for 2008 of £2.3bn, up 3.7 per cent. But £2.45bn of reductions on investment returns and economic assumptions helped to take the company to a £1.3bn pre-tax loss.

Andrew Moss, Aviva's chief executive, said holding the dividend was "the right balanced outcome" and that the group was holding up well in turbulent markets. "I'm not saying [the loss] is not an accounting loss because it is, but the front end is still growing," he said.

In the UK, where Aviva makes more than one-third of its revenues, life insurance premiums rose 32 per cent to £8.1bn, with European premiums up 15 per cent to £15.5bn.

Mr Moss said sales picked up in the final quarter of the year, indicating a "flight to quality" among customers. Mr Moss stressed that the investment markdowns were not cash losses but reflected the reduced value of Aviva's investments, which would recover.

Shares in Britain's biggest insurer lost a third of their value and hit an all-time low, leading big falls across the financial sector. Legal & General, which has also been beset by worries about its capital position, fell 29 per cent.

The FTSE 100 index lost 3.2 per cent, taking losses this year to 20 per cent. The banking sector continued to raise fears as Barclays slumped 24 per cent on renewed concern about losses on credit investments.

Fears about the financial sector have spread from banks to insurers. Investors are increasingly scared that tumbling share prices and rising corporate defaults will weaken capital buffers, forcing the sector to raise new equity in the market.

Mr Moss blamed short-sellers for some of the falls in the sector's share price. He said short-selling the stocks was a reasonable course of action but that "short-term short-selling of our shares is not a factor in running the company for the long term".

Analysts at Killick & Co estimated that Aviva's dividend yields a massive 14 per cent, indicating that the market thinks the payout is unsustainable.

"The decision to maintain the full-year dividend at 33p may come as a relief to those investors seeking yield, but it will do little to ease the market's concerns over the group's capital adequacy," the analysts added.

Aviva repeated guidance given last month that its year-end solvency surplus of £2bn would be £1.2bn if equity markets fell a further 40 per cent. The insurer also said unrealised losses on the value of corporate bonds amounted to 8 per cent of its portfolio – much higher than the highest real default losses of the last 100 years. Actual defaults were £140m and included the debt of AIG, Lehman Brothers and Bradford & Bingley.

"Below the line ... a combination of higher default assumptions, asbestos reserving and other unrealised losses generated a net asset value £1.6bn below our estimate," analysts at Deutsche Bank said. The analysts estimated that the dividend and equity market declines had stripped Aviva's surplus to £1.4bn.

Fears for insurers' financial positions also drove a surge in the cost of protecting their debt against default, with Aviva and Prudential leading the surge. Concerns were heightened by a report from Standard & Poor's threatening ratings downgrades for Britain's life insurers. "Depressed asset values and a weak economic outlook in the near term will in our view present growth and earnings challenges for the sector, while increased asset risks and liability risks will weaken balance sheets," the analysts at S&P said.

Old Mutual, whose shares fell 13 per cent, was downgraded by the rival ratings agency Fitch after the market closed.

Bernstein analysts argued that the fall in the insurance sector's share prices was too extreme because it assumed huge losses on the insurer's bond holdings. "We do not believe that anything approaching 30 per cent of investment grade corporates will default in the next five years," they said.

Aviva shares closed at 189.9p, down 51 per cent this year.