Life just isn't what it used to be for British insurance

If the British insurance industry were looking to buy a policy to insure itself against future woes, few would want to underwrite it. The Man from the Pru door-to-door salesmen selling their wares up and down the land have long since disappeared, along with the profits they pulled in for the once-prosperous UK insurance industry. These days, the insurance game is altogether more complex and the potential pitfalls facing the lead protagonists are much deeper.

The likes of Legal & General and Aviva (formerly Norwich Union) face the prospect of having to tap shareholders for billions of pounds as they grapple with creaking capital positions, the threat of new regulation from Brussels and Westminster, and falling demand for their products. The sector is also in the midst of a wave of consolidation as the former zombie fund raider, Clive Cowdery, eyes up potential targets after snaring Friends Provident last month. These are indeed interesting times for insurers in the UK.

The Association of British Insurers (ABI), the body that represents the industry, fired the first salvo last week in its battle with European regulators, who are looking to implement a new regime for insurers across the continent. Where the banks had to grapple with Basel 2, insurers get the snappily-titled Solvency 2 Directive, which is due to come into force in 2012.

The measures being laid down by Brussels are likely to mean insurers will have to radically increase the amount of capital they put aside for rainy days, of which they have had no shortage of late.

In a letter to the Chancellor, Alistair Darling, ABI's outgoing chief executive, Stephen Haddrill, said his members might have to raise £50bn to comply with Solvency 2, while pensioners face the prospect of their annuity payouts falling by a fifth if the plans are implemented.

The share prices of insurance firms with the greatest exposure to capital-intensive products fell heavily on the back of the ABI's claims, with Aviva tumbling by 4 per cent and Legal & General plunging by more than 7 per cent. L&G's chief executive, Tim Breedon, has described the rule changes as "a betrayal of savers".

The extent of the negative sentiment surrounding insurers last week was probably overdone. The chances of European regulators implementing Solvency 2 in its proposed guise are small, according to many insurance industry professionals.

"We doubt Solvency 2 will be implemented as currently envisaged," says Marcus Barnard, insurance analyst at Oriel Securities. "Even if it is, we doubt the impact will require £50bn of additional capital as reported. However, sorting out this proposed regulation will take time, so it is unclear for how long this story will run, and there is unlikely to be a quick resolution."

There are certainly plenty of imponderables facing the life companies in the run up to Solvency 2's implementation. For starters, UK insurers could up sticks and re-domicile in offshore locations such as the Isle of Man and the Channel Islands to avoid the solvency rules. In such jurisdictions, annuity investment returns aren't taxed. Prudential has already floated the idea of moving its headquarters abroad to avoid tax on foreign profits. Solvency 2 is bound to make others think of a move. Notionally changing the address of your head office or a subsidiary is not all that difficult, especially if it saves millions of pounds for the firm.

Another way British insurers could sidestep European regulations would be for them to ditch existing annuity liabilities by offloading them to re-insurers outside the EU, such as Swiss Re, which European regulators don't oversee. "Swiss Re isn't governed by EU Solvency rules and could write annuity reinsurance treaties, but I'm not sure how this would be treated, whether the capital requirements would 'look through' to the re-insurers' capital and require the ceding UK company to hold more capital," says Barnard.

One less-practical suggestion mooted last week was that insurers send their policyholders free fags, booze and pork pies, and hope the resulting rise in mortality rates reduces their liabilities sooner. Perhaps not.

Playing on the future uncertainty that will envelope the sector are the hedge funds. Crispin Odey, a hedge fund manager who won big by short-selling the banking sector before its demise, placed a hefty bet just last week that the price of Legal & General will fall. Earlier in the year, Lansdowne Partners, a London-based hedge fund, pocketed more than £13m after taking a short position in Aviva, which subsequently plunged in value amid concerns about its capital strength. Hedge fund managers often get their bets wrong, of course, and a takeover offer for L&G would leave Odey nursing heavy losses. Given the consolidation fever gripping the sector, with Cowdery's Resolution vehicle eyeing up the likes of L&G, Odey could take a bath on his latest bet.

Cowdery, the former salesman who left school without an A-level to his name, scooped more than £15m selling his company two years ago. He raised £600m on the London Stock Exchange in December to create a fund to buy up ailing life insurance companies and last month bought Friends Provident in a cash and paper deal worth £1.86bn. It was a deal that he told friends had to happen sooner rather than later.

When Aviva shares plummeted to 160p, the prospect of Cowdery buying the company wasn't perhaps as fanciful as it once might have sounded. But with Aviva's stock rallying to more than 400p, he probably has other names on his shopping list.

Top of the list is probably Clerical Medical, which is owned by the Lloyds Banking Group. In the spring, Lloyds hired the investment bank, Deutsche, to review all of insurance assets, including Clerical and Scottish Widows. Though Lloyds has remained tight-lipped about the findings of the review, which is believed to be ongoing, sales look likely.

Rumours have circulated that Lloyds could spin off Scottish Widows through an initial public offering, although that seems rather fanciful. Any sale of Clerical Medical would be completed at a considerable discount to embedded value, the tool used to measure insurance companies. Lloyds is currently allowed to value its insurance assets as capital for its wider banking book, so any sale would reduce the bank's core tier one capital ratio, a key measure of a bank's strength. Beside Lloyds, Legal & General would look to be a candidate for Cowdery's vehicle.

L&G's chief executive, Tim Breedon, has gone through a rollercoaster ride since taking over at the helm of the firm in 2007. On his arrival, he handed back £1bn to shareholders as markets boomed. But as the cycle turned, that move looks to have been a woeful miscalculation. A botched explanation of the company's capital strength at the start of the year sent L&G's shares into free fall. Certainly, Breedon is under pressure.

A rights issue remains likely at L&G but intervention from Resolution could dramatically change the course of events in the coming months.

Beside L&G, speculation persists that Prudential could split itself into two businesses: the UK and Asian operations. Hermes, an activist investor, wrote to Prudential's chairman in 2007 calling for a break-up of the group to unlock hidden value. Whether the same amount of value can be mined now is questionable, with an increasing number of analysts suggesting that the UK business is a helpful counterweight to fund the altogether racier developments of Pru in Asia.

On top of all this, insurers are having to grapple with the introduction of the retail distribution review, a radical overhauling of the way companies distribute their products to individuals that comes into force in 2012.

"Not that long ago, there were about 200 life companies operating in the UK," says Paul Bradshaw, the former head of insurance at Abbey and now non-executive chairman at Nucleus, a provider of services to the financial adviser community. "Now there are about 10 meaningful names left. The economics of running life businesses often just don't add up."

In the next two years, the number of players left could shrink further.

RSA's quiet man at the top: Haste brings unhurried success

City investors often bemoan the quality of management in the insurance sector but it's hard to find anyone with a bad word to say about Andy Haste, the chief executive of the general insurer RSA. That his reputation remains so strong is all the more remarkable given that the former banker asked shareholders for nearly £1bn in a 2003 rights issue, and plans to tap them for another £600m this autumn.

He has presided over a dramatic improvement in the fortunes of a company that was on its knees when he took over. Mr Haste successfully sold the company's draining American business early in his tenure. As one investor in the company put it: "We gave him a list of things to sort on his arrival and he's ticked every box. The only thing now is where the growth comes from?"

By looking to raise £600m from investors for Mr Haste clearly thinks that growth will come through chunky acquisitions. Previously, RSA has said it only had eyes for small, bolt-on buys but the rapidly changing landscape has altered opinion at the top.

Perhaps RSA's biggest challenge will be to keep hold of the press-shy Mr Haste, who has been linked to some of the most prestigious jobs in insurance.