As European life insurers face up to a much more competitive environment than they have been used to, S&P's new ratings offer a chance to judge their strengths, reports Fennell Betson

As Europe's life insurance groups line up for the start of the euro, their financial fitness is going to be under scrutiny as never before. For many it will be the first whiff of a new kind of competition, that of the euro-market. The question for those interested as customers of and investors in the insurance industry must be insurers' readiness for this changed environment.

Standard & Poor's European Life Ratings Digest in which it undertakes ratings of 70 of the major life groups in France, Germany, the Netherlands, Switzerland and the UK is a timely first step in trying to bring the diverse accounting standards used in each country into a common format so that some comparisons can be made. It also looks at the challenges that life insurers are facing nationally and wider. Not surprisingly, S&P finds wide diversity in insurers' financial strength and that the top-rated companies are likely to draw away from the competition in the euro insurance stakes. The highest-rated companies have strong capitalisation and strong earnings, often achieved through economies of large-scale and cost-effective distribution, as well as enjoying the advantages this brings in terms of capitalisation, distribution opportunities. They have built up strong track records on this basis.

But other insurers are under pressure: those without sufficient capital to compete effectively and constrained in their investment approach. Companies that have had poor earnings performance must put the sustainability of their future bonus payouts in jeopardy, if they are not to weaken their capital base.

The new European scene is going to highlight the strains and weaknesses and widen the distances between the best, the good and the not so good.

For some highly regulated markets, a number of insurers seem to be suffering from a bad dose of that once rampant condition, euro-sclerosis. These have grown fat in capital terms in their hitherto protected market environment but have basically lost the ability to move forward, perhaps as consequence of their sheltered regulatory regime. These groups are at a crossroads and will need to find their way soon. Having the necessary capital is no guarantee in itself of success. Their financial rating takes their current position into consideration.

S&P says most insurers should have few problems about meeting the guarantees attached to life policies, as these are not considered to be overly onerous". But the industry's customers expect to get more than the minimum and the rating given reflects consistent performance over the longer term. In particular, S&P warns about companies which adopt a higher payout philosophy than actually earned in order to position themselves favourably in the performance league tables, and as a consequence hitting their capital base.

For corporates and institutions shopping for insurance in European markets what are the lessons of the study?

Commenting on the overall findings, Paul Waterhouse, associate director, insurance ratings at S&P, and one of the analysts for the European market, says one of the main messages to be taken from the study is that the companies looked at are in the main strongly capitalised. "So there should not be any concerns about these rated insurers defaulting or disappearing in the next few years. But clearly with all the issues insurance companies are going to face with the reform of social security, Europeanisation and the increasing economic integration, an eye will need to be kept on some insurers, particularly as to their credit quality and financial strength."

There are some key questions that customers should ask of a particular company, he says. Firstly, 'Is that insurer going to continue to be around?'

One of the key elements of the S&P ratings is the risk of default, which is not about a company going broke, but missing a debt payment. "The difference between a triple, double and single A and a triple B ratings is minute in default terms," Waterhouse points out. "Ratings down to BBB are in the secure range, while a BB rating is in the vulnerable range. That is the big cut-off point. So we call a BBB rated company good, as its secure characteristics outweigh its vulnerabilities, but the opposite is true for a BB rating."

That certainly does not mean insurance should not be bought from a BB rated company, in his view. For a short-term contract renewed annually, such as a group life contract, with no long-term aspects such as disability cover, a BB company should be an adequate carrier of the risk. "But for longer term contracts, perhaps involving corporate savings elements, then a higher rating level needs to be considered."

For policies involving long-term returns, the other key factor, in addition to whether the company will be around, is the sustainability of historical returns. "We found that some German companies at the top of the league tables for product performance in terms of payout did less well in the analysis of their financial strength than other German insurers. The question to ask if you want a long-term contract is are these companies going to be at the top of the tables in the future." The sustainability criterion is another used by S&P.

Though these ratings for life insurers in Europe have only recently been published, Waterhouse says: "We hear that corporate customers are using the ratings even when selecting one-year term contracts." If the experience of the UK life insurance market, which has provided ratings for some years, is anything to go by ratings quickly become a competitive tool. "The higher- rated life companies do use their ratings very actively indeed," Waterhouse says, "Already we have heard of some of the lesser-rated companies on the continent finding that their competitors are using their ratings as a commercial tool against them."

The aim of the exercise is to ensure that an AA rating means the same in Germany as in the US, he says. There were many problem areas, such as the question of book values. "We had to develop tools to look at the asset side and convert these reserves effectively to market values. As reserving bases varied tremendously, we had to develop tools also to examine technical reserves for potential deficiencies or redundancies. This was particularly challenging where ratings rely just on publicly available information and interactive discussion with the company was not possible. But we are happy with the ratings and their consistency across markets."

The study looks at how life insurers manage their assets in terms of allocations and returns (see pages 10 et seq). "Insurance companies across Europe are taking asset management much more seriously," he says. "Some companies are trying to consolidate activities for all countries or to have a single asset manager operation for each country. A more professional approach is being taken, with separate specialist companies being established to run the assets, or the decision to be outsourced if the area is too specialist or an outside professional can do it better."

The realisation among insurers is that this is an area of their operations they can no longer be complacent about and an increasing focus is being put on investment returns.

"So far there is no sign of common European-wide trends to more equity investment. For example German and Swiss insurers still have significantly less than UK or Dutch companies." Waterhouse thinks that in individual markets insurance companies are concerned about stepping too far out of line with their competitors. "You may go out a bit, but not too far as it could affect your business." But the there will undoubtedly be a move to more Europe-wide portfolios with the arrival of the euro, though the pace at which this will happen cannot be predicted. This will further increase the pressures to build up centralised asset management operations to develop the investment skills required, which might indeed prompt mergers and other forms of co-operation, in order to be able to justify the use of experts, or else to outsource these needs."