After difficulties in the banking sector led to an indiscriminate sell-off of financial stocks, the UK insurance sector has underperformed. While insurers are major holders of financial assets, they have been unfairly punished given that they are not vulnerable to the same credit and liquidity problems as banks.

Rising yields and lower equity markets affected balance sheets. Accordingly, fee incomes were lower, total exposure to pressurised asset classes was very low and write-downs have been minimal. Full-year results broadly met or exceeded expectations, although outlook statements were more cautious.

More positive news
So far in 2008, the insurance sector’s performance has decoupled from that of the banks, outperforming the FTSE. Following strong growth in 2006 and 2007, we expect slowing growth and profits.

Weaker equity markets will lead to lower fee incomes, and continued uncertainty will reduce consumer appetite for equity-related products, although certain product lines offering guarantees could see stronger demand.

Despite weaker equity markets, the industry remains in a strong capital position, unlike earlier this decade when there were concerns over forced sales of equity and rights issues. While life insurance profits tend to be sensitive to the economy, property and casualty earnings are more defensive and cash generative, although subject to underwriting cycle fluctuations. We expect to follow UK motor rates closely, where industry profitability remains stubbornly low. An upturn has been widely expected but slow to arrive.

Embedding the value
Although market conditions may unsettle consumers, demographic changes mean that medium-term demand for savings and retirement products looks set to remain solid.

This dynamic is particularly pronounced in emerging markets, where Prudential’s unique Asian franchise still enjoys exceptional growth. If markets recover, there will be further potential for dividend upgrades, particularly from Aviva, where there is potential for ‘orphan assets’ (surplus funds to back liabilities) being freed up for shareholders.

In life insurance, avoid companies with just a UK focus and invest in large companies with diversified earnings and/or overseas exposure. Given the limited variation in price-to-earnings multiples, we are comfortable remaining with Prudential and Aviva. Although our fair value has less upside than Aviva, reflecting market volatility, Prudential is our top pick.

Prudential attractions
The Pru’s unique Asian franchise remains its key attraction and we expect the very strong growth to continue. Management recently announced that Asian new business targets will be met a year early, and guidance provided at the recent Asia investor day reiterated the positive outlook.

In the US, management has flagged up the fact that variable annuity sales will slow on account of volatile markets, but the upward-sloping yield curve and higher credit spreads point towards strong fixed annuity sales. In the UK, growth will remain subdued, following the exit from a number of product lines, but the group’s positioning in with-profits products should make it a strong contender to win any new contracts on the market.

With group cash flow improving, expect dividend upgrades. Trading on an undemanding price-to-earnings multiple of just 8.3 times, we expect investors to increasingly view Prudential as a cheap Asian play, compared with an average European one. It remains a takeover target but any approach would be complicated by the management’s stated preference for the independent route.

We remain cautious towards UK-focused life insurance businesses, although Standard Life surprised on the upside at its full-year results. A notable exception to our focus outside the UK is Old Mutual, at which overseas growth is eclipsed by currency and political risks. In non-life insurance, Admiral remains our preferred play, due to its individual strengths rather than for any thematic reason.

Henk Potts is equity strategist at Barclays Wealth