A lesson to be learned

LIFE insurance companies on both sides of the Channel have too little equity capital for the risks they run. If markets don't bounce back, they face a tough choice. They must raise more equity or reduce their risks. This means either selling their own shares or other people's.

Either route will put pressure on the stock market. Falling share prices thus increase the risk of further drops.

Until recently, this bear market has caused more trouble to the insurance industry than the banks. It was thought that the banks had been cunning and used derivatives to sell their worst credit risks to insurance companies.

But it is clear that banks still have troubles. Last week European banks announced soaring bad debts. US banks' shares have already been hit badly. Prices fell sharply over fears that their transactions with Enron may have been a bit dodgy. Traditionally contracts with insurance companies require 'utmost good faith'. So the banks' behaviour might invalidate their derivative contracts.

The insurance industry has also been trying to shift the blame. They have attacked the hedge funds for selling short. (That means they sell shares they don't own, with a view to making a profit by buying them back later at lower prices.)

In fact, short-selling should be encouraged. If there had been more of it in the past, stock markets would not have gone up so much. Rather than life companies blaming the hedge funds for pushing the market down, the hedge funds could blame the insurers for pushing it up. They won't, because it would be biting the hands that fed them. It is because there was buying at ridiculous prices that the hedge funds have had the opportunity to pick up a few crumbs of profit in the bear market.

Life companies resemble the common cormorant or shag which, according to Christopher Isherwood, lays eggs inside a paper bag. 'But what these unobservant birds have never noticed is that hordes of wandering bears may come with bags to steal the crumbs.'

When Wall Street crashed in 1929, the stage magazine Variety ran a headline Wall Street Lays an Egg. Human nature being what it is, investors who laid their eggs in the recent bubble now want to blame others.

It is important that we are not fooled. Only by recognising that the bull market was a folly can we avoid repeating the mistakes.

There are plenty of lessons to be learned. One is that professional investors should be able to recognise a bubble market. This will now be easier than it was, because we have more evidence. The more statistics we have, the easier it is to recognise a pattern. Bubbles are rare, the recent one is only the fifth in 100 years.

There was good evidence that shares became madly overpriced. Both common sense and statistics tell us that we can be more certain today. It would be crazy not to learn from the additional evidence that hindsight has given us.

www.smithers.co.uk