By Andrew Verity BBC personal finance reporter

Financial advisers are starting to refuse to recommend traditional investment policies run by life insurers because of growing fears about the impact of the falling stock market on the industry.

We no longer see with-profits as such a good investment

John Turton Best Invest

In a reversal of normal practice, the advisers are steering customers away from so-called with-profits policies - normally recommended for cautious investors.

And analysts are warning that policyholders can expect further deep cuts in the money paid in to their policies - known as bonuses - because life insurers have been devastated by falling stock markets.

"We no longer see with-profits as such a good investment," says John Turton of the independent financial adviser Best Invest.

"The falling stock market has taken a huge toll and many life offices are struggling to afford the cost of [doing] new business.

"There's a huge squeeze on their funds and we think even if the market recovers you will still see big cuts in bonuses."

Paying the price

For years, with-profits policies - including endowments, pensions and bonds - have been sold as a safe way for an investor to benefit from the stock market while avoiding the worst of its ups and downs.

Weakest insurers still selling policies (rated on a scale of 1 to 10 from weakest to strongest)

Sun Life Assurance fund (4) - (most Sun Life business since 1998 written to the much stronger Axa Sun Life fund) MGM (4) Friends Provident (5) Winterthur (5) Scottish Friendly (5) Rated by Best Invest using research by Cazalet Financial Consulting

And with-profits endowments and pension policies have delivered good returns in the last five years compared with the stock market.

But that has come at a huge cost.

Because life insurers have continued to pay good returns to policyholders while losing money on the stock market, they have eaten into their reserves of spare capital.

According to the independent consultants, Cazalet Financial Consulting, life insurers had �130bn in spare capital two years ago.

Now that figure is close to zero.

Cazalet warns that policyholders can draw no comfort from recent announcements by regulators and rating agencies that life insurers remain solvent.

Solvent but struggling

The UK financial watchdog, the Financial Services Authority (FSA), which regulates life insurers, recently stated that the top 20 major life insurers were solvent, even on its stringent criteria, with the FTSE 100 at the level of 4,000.

Falling share prices have led to smaller policy bonuses

The FSA also said that the sector could withstand "significant further falls" in the stock market below 4,000 and would still meet its statutory requirements on financial strength.

Equitable Life, one of the weakest life insurers, was excluded from its list of 20.

However, holders of life insurance policies can easily lose a great deal of money long before their life insurer starts to break the regulator's definition of technical solvency.

"The ability of a life insurer not to become insolvent at any point is quite different from them not giving their policyholders a very hard time," says Cazalet's principal Ned Cazalet.

How with-profits works

Holders of with-profits policies - an estimated 10 million people in the UK - pay premiums over to their life insurer.

The life insurer then puts that money in its main life fund which invests in a mix of shares, bonds and property.

Weakest closed funds (rated on a scale of 1 to 10 from weakest to strongest)

Equitable Life (2) Alba Life (formerly Britannia Life) (2) Sun Alliance & London (2) NPI (old fund) (3) Royal Sun Alliance (formerly Royal Life) (4) London Life (4) National Mutual (5) Rated by Best Invest using research by Cazalet Financial Consulting

At the end of the year, the life insurer looks at how well or poorly the investments have performed.

It then decides how much it can afford to pass on to its policyholders in the form of bonuses.

The bonuses are split in two.

First is the annual bonus which is added to the total value of the policy and, once added, cannot be taken away.

Second is the terminal bonus, a discretionary amount which is allocated to the policyholder but is not guaranteed.

In recent years, annual bonuses have been as low as 4.5%.

In a good year, terminal bonuses of another 3 or 4% might be added.

In a typical with-profits policy of �100,000, as much 50 per cent of its total value is in the form of terminal bonuses built up over the years.

Because that amount is not guaranteed, it does not show up as a liability in the life insurers' accounts.

So life insurers can respond to stock market falls by slashing terminal bonuses - perhaps removing up to half of the value of a customer's policy - without ever affecting its ability to pay its liabilities - and therefore its solvency.

In other words, the typical policyholder could lose up to half of the value of their policy while their life insurer would remain comfortably solvent.

It is only when life insurers begin to approach the point where they cannot pay the guaranteed part of the policy - the annual bonuses - that they come close to breaking the strict rules on technical solvency.

Terminal bonuses slashed

According to Standard & Poor's, the international agency that rates companies for financial strength, none of them are even close to insolvency.

"In terms of meeting payments as they fall due, even if the stock market fell below 3,000 and stayed there for more than 6 months, we don't think any of the major life insurers would be insolvent," says Paul Waterhouse of Standard & Poor's.

While remaining comfortably solvent, most life insurers now have a big gap between what they have in their coffers - their underlying assets - and what they have allocated for policyholders in terms of annual and terminal bonuses.

They are attempting to close that gap by cutting what they are promising to pay - in other words, the value of policies.

The cuts are being made by slashing the value of terminal bonuses rather than guaranteed annual bonuses.

Even the strongest companies have been forced to cut the value of policies after losing billions of pounds on the stock market.