Analysis
By Andrew Verity BBC personal finance reporter

Two life insurers managing the pensions and investments of more than five million people have been downgraded by the leading credit rating agency Standard & Poor's (S&P).

Although alternative capital-raising methods are possible, they are also considerably more difficult in the current climate. Manish Bakhda, S&P analyst

Standard Life and Prudential have been hit by downgrades following recent stock market falls which have damaged their finances.

The downgrades will come as a heavy blow to both companies but especially to Standard Life, which was lowered by two notches on S&P's scale - a highly unusual move.

Negative outlook

Standard Life has lost hundreds of millions of pounds from its reserves because of share price falls - largely because it stayed heavily invested in shares over the last two years.

As other companies sold shares to reduce their exposure to risk, Standard Life continued to keep the vast majority of its customers' money in equities in hopes of a rebound in share prices.

However, that rebound has so far failed to materialise, and most of Standard Life's spare capital - the assets over and above what it needs to pay its liabilities and meet regulations - has disappeared.

The ultra-cautious S&P analysts put the whole life insurance sector on a "negative outlook" last summer - meaning the finances of the companies were likely to deteriorate.

Share prices on the stock market have fallen by more than 10% since the start of this year - after falling 25% in 2002.

Less than two weeks' ago, Standard Life was forced to raise its "surrender penalties", also known as exit penalties, for customers who wish to cash in policies such as endowments and pensions before they mature.

The penalties were doubled to 20% for policies such as endowments and bonds, and to 25% for personal pensions.

Standard Life's chief actuary, John Hylands, said there was a significant difference between the amounts being paid to customers and the market value of the assets.

As a result, customers who surrendered their policies - withdrawing what they had been promised - were taking more than their fair share of a shrunken cake. That left remaining customers even worse off.

Shoring up finances

As well as boosting exit penalties, Standard Life, once reputed to have by far the strongest finances of any life insurer in the UK, has borrowed �1 billion on the bond market to shore up its finances.

S&P's analyst Manish Bakhda said it had taken account of these steps designed to improve Standard Life's financial strength.

But the life insurer's options were running out. "Although alternative capital-raising methods are possible, they are also considerably more difficult in the current climate."

He said Standard Life was likely to have to sell some of its portfolio of shares.

A spokesman for Standard Life said the group was disappointed at the downgrade, but noted the group still enjoyed the third highest rating of any company in the sector.

Prudential, which started to sell shares three years ago - and has therefore mitigated its losses compared to its rivals - was also downgraded.

In Prudential's case, its finances were hit by the cost of shoring up its US subsidiary, Jackson National Life, which was hit by weak equity markets in the US.

In addition, S&P said it had put Legal & General, Clerical Medical and Scottish Provident on a "negative outlook".