Are Insurers Credit Crunch's Next Victim?

Editor's note: The nagging credit crisis that has enveloped financial markets since the summer seemed to be catching up to insurers last week. American International Group on Thursday reported a $5.3 billion fourth-quarter loss due largely to $11.12 billion in charges tied to senior secured credit default swaps. On Friday, Swiss Reinsurance reported an 87% drop in fourth-quarter net profit thanks largely to a 1.3 billion Swiss franc charge on credit default swaps.

TheStreet.com highlighted the potential dangers the credit markets posed for insurers in the following Feb. 22 story, "Are Insurers Credit Crunch's Next Victim?," part of our occasional series, "Credit Crunch 2008." Earlier stories looked at mortgage lenders, banks, brokerages, ratings agencies and private equity.

Get ready for the latest chapter in the subprime saga: The hits in the insurance industry.

News earlier in February that insurance giant AIG(AIG Quote) had taken a charge of $5 billion related to mortgage credit derivatives catapulted the sector onto center stage. That was followed on Feb. 21 by a forecast from rating agency Fitch that the life insurance sector would take losses of up to $8 billion -- all related to home loans made to borrowers with sketchy credit histories.

The different parts of the insurance industry stand to fare very differently. Life insurers are likely to take a harder hit than health and property/casualty insurers because of their typical asset mix. In addition, the way assets in mortgage-backed securities are reported, there could be problems lurking in the future, even if balance sheets look solid now.

According to November data from the National Association of Insurance Commissioners, the average life insurance company held about 30% of its bond assets in mortgage-related or asset-backed securities, vs. about 23% for health insurers and 19% for property/casualty companies.

Life Insurers

A portion of life insurers' assets is generally in mortgage-backed securities and other assets like stocks or venture capital, because the long-dated nature of the liabilities gives life insurers the opportunity to add some risk in exchange for larger return. And that's especially so when compared to health insurers.

There is another quirk for life insurers. Even though the GAAP (generally accepted accounting principles) treatment for assets is the same for life insurers as it is for banks -- the value of debt held must be marked to the lower of cost or market -- the same is not true in insurance regulations.

The very people charged with ensuring that insurance companies have adequate capital to meet their obligations allow the firms to value bonds held at their original par value, even when the market price is clearly substantially lower.

"You can have an asset held on the balance sheet at a value of 100, even though its market value might be 60," explains Dave Merkel, director of research at Irvine, Calif.-based Finacorp Securities, who is also a practicing actuary, a 17-year veteran of the insurance industry and a RealMoney.com contributor.

"You do have to report the lower value, but it doesn't factor into the net-worth figures," Merkel says.

The rules on when to mark down the value of debt reported to the state regulators are a little murky, but if the debt goes into default it must be immediately reduced in value. In addition, if the impairment in value is more than temporary then the debt's value should be lowered. What counts as "temporary" is open to some interpretation.

It gets worse, because there is still a gaping statutory loophole in the valuing of mortgage-backed securities even when they need to be written down.

For regulatory purposes, when a mortgage-backed security is determined to be other than temporarily impaired it is marked down to the undiscounted value of the projected cash flows, explains Deborah Whitmore, a partner at Ernst & Young in New York.

That's different from GAAP, which would mark the security to fair value, which is essentially discounted cash flows, she says.

In other words, the regulators allow insurance companies to value impaired assets at a higher amount than fair value.

Health Insurers

For health insurers, the cash needs are much nearer term -- less than a year in many cases -- because of the constant need for medical cost reimbursement.

Faced with the need for speedy access to funds, health insurers typically invest in liquid short-term assets such as asset-backed commercial paper and collateralized debt obligations. Those are some of the very same securities which have been hardest hit in the credit crunch.