Are Insurers Credit Crunch's Next Victim?

Lingering liquidity problems in the credit markets could soon turn their wrath on insurers.
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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) - Get Report

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.

Market watchers are keeping an eye on that. Massachusetts investment strategist Peter Cohen worries that health insurer

Aetna

(AET)

, for example, could be hiding some risks inside its "non-revealing" long-term investment category. In its fourth-quarter report, the company reclassified some assets and now includes mortgage loans with its long-term assets.

"I don't even know what's in there," says Cohen, who has no investments in health-insurance companies. "I would definitely like to know how safe those investments are."

But even Aetna, which relies on investment income for roughly 40% of its earnings, has escaped without a major hit so far. The company suffered only a modest dip in investment income last quarter.

Fellow big insurers

UnitedHealth

(UNH) - Get Report

and

WellPoint

(WLP)

have also started offering more details about their investment portfolios in their regulatory filings. Goldman Sachs analyst Matthew Borsch, in a research note from Feb. 22, said he spotted no reason for alarm, noting that each took relatively modest investment-related charges last year.

"Both companies provided snapshots of their investment holdings that were consistent with management commentary provided last month on the earnings calls -- but with additional details," Borsch wrote. "We view the 10K disclosures positively relative to market speculation that auditors for one or both companies might have required significant impairment charges, given market developments over the past month as well as the recent writedowns at financial and non-health insurance companies."

It may be the very reliance on short-term assets by health insurers which end up saving those companies. That's because short-dated instruments are constantly being turned over. Older-vintage assets, say, from the heady debt-issuance days of 2006 and 2007, are replenished with new fresher and cleaner assets.

Property/Casualty Insurers

Property/casualty firms, likely the least risky of the three types of insurers, typically find their investing strategies constrained by the rating agencies, Merkel explains.

That's because the events against which they insure tend to have a lot of variability, meaning they are less predictable. For that reason, their investing policies and practices tend to be scrutinized closely.

"Rating agencies frequently threaten to downgrade P&C companies if they don't follow conservative investment policies," Merkel explains. For that reason, even the mortgage-related investments are typically of the highest quality, such as federally insured home loans.

In general, those practices seem to have steered property/casualty firms away from many of the potential landmines being felt in so many segments of the credit markets.

Analysts from Credit Suisse said of

Travelers

(TRV) - Get Report

insurance company that "investment in mortgage-backed securities totals $7.1 billion or 9.5% of invested assets only $286 million of these assets have subprime or Alt-A collateral (0.38% of invested assets)," in a January note. "There did not appear to be any credit impairment to these securities or significant change in fair value," and "none of these securities have been downgraded in 2007."

Even so, that doesn't preclude some short-term weakness in all the insurance stocks. A domino effect could take place.

As the bond-insurance companies, such as

Ambac Financial

(ABK)

and

MBIA

(MBI) - Get Report

, weaken or possibly disappear, the credit ratings of the bonds they insured could start to slip leading quickly to lower market values for the securities.

To the extent that those bonds are held by insurance companies, their balance sheets could take a hit, explains Justin Urquart Stewart, director at Seven Investment Management in London.

"It would be an unpleasant shock," Urquart Stewart adds, although he doesn't see any long-term weakness with the life sector.

Don Coxe, global portfolio strategist at BMO Financial Group in Chicago and a veteran of the life insurance business, agrees. He says the industry's long-term stability and conservative management should bring it through in the long term.

"It takes a lot of bleeding to kill insurance companies," BMO's Coxe says. "I don't know anyone who's gotten rich shorting" them.

Senior writer Melissa Davis contributed to this article.