The next big financial meltdown?

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While the general public is loudly applauding the new administration and the

Democrats, here is what other people are saying...

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The next big financial meltdown?

The mortgage and credit sickness that brought banks and brokers to their knees

has now infected the companies that insure lives and protect families.

By Brush

February 25, 2009

The life insurance companies that millions of Americans entrust to help protect

their families or pay the bills in their golden years are caught in a downward

spiral eerily similar to the one that has brought down banks and brokers.

Like Bear Stearns and Lehman Bros. (LEHMQ.N), U.S. life insurers Hartford

Financial Services (HIG.N), Principal Financial Group (PFG.N), Lincoln National

(LNC.N) and many others all have significant exposure to mortgage-backed

securities and other risky debt instruments.

They're reporting huge losses that -- if they continued -- could trigger a

meltdown.

That could wipe out shareholders, who already have suffered declines of 20% to

40% in the past week alone. Customers with annuities or insurance policies might

have to turn to U.S. state insurance backstop funds and settle for only a

portion of the money they were expecting.

Health, auto and property insurers are better off. But based on how far life

insurance stocks have fallen, investors are worried many won't survive at all.

What are the chances this doomsday scenario will play out?

" To know that, you have to gauge how bad this market will get over the next six

months, which none of us know, " responds Jim , an analyst with Morningstar

(MORN.O). It all comes down to how much worse things could get for the (U.S.)

economy and for the debt instruments and stocks that life insurance companies

hold.

" We're telling people to be more careful, particularly if you are going into

longer-range products that involve significant upfront funding like annuities, "

says Bob Hunter, the director of insurance for the Consumer Federation of

America. " You want to make sure that the company is actually around when you

want to get the money out. I'd say there's a good likelihood some of them will

go under. "

Death spiral

It's easy to imagine a spiral that takes many insurers out or at least has them

asking for help from the U.S. government.

It starts with those serious market losses. Life insurance companies rely on

investments in bonds and stocks to meet cash-flow needs years from now. But

because of exposure to dubious debt securities backed by shaky subprime and

commercial real-estate loans, they're now piling up investment losses big time.

In early February, for example, Hartford Financial reported a loss of $806

million, or $2.71 per share for the previous quarter, including a $610 million

realized loss on investments. Lincoln National reported a $1.98-per-share loss,

including a realized loss on investments of $238 million after taxes.

This isn't the end of it. Analysts at Stanley (MS.N), for example,

estimate Lincoln National is sitting on $7.6 billion more in unrealized losses

in its $58 billion investment portfolio. Many other companies have significant

unrealized losses, too.

These big losses create two problems for life insurance companies. First, they

have to reserve more capital against payments they promise by selling annuities

and life insurance policies.

More importantly, the erosion of their capital bases has ratings agencies

downgrading their debt. If that continues, big corporate customers and

individuals might consider them too risky and pull business -- sparking a " run

on the bank " at insurers.

" Over the course of 2009, we expect signs of a flight to quality on the part of

annuity buyers, " Wachovia analyst Hall wrote in a recent research note. He

thinks that's already playing out at Lincoln National.

All of this, then, brings another cycle of downgrades in credit ratings -- a

kind of vote on how likely a company is to pay back its debt. Taken to extremes,

investment losses that spark ratings downgrades -- combined with stock price

declines -- would make it virtually impossible for insurers to raise capital. It

would also be tough to roll over debt coming due over the next two years.

Poof. There would go your life insurance companies.

This scenario inched closer to reality in recent weeks as insurers announced big

fourth-quarter losses. The news had debt-rating agencies such as Fitch Ratings,

Moody's Investors Service and Standard & Poor's Ratings Services cutting their

ratings for Hartford, Principal Financial, Prudential Financial (PRU.N) and

Genworth Financial (GNW.N), citing " surging investment losses and weakening

earnings capacity. "

Some help from regulators

As a sign that the problems for insurers are getting more serious, regulators

are loosening accounting standards to try to help them out.

In the past few weeks, insurance regulators in Connecticut, Iowa and Ohio have

eased accounting standards for life insurers like Hartford and Allstate (ALL.N)

in an effort to help them meet standards for capital on hand.

State regulators are allowing insurers to count more deferred tax assets as

capital, which seems odd because these are tax refunds expected years from now,

not money in the bank. They are also permitting insurers to reserve less cash

against promised annuity payments. Again, this seems disconcerting, since you

might expect regulators to ask for more reserves at a time when investment

assets are falling.

" They are trying to grasp for other forms of capital, " says , an

accounting analyst with Gradient Analytics. " This is a sign of stress among

these companies. "

The Consumer Federation of America likens the practice to doling out " lollipops

at a barbershop. "

Don't worry, be happy

Though industry supporters acknowledge there could be serious trouble if the

U.S. economy and the markets sink low enough, they cite several reasons a

doomsday scenario isn't realistic:

* First, life insurers typically have very little money invested in stocks or

risky mortgage-backed securities. Most of it is in bonds -- and in a broadly

diversified portfolio of high-grade corporate or government bonds at that,

maintains Weisbart, the chief economist at the Insurance Information

Institute. " There may be one portion of their portfolios where they are

experiencing investment losses, but you have to look at their overall business

and how they are managing that business, " Ohio Insurance Director Jo Hudson

told me. " Based on the analysis that we do here in Ohio, the insurance companies

are safe and sound. "

* Next, outright bankruptcies are unlikely, says Sterne Agee analyst Nadel,

because life insurance companies have agreed to make payouts over the long term

-- typically several decades from now. They can survive near-term market

weakness because they aren't required to make payouts right away.

* Nadel also doubts a run on the insurance companies will occur, because they

charge hefty fees for cashing out accounts. Uncle Sam hits policyholders with

penalties for cashing out early, too.

* And unlike Bear Stearns and Lehman Bros., insurers did not borrow huge amounts

of money to make investments, Connecticut Insurance Commissioner Sullivan

says.

Despite recent downgrades to its debt rating, Principal Financial says its

capital position actually doubled in the fourth quarter to about $800 million

and that it still has relatively strong debt ratings and a strong capital base.

The company also says it won't have to pay out on many of its annuities and

policies for a long time, so it can wait out near-term unrealized losses on

investments. It also says that its wealth management divisions could continue to

operate well even if the company got lower ratings.

* Talk back: Which company will be the next to fall?

Last Friday, Hartford chief Ramani Ayer told investors: " We entered 2009

well-capitalized and with ample liquidity. The Hartford remains well-prepared to

meet our commitments to our customers, as we have for the past 200 years. "

And as for relaxed accounting rules, two state insurance commissioners I spoke

with defended the practice. Allowing insurers to take credit for deferred tax

assets makes sense because insurance companies typically overpay taxes on life

insurance premiums. The taxes get paid back to the companies over time, says

Hudson, Ohio's chief insurance regulator. So allowing companies to recognize 15%

of the deferred tax asset -- up from 10% -- is no big deal.

Next, insurers already reserve more than required for variable annuities. An

easing of the standards has been approved by the U.S. National Association of

Insurance Commissioners for 2010. Regulators are only speeding up that change,

Connecticut's Sullivan says.

It's also important to keep in mind that health, auto and property insurance

companies make fewer long-term investments, because their policies and payouts

stretch out over much shorter periods. They invest in more-liquid short-term

securities and may not face the same level of portfolio losses as life insurers.

As for those life insurers, the points above may be reasons to feel more secure.

But if the U.S. economy and the markets continue to tumble hard, the companies

won't be safe.

The number of insurance companies with supposedly safe debt that are on the

verge of slipping into junk territory hit an 18-year high in January, according

to Standard & Poor's. Nouriel Roubini of RGE Monitor thinks continuing economic

damage will ultimately push their credit losses to $3.6 trillion, up from recent

levels of around $1.6 trillion.

U.S. government guarantees

If an insurance company does go bust, a policyholder will get a hand from

" guarantee funds " run by states. Once the assets of a bankrupt insurer were

exhausted, policyholders could file claims against these state funds for

insurance losses or lost annuities.

One drawback is that these funds limit claims to a few hundred thousand dollars.

" If you have a million-dollar life insurance policy, you're going to get a

haircut, " says Hunter, of the Consumer Federation of America.

And a lot of these state guarantee funds don't actually have any money. Instead,

they assess surviving insurance companies for the money they need to satisfy

claims. In a real disaster scenario that took out a lot of insurance companies,

it might be hard for states to raise enough money to satisfy claims. At that

point, some states would dip into their general funds.

Ultimately -- in the meltdown scenario -- it might be Uncle Sam that would be

asked, once again, to save the day.

Last month, U.S. federal banking regulators approved applications from Hartford

and Lincoln National to acquire existing savings and loans and become thrift

holding companies. That move makes an insurer eligible for federal government

bailout funds.

Voilà. Problem solved -- assuming U.S. taxpayers will stomach more bailouts at

that point.

At the time of publication, Brush did not own or control shares of any

company mentioned in this column.