The Insurance Industry's Invisible Meltdown

As discussed previously in Next Bailout - Insurance Industry?, the insurance stocks have continued their disastrous sell off. Yet, I have seen virtually nothing in the mainstream press about the dangers of an imploding insurance industry. This invisible crash has reached the point where the Treasury and the Federal Reserve need to address this prior to the point of policy holder and public panic. The insurance industry is in many ways more important to our economy than the banks, and its problems need to be addressed soon.

The individual State guarantee funds backing the insurance industry are woefully under capitalized and were designed to address one failure, not an industry wide meltdown. The State funds rely on assessments of healthy surviving insurance companies when one fails; unfortunately this does not provide much comfort when the entire industry is starved for capital.

The price declines from my October 1, 2008 price summary (updated below) has been catastrophic to the industry’s ability to maintain confidence of their investors and policy holders as well as their ability to raise capital.

The insurance stocks went into a tailspin once it became obvious that commercial real estate values are declining rapidly as the economy continues its deleveraging. Commercial real estate had not been subject to the massive overbuilding and speculation that occurred in residential real estate and until recently had been considered relatively immune to the credit crisis. Since early November, however, the cost of buying default protection on AAA commercial debt via credit default swaps (CDS) has tripled from 200 to 550 basis points (down from a recent high of 847). Financing for new deals or maturing debt on many commercial loans has become almost impossible to obtain with AAA commercial securities trading at junk bond levels.

At Markit.com, the situation was summarized in their Credit Wrap as follows:

The commercial mortgage market, often in the shadow of its residential sibling, made its presence known this week. The CMBS sector has been under pressure since the government changed the focus of TARP away from buying distressed and illiquid assets and helped push spreads wider. But the real impetus behind the widening this week came from two CMBS deals. The securities, backed by hotels and a retail centre, are reported to be close to default… The CMBS meltdown was felt in the broader market. The Markit CDX IG widened to record levels, driven by the insurance sector. Life insurers such as Hartford Financial and Lincoln National have significant exposure to CMBS, and losses could well force them to raise more capital.

The insurance industry companies have always been major investors in commercial real estate as they seek to match long term assets with long term liabilities. The problem is the overallocation of capital to this one sector as reported by Smart Money.

Should commercial real-estate turn out to be next focus of the financial crisis, life insurers will be among the companies feeling the most heat.

Life insurers on average have the equivalent of about 41% of their equity invested in commercial mortgage-backed securities, or CMBS, compared with 23% on average for property/casualty insurers, according to a Thursday analysis of 10 large public insurers by Fox-Pitt Kelton analyst Adam Klauber. He said Hartford Financial Services Group Inc. (HIG), Protective Life Corp. (PL) and MetLife Inc. (MET) had the highest exposures.

Investment banks, by contrast, hold about 18% of their equity in CMBS.

While the financial crisis has come late to the life insurance industry, it has hit them hard. Shares of life insurers are down nearly 72% so far this year, a bigger drop than for other types of insurers. The pressure on life insurers, some of which may become bank holding companies to get access to investments from the Treasury, makes government efforts to contain the financial crisis yet more complicated.

The latest blow is coming from commercial mortgages, which are beginning to look like they may follow the dismal example of home mortgages, with a few big defaults hitting the news in recent days. Life insurers, big investors in mortgage-backed securities of all types, are taking another big hit.

UBS analyst Andrew Kligerman calls the concerns about commercial real estate the “leading factor” in insurance stocks‘ poor performance this week. Lincoln National Corp. (LNC) was the big loser Thursday, closing down 30.6% to 5.07. Shares of Hartford closed down 19% to $5.57 and Principal Financial Group (PFG) closed down 19.2% to $9.43.

Although some of these companies have applied for bank holding status so that they can access the Fed for borrowings, these six companies (representing only part of the insurance industry) have assets of over $1.7 trillion. Assuming significant losses as implied by CDS pricing, recapitalizing the insurance industry could easily consume the second half of the $700 billion bailout fund, while the demands on the treasury grow ever larger, as discussed in The Line at the Treasury Grows Longer.

There would seem to be a finite limit to the amount of losses/guarantees that can be assumed by the US Treasury (taxpayers). Bloomberg is reporting that the total Fed credit pledges and loans now exceed a staggering $7.4 trillion. Let us all hope that we do not find out what the limits of the Fed are. Obviously at some point, the US Government’s credit and ability to fund never ending losses will be questioned.

Stock position: None.

Comments

[safyst:]

Bunch of bunk...... commercial real-estate values will be worth something, maybe they were a little over valued like everything else.

However, the drop in stock prices seems to be a little neurotic.

However, I'm sure there are those who are making a killing.

When the market turns around like they say real-estate, real-estate, real-estate.


Let's hope so !

2008 Nov 25 08:34 AM

[epeon:]

Let the market correct itself. For example, LNC was down to $6/share and I decided to buy it. Why not, I sold the covered call at $7.5 for the middle of December for $1.30. These kind of bargains will attract buyers and the market will correct.

2008 Nov 25 09:46 AM

[Jeff B.:]

HIG's P&C business is still doing very well. Despite the over-investment in real estate, I think some of this insurance industry doom & gloom is simply market panic.

2008 Nov 25 10:50 AM

[dadbong:]

Lincoln has some of the best financials I have seen and an ability to borrow billions in the event of an emergency. They have little exposure to the realestate part of the equation so people need to take a deep breath and see agreat value. I am buying LIncoln

2008 Nov 25 01:26 PM

[epeon:]

Well, what can I say, I bought at $6 and wrote the covered call at $7.5. LNC is now almost $9. So, people who buy this low are going to make serious money. LNC does not need a bailout. It just needs people to see the bargain it is.

Damn, sure wish I hadn't wrote that covered call at $7.5

2008 Nov 25 02:01 PM

[livesinhiscar:]

>>The insurance industry companies have always been major investors in commercial real estate as they seek to match long term assets with long term liabilities.

Life Insurance companies always have this problem every cycle.
They have to match long-term liabilities and long-term assets, but they have to mark-to-market every quarter those assets.
One quarter where the assets decline serverly, even though they are not needed for perhaps decades out in the future can bring the company down.
We've seen this happen before in previous real estate cycles causing several life insurance companies to fail.
Curious that the industry has not found a solution to this long-term matching of assets/liabilies and the need to mark-to-market the assets short-term. Till they do, this problem will repeat every cycle.

2008 Nov 25 04:39 PM