FORECASTS & TRENDS E-LETTER
by Gary D. Halbert
April 7, 2009

IN THIS ISSUE:

1.  Are Insurance Companies The Next Shoe to Drop?

2.  2008 Was a Bad Year All Around for Insurers

3.  Credit Crisis Severely Impacts Some Insurers

4.  Reinsurance Companies Facing Similar Problems

5.  Insurance Companies Look to States For Help

6.  Look Out For Hurricane Season This Year

7.  What to Look For in the Financial Reports

Introduction

Some observers now feel that we’ve seen the worst of the recession and the credit crisis, and that things should slowly improve in the second half of this year.  People in this camp believe that the massive bailouts of major banks and President Obama’s huge stimulus package should work to unfreeze the credit markets later this year.  Others like myself are not so sure.

While most of the attention has focused on the major banks in recent months, there is another potentially huge problem that I will bring to your attention in this E-Letter.  The major insurance companies, with a few exceptions, may be in financial trouble.  The recession has meant a large drop in premium income for all but a select few large insurance companies.

Furthermore, the credit crisis has delivered a serious blow to the major insurers who are big players in derivative instruments such as Credit Default Swaps and Collateralized Debt Obligations and others.  Expect to hear much more about this in the weeks and months ahead.

Another serious problem for the major insurance companies is the bear market in stocks.  A.M. Best reported recently that stock portfolios for the top 25 insurance companies fell 28% on average in 2008.  Even with the latest rebound in the market, these portfolios are almost certainly down more this year.  For all these reasons, insurers are looking to their home states for relief, and some states are cooperating.  But will it be enough?

Next on the list of concerns is the upcoming hurricane season.  As I will discuss later, the Texas and Florida hurricane catastrophe funds are dangerously under-funded.  Neither the Texas nor the Florida legislatures have taken action to recapitalize these emergency funds.  If we have major hurricanes this summer or fall, the major insurance companies could be very hard hit.

The major insurance companies will be releasing their financial reports for the 1Q (10-Qs) and  for all of 2008 (10-Ks) over the next few weeks.  It is widely expected that most of these reports will be disappointing and may well raise some red flags.  I will tell you what to look for in these reports as we go along, in case you want to check up on your own insurance companies. This may be one of the most important and timely E-Letters I have published.   

Insurance Companies – The Next Shoe to Drop?

As the recession and the credit crisis unfolded over the last year, most of the media attention and Congressional hearings have focused largely on the big banks.  But we also know that the nation’s large insurance companies (property/casualty/life/health) are not immune from the recession or the credit crisis or the bear market in stocks.  We hear from sources close to the industry that 1Q financial reports, which will be released over the next few weeks, and revisions to 4Q numbers, are likely to raise concerns that some large insurance companies may be in trouble.

We don’t tend to hear a lot about these big companies because they are largely regulated by the states, not the federal government, although that may change before long, especially if these upcoming financial reports set off alarm bells at the Treasury Department.  A recently released A.M. Best Statistical Study suggests the upcoming reports could be quite ugly.  A.M. Best is a worldwide credit rating agency for insurance companies and banks.

In March, A.M. Best reported that total “admitted assets” for the top 25 US life/health writers declined 10.1% at the end of 2008 to $3.6 trillion and declined by 8.7% for the entire industry to $4.6 trillion.  Admitted assets include both general account assets and separate account assets. The study also shows just two insurers out of the top 25 with year-over-year profits in 2008.

A.M. Best noted that the main reason total admitted assets declined by over 10% at year-end 2008 from 2007 for the top 25 insurers was the substantial decline in separate account assets, down 28% year-over-year, largely due to the significant downturn in the equity markets.  The S&P 500 declined 37% for calendar year 2008.

The companies in the top 25 showing the greatest declines in admitted assets were: Nationwide Life Group, down 21.7%; Hartford Life Group, down 21%; Axa Financial Group, down 20.6%; Lincoln Financial Group, down 16.4% and Ameriprise Financial Group, down 15%.  AIG Life Group and Principal Life Group tied for the next spot, with both showing 14.9% drops in admitted assets.

2008 Was a Bad Year All Around for Insurers

Insurance company problems and losses in 2008 affected not only life/annuity insurers, but also property/casualty writers.  Losses were not only attributable to the recession, the credit crisis and the bear market in stocks, but also natural disasters. A.M. Best notes the following in regard to life/annuity insurers:

“The year 2008 was among the worst in memory for life/annuity operating performance – the key drivers being substantial realized and unrealized losses on investment portfolios, higher costs of capital and a declining revenue base. These trends clearly are continuing and could deepen well into 2009. The severe decline and volatility in the equity markets are causing capital strain for many life companies, especially large variable [annuity] writers. 

A.M. Best has taken a number of negative rating actions in the life insurance sector, triggered primarily by investment concerns and expects the pace of these negative rating actions to accelerate as it reviews life insurers’ year-end results. Increased sales of less creditworthy products, erosion of earnings power and reduced capital flexibility has led A.M Best to conclude that the life/annuity segment is of lower credit quality.

Individual Life [insurance] – The most direct impact of the recession, so far, has been the accelerating decline in annualized new business premium. Individual life sales were down 3% through the third quarter and, given the economy, this trend clearly will continue through at least the first half of 2009.

Individual Annuities – Many VA [variable annuity] writers are reviewing their product designs, leading to more restrictive choices and higher prices for guaranteed benefit riders –if offered, at all. Trends in VA net assets, sales and net flows are negative, but are being somewhat offset by increases in fixed annuity sales.

Life Reinsurance – Demand for reinsurance for variable products continues to outstrip supply, driven by larger net amounts at risk and higher hedging costs due to volatility in the equity markets.

Mergers and Acquisitions (M&A) – M&A activity is likely to accelerate in 2009 as the need to raise capital clearly is a concern. Investment losses also are motivating companies to find strategic partners.”

A.M. Best goes on to highlight concerns and challenges facing property/casualty insurers:

“Natural catastrophes and financial upheaval drove a sharp reversal in the property/casualty industry’s fortunes in 2008, and the effects spread to A.M. Best Co.’s rating activity… Several destructive tropical storm systems and continued turmoil on Wall Street marked the fourth quarter of 2008. These factors drove up combined ratios and put a dent in policyholder surplus for the U.S. property/casualty industry.

Net income was down and the combined ratio was up for 2008, as investment losses took a toll, a soft market [recession] cut premium income, and natural catastrophes drove up underwriting losses. Downgrades of property/casualty insurers totaled 57 in 2008, up from 43 in 2007… Downgrades may reflect adverse reserve development; shortfalls in profitability; imprudent growth; or capitalization dropping below that needed to maintain a company’s rating level.”

2008 was a higher than normal year for natural disasters such as hurricanes, but it was certainly not the worst we have seen.  But combined with the recession and the bear market, most property/casualty insurers are really hurting financially.

Credit Crisis Severely Impacts Some Insurers 

The recession and the bear market may have created the “perfect storm” for insurance companies, but the news gets even worse.  As it turns out, many of the largest insurers have been heavily impacted by the credit crisis, since many have been and are sizable players with large portfolios of derivative instruments such as Credit Default Swaps (CDSs) and Collateralized Debt Obligations (CDOs) and others.  As you know, it was some of these same derivative securities that got many of the big banks in trouble. Can the insurance companies be far behind?

The Wall Street Journal posted an online article on April 1 which focused on Hartford Financial Services Group, the fourth largest insurer in the US.  A research report from Credit Suisse called on Hartford to post collateral on $400 million of its CDS portfolio, following Hartford’s latest senior debt rating decline by Moody’s to Baa3, just one level above junk bonds. 

Reuters reported on March 31 that following Hartford’s debt rating decline by Moody’s, its cost for insuring its senior debt increased significantly:

“The cost of insuring the debt of Hartford Financial Services Group (HIG.N) jumped on Tuesday after Moody’s Investors Service cut the ratings on the insurer's debt to the cusp of junk territory. Moody’s late on Monday cut Hartford’s senior debt ratings two steps to Baa3, the lowest investment grade, and gave the company a negative outlook, indicating an additional downgrade may be more likely over the next 12 to 18 months.

A downgrade into junk territory can significantly increase a company’s borrowing costs. Credit default swaps insuring Hartford’s debt rose to 19.25 percent of the sum insured as an upfront payment, or $1.92 million to insure $10 million for five years, plus annual payments of $500,000, from 16.25 percent upfront at Monday’s close, according to Markit Intraday.

The downgrade ‘was driven primarily by the credit deterioration of the life insurance subsidiaries, as well as a reduction in financial flexibility,’ Moody’s said in a statement. The group’s financial leverage and earnings and cash coverage are expected to deteriorate further and be constrained over the medium term due to potential realized losses and reduced earnings capacity at the operating units, Moody’s said.

Hartford, the fourth largest U.S. insurer, in February posted a fourth-quarter loss and said it would slash its dividend by 84 percent in a bid to preserve capital.”

My sources close to the insurance industry tell me that other large US insurers are in similar financial straights as Hartford.  Therefore, sophisticated investors will want to pay particular attention to the financial filings (10-Qs for the 1Q and 10-Ks for 2008) that will be released over the next few weeks by the publicly-traded insurance companies.  

Reinsurance Companies Facing Similar Problems

Insurance companies traditionally offset some of their risk exposure by selling it to “reinsurers.”  Reinsurance is a means by which an insurance company can protect itself with other insurance companies against the risk of losses.  Individuals and corporations obtain insurance policies to provide protection for various risks (hurricanes, earthquakes, lawsuits, collisions, sickness, death, etc., etc.). Reinsurers, in turn, provide insurance to insurance companies.

The main purpose for reinsurance is to allow the company to assume greater individual risks than its size would otherwise permit, and to protect the company against losses.  Reinsurance enables an insurance company to offer higher limits of protection to policyholders than its own assets would allow.  For example, if the principal insurance company can write only $10 million in limits on any given policy, it can reinsure the amount of the limits in excess of $10 million.

Reinsurance companies have highly refined their policies in recent years to include applications where reinsurance was used as part of a carefully planned hedging strategy.   Reinsurance can help to make an insurance company’s results more predictable by absorbing larger losses and reducing the amount of capital needed to provide coverage.

The largest reinsurers include Swiss Re, Munich Re, Berkshire Hathaway/General Re (Warren Buffet), Hannover Re (Germany) and Reinsurance Group of America.  The problem is, due to the recession, the bear market and the credit crisis, more and more insurance companies are looking to reinsure more of their books to free up capital.  Yet the reinsurance companies are facing all of the same problems, plus in some cases, adverse currency exchange rates.

Reuters reported on April 1 that reinsurance rates for property catastrophe insurance rose by an average 8% worldwide based on January renewal rates.  Reuters also reported in the same news release that reinsurance costs for US catastrophe risks rose by as much as 40% in 2008.  So, it is clear that insurers around the world, and especially in the US, are struggling to find ways to reduce their risks in this very bad economic and financial time.

Insurance Companies Look to States For Help

When former Treasury Secretary Hank Paulson made it clear last year that TARP and federal bailout monies would not be made available to insurance companies (with the notable exception of AIG), dozens of insurers have approached their state regulators for relief from “capital and surplus requirements.”  The various states which regulate insurers have capital requirements that the companies must meet or exceed.

If insurers fail to meet these capital and surplus requirements, the states can put these companies under “supervision.”  If the deficits continue, the states have the power to put such companies into receivership (bankruptcy).  The last time this occurred with a life insurance company was in the case of Executive Life back in 1991.  More recently, property and casualty giant Reliance Insurance Company was placed in receivership by the state of Pennsylvania in May 2001 and filed for bankruptcy a month later.

The worst news is that a number of large US insurers have fallen below their capital requirements and have lobbied state regulators for changes in the accounting rules for how they value their assets and liabilities.  Surprisingly, several states are obliging.   The Washington Post reported on March 10 that several well-known insurers have been granted financial relief:

“State regulators trying to help life insurance companies cope with the financial crisis have granted $6 billion of relief from requirements meant to ensure financial stability, according to data released yesterday.

The top recipients were Allstate Life Insurance Co. with $1.4 billion; Jackson National Life Insurance Co. with $825.6 million and Hartford Life Insurance Co. with $655.2 million, according to the National Association of Insurance Commissioners.

The relief typically came in the form of accounting changes that allowed companies to pad their financial cushions, in effect making them appear stronger than they otherwise would. Insurance companies are required to maintain such cushions, known as capital and surplus, to absorb losses and pay claims.

Much of the padding involves increased counting of potential tax benefits that could end up being worthless to the companies.

Like other investors and financial institutions, life insurance companies have seen the value of their investments reduced by the financial crisis. Unlike banks, though, insurers have yet to receive federal bailouts to replenish lost capital.

Industry leaders have argued that regulatory relief could help insurers weather the crisis. They have expressed hope that it will stave off downgrades to their credit ratings, which can be damaging to their business. They also want to avoid having to raise capital from investors, which could cost a lot of money and dilute the value of shareholders' stock.

Critics such as the Consumer Federation of America have argued that the relief could weaken insurance companies and leave policyholders at greater risk… Some state regulators said they wanted to make sure their home-state companies weren't left at a competitive disadvantage. The result is an accounting hodgepodge that makes it harder to compare insurers and gives some companies an edge over others.

Other big recipients included Pacific Life Insurance Co. with $529.8 million, Transamerica Life Insurance Co. with $505 million, Metlife Insurance Co. of Connecticut with $396.1 million, and Lincoln National Life Insurance Co. with $313.4 million, according to the NAIC data. Many of the companies listed are part of larger families, such as the MetLife group, that operate multiple insurers.”

We can certainly argue whether giving large insurance companies breaks on their capital and surplus requirements in order to keep them afloat is a good or a bad thing.  But what we should be able to agree on is the fact that these accounting changes were granted because the companies are in trouble.  Further, it is all but certain that many more insurers will seek the same sort of relief from their states, if for no other reason than to remain competitive with those who have already received such breaks.

Look Out For Hurricane Season This Year

The insurance industry, especially property and casualty, is bracing for this year’s hurricane and storm season.  The hurricane and windstorm emergency funds in Texas and Florida are dangerously under-funded, and this could be particularly bad news for many large insurance companies if either state is hit by a serious hurricane(s) later this year.

In Texas, we have what is known as the Texas Windstorm Insurance Association (“TWIA”).  TWIA was created by the Texas legislature in 1971 to provide windstorm and hail coverage to those who are unable to obtain insurance from the traditional insurance market.  TWIA was created in response to market conditions along the coast after Corpus Christi was hit by Hurricane Celia in 1970.

The public policy reasons for creating TWIA included ensuring the availability and affordability of insurance along the TexasGulfCoast, thereby supporting general economic development of the coastal area.  TWIA issues insurance policies like an insurance company; however, it also functions as a pooling mechanism that allocates losses back to the insurance industry.

All property and casualty insurers licensed in Texas are required to become TWIA members as a condition of doing business in the state.  Should hurricane or storm-related losses exceed the amount in the TWIA fund, then excess losses are assessed back to the member insurers.  The greater an insurer’s share of the Texas market, the greater its potential for loss assessments.

In 1993, the Texas legislature created the Catastrophe Reserve Trust Fund (“CRTF”) as part of the state’s plan to specifically address catastrophic losses associated with major windstorms (ie – hurricanes).  The CRTF is funded by the TWIA, which deposits all of its excess funds on an annual basis into the CRTF.

Over the last four years, the TWIA and CRTF funds have been especially hard hit by Hurricanes Rita (2005), Humberto (2007) and Dolly and Ike (2008).  Hurricane Ike, for example, resulted in losses to TWIA/CRTF estimated at $2.3 billion.  Ike was the Category 2 hurricane that decimated Galveston last September.

Even though TWIA made excess loss assessments of over $630 million to those P&C insurers operating in the state over the last four years, it remains dangerously under-funded.  In fact, the CRTF currently has no money whatsoever.  There is not nearly enough money left in TWIA to recapitalize the CRFT, and the Texas legislature has thus far failed to address this matter by appropriating new monies to the CRFT.

The Florida Hurricane Catastrophe Fund (“FHCF”) was reportedly under-funded by at least $14 billion as of the end of last year.  As in Texas, the Florida legislature has thus far failed to address this issue.  Florida residents are likely facing a significant increase in homeowners insurance later this year.

The bottom line is that if Texas and/or Florida are hit by a major hurricane(s) this summer or fall, insurers that do business in these states are going to get hit very, very hard.

My sources close to the insurance industry believe that if a major hurricane(s) hits Texas and/or Florida this year, a number of large insurance companies could be wiped out.

Clearly, some major insurance companies are in financial trouble already, but things may well get considerably worse depending on this year’s hurricane season.

What to Look For in the Financial Reports

As noted earlier, most of the publicly-traded insurance companies will be reporting their 10-Q financial statements for the 1Q over the next several weeks, along with their 10-Ks covering all of 2008.  I am told by my sources close to the industry that these numbers, generally speaking, are going to look very bad, including a lot of downward revisions for 2008 profits and upward revisions to losses, largely as a result of the significant decline in the stock markets and shrinking premium income.

One of the simplest ways to evaluate these particular financial reports is to go directly to the “operating income” number and compare that to the total income.  If the operating income is a small percentage of total income, it may indicate that the company’s core insurance business is in decline, and that it is relying on other sources for income.  Also, if the operating income fell off sharply late last year and in the 1Q of this year, it may be a very good indication that the company was making much of its money from the bull market in stocks.  This could also be an indication that the company may be in financial trouble already, or soon will be. 

LIMRA, a well-know insurance industry consulting firm, reported in March that individual life insurance sales saw a 14% drop in the 4Q of 2008, ending the year with an overall 7% decline, according to its quarterly sales survey.  The 4Q marked the single sharpest decline in premium income since the 4Q of 1951, according to LIMRA. The overall decline for the year erased the strong 7% gain in 2007, and was the largest one-year decline in the organization’s records.

Conclusions

As should be obvious from the information above, we need to keep a close eye on the insurance industry in the weeks and months ahead.  Look for the upcoming financial reports to be quite negative overall, with disappointing 1Q results and downward revisions to their 2008 financials.

This could be the next shock in the credit markets and the stock markets as well.  While this may not be the most interesting topic to think about, virtually all of us have exposure to the major insurance companies, directly or indirectly.  Certainly, the fate of the major insurance companies will impact the economy and in turn, the recession.

While the latest recovery in the stock market is impressive, I continue to recommend that you take steps to reduce downside risks in your investment portfolio.  If you would like to discuss ways to do so, give us a call at 800-348-3601 or e-mail us at info@halbertwealth.com.

Hoping we can help you in these tough times,

 

Gary D. Halbert

SPECIAL ARTICLES:

States Give Regulatory Relief to Insurers
http://www.washingtonpost.com/wp-dyn/content/article/2009/03/09/AR2009030902964.html

Failure worries drag down life insurers
http://www.charleston.net/news/2009/mar/15/failure_worries_drag_down_life_insurers/

Aftermath of the Financial Crisis for Life Insurers
http://www.insurancenetworking.com/news/life_insurance_LIMRA_LOMA_financial_crisis-12098-1.html

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