Friday, February 13, 2009

FT Alphaville has been unable to locate the upside to investing in the insurance industry.

From Free Exchange:

"
SELL: Insurers

This is a reader appeal.

FT Alphaville has been unable to locate the upside to investing in the insurance industry. Surely its somewhere… after all, the insurance sector has fared relatively well of late.

We have, we might add, been very able to find plenty of reasons not to invest. Or rather, sell. Urgently.

We noted the other week, for example, what bad fixed income investors many US life insurance companies were.

And in light of HBOS catastrophic writeoff against its corporate loan book barely an hour ago, we feel that insurers’ position is even more untenable.
UK insurers are, afterall, hugely exposed to corporates — be it through equities or bonds.

To boot, it’s probably quite reasonable to think of insurers as highly leveraged companies - certainly in effect, if not in actuality. In the UK, because of particularly stringent regulatory requirements, for example (specifically, the strict requirements placed on safeguarding policyholders’ collateral), it should only take a relatively small decline in insurers’ large books to potentially wipeout shareholder equity. Because of minimum capitalisation requirements, the equity very much functions as a first loss tranche - and very much carries a nasty cliff risk.

The wrinkle is that insurers do not mark their books to market: in other words, the market declines in bond prices that we have seen of late, are not in themselves a matter for concern at the insurers. The rationale is that as long term investors, insurers do not need to worry about market risk (the bond, of course, redeemed at par) but rather, have only credit risk to worry about - the actual default of their bonds.

This is revealing. It explains why, in spite of unprecedented market turbulence, insurers’ massive investment portfolios are holding up. They are only significantly affected by defaults.

This has the FSA worried. Because the defaults are coming. And the default cycle is broadly assumed to be severe enough to cause significant damage to the insurers.

Damage in the sense that it could wipe them out.

We reproduce the below table from Deutsche Bank, which we feel is potentially explosive.

The table shows the percentages of insurer holdings as against the insurers’ UK legal solvency requirements (100 per cent = the legal solvency requirement)

Insurers solvency

As should be evident, Legal and General and Prudential are not in pleasant positions. Before we even consider the corporate bonds, just look at those structured holdings.

Put bluntly, defaults in those structured product portfolios could easily render L&G and Prudential insolvent.

And even if the defaults don’t occur , the FSA’s new conservatism will surely render capital raising inevitable to protect against eventualities.

What’s more, the above figures only detail trouble for the insurers at the shareholder level. The insurers hold hundreds of billions of corporate bond and equity assets at a policyholder level - ringfenced in a seperate non-profit part of the business. Stress testing may well reveal much steeper default provisioning requirements at the policyholder level, which would require even greater capital levels than insurers have currently.

In short, there are a host of capital threats to the UK insurance industry.

Me:

Don the libertarian Democrat Feb 13 19:01
The upside is that there are a lot of people like you who don't see an upside. So, I'm going to assume that prices are going to be driven too low by stories like this one, and I'll cash in if you're wrong.

I wouldn't do this, but it is a possible upside, especially if the government somehow steps in. Instead of their fundamentals, I'd be looking at their lobbying efforts if I were interested in this kind of investing/speculating.

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