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By Jeremy Glaser | 10-06-2010 04:06 PM

These Bonds May Be Riskier Than You Think

A tough competitive environment and exposure to market fluctuations make life insurance firm bonds less stable than many investors believe.

Jeremy Glaser: I'm Jeremy Glaser with Morningstar.com. I'm here today with associate director Brett Horn to take a look at the life insurance industry and see if it's a little bit riskier that a lot of people think it is.

Brett, thanks for joining me today.

Brett Horn: Sure, no problem.

Glaser: So, what's the historical view that the rating agencies have really taken on the life insurance companies?

Horn: Well, I think historically, people viewed life insurance as a very safe, very staid business. If you look pre-crisis, the most typical credit rating for a life insurance company was AA, which is obviously a very high rating. So, going into the financial crisis, there was not a lot of worries about these companies.

Glaser: Is our view is a little bit different? Because we saw during the crisis that they certainly had their share of problems.

Horn: Yes. These companies struggled greatly through the crisis. Basically, the issues that they had to play were basically that, over the last decade, they've increasingly moved away from traditional life insurance products towards annuities. A lot of those annuities carried guarantee returns. So, when the markets fell apart those were very burdensome products to have out there.

On the other side, like any other insurer, they carry a large investment portfolio to cover eventual claims. They were taking big hits on the investment portfolio because they've bought a lot of asset-backed securities. So, they had a hit on both sides of the balance sheet and because they've been viewed historically as very safe companies, they felt like they could lever up much more than most other insurance companies.

When the time came and they took hits on both sides of the balance sheets, there was not a big cushion there to absorb those losses. So, basically, all other life insurance companies we covered, raised equity capital throughout the crisis and some of them actually had to apply for TARP funds. So, it was a rough ride for them.

Glaser: So, why do you think the life insurance companies got into this problem in the first place?

Horn: Well, I think for us, really it all starts with the moat perspective. On the whole, we don't view insurance generally as terribly moaty industry. It's not a great industry. It's not a horrible industry. But we think the competitive dynamics in the life insurance industry are worse than other areas. Basically, because while insurance as a whole is for the most part of commodity product, life insurance is really a pure commodity product.

They all use the same actuarial tables. There is not a lot of guesswork in terms of mortality rates. So, there is no really a way to differentiate yourself there. So, that's what sparks the move towards riskier products and a more leveraged balance sheet--it was to basically kind of goose your returns for a short period. And that's what then ultimately led them into the mess. It's kind of a particular dynamic of the insurance industry that a bad decision made today probably most likely won't come back to haunt you until three, four, five years later.

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