Our Outlook for the Life Insurance Industry

Once a bastion of stability among the financials, life insurers have finally taken their turn and been hit as hard as their brethren in the last few weeks. Wild fluctuations in stock prices have the shares of many of these firms hitting lows not seen since their IPOs earlier this decade, when several of these companies first demutualized. The question is how much of this is based on fear and panic spreading from the banks, and how much is based on fundamentals?

Three main concerns surround the life insurers; let's take a look at each of them.

Investments May Suffer a Permanent Blow
Like many of the banks that have fallen victim to the collapse of the housing market bubble, life insurance companies are taking heavy losses as mortgage delinquencies and defaults increase. Generally speaking, in order to match the long-term duration of policyholder claims, their biggest liability, life insurers purchase government and corporate bonds. However, in the pursuit of higher yield, many of them also hold a substantial portfolio of mortgage-backed securities, or MBSs. While the insurers generally hold higher-quality tranches of MBSs that have continued to generate cash flow, widening credit spreads have led to unrealized losses on these securities. Due to their steady operational cash flows, the life insurers have been loathe to mark these investments down to what they feel is an unrealistic market valuation level, since they are able to hold on to MBSs until maturity--a point when they feel they will ultimately recover their principal. While it is likely true that current market levels are lower than what the discounted cash flow on these securities will ultimately be, it is extremely difficult to estimate how much of the discount reflects a lack of liquidity for MBSs and how much is a permanent impairment in their cash flows. The unrealized losses are reflected in shareholders equity and not on the income statement, but as time passes and they persist, odds are that these securities will be judged to be "other than temporarily impaired," resulting in a hit to the insurer's statutory capital.

Moving Deferred Costs Forward Hits Earnings
Deferred acquisition costs, or DACs, are an accounting asset used by the insurance industry to attempt to match up-front expenses related to writing a policy, such as commissions to salespeople, with premiums, which are earned over a number of years. Thus, instead of charging off these expenses immediately through the income statement, they are added to the balance sheet. In order to estimate how much of these costs to capitalize and amortize in any one year, management of the insurance company has to make assumptions about the profitability of the policy sold. In the case of variable annuities, or VAs, which charge fees based on the amount of assets under management, or AUM, one of these assumptions is the long-term return on the equity markets. When the actual market return lags the estimate as it has in 2008, insurers are forced to write off more of the DAC asset than anticipated in a process known as retrospective unlocking (prospective unlocking, on the other hand, occurs when future estimates are updated). In this situation, insurers will earn lower fees on lower AUM, resulting in a hit to earnings and a smaller book value as the asset side of the balance sheet contracts.

On the Hook for Guarantees
Guaranteed benefit riders have become a popular option for VA holders over the past few years. In exchange for a fee, these riders offer a minimum return guarantee or a minimum principal guarantee, protecting policyholders from wild downswings in the equity markets. While many insurance companies engage in hedging to mitigate the effects of market declines, the effectiveness of these hedges have yet to be tested in stressed conditions like the past few months, and the high volatility in the equity markets causes the cost of these hedges to increase mightily. In cases where the firms don't hedge, they will be on the hook for the guarantee, and with the S&P down 33% year-to-date, those sums can be significant.

So while there is a basis in fundamentals for the recent declines in the share prices of life insurers, several large players have preannounced third-quarter earnings well in excess of the realized losses. Looking forward to the fourth quarter and beyond, the main concern for investors is how much of the unrealized losses will ultimately affect the firms' free cash flows. Also, if the cumulative balance sheet losses cause the rating agencies to consider downgrading any of these companies, they may be forced to raise capital at depressed prices in order to sustain their ratings (thus diluting existing shareholders) or suffer from a loss of reputation and market share.

These Two Picks Stand Out from the Crowd
The fear has even spread beyond insurers with large equity market and retail MBS exposure, creating a couple of great opportunities for investors. Two of the most profitable life insurers we cover,  Aflac (AFL) and  Torchmark (TMK), are trading at the lowest price-to-book multiples we have seen in years, despite the fact that neither of them have exposure to the equity markets through VAs or have exposure in their investment portfolios to MBSs. Torchmark is currently trading below our Consider Buying price.

While the near-term uncertainty for many life insurers continues to be very high, since we ultimately don't know when the housing or equity market will begin to recover, there is a silver lining for these companies: an increase in demand for safety and security. With many baby boomers nearing retirement age cashing in a 401(k) account that has taken a significant hit from a year ago, the life insurance companies may see large inflows as consumers protect themselves from further downside risk by purchasing VAs with guarantees.