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Stock Strategist Industry Reports

Dissecting Life Insurers' Investment Portfolios

Which companies' balance sheets reveal attractive risk/reward ratios?

The second half of 2008 saw one of the worst performances for stock markets around the world in many decades, and the life insurance industry's performance was much worse. Large investment losses, combined with high leverage, made investors question the ability of many of these companies to survive without additional capital. The "arms race" over market share in the variable annuity space also caused its share of problems (the policies had financial guarantees built into them regardless of stock market performance), but the recent stabilization of the equity markets has moved the concern back to the investment portfolio. We remain concerned about these firms' capital adequacy given the small equity cushion most carry and the ongoing uncertainty in capital markets.

To quantify the exposure of the industry to each asset class it invests in, we took 11 life insurance companies and dissected each of their investment portfolios as of Dec. 31, 2008. The companies included in this analysis were  Prudential Financial (PRU),  MetLife (MET),  Lincoln National (LNC),  Hartford Insurance Group (HIG),  Genworth Financial (GNW),  Principal Financial (PFG),  Protective Life ,  Aflac (AFL),  Torchmark (TMK),  Unum Group (UNM), and  Manulife Financial (MFC). You can see the average percentage of assets that these firms have in each investment category in this chart.

Even a cursory examination of industry holdings shows that there is no mystery as to why current economic conditions have had such an effect on the financial position of insurers. For example, with corporate bonds, the number of defaults can be expected to rise as GDP declines. This has been reflected in downgrades of many of these bonds by the rating agencies, which impact the firm's risk-based capital levels and through greater credit spreads increase the amount of unrealized losses on the balance sheet. A similar effect can be expected with the insurer's real estate exposure, be it structured securities, mortgage loans, or direct property holdings. Even many government bonds that insurers hold are not immune, as municipal bond values have declined along with tax receipts, and sovereign credits have been downgraded.

While the average holdings demonstrate the industry's susceptibility to a general economic downturn, each company has its own idiosyncratic risks within its investment portfolio. Here is the percentage of investments in each category as of Dec. 31, 2008, by company.

As you can see from this table, corporate debt is generally the largest portion of most life insurers' investment portfolio. Of the companies on this list, Hartford has had some of the most well-publicized problems due to the poor performance of many of its asset-backed securities, especially its CMBS portfolio. This is despite its large property-casualty insurance business, which has tended to perform better than the life insurance business through this cycle. Unfortunately, the problem with trying to use these data to predict the relative safety of each company's balance sheet is that there can be no assurance that any asset class is safe (with the possible exception of U.S. Treasuries). Also, even with asset classes, risk can vary. Aflac is a perfect example of this; despite a very profitable franchise and a relatively solid balance sheet with little exposure to the structured securities that were the first shoe to drop in this crisis, the firm's portfolio of perpetual preferred securities has caused consternation among investors. The vast majority of these securities were issued by European financial institutions, and as the securities lie somewhere in between debt and equity in the capital structure, their treatment in the context of potential nationalization is a huge question mark.

Because the relative levels of investment in each category are meaningless on their own, we also looked at each firm's leverage by comparing their tangible equity (book equity excluding the value of goodwill) to their total investment portfolio, in order to see how much each firm could take in additional losses on its investments before wiping out its tangible equity. This chart compares each company's level of tangible equity to its investment portfolio:

As you can see, the margin of error for most of these firms is quite slim. Some of the firms on this list have seen their tangible equity/investments ratio cut in half by the events of 2008, and anything close to a duplication of those results going forward could lead to brutal consequences for shareholders, such as regulatory seizure or severe dilution. For most of the companies in this industry, we feel this scenario is too plausible to ignore.

So with the ability of many of these companies to withstand the pressures on their balance sheets still in question, why are the stocks of these firms joining in on the recent market rally? Other than the emerging thought that the worst is over, the wild card is the involvement of the federal government, specifically through the Capital Purchase Program (CPP) of the Treasury's Troubled Asset Relief Program (TARP). While some continue to assume insurers that have applied for inclusion in the program such as Lincoln, Prudential, Principal, and Hartford will eventually be approved, there have been no definite statements from the Treasury Department, and the timing and amount of the available funds remains unknown, if indeed any are forthcoming.

In our view, the results of this analysis confirm our thesis that anyone looking to invest in this part of the market should tread very carefully. In fact, with an extreme uncertainty rating on six out of 11 of these companies, we would not recommend them at any price to the long-term investor, as the risk of permanent capital loss is too great to ignore. The possibility of a dramatic recovery in the economy, along with the bond and stock markets, remains, however. But the balance sheet leverage of these companies makes them highly sensitive to changes in the value of their investment portfolio, and the essentially unpredictable nature of the debt and equity markets justifies our high to extreme uncertainty rating on these firms.

That said, the analysis highlights one balance sheet that an adventurous investor may find represents a worthwhile risk/return ratio: Torchmark.

In addition to being one of the most profitable life insurers, Torchmark has avoided investing in the structured assets that have plagued many of its peers. While the preponderance of corporate securities in its investment portfolio has led to large unrealized losses as corporate credit spreads have blown out, the firm still has a very healthy 22% of tangible equity to investments, which should allow it to absorb what the economy throws at it. The firm is currently trading at a 4-star rating.

Editor's note: We revised some article graphics and text to indicate that Hartford's exposure to corporate equities was not as great as we initally stated. Please click here for more details.

Alan Rambaldini does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.