HEARD ON THE STREET: Insurers Feel Cumulative Impact Of Sept. 11, Accounting Scandals
By HENNY SENDER and CHRISTOPHER OSTER
Staff Reporters of THE WALL STREET JOURNAL
The declines in the stock and corporate-bond markets haven't led to dangerous concentrations of risk in the financial sector.
Or have they?
Signs are surfacing that the ripple effects from Sept. 11 and accounting blowups that began last fall with Enron Corp. are being felt in the insurance sector in ever-widening circles.
Consider insurance firms. As natural destinations of risk, they are exposed to all the financial markets. While losses in any individual market may not be all that significant, the cumulative impact may be severe, especially for those insurers that have been aggressive in taking on new kinds of risk, particularly in the derivatives market, which involve financial instruments tied to underlying securities or indexes. An example: Chubb Corp., though it maintains it runs its business most conservatively.
Alan Murray, an analyst with Moody's Investors Service in New York, used to focus just on the traditional perils of stock and bond holdings. Now his worries include more exotic exposures. These arise from sales of financial products that include insurance that protects investors against the risks of corporate-bond defaults, guarantees that pools of debt won't lose value and promises to reinsure the exposures about which other insurers are nervous.
"Life insurers have been hit by long-term, lingering issues, including competition from outside the industry," says Keith Buckley, a managing director at Fitch Ratings. "When you layer on these credit-market and financial issues, it's getting to be an increasingly negative environment." Adds Lynn Exton, a managing director for Moody's in London: "The risks in corporate-bond portfolios have been underappreciated."
That more losses haven't cropped up has roots in overseas regulatory forbearance, discretion in accounting and the use of certain cutting-edge products by the insurers themselves that have the effect of making real results harder to understand.
But here is the upshot: Earnings for many insurance concerns are likely to be disappointing in coming quarters, ratings agencies are likely to downgrade the financial strength of large numbers of these companies, and some insurers may need capital injections.
"We expect one in three life-insurance-company ratings will be downgraded by the end of the third quarter," says Mr. Buckley of Fitch.
Certainly, some losses have been posted and some companies have been candid about more disappointments on the way. MetLife Inc. has warned of lower investment returns for the third and the fourth quarters as a result of the drop in the stock market and has told investors to expect net investment losses of $100 million to $150 million for each period. Yet stocks are less than 1% of MetLife's $174.6 billion investment portfolio. For the second quarter, the company took a write-down of $215 million on WorldCom Inc. bonds alone, leading to $260 million of realized losses on a pretax basis, though realized gains helped reduce the net investment loss to $117 million.
In a report released Friday, Moody's tallied the insurance industry's exposure to 10 corporate-bond issuers with woes that in half the cases have pushed the companies into bankruptcy court. (Besides Enron and WorldCom, there's Adelphia Communications Corp., Global Crossing Ltd. and Kmart Corp.) Moody's "has become increasingly concerned about the amount of credit losses that have already impacted and are likely to continue to negatively impact U.S. life insurance companies," the report says.
Of the roughly $23 billion of securities issued by the 10 companies, Moody's found that 13 insurance-firm groups each had more than $500 million of the bonds as of last year. To be sure, bondholders typically receive some proceeds under a liquidation or reorganization plan, so ultimate losses could be well short of the $23 billion. Moody's notes that insurance concerns generally have widely diversified portfolios. Still, "the total exposure of certain insurers to these 10 credits is quite substantial in several cases," including John Hancock Financial Services Inc. with various Enron-related investments. A spokesman for John Hancock declined to comment.
In other cases, "the cumulative effect of exposures to a number of potential problem credits is a concern." U.S. life-insurance groups with the highest exposure as a percentage of total bonds, as of last year, were the U.S. subsidiaries of European groups including Legal & General Group, Fortis Inc., and Zurich Financial Services Group and Horace Mann Life Group of Springfield, Ill. Spokesmen for Fortis and Zurich point out that their exposure to these companies is a tiny part of their overall portfolios. At Horace Mann, Controller Bret Conklin says the company has revised its concentration guidelines to better limit exposure to any one company. Legal & General couldn't be reached to comment.
But, industrywide, relatively few losses have surfaced so far. One reason: Accounting rules allow insurers discretion in taking these losses, with many waiting at least six months to declare as impaired any asset that has dropped in value. In addition, some insurance firms may be offsetting losses by selling bonds with realized capital gains, which have resulted from falling interest rates.
Moody's dubs such a strategy "window dressing," explaining: "By prematurely realizing these gains, the companies are essentially front-ending future profits. This income is needed to cover future product benefits and crediting rates, and accelerating their reporting by realizing gains will cause lower reported investment income and earnings in the future."
Potential losses stemming from exposure to corporate bonds at a time when default rates are close to record highs are compounded by new activities. Some insurers are the leading providers of insurance to corporate bondholders to protect the value of their holdings if a company defaults, using so-called credit-default swaps. Emerging as "aggressive market participants," insurance concerns represented about 25% of the credit-protection market as of year end, up from 16% in 1997, according to Fox-Pitt, Kelton, a research boutique.
Insurance firms have become big promoters of "collateralized-debt obligations." With such CDOs, insurers essentially agree to pay a certain amount of the losses on a basket of bonds held by investors. Analysts question whether the insurers understand the so-called credit-derivatives market well enough to be adequately compensated for the risks they are taking on. While banks use the market to hedge positions, insurers in essence have made a one-way bet that companies won't default across a whole series of markets.
Take Chubb, which recently launched its Chubb Financial Solutions operation. Just two years old, CFS has a portfolio of credit derivatives backing bonds valued at $20 billion. For the second quarter, the unit took a pretax loss of $16 million to reflect the fact that the market price of assuming credit risk has increased, according to a spokesman. In a recent conference call with investors, executives played down the issue. "We don't have the first dollar of loss," Chief Executive Dean O'Hare said. "A 100% loss in a credit-default swap is as remote as all the property we insure burning," he said, adding that Chubb's approach "reflects our conservative business philosophy."
All this happens when measuring losses from the basic insurance business has never been more challenging, thanks to relatively new forms of reinsurance, which in short is insurance obtained by insurers. By paying a reinsurer a premium based on the present value of an expected loss from an insurance policy, an insurer can transform the loss into an innocuous expense item on the financial statement.
Write to Henny Sender at henny.sender@wsj.com1 and Christopher Oster at chris.oster@wsj.com2
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Updated August 15, 2002
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