Concerns about what losses insurance companies might have taken in derivative instruments and mortgage-backed securities are being raised by industry insiders.
While devastating losses from derivative and mortgage-backed securities have not been uncovered, industry experts warn insurers have proven in the past to be just as vulnerable as other institutions to big investment losses.
Given that insurers got burned along with other institutions in junk bonds and real estate, ratings firm A.M. Best Co., Oldwick, N.J. recommends "greater vigilance by management, regulators and ratings agencies in understanding the true risks and rewards" of investing in derivative and mortgage-backed securities.
"We're looking very closely at this issue," said Michael Albanese, assistant vice president for Best.
Frederick Townsend, president of Townsend & Schupp, a Hartford, Conn., insurance consultant, said insurers could be faced with the same type of problem they faced with junk bonds early this decade, although he doesn't have direct knowledge of big losses among insurers.
Given the competitive nature of the insurance business, insurers are compelled to offer as high a yield as possible on GICs and annuities, which in turn encourages investment in higher yielding securities like junk bonds and collateralized mortgage obligations.
Best estimates mortgage-backed and CMO holdings by insurers to have jumped to $295 billion, from $98 billion in 1988, making up 28% of the industry's fixed-income investments.
Mr. Albanese and two co-authors write in a Best report that the meltdown of various institutions using derivatives has "raised the general consciousness of industry observers about the ability of insurers to safely manage these investments. With the memory of insurers' problems with junk bonds and real estate fresh in most observers' minds, these concerns are not without merit."
And the concern about these losses comes at a time when insurance companies already face earnings pressure from unrealized losses carried in their portfolios of regular fixed-income instruments. The losses were sparked by one of the worst bear bond markets ever in 1994, and coincidentally came the same year that public insurance companies were required to mark to market a significant portion of their portfolios, under Generally Accepted Accounting Principals.
Insurers would incur "substantial losses" on fixed-income securities bought before rates jumped, were they to sell them, Mr. Albanese said.
And looking to what return insurers must offer, those securities bought before rates jumped last year aren't paying enough for insurers to hold them profitably.
Consequently, "interest margins are becoming compressed," which is the converse of 1993 when margins were "increasing, or overstated," Mr. Albanese said.
Fixed-income losses are "definitely going to pinch the earnings" of insurance companies, said Aaron Mowbray, vice president of structured finance for Washington Square Advisers, Minneapolis, an insurance company-owned money manager. "Mortgage-backeds could have caused more pain than what investors expected," he said.
As a result, public insurers are marking those unrealized losses against stockholders equity, the effect of which really hasn't been picked up by the financial markets, Mr. Albanese said.
But not all industry participants are as concerned about derivative and mortgage-backed losses at insurance companies.
Weston Hicks, analyst for Sanford C.Bernstein & Co. Inc., New York, said most life insurance companies immunize themselves against big changes in interest rates, so assets and liabilities move in tandem. He acknowledges, however, that insurance companies took big losses on fixed-income assets in 1994.
Likewise, Martha M. Butler, vice president for Duff & Phelps Investment Research, Chicago, said insurance companies are pretty strict with their asset-liability management. Although insurers do own a lot of mortgage-backeds, for the most part they have stayed away from the esoteric types of investments that caused problems with other large institutions, she said.