Why you should steer clear of insurers

Two recent headlines in the Wall Street Journal have confirmed my worst fears are coming true... much faster than I thought they would:

On Tuesday 31 March, the Journal ran a story called Life Insurers Are Finding Their Fates Tied to Stocks. It confirmed what I told my subscribers in the latest issue of Extreme Value. Stock market losses might hit more than your equity portfolio...

Many life insurance companies sell variable annuities and other guaranteed return products. These products guarantee the investor will receive either a minimum return... or the gain in the S&P 500... whichever one is larger.

Subscribe to MoneyWeek

Subscribe to MoneyWeek today and get your first six magazine issues absolutely FREE

Get 6 issues free

Sign up to Money Morning

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Sign up

With the big stock indexes way down, losses have already piled up. The hedging that supports guaranteed investment products is too dense to get into here... But as the Journal pointed out on Tuesday, big life insurers like Lincoln National and Hartford have already suffered ratings downgrades due to investment losses and exposure to variable annuities. Moody's also said there's a risk of even greater losses.

But variable annuities aren't even the biggest problem. No one has quite caught on to the real issue yet...

Last week [26 March], the Wall Street Journal ran a story called Commercial Property Faces Crisis. It reported default rates on $700 billion of commercial mortgage-backed securities could hit 30%, and noted that as many as 700 banks could fail as property loans go sour.

So what does all that have to do with life insurance companies? Everything...

The life insurance industry has put a lot of money into the commercial property market. Connecticut-based hedge fund Bridgewater Associates estimates 10% of the life insurance industry's investments are direct commitments to commercial real estate projects.

Commercial real estate losses are rising rapidly. The delinquency rate on commercial mortgage-backed securities is already nearly as high as in the 1990s recession. Back then, the financial industry lost $48.5 billion on commercial real estate debt holdings.

The current commercial real estate crisis will certainly be much worse, due to the much larger real estate bubble this time around. The Journal reported US banks could lose as much as $250 billion on commercial real estate. They're not the only ones.

Insurance companies are state regulated. Every state determines how much capital insurance companies have to keep on hand according to their financial strength and credit ratings.

As commercial real estate continues to collapse, life insurance companies won't have enough capital on hand. That will cripple their business... and their shares.

Take MetLife for example. MetLife has $36 billion worth of direct exposure to commercial real estate... and less than $19 billion of tangible equity. A 25% drop in the value of its commercial real estate holdings would cut tangible equity in half. That would crush the stock.

MetLife isn't alone. I've got my eye on 13 North American insurance companies. And all of them will take large writedowns due to commercial real estate and variable annuity exposures. At least one of them will fail over the next year.

I wish I were wrong about this. And I have nothing against any of the companies involved. Many are well run and, until now, had decent track records as good investors.

But they simply can't get out of the way. They're like giant hotels sitting on a sunny tropical shore... with an enormous tsunami headed straight for them.

Right now, it's time to go short on the biggest US insurance stocks. The next headline to look out for is the one that finally connects the dots, the one that tells you corporate-bond downgrades will result in permanent impairments to life insurance company capital levels.

Life insurance companies have even worse times ahead than what they've already endured. Investors who short now can spare themselves the pain.

This article was written by Dan Ferris for the free daily investment newsletter DailyWealth