2009: The Coming Meltdown. Part Two: Insurance

The September 2008 bailout of American International Group (AIG) as “TBTF” (Too Big To Fail) has generated continuing headlines as the scope of its losses has become apparent. What initially was an $85 billion “cash infusion” has turned into a nearly $130 billion loan/purchase of equity by the US Government by the end of 2008, and may reach over $150 billion.

But this article isn’t about AIG, or its buyout. Rather, it’s about the dirty little secret of the insurance industry, and the impact that it can have on the economy.

That secret? What happens to your premiums once they’re received.

Most people think that when they pay an insurance premium, the insurance company puts their money into a box somewhere to be used if there’s a claim. Not so. Most premium money is used by your insurance company…for investments. Purchasing stocks, bonds, securities, investments in other businesses, investments in money market and mutual funds, and T-bills. And the purchase of collateralized debt obligations (CDOs), mortgage-backed securities, and other investment vehicles. (For a prescient article by BLN contributor Kurt O’Keefe discussing this, read his August 6, 2007 blog, “There’s No There There, Sub-Prime Mortgage Crisis Continues.”)

When their investments do well, the insurance companies make a lot of money. But when they do poorly…well, AIG is a poster child for what happens. Suddenly, although there may be enough money to pay claims (and state insurance commissions have strict requirements for the segregation of claim reserves), the insurance company can’t pay its other bills. And in the tightest lending market we’ve seen in two generations, they can’t borrow to get themselves through tough times. So, you hope you’re TBTF, and that the government steps in to act as the lender of last resort.

But AIG is only one of many US insurance companies with exposure to bad investments. What of State Farm, Allstate, Travelers, Liberty Mutual, CNA and The Hartford? Are they a hurricane, earthquake, flood, terrorist attack or other large loss away from failure? What happened in 2008?

The picture isn’t pretty. The Harford saw its stock price plummet by 75% during 2008. MetLife and Prudential lost over 50% of their value. The dollar losses were staggering, so bad that The Hartford Financial Services Group, Lincoln National Corp., Genworth Financial Inc. and Aegon NV all submitted applications to become bank holding companies to the Office of Thrift Supervision, so that they would be eligible for TARP bailout money. And all this was without a major natural or man-made disaster to pay for.

The horrid losses from investments in CDOs, mortgage-backed securities, Lehman Brothers, and others was bad enough. But what will happen if there is another Katrina ($25 billion in losses), 9/11 ($40 billion), or other disaster? Yes, there is reinsurance. But the losses can be spread only so thinly when everyone is hurting. And when your investments not only aren’t bringing in income, they’re actually losing money, it doesn’t take too big a loss to result in a collapse.

What would happen if a large insurer were to be unable to stay alive? Money market funds, 401(k) plans, IRA’s, and other investors purchase large amounts of insurance company stock and bonds, believing insurance companies are a secure, solid, conservative and secure investment. Defaults on these bonds and loss of stock value would flow through to these investors, lowering the value of their portfolios, worsening most folks’ already dreadful retirement account statements, and impacting the banking and money system.

Many will remember the crisis that resulted when the $62 billion Primary Fund from the Reserve, a New York money-market firm, “broke the buck” — that is, its net asset value fell below the $1-a-share level that funds like this must maintain. What happened? A run on the banks—over $1 trillion dollars was withdrawn from money funds over the ensuing weeks, many funds restricted or prohibited withdrawals, and the credit market dried up. While things have recovered slightly—very slightly– investor and consumer confidence is still at all-time lows, and it wouldn’t take much to push Wall Street and Main Street back into the fiscal panic mode that existed in the fall of 2008.

Sadly, this could occur if a major insurer who is not “TBTF” runs into trouble in the coming months.