Possibly The Next Savings And Loan Bailout -- Insurance Companies

February 9, 2009

Today, CNA Financial Corporation (NYSE: CNA) released their quarterly earnings report for the period ending December 31, 2008.  It was not pretty.  According to the Business Wire release on February 9, they had a net loss of $336 million.  Net book value dropped from $37.36 per share on December 31, 2007 to $20.92 on December 31, 2008.  According to my calculations, this represents a book value drop of about 44% in one year.  

Allstate Corporation (NYSE: ALL) also reported dismal numbers earlier.  They had a net loss of $1.1+ billion (again, according to their SEC filing on January 29, 2009).  Although this number is big, it overshadows another line item found deeper in their SEC filing.  That number is tangible equity.  If you go into their balance sheet you will see that their total shareholder’s equity has dropped from $21.851 billion on December 31, 2007 to $12.641 billion on December 31, 2008.  That is a drop of over 40% in one year.  No doubt this is difficult news for any shareholder to see. 

ACE, LTD (NYSE: ACE) also recently posted disappointing results.  Their net income dropped dramatically from the year ago period.   Shareholder equity also declined from the year ago period.

Loews Corporation (NYSE: L), today, reported a quarterly net loss.  This was according to their press release today.  The book value per share also declined on an annual basis.

Travelers Companies, Inc. (NYSE: TRV) and Chubb Corp (CB) also posted a year over year decline in shareholder equity, albeit much smaller ones.

However, the point of this article is not to beat up on any of these insurance companies.  They are all working hard.  The point is to bring to light an emerging issue that the US economy may need to address in the next couple of months.  What happens if the insurance companies’ shareholder equity approaches zero?  Will there be a rescue like the savings and loan bailout of the late 1980’s?  Where will the money come from?  These are all questions which may quickly get the spotlight if the insurance industry continues to face continued write downs and rapidly diminishing shareholder equity bases.

A fundamental issue may exist with insurance companies.  I call it the interest rate gap.  I define this as the gap between the guaranteed annuities/payments insurance companies underwrote and have to service vs. the return on equity they can generate from the money they took in, in the form of premiums and one time policy payments. 

For example, I take $100 from you and promise I will pay you $8 per year for the rest of your life.  Payments do not begin for 5 years.  The benefit to you is that you get the “guarantee” of $8 per year for the rest of your life (starting in 5 years).  For me, I get the benefit of keeping all the money earned above the $8 payout every year.  I also get to keep the $100 when you die.  Sounds like a good deal for both of us.  However, here is where it can go wrong.  If, during, the first years of the policy I cannot achieve a good rate of return for your money, I may end up in a situation where I am paying you more money than what I am getting in, causing a loss.  Sounds like a bad deal for me now. 

Let’s make the situation worse.  Let’s say I not only did not get the return I need to cover your payments but also end up losing some of the principal I had started with.  Now I really have a problem.  In order for me to keep making those $8 payments to you, I will need to make an even higher return on the remaining money (because of the smaller investment base to work with).  Now, it sounds downright scary for me.

In my opinion, if interest rates stay below their long-term trend line for an extended period of time, it makes it increasingly difficult to service commitments that were made when interest rates were at or above the trend line.