Troubled Asset Relief Program

On March 8, The Treasury Department announced that bailout funds would be available to life insurance companies. The specifics have not been determined, at this writing, other than the stipulation that only companies that own a bank will qualify.  Consumers are bound to assume life insurance companies are in the same pile with AIG and other financial institutions that are getting federal bailout money to make good on bad decisions. But we need to understand the difference.

AIG's financial crisis did not come from making the normal decisions a life insurance company makes in the process of doing business. The AIG financial products unit, not the life insurance company, participated in the sale of a financial instrument (some would say developed the instrument) that was not only risky, but also almost impossible to value accurately.

In the most simplistic terms, AIG sold credit default swaps, among other instruments. These credit default swaps provided guarantees to the buyers of debt instruments, in this case mortgages, that the debtors would not default. The company's high rating made its guarantee worthwhile. As packages of mortgages were sold, and repackaged and resold, the already complicated mortgaged-back security market became further complicated and AIG ended up guaranteeing all kinds of securities. AIG made money on the guarantees (the insurance) and did not reserve against the risk of loss. I do need to repeat that last statement, in case a reader missed it: AIG did not reserve against the risk of loss.

Since the area of the company doing this business was not the insurance company, it did not have a set of reserve rules to follow. Even if it did, this business was outside of any normal definition, other than as it relates to real estate mortgages, which were thought to be a generally conservative investment. Adding the caveat that this writer is not an economist or a financial guru, it is very hard to imagine how those making decisions could commit to backing as much debt as they did and not consider the depth of risk.

Leaving that aside, let's look, in simplistic terms, at the life insurance companies that are struggling for two reasons: They purchased mortgage backed securities, which have now fallen in value and unrealized and actual capital losses are decreasing their reserves. Also, they sold guarantees on variable annuities, which they did reserve against, but are now in play due to how low the market has fallen. In both cases, the carriers were doing business as always, using reserves and hedges against loss. Regulators reviewed their financial statements and approved their products and reserves.

In most cases, the financial issues that carriers are facing have not been realized. The loss of asset value and the fact that VA values are under the guarantees does not create an actual loss for the carrier. The loss to the carrier occurs when or if they need to pay out on the guarantee in the VA and the market hasn't come back, and then only to the extent of what they are obligated to pay. The loss in asset value only becomes an issue if they have to liquidate the asset before the value comes back. However, they have to increase reserves to offset both risks; that's what life insurance companies do. Their obligation to hold certain reserves is causing the crisis for most companies. They are not having trouble paying their claims. They are having trouble keeping their reserves at required levels.

The fall in insurers' stock prices has nothing to do with their ability to operate profitably except for their ability to borrow money, which would help them deal with their reserve issue. So, getting money from the Troubled Asset Relief Program (note it's supposed to be about the troubled assets, not a bail out) will help them through until the underlying asset problem resolves. I think that's what the TARP is about - to get the pillars of our financial system stable while we recover.

So, when a client lumps any life insurance company in with AIG, I think it's worth taking a minute to explain the difference. Life Insurance companies have very strict risk standards on how they invest (risk based) and they have followed these rules. They reserve against claims payments. In fact, they have reserved against claims payments. The AIG financial products division sold some instruments that were unknown, untried, and unregulated. AIG never considered the risk or reserved for claims payments. If the life insurance company had done that, regulators would have stepped in during the first quarter when such products were sold, if they ever got sold.

If the TARP money provides relief for life insurance companies, which have long been an important part of our financial structure, it seems that is well used. If the companies that take advantage of the opportunity did business the right way and followed the rules, getting this assistance just makes sense and shouldn't place a stigma on the recipients. Nobody understands these issues as well as we do, so it's up to us to make sure we understand it well and spread the word.

Written by Michael Huffman, Director of National Development