Annuity (Mis)Management is destroying well-known Insurers

In literally 6 months (or less), we may see a "run on the bank" in the Insurance industry -- specifically a withdrawal of Variable annuity and possibly Fixed annuity assets from weaker players such as Genworth, Hartford, and Lincoln (Symbols GNW, HIG, and LNC). Once annuityholders and/or their financial advisors get the belief that their policies are in any danger of nonpayment, advisors will switch clients out of perceived weak institutions within weeks if not days. The fact that these three companies are now buying captive banks in order to qualify for TARP assistance does not solve the intermediate-to-long term problems of deteriorating investments.

As the bulk of the recent market correction occurred beyond the conclusion of the third quarter, surely additional losses have occurred in the past 6 weeks. Capital levels are severely impaired and the prospect of raising new capital is limited in this environment.

Balance sheets of the major insurers can't simply be 'fixed'. The Hartford, for example, has any number of asset deterioration issues, including $10 Billion of CMBS bonds, $2 Billion of Subprime, and $5 Billion in formerly safe Financial Services industry bonds (GE, Citi, AXP, and so forth). $11 Billion in DAC (Deferred Acquisition Costs), sitting there as an asset -- a significant portion of that is related to VA business written in the past few years which will never be profitable. Life division only: $46 Billion in bonds and real estate, 'pick a number' as to what that is worth. Liabilities for future unpaid benefits: $16 Billion. the $16 Billion in future benefits is a lowball number based on some kind of prior 'normalized level' VA utilization rate on the guaranteed payouts....so the REAL liability could be multi-billions higher. On the income side, revenues are no doubt grinding to a halt the past two months.

Principal Financial Group $60 Billion of investable assets, $20B rated Baa or lower, $400 Million in impairments aka writedowns for the first 9 months of 2008, $86M of which was Lehman. Principal carries $4 Billion of net Unrealized losses on its fixed income assets (1.8 B on securities maturing in 12 months or less) - compare to 12/31/07, a small net unrealized gain. Potential commercial mortgages listed as a potential problem": just under 1%. Principal holds almost $10 Billion of res/commercial MBS and other ABS. What's worse - top-line revenue is stagnating in conjunction with the funding issue...what a deadly combo. Analogy: it's like an individual who has to take a huge pay cut to keep his/her job, while at the same time their credit card lines are closed off and they have a limited amount of liquid assets to tap in order to meet the monthly expenses, which are mostly of a fixed nature.

The real drivers of financial volatility in this sector are DAC writedowns, hedging losses associated with insuring benefits within VA, and profitability models that will not be realized. DAC represents the cost of the commission (approximately 7% of the total contract) that is fronted by an insurer to the salesperson/agent. Hedging losses are linked with investments designed to cover the cost of future payments (‘living benefits’) to policy holders if the equity markets fail to perform. This leaves a significant portion of an insurer’s portfolio unprotected against loss. What will be the future utilization rate of the lifetime living benefits feature? Insurers are now on the hook to pay income to their client base for an indefinite period of time -- conceivably 20-30 years if clients begin to exercise this option en masse in the near future. Does an insurance company have sufficient cash reserves to pay claims or surrenders in an environment where underlying investments have fallen apart? When you calculate the bond/real estate losses backing the FA, the VA DAC write-downs, breakage of hedging strategies, and mispricing of living benefits that are certain to have much higher utilization rates than expected, the all-in writedowns/losses easily climb into the Multi-billions.

Holiday retail sales: not the horror show presented in mainstream media

Ever since October's retail sales figures were released, there has been a growing chorus of Grinches declaring the yet-to-arrive 2008 Christmas season a total washout. Respected (?) professional investors are yelping about the "Worst Holiday season in 25 years" and such. Here's a thought: Instead of extrapolating October's awful numbers in a three-month straight line to a December mass-markdown, how about we inject a little Behavioral psychology into the thought process?

• Consumers aren't oblivious to the fact that the Holiday season is right around the corner -- they stopped spending money in October, at least partially, because they don't want to disappoint their kids/families come Christmas. What is happening to some extent is a 'substitution effect' whereby October sales were sacrificed into the future and will manifest as late-November and December spending.
• Analysts have taken expectations down so low that we have plenty of room for an 'upside' surprise. Even though sales will certainly be less than recent years, they will exceed the now-developing horrendous consensus. Retail stock rally in late November, anyone?
• Concomitant with the development of this post, I did a search in the New York Times to see if any previous Holiday seasons had surpassed lowered expectations in a weak economic environment. Lo and Behold, it happened in one of the worst years since WWII -- December of 1974. Don't be surprised to see the same kind of headline in about six weeks.

Don't get me wrong - I am quite Bearish on the economic picture for 2009, starting literally right after the New Year's Ball drops (great metaphor). Forget about small fry like Circuit City, we are going to see some Major-league store closings next spring. More on this topic to come in December...stay tuned.

Triple-levered equity indexed ETFs are now trading

Three times the return of a market index, easily accessible to any retail investor? No problem! Within the complete prospectus filed at the SEC , take a gander at the subsection entitled "Principal Risks". Notice all those capitalized X's in the chart? Yeah...me too. Oh...and I believe these exchange-traded instruments are fully Marginable at 50%, so your theoretical leverage could be SIX to one. Perfect for the 401K !

There are a few other blogs/sites that have questioned the wisdom of listing such securities as we fall headfirst into the biggest credit crisis and deleveraging of all time -- but I'd like to take it a step further, back to the Source. ETFs don't just magically appear for trading, they are allegedly put through a stringent review process. Exactly what was the conversation at the SEC a week or so ago, when these funds were given a government stamp of approval? I doubt that discussion is a matter of public record, but let's look at a few realities:

1. This is an even more egregious circumvention of Federal Reserve margin requirements than the current Ultra ETFs with 2x leverage;

2. Retail or institutional investors who need exposure to equity index movements can already get substantial leverage in the super-liquid Futures and Listed Options markets;

3. To sanction these ETFs at this particular time, in the face of a systemic DE-leveraging currently traversing worldwide financial markets (not to mention a credit crunch that has prompted in excess of a Trillion $ of emergency funds from the Fed), is just incredibly tone-deaf. It's as if the SEC's investment management division has no experience in either the structure of equity markets or judicious public relations.