Why solvency of insurers proves tougher to discern

Global insurers are following a plot with an ending that may seem grimly inevitable.

Their shares have sunk on worries that losses on their investments will leave them insolvent. Regulators and executives have tried to reassure investors, but been met with dark mutterings about insurers' reluctance to mark assets fully to market and their habit of inflating their capital with hybrid debt rather than plain equity. Some insurers' credit-default swaps, which measure the risk of bankruptcy, have soared to scary levels.

Pessimists argue that the final act -- government bailouts -- has begun. In the Netherlands, both ING and Aegon have received capital injections from the government. America's life insurance companies, a couple of which have already raised capital, are lobbying to be included in the Treasury's $250 billion program to purchase stakes in financial firms.

Are insurers really the new banks? Like lenders, insurers' assets include shares and securities that have tumbled in value. But on the other side of the balance sheet, the comparison becomes murky. Unlike banks, which rely heavily on debt funding, insurers' main liabilities are the claims they will pay their customers -- for life insurance firms, those stretch over many years. Whereas the depositors and lenders who provide funds to banks can jump ship overnight, insurance customers find it hard and expensive to wriggle out of their contracts.

A run on an insurance company is thus hard to imagine. In theory that means capital adequacy can be reviewed at a dignified pace. But the industry has failed to create any measure of solvency that is accessible to outside investors. Insurance subsidiaries in individual countries and American states are regulated separately, often using different rules on, for example, mark-to-market accounting. European holding companies do have a single, numerically expressed, standard, called the insurance groups directive (IGD). Virtually all big companies still pass this, but most experts argue that it is too primitive to be useful.

So the question of solvency has largely been outsourced to the credit-rating agencies, with almost all companies targeting the equivalent of a AA rating from Standard & Poor's (S&P). This has its advantages. A snapshot of some firms' balance sheets might not pass strict AA standards.

But Mark Puccia of S&P said that, although some downward drift in global insurance credit scores is likely, the agency is not "marking to market." Insurers have time to rebuild their capital through earnings. Ratings also reflect subjective factors such as the quality of management. With the exception of American International Group, the agencies have not serially downgraded big companies in the midst of the crisis.

That the agencies are not putting guns to insurers' heads is confirmed by Michiel van Katwijk, Aegon's treasurer. He said the decision to solicit $3.8 billion of government funds was "precautionary." Based on valuations Sept. 30, Aegon's new cash could leave it with twice the capital needed under Europe's IGD rules.

The stance of both executives and the rating agencies suggests that insurers will avoid an avalanche of emergency capital raising, although some will cancel dividends and tap governments if the terms are favorable. The problem for investors is the sheer opacity of insurance solvency models. In today's markets, "trust me" just doesn't cut it.