Commentary: Is Japan Covered For This Disaster?

As any insurance agent will readily tell you, life is fragile. And when it comes to Japan's $250 billion insurance market, the grim reaper is on a rampage. The collapse of Chiyoda Mutual Life Insurance Co. on Oct. 10 under the weight of $27 billion in debt marks the biggest corporate failure in postwar Japan. And it follows the demise of two other insurers, Daihyaku Mutual Life Insurance Co. and Taisho Life Insurance Co., so far this year.

Is Japan on the cusp of another financial sector upheaval to rival its world class banking mess? Analysts say no, at least in terms of scale. But just like Tokyo money-center banks, life and property insurers are grasping for survival strategies at a time when their balance sheets are ugly and foreign competitors are starting to make serious inroads into Japan.

LOAN LOSSES. The proximate cause of death at Chiyoda was a dreaded financial ailment called negative yield spread. That's insurance jargon for a very simple problem. Back in the late 1980s, insurers issued whole life insurance policies promising 4% or so returns to policyholders who saw these policies as safe ways to save. But Japan's bearish stock market and ultra-low interest rates since the mid-1990s have depressed returns on premium income invested in stocks and bonds to roughly 2%. That gap meant multi-billion-dollar investment losses for the top five life insurers (table) last year. There is no way for smaller play- ers like Chiyoda, whose bankruptcy was announced by its president, Reiji Yoneyama, to survive the contagion.

On top of that, insurers are still grappling with a legacy of poor lending into speculative real estate ventures in the late 1980s--just like their brethren in Tokyo's banking quarter. For the fiscal year ended last March, government financial auditors recently uncovered $30 billion in bad real estate loans on the books of 19 major life insurers, instead of the $11 billion the insurers had claimed.

Right now, the biggest concern is that a couple of additional insurance company failures will trigger a vicious circle of policy cancellations, shrinking premium incomes, and market jitters that will push portfolio returns even lower. So Prime Minister Yoshiro Mori's government is throwing $4 billion more into an existing $6 billion industry-run emergency fund to protect policyholders from losing their savings.

But the hole may be too big to fill. Morgan Stanley Dean Witter Co. analyst Hideyasu Ban figures long-term bond rates will have to more than double to 4% or 5% from existing levels to allow insurers to generate enough investment returns to cover their policy payouts. Trouble is, insurers are huge investors in the Japanese bond market already. And rising interest rates will knock the stuffing out of current bond prices. So insurers would take a haircut on their existing bond portfolios before benefiting from higher returns later.

Insurance companies are also suffering from some bad bets in international markets. Their U.S. Treasury holdings were savaged when the dollar collapsed against the yen in the mid-1990s. This year, their European bond and stock holdings have been whacked by the decline of the euro.

To help reduce the red ink, the government is toying with the idea of exempting the industry from new rules requiring insurers to list their stock and bond investments at prevailing market values rather than prices at the time they were acquired. Such a financial feint may make accountants cringe, but that and tougher audits to catch solvency problems early at smaller insurers is key to avoiding a wave of policy cancellations that could cause trouble even for major insurers, whose capital adequacy ratios are still strong.

The burning question is whether a very coddled pack of Japanese insurance execs can learn to compete against the global players that are now deepening their presence in Japan. Prudential, Zurich Insurance, and Aetna are all busy snapping up distressed assets and exploiting openings afforded by the Big Bang reforms under way in Japan since 1996. They boast leaner cost structures, cleaner balance sheets, and more sophisticated financial products like fancy annuities to attract Japanese savers worried about the future.

The hope is that all this will prompt the better-run outfits to hone their competitive edges, while weaker players like Chiyoda, now in talks with American International Group Inc. (AIG), may get a new lease on life. But make no mistake: The coming shakeout in Japan's overcrowded insurance field has just begun.

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