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Life insurance headwinds may continue to affect AMP

An interesting report in the Australian Financial Review highlights the depth of problems facing the life insurance sector and should act as a warning bell to investors of the potential for near-term sector-wide earnings downgrades.

Insurer and wealth manager AMP (ASX: AMP) stunned the market in June when it released an earnings update noting “experience losses for Australian wealth protection were A$32 million for the five months to 31 May 2013.”

The AFR’s report suggests issues are widespread, with US-based Reinsurance Group of America (NYSE: RGA) recently filing a report that showed “it lost $300 million in the Australian group life market in the three months to June.” What’s more, Reinsurance Group has suspended all further writing of total and permanent disability (TPD) insurance in Australia, citing an unstable market. Reinsurance Group’s view of the problems besetting the market would appear to be in line with AMP’s claim of an “ongoing volatile nature”, with the industry experiencing increased pressure on insurance claims and policy lapses.

Meanwhile, Macquarie Group’s (ASX: MQG) research department is reportedly forecasting AMP’s experience losses will grow to $38 million for the first half and that the insurer will experience a further $26 million in losses in the second half. Macquarie has pointed the finger at higher rates of job losses amongst senior executives in Australia as one reason causing higher claims rates of TPD benefits.

Insurance is very much a cyclical business however it appears to have taken many investors by surprise how quickly the life insurance market has moved into a high claims environment. How other major players such as Suncorp (ASX: SUN) and Challenger (ASX: CGF) are faring remains to be seen.

Foolish takeaway

For investors in insurance companies, periods of higher claims and higher losses are part and parcel of the insurance cycle. With a long-term outlook, investors need not concern themselves overly with these short-term gyrations, instead focussing on ‘through-the-cycle’ earnings.

More importantly, investors need to have a sound understanding of the underlying strength and quality of the capital supporting an insurance company; otherwise an investor does not know if an insurer has the capacity to absorb losses. The capacity to absorb losses can not only affect the potential to maintain dividends but can also affect the potential of an insurer to survive.

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Motley Fool contributor Tim McArthur owns a share in Macquarie Group.

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