Life insurers were unprepared for the widespread credit crunch of the past two years, and the industry could suffer financial repercussions for its investments in mortgage-backed securities, according to Etti Baranoff, associate professor of insurance and finance at the Virginia Commonwealth University School of Business.

Life insurers reduced capital as they added mortgage-backed securities to their portfolios between 2003 and 2006, writes Baranoff in the study, "Mortgage-Backed Securities and the Capital of Life Insurers: Was the Industry Prepared for the Credit Crunch of 2007-08?", that she co-authored with Thomas Sager, a statistics professor at the University of Texas.

"Insurers behaved as though mortgage-backed securities raised the quality of their portfolios," said Baranoff. "Their reduction of capital indicates that they either were not aware or not concerned with the potential pitfalls of the securities."

Examining the potential impact on life insurers if the credit ratings of the mortgage-backed bonds are lowered, Baranoff and Sager found evidence that the full implications of the insurance industry's investments in the securities have yet to be realized.

"In general, bonds carry lower risk ratings than mortgages. Bundling mortgages into securities and calling them bonds makes it appear that the bundled mortgages are less risky than they really are," Sager said. "If mortgage-backed securities were re-rated to recognize their true risks, life insurers could face the need for significant additions to capital, according to our capital-risk models." More.