Value hunting in insurance wreckage

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Shares of prominent life insurers Hartford, MetLife and Prudential have plummeted this year due to exposure to mortgage assets and failed financial firms.

NEW YORK (CNNMoney.com) -- The credit markets are showing some tentative signs of defrosting, and shares of several big banks were up Monday morning.

But it's not all puppies and sunshine in the world of high finance.

Wall Street is turning its gaze to another troubled industry in the financial-services sector: life insurers.

Shares of Prudential Financial (PRU, Fortune 500) sank like - I can't resist this - a rock on Monday after Goldman Sachs analyst Thomas Cholnoky downgraded the insurance giant to "sell." The stock fell nearly 9% late Monday morning before bouncing back a bit later in the day.

Cholnoky also downgraded shares of MetLife (MET, Fortune 500), to a "neutral" rating. The stock fell about 3% in the morning before rallying in the afternoon. Shares were up about 2% in mid-afternoon trading.

The downgrades initially pushed down the shares of many other life insurers as well. Principal Financial Group (PFG, Fortune 500) was down more than 4% Monday morning but inched slightly higher in the afternoon and Hartford Financial Services (HIG, Fortune 500) sank about 7% in the morning before also climbing into positive territory.

In his note, Cholnoky wrote that "widening credit spreads and a deteriorating mortgage environment are likely to weigh on life insurance company balance sheets for the foreseeable future."

But other analysts who follow the sector said there was not much new news to justify Monday morning's selloff.

The insurers have already warned of weak results to come, these analysts say, and the stocks have already plunged as a result.

"The companies, for the most part, have reported they expect to take writedowns because of investments in troubled financial services firms whose names we all know," said Steven Schwartz, an insurance analyst with Raymond James.

Randy Binner, an analyst with Friedman Billings Ramsey, agreed, noting that shares of major life insurers are down some 50%. "The most important trend for the group is the credit exposure. But credit has been an issue for the whole year so it would appear to be already priced into stocks," Binner said.

Many of these firms also held stocks and bonds of failed or floundering financial firms, such as Fannie Mae (FNM, Fortune 500), Freddie Mac (FRE, Fortune 500), Lehman Brothers, Washington Mutual and AIG (AIG, Fortune 500).

The life insurers have been hit hard by their bad bets. And some have been forced to raise more capital. MetLife announced earlier this month that it planned to sell about $2 billion's worth of stock while Hartford is receiving a $2.5 billion investment from German financial firm Allianz.

One analyst points out that investors seem to be worried that the life insurers will need even more cash to ensure that credit-rating firms like Moody's and Standard & Poor's don't downgrade their debt.

"There are concerns over capital raising and questions over whether current levels are sufficient to maintain rating agency ratings and weather the current crisis," said Mark Finkelstein, an analyst with Fox-Pitt Kelton Cochran Caronia Waller.

"The rating agencies do appear to be putting more scrutiny on the group," Finkelstein added.

Still, Binner thinks that several of the insurer stocks, particularly MetLife and Prudential, have been dramatically oversold. And Schwartz said that despite the problems facing many life insurers, he did not expect any of them to fail or wind up in bankruptcy.

That remark appeared to be a jab at Senate Majority Leader Harry Reid (D-Nev.), who helped spark a sector-wide selloff earlier this month after cavalierly suggesting that a major insurer was on the verge of going bankrupt if Congress did not act to pass the bank bailout bill.

If anything, Schwartz said that life insurers might seek to take advantage of the turmoil in the sector and scoop up parts of AIG, which is expected to sell off many assets to pay off the $85 billion it borrowed from the Federal Reserve.

AIG bought SunAmerica in 1998 and American General in 2001, for example, and Schwartz said they both have "attractive life insurance policies."

Binner added that he also wouldn't be surprised if the big life insurers wind up purchasing parts of AIG. In addition, he said there may even be some big mergers as well. As such, there were reports a few weeks ago that indicated MetLife and Hartford held some preliminary merger talks.

"These companies' main businesses are life insurance and annuities. They are all consumer focused so it makes sense to have economies of scale," he said.

But Schwartz isn't as sure that huge deals are in the cards. He conceded that a merger could lead to greater efficiencies at a time when cutting costs is paramount.

However, raising capital is the biggest concern right now for most insurers. So a combination of two companies that each face that challenge might not make sense.

"I'm not sure what merging two insurers does to shore up their balance sheets. If there are two holes, there's going to be one hole that's going to be bigger," he said.