The financial crisis is reverberating through the insurance industry, causing significant drops an assets and surplus, and bringing the strong possibility of increased merger and acquisition activity as weakened firms sell out to larger competitors, according to a new report by Conning Research and Consulting, Inc.

However, for the strongest companies this time of turmoil may lead to opportunities to solidify their market share for the future, when an aging population will increasingly turn to insurance products as a way to finance longer retirements, according to Terence Martin, an analyst at Hartford-based Conning.

Martin said there are many ways in which the financial crisis has hurt the life insurance industry and will continue to cause problems for some companies through the next two or three years. First, asset values have gone down as the stock market and mortgage markets have sunk, he said. Secondly, especially for annuity writers, the need for reserves have increased dramatically.

“A lot of individual annuities had performance guarantees,” he said, which means the product promised that the annuity would provide a certain amount of income no matter what happened to the underlying assets. Now that the assets are worth a lot less, “the insurance companies are on the hook.”

While people are not cashing out or annuitizing their annuities in droves, insurers are still required to reserve the cash to cover all those guarantees – and that particular liability is creating a huge drain on the industry, he said.

Conning projects a dramatic hit to surplus plus Asset Valuation Reserve (AVR) at the end of 2008, with an industry-wide total of $237.3 billion, a 24.4 percent drop from 2007.

“That 2008 decrease erases all gains since 2000,” Martin said. “It’s a big hit. Is it fatal? No. But it’s a big hit, absolutely.”

Increasingly insurers are looking for new sources of capital, courting investments by other companies and floating stock, he said. Conning predicts an increase in mergers and acquisitions as capital-starved insurers look to sell lines of businesses or themselves entirely.

Martin said some of the consolidation may come from insurers exiting certain lines of non-core businesses – like individual annuities – that are now suffering thanks to the market turmoil. “Whenever the market goes down, you get some companies that get shaken out of the individual annuity area. We saw that in ’99, 2000 and 2001, and we see that kind of process again.”

Meanwhile, more established players could use the time of flux to pick up bargains, increasing assets under management, adding distribution, and building scale for the future, he said.

“There’s an aging population, and as people get older and towards retirement and such they are going to want a guaranteed income stream. That points towards fixed annuities picking up,” Martin said.

The Conning Research report, “Life-Annuity Forecast & Analysis, Year-End 2008” is a semi-annual analysis of life insurance and annuity industry performance and metrics.â–