American International Group (NYSE: AIG) is back in positive territory that’s being fed by optimism about the prospect of improving conditions at the insurer, reports Michael Baron for TheStreet. A recent Government Accountability Office report showed that while AIG’s  fate is still a question mark, there were signs of stabilization and improvement in its businesses.

Gary Gordon for ETF Expert says that he believes that insurance ETFs are due for a “larger-than-broad-market” sell-off of between 10% and 15% anytime now.

Any sell-off could be due just because the seven-month bullish stampede may have run out of steam. Because of the nature of the insurance industry, while most companies are busy selling less and/or turning smaller losses from one year ago, the insurance industry may turn out to impress you.

Gordon says that at best, if key companies in the S&P 500 Index revise earnings estimates higher for 2010, insurance ETFs could outperform the broader market in a year-end, post-pullback push.

Whether this actually comes to pass remains to be seen, but if the predictions turn out to be correct, have your strategy in place to act on, if necessary.

• SPDR KBW Insurance (NYSEArca: KIE): up 32.8% year-to-date



• iShares Dow Jones US Insurance (NYSEArca: IAK): up 14.9% year-to-date



• PowerShares Dynamic Insurance (NYSEArca: PIC): down 4.4% year-to-date

For more stories about insurance, visit our insurance category.

Since the market lows on March 9, financials have rebounded handsomely, up as much as 140% since then. Most of them are perched firmly above their 200-day moving averages, as well.

There are a variety of ETFs that cover the sector. Because of the sector’s high profile, it is essential to know exactly what is under the hood of these ETFs.  The sector can be  subdivided into the following: broad-based, regional banks, capital markets, insurance and REITs.  John Gabriel of Morningstar breaks down the sector and provides an in-depth analysis of industries that constitute the financial sector.

The most widely held and common financial ETFs are broad-based financials, which include the SPDR Select Sector Financial (NYSEArca: XLF) and the Vanguard Financials (NYSEArca: VFH). Banks constitute nearly half of the asset base of XLF and 42% of VFH, insurance companies account for nearly 18% of XLF and 22.5% of VFH and capital markets soak up about 19% of both XLF and VFH.

In regard to the banking sector, some common ETFs investors look at are the SPDR KBW Bank (NYSEArca: KBE) and the PowerShares Dynamic Banking (NYSEArca: PJB). KRE is heavily exposed to banks operating in the Pacific region, nearly 25% of its assets, whereas PJB holds about 6% of its assets in this region.  Additionally, KRE is the only regional bank ETF which doesn’t hold stakes in large money center banks, whereas 10% of PJB’s assets are allocated to this specialty.

As for capital markets, investors can grab exposure to exchanges alongside brokers, money managers, and former investment banks through the SPDR KBW Capital Markets (NYSEArca: KCE) and the iShares Dow Jones US Broker-Dealers (NYSEArca: IAI). Both funds are nearly identical, except that KCE includes a sampling of traditional asset managers in its mix.

When it comes to insurance, investors can grab exposure through the PowerShares Dynamic Insurance (NYSEArca: PIC), SPDR KBW Insurance (NYSEArca: KIE) and the iShares Dow Jones U.S. Insurance (NYSEArca: IAK). The major difference between these ETFs mainly lies in their exposure to life insurers.  PIC has 3% of its assets to the subindustry, whereas KIE and IAK have 22% and 23% allocated to life insurers, respectively.

As for real estate investment trusts (REITs), the most common ETFs include the iShares Dow Jones U.S. Real Estate (NYSEArca: IYR) and the Vanguard REIT Index (NYSEArca: VNQ). A big difference between these two ETFs is that IYR contains mortgage REITs and unconventional holdings such as timber REITs and real estate services firms while VNQ limits itself to primarily conventional REITs.

In addition to knowing what an ETF holds, we suggest one watch the trendlines and have a strategy as this sector continues its recovery, as well.

For more stories on financials, visit our financial category.

Kevin Grewal contributed to this article.

A number of life insurance companies have met eligibility requirements for government capital, and their applications are being considered, reports David Lawder for the Associated Press. They were able to meet requirements by virtue of their bank holding company status.

In addition to Met Life (MET) and Prudential (PRU), other insurers with such status include the Hartford Financial Services Group Inc. (HIG) and Lincoln Financial.

Such a move would help stabilize the life insurance industry, which has suffered massive investment losses over the past year. Ieva M. Augustums for the Associated Press reports that insurers have been under enormous pressure to keep ratings up and maintain solid capital positions. Lower ratings mean higher costs and higher costs equal possible loss of business.

• SPDR KBW Insurance (KIE): down 23.9% year-to-date; Prudential Financial 3.9%; Hartford Financial 2.1%; Lincoln National Corp. 1.8%

• iShares Dow Jones US Insurance (IAK): down 26.6% year-to-date; Prudential Financial 4.9%; Hartford Financial 1.7%

These groups have historically been known to lead market recoveries, but then again, this isn’t a typical market.  Last Friday was a promising day for the Hartford Investment Group (HIG), Travelers (TRV), Chubb Corp (CB), PartnerRe Ltd. (PRE), and SPDR KBW Insurance ETF (KIE), which have all gained tremendous ground from its bottomed-out values seen in October, states Michael Kahn at Barron’s. KIE is down 50.5% year-to-date.

Kahn also suggests that the price of KIE made a lower low in November, but indicators as the relative strength index made a higher low suggesting waning downside momentum and a turnaround.  Another good sign is that the ETF withheld short-term resistance when the market dipped 8%, indicating that demand is outpacing supply. Lastly, the ETF is in an elite group of funds in that it is edging close to its 50-day moving average, a strategy which we use to determine whether to consider an index or stock in this market recovery.

This is a vast improvement when compared to the troubles that the industry faced earlier on the year, forcing the Federal Reserve to bail out the industry’s largest player, American International Group (AIG). AIG isn’t done yet, either: they face another $10 billion in losses, report Serena NG, Carrick Mollenkamp and Michael Siconolfi for the Wall Street Journal.

When analyzing the sector, it is important to be mindful that it is very broad and not all groups within it are strong and making a comeback.  Some other ETFs to consider are:

iShares Dow Jones US Insurance (IAK): down 55.2% year-to-date

PowerShares Insurance Portfolio (PIC): down 22.2% year-to-date

In layman’s terms, a credit default swap (CDS) is a credit derivative contract between two counterparties, in which the buyer makes payments to the seller and in return receives a payoff if an underlying financial instrument defaults.

The beauty of this innovation was that investors didn’t mind owning corporate debt which, in turn, lowered the cost of capital.  The failure of big banks and American insurers, such as AIG (AIG) and lack of transparency resulting in no one really knowing the extent of investors exposure to CDS’s has lead to the demise of the CDS, states the Economist.

Some argue that the CDS should be completely abolished, while others believe that reform is the next step. It may take years before the markets can view CDSs with some perspective.

The impact of the CDS market is far-reaching. Among ETFs impacted in one way or another include:

• SPDR KBW Insurance (KIE): down 51.49% year-to-date

• iShares Dow Jones US Insurance (IAK): down 55.52% year-to-date

Shares in the world’s largest insurer have plunged by almost half this morning after the $85 billion bailout that would give the government control of the company. This comes just two weeks after the Treasury took over Fannie Mae and Freddie Mac.

AIG’s time ran out after it failed to get a bank loan and avoid bankruptcy, and the rescue plan was hatched Tuesday night, report Edmund L. Andrews, Michael J. de la Merced and Mary Williams Walsh for the New York Times. Had AIG collapsed, institutional investors all over the world would have been forced to reappraise the value of all the risky securities AIG had insured.

As seemingly one institution after another is taken down in this crisis, some experts and lawmakers are floating the idea of creating an agency that would buy troubled assets from these companies. We’re seven weeks from a presidential election, so the government probably wouldn’t move with lightning speed on a plan that would put taxpayers at risk for hundreds of billions in bad assets, reports Stephen Labaton for the New York Times.

Floyd Norris at the New York Times points out a paradox: it’s too bad that the government didn’t think of such a crisis when they opposed an effort to regulate the very markets that are now in such dire straits, because it would have been interfering with free enterprise. Now they have to step in because they see it as a national emergency.

What about what caused this problem in the first place? It might be time to think about that. Economists are meeting to discuss how we get out of this mess, but no one seems to be talking about what got us here, David Leonhardt for the New York Times writes. He expresses frustration that government is focused on the immediate crises, but given nary a thought to the underlying issues, including stagnant income, higher debt and a lack of government oversight.

Most of these big investment firms and banks are components in financial ETFs. AIG is a holding in:

• KBW Insurance (KIE): down 21.8% year-to-date; AIG is 7.3%
• iShares Dow Jones US Insurance (IAK): down 30.9% year-to-date; AIG is 13.2%

The world’s largest insurer lost more than $5.6 billion in credit default swaps – insurance policies to protect bondholders against defaults, reports Madlen Read for the Associated Press. Before taxes, AIG has lost more than $25 billion in the last three quarters in the swaps and another $15 billion in other investments.

Shares fell by the most in at least 28 years, says Hugh Son for Bloomberg. The losses suggest that despite raising $20 billion in capital, the company’s financial position is questionable.

Particularly hard-hit by the news are insurance ETFs, which could AIG as a top holding:

• KBW Insurance (KIE): down 17.5% year-to-date; AIG is 5.5%
• iShares Dow Jones US Insurance (IAK): down 22.6% year-to-date; AIG is 13.4%

In better news, home sales contracts signed in June rose across the country to their highest level since October 2007. They’re still below last year’s levels, though. Overall, the Pending Home Sales Index is up 5.3%, reports Glenn Somerville for Reuters. Economists were forecasting a loss of 1%.

The positive news might not be enough to overcome the negative reports from AIG, as real estate ETFs are trading lower today:

• iShares FTSE NAREIT Real Estate 50 Index Fund (FTY), up 1.4% year-to-date
• SJ Wilshire REIT (RWR), up 2.2% year-to-date
• Vanguard REIT Index (VNQ), up 2.7% year-to-date

The key interest rate remained unchanged at 2%, reports Martin Crutsinger for the Associated Press. The benchmark prime lending rate will also stay at 5%, its lowest level since 2004.

Chairman Ben Bernanke said tight credit conditions, high energy prices and the continued contraction in housing will continue to weigh on U.S. economic growth.

Many economists believe that the rate will remain unchanged for the rest of the year.

There was other good news (at least, if you’re not holding oil futures) for the market: oil dropped as low as $118 a barrel. That’s its lowest point since early May. Crude is now nearly 20% off its all-time trading high of $147.27 hit on July 11.

The service sector contracted in July, as well, but it was less than expected. New orders fell as prices climbed, putting a crimp on growth for retailers, truckers and insurers, reports Ellen Simon for the Associated Press.

The reading was 49.5, up from 48.2 in June. Economists were predicting a reading of 49. A number below 50 signals contraction, while above 50 signals growth.

Some ETFs that could be affected by contraction in the service sector include:

• PowerShares Dynamic Insurance Portfolio (PIC), down 8.5% year-to-date
• iShares Dow Jones U.S. Insurance Index Fund (IAK), down 25.1% year-to-date
• Vanguard Consumer Discretionary (VCR), down 15% year-to-date
• SPDR S&P Retail (XRT), down 11.1% year-to-date