By Dan Ferris in the S&A Digest:

Yesterday, the government announced it would expand bailout efforts to include insurance companies, earmarking some of the $130 billion in remaining TARP funds to boost confidence in the sector. It's true the government has already rescued AIG, the largest recipient of government funds to date, which is an insurance company. But AIG's losses stemmed from the sale of credit-default swaps, not its life insurance operations.

The decision to bail out insurers makes sense. Millions of Americans depend on these companies to protect their families in times of crisis... and if they decide to cash in their policies, it could cause a "run on the bank" situation, wiping out the insurers.

Also, insurance companies use their collected premiums to invest in the stock and bond markets. If they were forced to sell in order to shore up capital, it would be disastrous for the market.

So far, the government has only put one condition on an insurer's eligibility... It must own a federally chartered bank in order to apply for money. The Treasury announced that condition last year, but hadn't officially decided to dole out the cash at that point.

In order to qualify for government funds, several insurers - including Hartford Financial, Genworth Financial, and Lincoln National - bought banks last fall. Hartford, Lincoln National, and Prudential have already applied for TARP funds. MetLife, the biggest publicly traded insurer by assets, owned a bank before the crisis struck, but has not said whether it has applied for TARP money.

I think there are two considerations with a potential Treasury bailout of the life insurers: the reality and the perception.

The reality is that the government can't possibly bail out 18% of the corporate bond market, the entire stock market, and a big chunk of the commercial real estate sector, not even if it spent 100% of the remaining $130 billion of TARP money on life insurers, which is highly unlikely.

According to a recent report by Bridgewater Associates, between ratings downgrades and actual losses, the 13 largest publicly traded U.S. life insurance companies would need about another $400 billion just to stay afloat. But what if that's not enough? Everything the government has spent so far hasn't been enough to fix anything.

The government can't prevent losses from happening by systematically rewarding failure and punishing success, any more than the Financial Accounting Standards Board can prevent losses by changing accounting rules. Losses must be taken. If the current marks were classified as other than temporary, it would obliterate 150% of the tangible equity of the 13 big life insurers on my Extreme Value victim list.

It's a legitimate question, whether losses will be taken by the insurance companies, their investors, and their clients (which is what ought to happen) or whether they'll be taken by the taxpayers (which would be a real crime). I don't see how the government could put it on the taxpayer without risking hyperinflation. It would have to print trillions, which it has done already to no avail.

How things will unfold is unpredictable. But between the market and the government, I'll bet on the market and against the government.

That's the reality.

Meanwhile, the perception that the government can save insurance companies is whipsawing short sellers and could ruin them if the rally continues in the life insurers. I'm betting reality will win out over the mistaken belief that government can save the life insurance industry from itself. I'm staying short

Crux note: Learn more about Extreme Value.

A huge crisis is just starting to hit the headlines...