The newest toxic asset class made its debut last week, when Morgan Stanley raised concerns over insurer Aflac Inc.'s (AFL) outsized investments in so-called hybrid securities issued by troubled European Union banks. Aflac and, to a smaller degree, other insurers, hold investments in preferred share-like securities called perpetual debentures. These securities are hybrid in nature because they are in part equities - deriving some of their return from preferred share-like dividends - but also have debt characteristics.

Some insurance companies with these investments include American International Group Inc. (AIG), MetLife Inc. (MET) and Principal Financial Group Inc. (PFG). As a percentage of their book value, other insurers hold far less of the securities than Aflac does.

The concern has been that European issuers of these securities would come under government control, wiping out or diluting shareholders and destroying the value of the securities. While some of those fears have eased in recent days, the concerns haven't evaporated entirely.

Aflac's shares fell more than 30% after the Morgan Stanley note brought attention to the issue.

Standard & Poor's piled on with a one-notch downgrade of Aflac to A- and put the insurer on watch for a potential further downgrade. Investment losses on the securities of $400 million will result in a further one-notch downgrade, and $800 million will result in at least a two-notch cut, S&P said. Insurance rating agency A.M. Best so far has kept the company at A+.

Aflac said in a Friday press release that it expects to report a risk-based capital ratio of 425% to 475%, well ahead of an A credit rating standard, and noted that virtually all of its debt securities and perpetual debentures were rated investment grade by ratings agencies at the end of the year.

Shares of Aflac surged Wednesday along with other financial services stocks on reports that President Barack Obama and his team were closing in on a "bad bank" plan that will have the government taking on responsibility for some toxic assets.

Aflac draws the most attention because of its outsized exposure to the securities, but the issue could come up on a smaller scale for other insurers with investments in bank-issued hybrid securities and preferred shares, said UBS analyst Andrew Kligerman. In terms of dollar amount, the hybrid holdings of American International Group and MetLife come close to the level of Aflac's exposure, with MetLife holding around $7.2 billion and AIG holding around $7 billion at the end of the third quarter - the latest figures available - Kligerman said, though both of those insurers have much larger overall investment portfolios. Aflac's hybrid holdings at fair value were $8.1 billion at the end of 2008, around 11.8% of its consoldiated investment portfolio of $68.6 billion.

Other insurers with substantial exposure to hybrids as a share of their book value are Principal Financial, Protective Life Corp. (PL) and Phoenix Cos. (PNX). In terms of third-quarter adjusted book value after AOCI (accumulated other comprehensive income), These three companies' exposure levels are at 9%, 8% and 7%, respectively, compared with 63% for Aflac, 5% for Metlife and 1% for AIG, Kligerman said.

Principal Financial is "very comfortable with our preferred portfolio exposure," said Susan Houser, a company spokeswoman, in an emailed statement. "Our exposure is to high-quality companies, including banks. We have stated in our recent investor day and other forums that we continue to believe that where financially possible, governments will support their banking systems and have shown clear evidence of that."

Representatives for AIG, MetLife, Protective Life and Phoenix didn't immediately respond to a request for comment on their hybrid securities holdings.

The fear that banks that come under government control will stop paying dividends on the securities was eased somewhat Tuesday and Wednesday for U.S. banks. Citigroup Inc. (C) Chief Executive Vikram Pandit reassured investors that the bank will keep paying dividends on the company's preferred shares, while playing down the likelihood that the U.S. government might nationalize a major bank.

Hybrid securities rank ahead of preferred shares in line for payment in case of a bank failure, but below subordinated debt that carries a stated maturity date. The lack of a maturity date pushes the hybrids closer to equity shares and raised fears that a takeover would wipe them out along with other types of equity, such as common and preferred shares.

The closest precedent so far would be the takeover of U.K. mortgage lender Northern Rock in February. The government allowed the bank to continue paying coupons on its perpetual debentures, but "that was a long time ago, and things have changed," Kligerman said. Future takeovers might follow different rules, he said.

Another precedent would be the seizure of U.S. mortgage acquirers Freddie Mac (FRE) and Fannie Mae (FNM), said Nigel Dally of Morgan Stanley in a note last week. Preferred shareholders were wiped out in the U.S. government's rescue last year.

"I do think the market is concerned about coupon deferral for U.S. banks and we have seen these securities sell off for these banks as well, most particularly in Citigroup and Bank of America," said Timothy Compan, portfolio manager for Allegiant Asset Management. "Most all of the money center U.S. banks have some form of hybrid capital outstanding."

Generally, investors are counting on governments to take care of securities holders, but confidence is slipping as the economic picture grows worse, Kligerman said.

"Some of these bonds are trading at less than 35 cents on the dollar, which indicates there is a reasonable possibility of default," he said.

If there is a government bank takeover, prices may go yet lower, Compan said. "It will depend on what signals government authorities send with respect to the payment of dividends."

-By Lavonne Kuykendall, Dow Jones Newswires; 312-750-4141; lavonne.kuykendall@dowjones.com