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Capital Losses Reduce Industry Surplus In First Half of 2002

By Frederick S. Townsend

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Capital losses in the bond and stock markets contributed heavily to the life insurance industry reporting aggregate surplus declines of 5.1% in the second quarter, and 3.8% in the first six months of 2002.

In the Townsend & Schupp Industry Composite of 130 life insurers with 85% of the life insurance industrys assets, 117 of the 130 companies, or 90%, experienced net capital losses in the first six months of 2002. Aggregate net capital losses of $11.6 billion were nearly double the aggregate operating earnings of $6.3 billion. Shareholder dividend payments of $5.5 billion consumed 88% of operating earnings.

Seventy percent, or 91 of the 130 companies, experienced a reduction in their total surplus positions (statutory surplus, asset valuation reserve and interest maintenance reserve), after the one-two impact of net capital losses and shareholder dividends.

This is the only surplus decline reported for the life industry in the last decade. The lowest surplus gain in the last 10 years was 1.6% in the first six months of 1994, when an increase in interest rates and decreased health insurance margins caused 40 of 130 companies to report a six-month surplus decline.

In the nine years prior to 2002, the Townsend & Schupp Industry Composite showed an average six-month surplus gain of 4.6%, compared to the 3.8% surplus decline in the first six months of 2002.

Table 1 shows the components of surplus changes for the 130 T&S Composite companies in the first two quarters of 2002, and in the first six months of 2002 and 2001. Surplus includes the asset valuation reserve and interest maintenance reserve, while operating gain excludes amortization of the interest maintenance reserve.

Comparing six months of 2002 and 2001, four basic sources of surplus gains declined. Operating earnings fell 15%, net capital losses more than doubled, new surplus paid-in fell 55%, and non-recurring codification accounting changes added $9 billion to surplus in 2001.

Table 2 shows net surplus paid-in exceeded shareholder dividends paid-out by $1.3 billion to $2.1 billion per year in 1991-1993, to meet consumer solvency fears, rating agency demands, and risk-based capital standards.

Shareholder dividends paid-out exceeded surplus paid-in by $1.1 billion to $8.0 billion per year in 1994-2001, averaging $4.2 billion per year, as stock life insurers sought to reduce equity and, thus, increase returns on equity.

In recent weeks, rating agencies have announced negative outlooks for the life insurance industry, reflecting a combination of the declining trend in operating earnings, recent capital losses, and redeployment of capital (shareholder dividends) to increase returns on their retained equity.

Table 3 shows net investment yield on mean invested assets, return on mean equity, and capital ratio (total surplus to invested assets) for the T&S Industry Composite of 130 companies, for 1990-2001 and six months of 2002.

Annualized net yield of 6.54% for six months of 2002 is a 54 basis point drop from the full year 2001, and is potentially the largest single year decline in this interest rate cycle. The T&S Industry Composite had a 51 basis point decline in 1992.

With 5-, 10- and 20-year U.S. Treasury bonds yielding 3.08%, 4.03% and 4.98%, respectively, on Sept. 10, 2002, it is not surprising that the industry net yield continues to decline and many life insurers have increased their mix of bonds rated BBB and lower. This trend is also a concern to the rating agencies.

In mid-September, the 10-year U.S. Treasury bond was yielding 5.81% in 2000, 4.55% in 2001, and 4.03% in 2002.

Return on mean equity was only 6.4% in the first six months of 2002, threatening to break the previous 12-year low of 6.4% set in 2001. This low level of profitability has also raised rating agency concerns.

In 2002, depressed interest rate margins on fixed interest rate guarantee products, a reduction in fee income on variable products (due to asset value declines and policy terminations), and increased claims for minimum death benefits on variable products, are major contributors to the decline in operating earnings.

Rating agencies are also concerned over declining capital ratios, which T&S defines as the ratio of total surplus funds to general account invested assets (where the company is at risk for investment losses).

After Executive Lifes failure in 1991, the life industrys capital ratio rose 63%, from 7.3% at Dec. 31, 1990 to 11.9% at Dec. 31, 1999. It then fell to 9.8% at June 30, 2002, as 56, 47 and 91 of the 130 T&S Composite companies reduced their total surplus in 2000, 2001, and the first six months of 2002, respectively.

Table 4 shows components of surplus changes for each of the 130 companies in the T&S Composite. Surplus includes the AVR and IMR, and operating gain excludes amortization of the IMR.

Twenty-two (17%) of 130 companies earned more than $100 million in six months of 2002. Seven companies comprised 43% of the T&S Composite earnings: Metropolitan, $719 million; American General, Texas, $365 million; Travelers, $326 million; Connecticut General, $316 million; Prudential, $312 million; Teachers, $312 million; and SunAmerica, $308 million.

Operating losses for six months were reported by 35 of 130 companies in 2002 (the most in the last 10 years). Highest losses were caused by reserve increases (and claims) for minimum death benefits on variable life and annuity contracts.

One hundred seventeen (90%) of 130 companies had net capital losses in six months of 2002, compared to a previous high of 86 (in 2000) for the last 10 years.

Among the 13 companies with net capital gains, the largest gains were reported by GE Capital Assurance, $99 million; Sun Life Assurance Canada-U.S., $43 million; and Primerica, $40 million.

Twenty-seven of 130 companies had both operating losses and capital losses for six months of 2002. The 27 companies set a 10-year high, and were more than double the previous high of 11 companies in six months of 2001.

Twenty-two of 118 stock companies paid in new surplus of $2.9 billion gross and $1.8 billion net in the first six months of 2002. While 22 companies ties the highest number of contributors in the last 10 years, the net dollar amount paid-in was the lowest net contribution since $1.6 billion was paid-in in 1996.

Forty-seven of 118 stock companies paid shareholder dividends in the first six months of 2002. Shareholder dividends paid in six months show an upward trend from 1993 to 2002: $1.1 billion, $1.6 billion, $2.3 billion, $2.7 billion, $3.3 billion, $5.2 billion, $3.3 billion, $4.5 billion, $5.8 billion and $5.6 billion, respectively.

All other surplus changes were a positive $1.4 billion in 2002, compared to negative changes of $0.5 billion, $0.4 billion, $0.7 billion, $2.1 billion, $7.7 billion and $3.3 billion in 1996-2001, respectively.

The largest aggregate surplus gains for six months of 2002 were reported by Travelers, $1,565 million; SunAmerica, $263 million; AIG Annuity, $137 million; and Allstate, $152 million. Gains were predominately operating earnings for SunAmerica, and surplus paid-in for the other three companies.

Excluding surplus paid-in, the largest percent gains in surplus in six months of 2002 were MetLife Investors USA Ins., 21%; SunAmerica, 12%; and Jefferson-Pilot Life, 6%. Since only 39 of 130 companies had surplus gains, and only 15 of 130 companies had capital gains, only these three companies achieved a surplus gain exceeding 5% in the first half of 2002.

Surplus declined for 91 of 130 companies in six months of 2002, compared to previous highs in the last 10 years of 56 declines in 2000 and 47 declines in 2001.

Largest percentage surplus declines in the first six months of 2002 were reported by AIG SunAmerica Life, 64% (after a $552 million reduction in previously paid-in surplus); Allmerica Financial Life & Annuity, 45% (after a $135 million operating loss); and United Insurance Company, 34% (after a $357 million shareholder dividend).

In the Separate Account business of the T&S Industry Composite, assets fell by 4.6% from Dec. 31, 2001 to June 30, 2002, and fee income for six months fell 4.5% from 2001 to 2002.

Frederick S. Townsend, a founder of The Townsend & Schupp Company, is an investment banker in Hartford, Conn.

Reproduced from National Underwriter Life & Health/Financial Services Edition, October 7, 2002. Copyright 2002 by The National Underwriter Company in the serial publication. All rights reserved.Copyright in this article as an independent work may be held by the author.