Capital Losses Reduce Industry Surplus In First Half of 2002

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).