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It was bad news that financial strength downgrades trumped upgrades by three to one in 2002, but the bad news isnt over, according to a Moodys Investors Service report, which says that downgrades again are likely to outpace upgrades in 2003.

In fact, Moodys has changed the near-term outlook for the whole U.S. life insurance industry to negative from stable.

New York-based Moodys cites factors including credit losses, declining equity markets and low interest rates as a few of the challenges the life insurance industry currently faces.

Offsetting these problems, according to the Moodys report, “Credit Issues and Trends for U.S. Life Insurance,” are “core strengths” that include “adequate capital supporting conservative balance sheets, predictable and profitable blocks of seasoned liabilities and tax-favored product offerings.”

Robert Riegel, managing director at Moodys, says the best scenario that would lead to the removal of the negative outlook would include an improvement in the economy, significantly lower corporate bond default rates and a slow rise in interest rates as well.

The interest rate increase, according to Riegel, could not be a spike because it would encourage disintermediation to bank CDs or new fixed annuity contracts.

The current interest rate environment is not good because of spread compression on the difference between rates guaranteed in contracts such as fixed annuities and rates currently available for investments, Riegel explains.

Expanding on the reports prediction that acquisitions of blocks of business will become more prevalent, Riegel says variable annuities are one product line in which players will experience consolidation.

VAs are a “low margin, commodity-like product, so it is critically important to have significant scale to make a go of it,” he adds. Advantages such as scale and distribution are important to success in this product line, Riegel says. In fact, he adds he has heard of companies that have decided to stop selling VAs and to sell their in-force business.

Market declines have made the VA business, particularly contracts with guarantees, more difficult to manage, the Moodys report notes. “Low frequency, high severity risk” associated with secondary guarantees, including guaranteed minimum income benefits, guaranteed minimum death benefits and guaranteed minimum accumulation benefits as well as “other risks that continue to appear” such as dollar-for-dollar partial withdrawals continue to be a concern of Moodys, the report says.

The difficulty, according to Riegel, is that distributors continue to demand those features. Going forward, more VA writers will be looking at the risk profile of those options and pricing for them more appropriately.

Banks and securities firms would never have gotten into the position of some insurers because they would appropriately price and charge for those options, he says. Some companies gave options away to contract holders, Riegel adds.

And, some companies were approached by investment banks several years ago to recommend that they hedge those guarantee risks, he says. But some of those insurers chose to go naked and not take a position in options that would have covered their risk, Riegel says.

Many companies that have focused on traditional protection products have done a good job, he says. But going forward, market demand will necessitate broadening product offerings, he adds.

For instance, the report cites the potential growth of long term care insurance. Riegel also notes the potential but says there are four risks associated with the product that need to be monitored: lack of morbidity experience; low interest rates that will not generate enough revenue for insurers to pay for future claims; the potential for adverse selection; and, policyholder behavior.

On the last point, Riegel notes that lapse assumptions of 3-4% have proved higher than actual lapse rates of approximately 1%.

Another ongoing concern that the report details is continuing exposure to credit risk resulting from bond defaults. The report notes that in 2002, global defaults peaked at 5.3% of all bonds, up from 4.2% in 2001.

Even though defaults seem to have peaked, they will probably remain at high levels throughout 2003, says Riegel.

The report also says that mutual insurance companies have a competitive marketing advantage because they can offer participating insurance products. It also mentions mutuals above average credit quality relative to the rest of the industry.

Riegel notes that there is a divergence between the average rating of stock companies vs. mutual insurers, noting the added pressure for stock companies to serve both policyholder and shareholder interests. Those interests weigh the concern for financial strength with the optimization of a capital structure by stripping out excess capital, he continues.

In more challenging economic times, a reduced capital cushion could cause additional pressures, he says.


Reproduced from National Underwriter Life & Health/Financial Services Edition, June 2, 2003. Copyright 2003 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.