Industry Starting To Recover From The Stresses Of Last 3 Years
In 2003, the North American life insurance industry is recovering from the effects of an unprecedented confluence of environmental factors. These factors included the worst credit markets in more than a decade in both 2001 and 2002, a bear market for equities since early 2000, and the lowest interest rates in more than 40 years.
These factors swirled on top of fundamental negative trends that have existed in the life industry for several years. All of this has created the most challenging environment for life insurers in recent memory.
Fitchs Rating Outlook for the North American life insurance industry is Stable. The outlook was revised from Negative at the conclusion of a comprehensive review all life insurance company ratings in September 2002. The Stable rating outlook reflects Fitchs belief that downgrades from the continued slow and steady deterioration of the industrys credit fundamentals will be offset somewhat by upgrades related to consolidation.
Even with the above-mentioned slow and steady deterioration of long-term fundamentals, the credit quality of the industry remains very strong. The average insurer financial strength rating of Fitchs life insurance universe is AA-. The average senior debt rating is A-.
Core Challenges. Downgrades significantly have outnumbered upgrades for Fitchs life rating universe over the past several years. The two core drivers are intense competitive pressure from inside and outside the industry, and a shift in business mix away from traditional life insurance and other protection products to lower margin products such as variable annuities and mutual funds.
The manifestation of these two challenges has resulted in increased earnings volatility, stressed risk-adjusted profit margins, and henceforth declining sustainable earnings and capital growth rates. Fitch believes these long-term negative fundamentals will not dissipate in the near term.
Credit Environment is Improving. During the economic downturn, credit defaults soared and recovery rates plummeted. Fitchs high yield bond default index reached 16% in 2002, a 12-year high. Recovery rates were a weak 22% of par. The timing of this down credit cycle was inopportune as the industrys bond portfolio has trended toward moderately higher credit risk and lower liquidity over the past few years. This has resulted in the industry experiencing higher than expected realized losses and write downs.
In addition, exposure to below-investment-grade bonds has increased to approximately 8% of the bond portfolio as many corporate issuers have been downgraded from investment-grade rating levels. Even within the investment-grade portfolios, there has been downward migration in credit quality for many corporate and some structured finance issuers.
Through the first six months of 2003, Fitchs high yield default bond index fell to 6% annualized. This level is higher than historical averages but a significant improvement from the 2002 levels. Recovery rates improved 50% from 2002 levels to 33% of par. In addition, credit spreads have tightened materially throughout 2003. These factors will translate into improved investment performance for the life insurance industry in 2003.
Other Than Temporary ImpairmentsNot a Rating Issue. Fitch believes that some companies may be too liberal in their definition of other than temporary impairments (OTTI) of investments and that there are broad differences in OTTI standards used by the industry. As a result, Fitch performed a comprehensive “stress-test” analysis of year-end 10(k) disclosures and statutory statements to prospectively judge whether OTTI issues could cause write-downs in the future and the ability of capital to absorb such write-downs.
The stress test adjusted capital and RBC levels for all below-investment-grade securities that had impairments of greater than 20% for six months or more. Additional information was analyzed if an individual companys stress test resulted in a significant migration of capital levels outside of Fitchs current rating expectations.
Overall, very few companies fell materially outside of Fitchs expectations for capital levels with this rather punitive stress test. Therefore, Fitch concluded that the industry does not have a significant rating exposure to large bond write-downs in the pipeline as of year-end 2002. Since Dec. 31, the stress test results have improved due to the significant tightening of credit spreads.
Lowest Interest Rate Environment in 40+ Years. The low interest rate environment has caused profit spreads to narrow for fixed-product writers. Minimum crediting rate guarantees create a floor for what companies can pay to their customers. As the average portfolio yield falls due to declining interest rates, increased prepayments on residential mortgage-backed securities and lost investment income from defaulted bonds, the crediting rate cannot be adjusted to fully reflect the impact of these factors.
The industry is receiving regulatory relief on the 3% mandated minimum-crediting rate from the National Association of Insurance Commissioners and individual states. However, this relief only applies to new products sold and not for the large amount of in-force liabilities.
Another contributing factor to lower portfolio yield is companies selling higher coupon bonds at a gain and reinvesting proceeds in the current low rate environment. Companies have taken this action to mask credit losses on a GAAP basis. Fitch believes this strategy is short-sighted and not emblematic of strong credit fundamentals.
Strategies companies can employ to deal with spread compression include a reach for yield by investing in higher risk assets or increasing asset duration, reducing new premium targets and accepting lower profit margins for a period of time. Fitch expects these trends to continue as long as interest rates remain low. The best case scenario for the industry is for a slow, steady increase in interest rates.
If interest rates were to increase rapidly, then the industry would face significant challenges. Surrender activity would increase as customers trade out of their low yielding policies. Companies would be forced to liquidate bond investments at a loss to fund the surrender requests. The specific liability profile for each company would be a key determinate of how that company weathers a dangerous environment.
Equity Markets Looking Up. Historically, equity market performance has not had a major impact on life insurers, from an investment perspective, due to relatively low direct exposure to equity investments. This, however, has changed in recent years as the life industry shifted its business mix to equity-linked products like variable annuities, variable life insurance, equity-indexed annuities and mutual funds.
For companies writing these products, equity markets performance can drive sales mix and levels, fee income tied to assets under management, reserving for minimum death benefit/income guarantees, rate of DAC amortization, surrender activity and allocation of fund balances between the fixed-rate option and equity-linked subaccounts.
The S&P 500 index fell 23% in 2002 after declining 13% in 2001. The adverse environment placed considerable pressure on the industrys earnings and capital levels. Through July 31, 2003, the S&P 500 index rebounded 13% from year-end 2002.
While a sustained improvement in equity market performance would certainly lift some of the pressure on the life insurance industry, Fitch does not believe this would be a “cure all” for the industrys woes. Overall, the industry suffered more in the down market than it benefited in the up market. Competitive pressures and the need for scale with equity-linked products will preclude companies from significantly expanding profit margins and cutting back on some of the more aggressive product features in an improving market.
Consolidation Helps Offset Negative Fundamentals. The skittish capital markets have kept a lid on consolidation activity in the life insurance industry, as well as most sectors. Fitch believes this has been a temporary respite for an industry that requires additional consolidation.
The products sold today by the industry are scale-oriented products. Therefore, size is an increasingly important component of viability. Similarly, diversity of products and distribution is more valued in this difficult environment. Therefore, Fitch expects a material increase in acquisition activity in 2003 and beyond.
The likely form will include current life industry participants buying others of a smaller or equal size. Fitch expects some movement among the small to midsized mutual companies as these participants are challenged by diversification, technological needs and scale issues.
Fitch does not expect significant interest from European insurers in the near term. Those companies that have been most active in recent years–AEGON, AXA, ING and Fortis–are dealing with challenges in their domestic markets. Similarly, Fitch does not expect significant interest from banks. These institutions (with the notable exception of BankOne) have been happy to serve as distributors of insurance products and show little interest in manufacturing these products.
The expectation of increased consolidation activity is a critical component of Fitchs Stable Outlook for the North American life insurance industry. Generally, stronger companies buy their weaker brethren. This often leads to rating upgrades. Recent examples of this phenomenon include Prudentials purchase of American Skandia and Great Wests acquisition of Canada Life. This activity is expected to mitigate the continued negative fundamental operating trends in this business and downgrades that would otherwise result.
Capital Challenges Persist. Fitchs biggest long-term credit concern for the life insurance segment is its ability to grow capital on a sustained basis. In 2002, statutory capital and surplus declined approximately 3%. This decline stemmed primarily from corporate bond losses, reserving for guaranteed minimum death benefits and equity investment declines. Capital raising activity in the second half of 2002 helped stave off even larger declines from earlier in the year. This external capital raising momentum continued into 2003.
Compounding the decline in statutory capital levels is an increase in required capital. The shift back to fixed products and the shift within VAs from equity subaccounts to fixed subaccounts caused higher risk-based capital charges. Therefore, RBC ratios fell measurably in 2002. Fitch estimates the industry aggregate RBC fell from 341% at year-end 2001 to 307% at Sept. 30, 2002, before recovering to 320% by year-end 2002. This represents considerable volatility in risk-adjusted capital levels for the industry.
Capital growth on a GAAP basis has been pressured by acceleration and impairment charges on deferred acquisition costs, refinement of GAAP reserving practices for variable annuity guarantees, spread compression and pension liability charges. GAAP results are the key driver of financial flexibility since capital providers typically focus on these measures.
An industry that was touting its excess capital, share repurchase programs and acquisition opportunities just a few years ago, has shifted its focus to capital preservation. As a result, Fitch expects companies to continue pursuing capital-enhancing strategies such as financial reinsurance, closed block securitizations, selling undervalued assets, divesting noncore businesses, exiting investments with high capital charges and issuing equity-like securities.
Move To/From Offense/Defense. The adverse markets put most companies back on their heels. Fitch expects some of the large companies to take a more offensive stance. These are companies that played defense, while many of the niche-product providers were aggressive in the late 1990s. Now they sense the opportunity to use their balance sheet to gain an advantage over competitors. This may be manifested by some companies starting to offer aggressive product features on VAs for the first time as well as pursuing acquisitions.
Other companies will play defense while they rebuild capital and wait for the environment to settle down. This includes large diversified companies as well as smaller niche companies. These companies may be more willing to put themselves up for sale than they would have been just a few years ago.
Julie A. Burke is a managing director in Fitch Ratings North American Insurance Rating Group, Chicago, Ill. She can be reached via e-mail at firstname.lastname@example.org.
Reproduced from National Underwriter Life & Health/Financial Services Edition, August 18, 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.