The Perfect Storm Relented In 2003
Industry buoyed by significant turnaround in the macro environment

By Julie A. Burke

The U.S. life insurance industry has emerged from the most difficult macro environment in recent history. Fitch Ratings and others have referred to the confluence of negative events that affected the industry in the 2001 to 2002 period as “the perfect storm.” In 2003, the storm relented.

The significant turnaround in the environment and in sentiment flowed through to the industrys financial results. These swings in financial results highlight the increasing correlation of industry results to the financial markets as the industry continues to shift toward products that are primarily spread-based and/or equity-based, and away from traditional underwriting risks.

2003 Results

When looking back at 2003 results, key industrywide conclusions are as follows:

Capital levels and NAIC risk-based capital (RBC) ratio increased materially.

RBC ratio has been remarkably volatile over the past 2 years.

RBC levels have peaked for the industry and will migrate downward in the near future.

Operating results are increasingly influenced by equity market.

Realized capital losses moderated.

Bond durations were actively managed.

In 2003, total adjusted capital (TAC) rose 13% to a record level of $213 billion for Fitchs universe. This recovery came after several years of declining or flat capital levels. The previous high at the end of a year was $190 billion in 2000. The macro environment that followed in 2001 and 2002 was dominated by terrorism, economic recession, declining stock markets, rising corporate defaults and a crisis in investor confidence from corporate fraud and other malfeasance. In 2003, the environment changed for the better.

With the material growth in TAC, it is not surprising that the industrys RBC level increased as well. Fitch estimates that RBC improved from 320% at year-end 2002 to 352% at year-end 2003. Fitch believes this level will be the high-water mark for the industry. While many companies target 300% over the long term to meet return hurdles, they were willing to allow capital to run up in 2003 with the difficult market environment fresh in everyones memory.

Another reason Fitch believes RBC levels will migrate downward is the higher capital required from pending changes in the formula. The NAIC is currently revamping the way variable product risk is calculated in its RBC formula. This change is expected to increase required capital for variable annuities with embedded guarantees. Fitch believes this change is long overdue. While VAs began as a low-risk product with minimal death benefit guarantees, most offerings have morphed into higher risk liabilities with enhanced death benefits and living benefits.

In 2003, statutory net gain from operations improved 38% to $24 billion for Fitchs universe. Earnings were aided by the favorable effect of rising equity markets on minimum death benefit reserve levels and fee income. The strong equity market performance in 2003 is illustrated by the following common indices: Dow Jones Industrial Average increased 25%; the S&P 500 rose 26%; and the NASDAQ composite skyrocketed 50%. Other favorable contributors to operating profitability were higher amortization of interest maintenance reserve (IMR), increased expense efficiencies and generally favorable mortality.

Somewhat offsetting the favorable earnings items, was continued spread compression from the low interest rate environment. Investment yield declined from 6.45% in 2002 to 6% in 2003 as higher yielding bonds matured, prepaid or were sold, and proceeds were reinvested at lower market rates. At the same time, the ability to reduce crediting rates on a dollar-for-dollar basis is limited by guaranteed minimum rates as well as market dynamics.

Fitch estimates that realized capital losses were $3 billion in 2003, down significantly from $12 billion in 2002. A disproportionate amount of the 2003 losses were concentrated in the first quarter as the poor 2002 environment spilled over into early in the year impairment recognition. The better realized loss experience in 2003 was due to significantly improved bond market fundamentals. Fitch expects continued improvement in 2004 and 2005.

In 2003, IMR balance increased 40% to $12 billion for Fitchs universe. This result is surprising given the significant drop in credit impairments. Net realized losses were lower so companies had less incentive to “hide” losses on a GAAP basis by taking interest rate related gains. Fitch believes that many companies actively managed their bond durations during 2003. Some insurers shortened their bond portfolio duration in anticipation of rising interest rates. Other companies lengthened their duration to help offset spread compression. Therefore, the rationale was not to generate gains to hide losses but to increase liquidity to invest in an expected rising rate environment or to go out on the yield curve in search of higher yields today.

Industry Outlook

Fitchs Rating Outlook for the North American life insurance industry is Stable looking over the next 12-18 months. The stable rating outlook includes an assumption of continued consolidation activity in 2004 and beyond. As life insurance consolidation typically results in stronger companies buying their weaker brethren, transactional upgrades are expected. Over time, Fitch believes more and more of the business written by the industry will flow to companies with strong financial flexibility and large balance sheets to absorb emerging risks.

Without consolidation, Fitch believes downgrades will continue to outpace upgrades over the 12-18 month rating outlook period. The 2 core drivers continue to be intense competitive pressures and changes in product mix. Even with better economic and capital market environments, Fitch believes these long-term negative fundamentals will not go away and expects continued downgrades related to these long-term trends.

Emerging Challenges

The challenging markets of recent years have led insurance and annuity buyers to demand products with nontraditional guarantees. Many insurers are providing these guarantees to maintain competition positioning. Hence, product complexity has grown and company results will be increasingly influenced by policyholder behavior. There is a growing list of product features in which policyholder behavior is a key component of product performance. Examples of such features include asset allocation, withdrawal and annuitization assumptions on VAs, and lapse assumptions on long dated term life insurance and no-lapse guaranteed universal life products.

Often, assumptions about policyholder behavior in new products are more of a guessing game given the limited historical data available. The industry has a propensity with new products to underestimate adverse policyholder behavior. Recent examples include higher than expected claims in individual disability income insurance, lower than expected lapses on long term care insurance and higher than expected claims in workers compensation carve-out business.

Going forward, Fitch is concerned with the industrys competitive rush to write nontraditional guarantees into products. The “hottest” life product in the market today is universal life insurance with “no-lapse” guarantees. These secondary guarantees create both a pricing and reserving risk. Specifically, certain product designs may limit an insurers ability to adjust interest crediting rates and cost of insurance to maintain profitability. Pricing assumptions appear to have excessive lapse assumptions, aggressive mortality underwriting and higher implied crediting rates than may be warranted. Obviously, this pricing environment can create significant risk if these assumptions do not hold.

In addition, there is capital and surplus risk not reflected in current statutory statements. New statutory reserving requirements (Regulations XXX and AXXX) can be quite onerous and create surplus strain 5 to 10 years after issuanceFitch estimates that additional industry surplus to the tune of $50 billion to $100 billion will be required. Life insurers are pursuing a number of alternatives to control this surplus strain such as: utilizing existing financial reinsurance contracts, contemplating securitization options, and creating offshore subsidiary reinsurers. Fitch believes these activities require scale and will further the momentum toward industry consolidation.

Julie Burke, CPA, CFA, is a Managing Director in Fitchs North American Insurance Group. She can be reached via e-mail at Julie.Burke@fitchratings.com.


Reproduced from National Underwriter Edition, August 12, 2004. Copyright 2004 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.