Turnaround in the bond and equity markets drove improvements

The financial profile of the U.S. life insurance industry showed further improvement in 2004, building on the momentum established in 2003. The primary factors driving the improvement in industry balance sheet fundamentals and earnings performance over the past two years have been the turnaround in the bond and equity markets, and slowly rising interest rates.

Swings in the industry’s financial profile highlight the increasing correlation of industry results to the financial markets as product mix shifts increasingly to spread-based and equity-based risks.

In recent years, the industry has demonstrated a tendency to compete more on price and structure to generate increasing levels of sales and assets under management. Fitch Ratings believes that very few companies possess sustainable competitive advantages that allow them to achieve above-average growth rates without making compromises that ultimately add risks to the company’s profile.

2004 Results

The U.S. life insurance industry reported favorable trends in a number of key financial areas in 2004. Here are some of the highlights:

Improved Asset Quality…

Investment in bonds continues to represent the largest asset class for U.S. life insurers, accounting for 77% of cash and invested assets in 2004 for Fitch’s universe of U.S. life insurers (also referred to as “the industry”). The performance of the bond market is a key driver of industry earnings performance and capital formation rate. The U.S. corporate bond market had a strong year in 2004.

According to a recent study by Fitch, the par value of U.S. high yield bond defaults totaled just $10 billion in 2004, less than one-third of 2003′s $33.8 billion and far less than 2002′s record $109.8 billion. Accordingly, the default rate declined to 1.5% in 2004 compared with 5% and 16.4% in 2003 and 2002, respectively. The default rate in 2004 was the lowest since 1997. Lower default levels in 2004 benefited from a robust domestic economy, improving corporate fundamentals and a market eager to extend credit to one and all, even companies on the lowest rung of the rating ladder.

For U.S. life insurers, the improvement in the bond market led to improved investment results and a higher quality portfolio. The industry reported realized net capital gains of $0.2 billion in 2004 following realized net capital losses of $4.2 billion and $13.9 billion in 2003 and 2002, respectively.

The industry’s exposure to below-investment-grade (BIG) bonds declined by 11% in absolute terms in 2004 and represented 53% of total adjusted capital compared with 65% in 2003. Further, the industry’s exposure to NAIC 5 (Lower Quality) and NAIC 6 (In or Near Default) bonds declined to 11.7% from 14.4% of total BIG bonds.

Fitch believes macroeconomic and credit conditions will continue to support below-average default rates in 2005, which should lead to favorable investment results and further improvement in the credit quality of life insurers’ bond portfolios. In the first quarter of 2005, U.S. life insurers reported net realized capital gains of $0.4 billion.

Mortgage loans represent the second-largest asset class for the industry (6% of total cash and invested assets in 2004). Mortgage loans consist primarily of commercial mortgage loans on real estate. The industry continued to report very favorable default experience in 2004. The industry’s exposure to troubled real estate-related investments declined 11% in absolute terms in 2004 and represented a modest 0.7% of total adjusted capital compared with 0.9% in 2003.

While Fitch’s near-term outlook for the commercial mortgage loan market is good, Fitch is starting to see some weakness in the office sector and does not believe that the current low level of defaults is sustainable.

…But Lower Net Investment Yields

The low interest rate environment is a double-edged sword to insurance company investment portfolios, bringing improved market valuation of most fixed-income investments but lower investment yields due to lower new money rates.

Lower new money rates were negatively affected in 2004 due to the general low interest rate environment, some flattening of the yield curve and tighter credit spreads. Fitch estimates that the net investment yield for the industry declined to 5.9% in 2004 compared with 6.1% in 2003.

This continues to be a very challenging interest rate environment for U.S. life insurers selling spread-based products. Fitch believes that the best-case scenario is a gradual increase in interest rates and credit spreads, and a steeper yield curve. Fitch is most concerned about the impact of a rapid rise in interest rates, which would lead to increased disintermediation and lower market valuations on bonds.

Earnings Rebound Continues

In 2004, statutory net gain from operations improved 8.5% to $30.5 billion for Fitch’s universe of companies. Similar to 2003, statutory earnings benefited from the favorable effect of rising equity markets on variable annuity death benefit reserves and fee income. Results in 2004 also reflected better-than-expected morbidity results, stable mortality experience and improved expense management due to increased management focus, greater scale and progress on recent acquisition integrations.

Industry earnings continue to benefit from favorable life reinsurance arrangements established in the late 1990s, which have allowed direct writers the opportunity to effectively “lock-in” pricing assumptions and a future earning stream.

Industry statutory results in 2004 were affected by reduced net investment yields, which pressured interest margins and earnings on spread-based products such as fixed annuities. The industry’s ability to lower crediting rates in line with the reduction in net investment yields on a dollar-for-dollar basis is limited by guaranteed minimum rates and competitive pressures. Most of the industry’s in-force fixed annuity reserves carry a minimum crediting rate guarantee of 3% or more. Continued low interest rates over an extended period also will cause problems for universal life products with no-lapse guarantees.

Statutory Capitalization Very Strong

Total adjusted capital (TAC) increased 10.5% to $227 billion in 2004 for the industry. The increase represents the second year of recovery in TAC after several years of declining or flat capital levels. Fitch estimates that the industry NAIC risk-based capital (RBC) ratio increased to 382% (of company action level) in 2004 compared to 352% in 2003.

Fitch believes that this level will be the high-water mark for industry RBC. While many companies target RBC at 300% over the long term to meet return hurdles, they were willing to allow capital to run up in 2003 and 2004 after coming out of a difficult environment in the 2000-2002 time period.

In addition, Fitch expects that RBC levels will migrate downward due to higher capital required for secondary guarantees on variable annuities (referred to as “C-3, Phase II”), which is expected to be implemented effective Dec. 31, 2005, using a phased-in approach.

Furthermore, new statutory reserving requirements (Regulation XXX and AXXX) can be quite onerous and create surplus strain 5-10 years after issuance–Fitch estimates that additional industry surplus to the tune of $50 billion to $100 billion will be required if mitigating actions are not taken. Fitch is aware that a number of life insurers are pursuing a number of alternatives to manage this surplus strain, including the use of various reinsurance and securitization solutions.

Industry Outlook

Fitch’s Rating Outlook for the North American life insurance industry is Stable looking out over the next 12-18 months. The Stable rating outlook includes an assumption of continued consolidation activity in 2005 and beyond. As life insurance consolidation typically results in strong companies buying their weaker brethren, transactional upgrades are expected to offset a limited number of downgrades due to fundamental pressures.

The life insurance business continues to be a fragmented industry. Over the next 5-10 years, Fitch expects significant consolidation of life insurance companies as more of the industry’s business will be concentrated in the large, strong and diversified players with competitive market positions and good financial flexibility. Smaller, less diversified companies must pursue a niche-oriented strategy or face being increasingly marginalized.

Industry consolidation reflects broad macro and industry trends that are increasing the importance of franchise, size, scale and diversification as a means of competitive advantage.

Key factors driving consolidation include the continued shift to scale-oriented, asset accumulation products, increased cost of regulatory and legal compliance, higher technology investment requirements, shrinking shelf space at large institutions, and the need for leverage with third-party service providers such as asset managers.

Without consolidation, Fitch believes that long-term negative rating trends will persist. The two core drivers continue to be intense competitive pressures and changes in product mix. Even with recent improvement in the economic and capital market environments, Fitch believes these long-term negative fundamentals will not go away. Fitch expects continued downgrades related to these long-term trends.

Fitch believes the North American life insurance industry remains strong. The average senior debt rating for Fitch’s universe is ‘A-’, which is high relative to other corporate issuers. The average insurer financial strength (IFS) rating is ‘AA-’ (very high). Key industry strengths include capitalization, asset quality and in-force block of stable liabilities.

Douglas L. Meyer is a Senior Director in Fitch Ratings’ North American Insurance Rating Group.