Favorable Financial Markets Buoyed Industry Results

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.