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.
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.