The U.S. life insurance industry is overcapitalized, and that level of overcapitalization increased in 2006.

Such was the assessment given by Douglas Meyer, a managing director in Fitch Ratings’ Chicago office, during a teleconference focusing on the firm’s Prism capital model.

Fitch has incorporated the Prism model, which relies on stochastic forecasting techniques, into the rating process the firm uses both for life and property-casualty insurers.

Stochastic modeling involves use of computer simulations to determine how a product or company might perform under a wide range of randomly changing conditions.

The U.S. life industry ended 2006 with $253 billion in capital, or about $54 billion more than it needed to meet the Prism aggregate AAA rating standard, Meyer said.

At the end of 2005, the industry had $249 billion in capital, or about $45 billion more capital than it needed to meet the AAA standard, Meyer said.

The average Prism score for the U.S. life universe as a whole held steady in 2006 at AA+.

For the life insurance sector and large mutuals, the overall Prism rating was AAA.

The overall Prism rating was AA+ for the annuity sector, large stock companies, foreign-owned companies, and life and health companies.

The strong capitalization levels are not surprising, Meyer says, given the benign credit environment and strong stock market performance that prevailed in 2006.

The life industry’s capitalization was also helped by mutual life insurers that focus on whole life insurance products that require less capital, according to Meyer.

“Prism indicates that whole life insurance requires very little capital, often as little as 2% of reserves at the AA capital level threshold,” Fitch analysts write in a discussion of the results. “This in part is based on recognition that much of the product performance deviation can be passed to the policyholder via the dividend mechanism.”

Fitch is finding that the Prism capital model requires more capital for variable annuity products than required by the C3 Phase II approach that most regulators and insurers now use, Meyer said.

The Fitch model ends up requiring more capital for VA products because of differences in the way the Fitch model handles hedging and the weighting given to risk measurements, Meyer said.

During the call, Julie Burke, another Fitch managing director, said 2006 was a “banner year” for most insurance companies as measured by the Prism capital model.

Going forward, the stochastic model will be “an integral part of the ratings analysis, Burke said.

The development of the Prism model fits with European efforts to develop the Solvency II framework and U.S. efforts to shift to principles-based reserving, she said.