Fitch Ratings has changed its outlook for U.S. life insurers to ‘negative.’ This reflects the “significant deterioration” in the credit and equity markets and the expected impact of realized and unrealized investment losses on life insurers’ capital levels and profitability,” the Chicago-based firm says.

The industry downgrade from a ‘stable’ outlook also reflects “ongoing concern regarding the industry’s expanding equity market exposure driven by growth in variable annuities, market performance guarantees which can add significant volatility to financial performance and capital in a period of unstable market conditions.”

Fitch also says it is “concerned that liquidity pressures could develop if capital markets remain unstable and funding needs can not be met.”

The ‘negative’ change in outlook means that over the next 12-18 months, Fitch expects more downgrades than upgrades across the life insurance industry but cautions that it does not mean all or most insurers will be downgraded.

Rather, life insurers that have above average exposure to mortgage-related investments, below-investment grade bonds, variable annuities or products or businesses related to institutional funding such as guaranteed investment contracts will be more vulnerable to downgrades. Another trigger cited by Fitch is limited excess capital relative to prior rating expectations.

Fitch notes that in the first half of 2008, its universe of life insurers reported combined statutory net income of $2.2 billion compared to $28.6 billion for full-year 2007. Investment losses are expected to cause further deterioration of statutory earnings in the second half of 2008 and into 2009.

In addition, Fitch says it expects “the deterioration in industry statutory capital levels, which declined an estimated 4% in the first half of 2008, will accelerate in the second half. This will be heavily driven by greater recognition of unrealized investment losses as ‘other than temporary,’ prompting impairment-related write-downs. Fitch believes a number of life insurers have been slow to recognize investment impairments against statutory capital, and that such recognition will pick up markedly in the second half of 2008.