U.S. life insurers saw revenue strengthen in 2006 as growth in premium and separate account asset-based fee income offset continued flat investment income.
Strong equity market performance and an unfavorable interest rate environment in 2006 accelerated the trend away from traditional fixed products in favor of variable products. Variable annuities with living benefit guarantees were the primary driver of growth, offsetting declines in fixed annuity sales.
Regulatory uncertainty continued to be a drag on equity indexed annuity sales.
Individual life sales also improved in 2006 with stronger growth in all product lines except universal life, which was relatively flat. Life settlements likely had a significant impact on 2006 sales, particularly in the UL line, although it is difficult to quantify.
U.S. life insurers’ statutory operating earnings declined modestly in 2006 due in part to statutory strain related to strong VA sales. Policyholder dividend payouts also increased slightly. The industry continues to manage operating expenses as indicated by the trend in the expense to asset ratio in the accompanying chart. Net income declined 5% despite improved realized investment gains, due primarily to higher tax payouts.
Tight spreads on fixed products continued, with the industry portfolio yield down again to 5.72 in 2006 from 5.77 in 2005. Insurers did little to discourage higher surrenders of individual fixed annuities and the roll-off of maturing group fixed annuities in 2006 and the first half of 2007. Five-year single premium annuities sold in 2001 and 2002 undoubtedly account for much of the activity on the individual side. Group annuities have been increasingly made up of medium-term notes, which insurers offer to institutional investors opportunistically when the investment climate allows them to do so profitably. That has not been the case in recent years, although widening credit spreads may change that in the second half of 2007.
The higher surrenders contributed to anemic growth of the industry’s overall invested or general account assets. They grew just 3% in 2006, not even keeping pace with the portfolio yield. The growth rate compared to a year-over-year increase of 4% in 2005 and 7% in 2004. Some large VA writers saw a slight decline in invested assets for the year. Separate account assets associated with variable products grew 17% in 2006, reflecting favorable equity markets and the popularity of VAs with living benefit guarantees. A number of large VA writers also reported that fee income was actually overtaking spread income as the primary driver of earnings. That trend continued in the first half of 2007, although it may reverse itself in the second half of 2007, as fixed income spreads were widening in the wake of recent turmoil in the credit markets.
Strong balance sheet fundamentals
The industry’s capital remains strong, with total adjusted capital (TAC) up 5% in 2006. Unrealized gains, increased paid-in capital and a modest reduction in stockholder dividends contributed. The industry’s year-end risk-adjusted capital ratio is estimated to be in the 400% range, flat with the prior year. Operating leverage, which measures general account liabilities in relation to total adjusted capital, declined slightly to 10.7 in 2006 from 10.8 in 2005.
There was little change in the mix of invested assets for the life industry in 2006. Companies continued to reduce their exposure to below-investment grade bonds during the year as they have over the past couple of years due, in part, to historically tight credit spreads. Below-investment grade bonds as a percentage of total adjusted capital was at its lowest level in 5 years at 41% at year-end 2006 compared to 63% in 2002. Insurers did seek yield in modestly increased allocations to alternative investments, including private equity and limited partnerships usually reported as Schedule BA assets. Schedule BA assets in relation to TAC was 26% at year-end compared to 23% in 2002. Strong performance of some of these assets has supported modest growth of investment income in recent years, although that may not be sustainable. Troubled real estate remained very low, at less than 1% of TAC.
If wider credit spreads continue in 2007, it could increase insurers’ appetite for taking on more investment risk, although it is also expected to result in an increase in unrealized losses.
Fitch expects variable annuities with living benefit guarantees to continue to drive revenue growth in 2007, although increased equity market volatility in the second half of the year could weaken separate account asset growth and associated fee income. Fixed product spreads for new business are likely to improve, although they will remain a challenge for in-force blocks of business with higher minimum rate guarantees. Life sales could slow again in 2007 as the industry takes a cautious approach toward the types of life settlement business it puts on the books.
Cynthia Crosson is director in the insurance group, Fitch Ratings, New York. She can be reached via e-mail at .