When Standard & Poor’s downgraded the U.S. sovereign credit rating on August 5, the move came as an unwelcome surprise for many–especially those federal legislators on whom the downgrade was largely blamed. Citing an inability to reach debt ceiling consensus, S&P downgraded the country’s sovereign credit rating for the first time, sending a spasm of disbelief throughout the world, especially given that the U.S. did not default on any payments, and federal government’s political bickering before raising the debt ceiling was seen by many analysts as hardball political negotiations without any real intent to send the country over a financial cliff.
But S&P then went a step further and subsequently downgraded the credit rating of certain mutual insurers from AAA to AA+, just one day after downgrading the U.S. credit rating from AAA to AA+.
Insurers whose ratings were downgraded to ‘AA+’ from ‘AAA’ on its long-term counterparty credit and financial strength included Knights of Columbus, New York Life, Northwestern Mutual, Teachers Insurance & Annuity Association of America (TIAA), and the United Services Automobile Association (USAA).
The outlooks on the ratings for all of these companies were changed to negative. Standard & Poor’s also said that it lowered the ratings on approximately $17 billion of securities issued by New York Life, Northwestern Mutual, TIAA, USAA, and their affiliates. The reason cited for the various downgrades was that these insurers had invested heavily in U.S. Treasuries and their business was heavily concentrated in the United States.
At the same time, Standard & Poor’s affirmed the ‘AA+’ ratings on the members of five other insurance groups–Assured Guaranty, Berkshire Hathaway, Guardian, Massachusetts Mutual, and Western & Southern–and revised the outlooks on ratings on these companies to negative from stable.
But What Does it Mean?
The fallout on life insurers from these downgrades, however, may turn out to be a tempest in the teapot, according to Jay Golonka, a partner at RSM McGladrey’s Kansas City, Mo. office. McGladrey is based in Bloomington, Minn. and provides accounting and consulting services for small and medium sized life insurance companies. Regulators and customers do not appear to be concerned that life insurers are being downgraded, even though the share prices of stock insurers are being affected by ratings-related market volatility, Golonka says. A greater concern is the depressed interest rate environment, which will continue to challenge insurers more than the S&P downgrade.
Low interest rates impact the profit margins of life insurers and it is interest rates that make life products attractive to customers. As an example, Golonka cited the industry’s current most attractive product–”living benefits” annuities, which offer a guaranteed return to investors.
Besides the limited negative impact of the downgrade, the downgrade itself could yield a positive unintended consequence. In early August, Jeff Schuman, a securities analyst at Hartford, Conn.-based Keefe, Bruyette & Woods reduced earnings estimates for 2012 on the group of insurance stocks his firm covers by an average of just one percent.
He sees the downgrade as “extremely modest” in relation to the stocks’ recent declines, mainly because the dramatic price correction in the share price of life insurance companies following downgrade-related market turbulence merely makes it cheaper for life companies to buy back their stock.
“This provides “a material offset for many companies” for their lower stock prices, Schuman said.
He noted that market volatility, problems in Europe and the fear of a double-dip recession have made stock life trades, on average, 6% below their levels of Oct. 1, 2010.
“This performance is despite the fact that the life insurers have posted three good earnings quarters in the interim, have continued to perform well on credit, have grown book values significantly, and are sitting on strong capital positions, which they are increasingly redeploying,” Schuman said.
Shrugging it Off
Schuman joined Citi, Sandler O’Neill and UBS in publishing investor’s notes which said that they believed the overall impact of a U.S. ratings downgrade would be modest on life insurers, in fact, the smallest of all compared to other financial services providers.
Citi, Sandler O’Neill and UBS all noted the decision of the NAIC to confirm its ratings on securities held by insurers.
In a statement by Susan Voss, NAIC president and Iowa insurance commissioner, the NAIC said that, “There is no impact on insurer investments in U.S. government and government-related securities from the actions recently taken by the rating agencies.
“Risk-based capital and asset valuation reserves are unaffected,” she said. “State insurance regulators and the NAIC will consider changes to our regulatory treatment if it becomes necessary in the future.”
In a separate statement, Dave Jones, California insurance commissioner, stated that the reason for S&P’s downgrade of some insurers is its policy that no insurer with significant investments in U.S. securities may have a rating higher than the rating of those securities.
“While an AAA rating is the highest possible rating, an AA+ rating is a very strong financial rating,” Jones said.
He said the new ratings have no impact on insurer investments in U.S. government and government-related securities and therefore no impact on insurers’ financial reporting of risk-based capital and asset valuation reserves.
“Further, S&P’s downgrade to AA+ has no impact on insurers’ claims-paying abilities,” Jones said. He added that the California Department of Insurance and other states’ insurance regulators would continue to exercise strong financial oversight and carefully monitor the financial condition of insurers.
Brad Wenger, president of the Association of California Life and Health Insurance Companies, said that Jones’ statement was clear and unequivocal.
“The promises life insurance companies make to consumers will be kept,” Wenger said. “Like every other segment of the U.S. economy, insurers are addressing serious economic challenges, but that’s nothing new for an industry that’s been around for hundreds of years.”
Wenger added that life insurers own $5 trillion in stocks, bonds, mortgages, real estate and assorted other investments, with $546 billion in California alone. The diversity of the industry’s assets will see them through the current economic doldrums as it did through multiple wars and depressions.
“This matter is unrelated to our financial strength and claims-paying ability which remain exceptionally strong,” A spokesman for TIAA-CREF said of the company’s downgrade. “We continue to be one of the highest-rated insurance companies in the United States.”
William Werfelman, a New York Life spokesman, said, “We disagree with S&P’s view that AAA rated insurers should be adjusted in lockstep with the U.S. Treasury.”
He said both Moody’s and Fitch “are of the opinion that financial institutions can have a higher rating than the federal government, and we agree with their assessment.”
Moreover, he said that, “Even with this action by S&P, New York Life still has the highest-possible rating from S&P of any financial institution, and remains one of only three life insurers with the highest ratings from all four major rating agencies.”
Citing the fact that insurers are state-regulated, Paul Newsome and Edward Shields of Sandler O’Neill Partners in Chicago said, “We do not think that the impact would be as bad for insurers as it might be for other financial services companies.”
In a statement consistent with the views of analysts, Andrew Kligerman of UBS said that the greatest immediate implications for the U.S. life group likely will be interest rate-related, given their sizable bond portfolios.
“An ensuing weaker economy and equity markets would clearly have negative implications for new sales and variable product earnings,” Kligerman said. “We are less concerned about liquidity and do not expect material capital implications for our U.S. life insurers because the same risk-based capital charge is applied to AAA, AA, and A rated securities under the present U.S. insurance statutory accounting regime.”
He noted that one recent action comes from MetLife, which indicated that it has both extended all near-term Treasury maturities past August and added several billion dollars of excess cash.
Colin Devine of Citi said that even if the value of Treasury securities held by insurers decline, Citi does not anticipate any forced selling of either their Treasury or agency investments.
“Japanese life insurers adapted to that country losing its “AAA” rating and continue to hold large levels of government bonds,” Devine said. “We see no reason why U.S. insurers won’t do so as well.”
In terms of interest rates, Devine notes that any increase in long-term yields would be positive with respect to both future investment income and liability valuations.
“It could also, in isolation, potentially be favorable for life insurer’s share valuations,” Devine said. Conversely, any decline in equity markets would intensify existing earnings pressures on variable annuity lines and could potentially lead to either higher benefit costs and/or accelerated amortization of deferred acquisition costs (DAC).
Shields, of Sandler O’Neill, said that, one area of “potential concern for life insurers involves “speculation” that the risk for life insurance companies lies with guaranteed investment certificates, separate accounts and other products that could require investments in AAA-rated securities.
“After doing some research and speaking with company representatives, we believe that neither investment-only GICs nor funding agreements (i.e., medium-term notes) typically have AAA investment requirements,” Shields said.
Officials of the other companies contended that the decisions were inappropriate, pointing out that Moody’s and Fitch have decided to maintain the AAA ratings of the five companies involved.
In a statement from the Supreme Knight, the Knights of Columbus said that, “Today’s action by S&P does not reflect in any way on the business operations or performance of the Knights of Columbus.”
The statement said that S&P’s action–as their statement indicates–was caused by the downgrade of the rating of the United States in response to this country’s debt crisis.
The Knights of Columbus insurance firm statement added that, according to S&P’s statement on the methodology for their decision, “the U.S. sovereign credit rating constrains the long-term ratings on these U.S. insurers.”
The statement added that, S&P’s latest release cites the “very strong financial profiles” and “favorable business profiles” of the Knights of Columbus and other insurers affected by their rating revision, the Supreme Knight said. “In addition, they cite the benefit the Knights of Columbus has from our ‘affinity relationships with our policyholders’.”
In its statement, Northwest Mutual said the S&P action was “is not unexpected,” and entirely due to S&P’s belief that financial firms like Northwestern Mutual cannot have better strength ratings than the U. S. government.
But, the statement said, “There has been no change in our financial fundamentals, and there still is no life insurance company that the rating agencies rate more highly than Northwestern Mutual.”
The statement added that, “the change in rating by S&P doesn’t alter our conviction that no life insurer is stronger than Northwestern Mutual or provides better long-term or product value. It doesn’t change the fact that we pay more dividends than any competitor.”
Moreover, the statement said, “Uncertain economic conditions continue to play to Northwestern Mutual’s greatest strengths. Consumers continue to focus on managing risk, dealing with financially strong companies and working with trusted advisors who can guide them through the emotion and uncertainty of the times.”