Grading Error

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.

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