Strong asset valuations, an expected gradual rise in interest rates and continuing economic gains will underpin a stable outlook for U.S. life insurers in 2015, according to new report from Moody’s Investors Service.

A November brief from the credit rating agency forecasts that an improving macroeconomic environment will help fuel increases in the insurers’ revenues and earnings for over the next 12 to 18 months.

“With few significant threats to the U.S. economy, we believe there is little to impede life insurers’ ongoing financial improvement in the coming quarters,” the report states. Contributing to Moody’s stable outlook are these factors:

A continuing strong equity market that supports the health of legacy variable annuity (VA) blocks and fee-based income

U.S. equity market levels ranging from 15 percent to 30-plus percent above pre-financial crisis levels will boost the performance of legacy VA blocks, reducing a primary drag on the industry’s earnings recovery. AUM-driven fee businesses (e.g., pensions, mutual funds, institutional asset management business) will also continue to see improving profits.

The report cautions, however, that “a prolonged market correction” that reverses VA gains, or a continuation of depressed interest rates, could prompt Moody’s to change its outlook to negative.

Product redesign and re-pricing that improves the risk/profit profile of new business

Such improvements may encompass VAs features like volatility control funds that shift equity and hedging risks to policyholders; or “no-lapse” universal life (UL) insurance products that continue to be re-priced for lower interest rates.

“Strong pricing and product discipline will improve the industry’s liability profile as new sales replace maturing business over time,” the report states.

Rising interest rates in 2015 and beyond that gradually improve interest-sensitive earnings

Moody’s expects that monetary tightening by the Federal Reserve next year will boost interest rates, thereby easing spread compression on products like fixed annuities and universal life solutions. Higher rates will also reduce earnings pressure on certain long-term care products, while halting and/or reversing the slow decline in net investment yields.

The strong equity market and an improving U.S. employment outlook will “create incremental wealth” for U.S. households. Discretionary life insurance purchases, Moody’s believes, will increase demand for life insurance and annuity products. Wealth gains will also be reflected in higher contributions to 401(k) and other pension plans.

In tandem with higher earnings, consumers will also allocate more of their money to new fixed products, including fixed annuities. Individuals will also put more into their pension plans, increasing assets and fees for insurers.

On 10 November, the S&P 500 Index hit a record 2038.26, surpassing the previous 2000-plus record set in September. Continuing market gains over the last five years, Moody’s states, have contributed to life insurers’ earnings recovery, notably via their equity-sensitive and fee-based businesses. The gains contrast, however, with a “gradual decline of spread-based earnings” in the current low interest rate environment.

“Although recent global growth jitters have generated higher price volatility in October and November, we expect US equity market prices to continue to progress in 2015, albeit at a slowing pace, providing healthy fee-based income again in 2015,” Moody’s states. “However, VA hedge ‘noise’ — from derivative-based accounting mismatches, hedge inefficiency, etc. — will keep earnings, as well as VA reserves and regulatory capital, volatile.”

The Moody’s brief indicates that equity-sensitive and AUM-driven fee-based businesses have been a small proportion of revenue: 4 percent of statutory revenues in 2013 and through the first half of 2014. They have, however, been a growing source of industry revenues and earnings.

Moody’s expects this trend to continue next year, reflecting the industry’s greater focus on less capital-intensive products. Exhibits 2 and 3 below show the growth of statutory fee income and the composition of industry statutory revenues, respectively.

In response to continuing improvement of the nation’s economy — as reflected in reduced unemployment, low inflation and rising gross domestic product — the Fed discontinued its bond-buying program on October 31. During a September meeting, a majority of Federal Reserve Open Market Committee members cautiously agreed that 2015 would be the “appropriate timing of policy-firming.” Translation: a short-term federal funds rate rising in tandem with the continuing economic recovery.

Exhibit 4 below show interest rates for U.S. Treasury notes over a 60-year period. Exhibit 5 forecasts a continuing, steady rise in interest rates for these notes through 2018.

“With so much of life insurers’ business sensitive to interest rate fluctuations — from investments and liabilities, to insurance products and sales — next year’s expected gradual rise in interest rates cannot come soon enough,” the report states. “A gentle rise in interest rates next year means life insurers will be able to offer incrementally higher crediting rates (and/or increase their crediting rate margins) as yields on new investments rise. This will help them manage the persistency on in-force policies, while also attracting new sales.”

Moody’s cautions that the rising stock market valuations and improved employment picture of recent months have to be weighed against historically low economic growth numbers. GDP is expected to top out 2.2 percent and 3 percent, respectively, in 2014 and 2015. These growth rates will nonetheless be sufficient to bring unemployment down to below 6 percent next year. (See exhibits 6 and 7).

“Although there are some downside risks, none is significant enough to likely knock continuing favorable economic developments off their track in the US,” the report states. “Nonetheless, the sources of risk are the following: (1) a sharper, more protracted economic downturn in China than expected, due to a steeper downturn in the property sector than assumed (the global economy would be affected by trading ties and a loss of confidence for investors); and (2) a broad-based market correction, triggered by concerns over a rise in interest rates in the US, causing sharp global market volatility that results in a loss in household and economic wealth.

“However, only a sharp, prolonged, and widespread market correction, with significant losses for banks, would have a visible effect on the global economy,” Moody’s adds.