Lower ratings could result in securities being sold at a loss, higher capital charges and “material declines” in RBC ratios.

U.S. life insurers are more exposed to corporate credit risk than they were before the 2007–2009 financial crisis. And that makes them more vulnerable to a downgrading of their credit ratings if credit markets and the economy take a turn for the worse.

The source of this analysis: Fitch Ratings. A special report of the credit ratings agency, “U.S. Life: Growing Exposure to Corporate Bond Migration,” warns that U.S. life insurers’ credit ratings could be revised downward in a future recession because the carriers’ assets enjoy “lower credit quality and lower liquidity characteristics” than they did before the 2007-2009 downturn.

Lower ratings could result in securities being sold at a loss, higher charges to capital (in recognition of the loss) and “material declines” in ratios of the carriers’ risk-based capital or RBC — a 1990s-era regulatory regime instituted by the National Association of Insurance Commissioners (NAIC) limiting the amount of risk the insurers can absorb.

Why are the carriers’ ratings more vulnerable?

The Fitch report cites a shift by the carriers between 2007 and 2014 to corporate securities from poorer-performing structured securities (pre-packaged securities based on derivatives). Over the same seven-year period, the insurers increased their capital exposure to higher-risk corporate bonds.

The most notable shift is from the National Association of Insurance Commissioners’ NAIC 1 investment-grade category (AAA- to A-rated corporate bonds) to the NAIC 2 category (‘BBB’). The NAIC 1 allocation fell to 53 percent at year-end 2014 from 64 percent of corporate bonds at year-end 2007.

During the seven-year period, the NAIC 2 category allocation increased to 39 percent from 29 percent. That ratcheted up the insurers’ capital exposure to BBB securities to 170 percent from 120 percent.

In tandem with these shifts in corporate bond credit quality, the Fitch report notes, U.S. life insurers also modestly increased holdings of private placement securities relative to publicly traded bonds (rising to 34 percent in 2014 from 33 percent in 2007); and increased their exposure to statutory capital (to 147 percent from 135 percent over the seven-year period.)

These changes, the report notes, lowered liquidity of the insurers’ corporate bond portfolio. Meanwhile, the quality of the carriers’ stated regulatory capital also dipped because:

1. Regulators allowed the companies to make permanent “deviations” from statutory accounting principles; and

2. capital management strategies spearheaded by the carriers (e.g., in respect to reinsurance, securitizations and reserve financing) “materially altered” their financial statements.

The result was a heightened exposure to corporate securities, as well as lower credit quality and liquidity, than the insurers had before the 2007-2009 economic downturn.

“Relative to reported statutory capital, the quality and liquidity of the corporate bond portfolio has deteriorated,” the report states. “And this deterioration is further compounded by reduced quality of capital in the industry.”