Industry Starting To Recover From The Stresses Of Last 3 Years
In 2003, the North American life insurance industry is recovering from the effects of an unprecedented confluence of environmental factors. These factors included the worst credit markets in more than a decade in both 2001 and 2002, a bear market for equities since early 2000, and the lowest interest rates in more than 40 years.
These factors swirled on top of fundamental negative trends that have existed in the life industry for several years. All of this has created the most challenging environment for life insurers in recent memory.
Fitchs Rating Outlook for the North American life insurance industry is Stable. The outlook was revised from Negative at the conclusion of a comprehensive review all life insurance company ratings in September 2002. The Stable rating outlook reflects Fitchs belief that downgrades from the continued slow and steady deterioration of the industrys credit fundamentals will be offset somewhat by upgrades related to consolidation.
Even with the above-mentioned slow and steady deterioration of long-term fundamentals, the credit quality of the industry remains very strong. The average insurer financial strength rating of Fitchs life insurance universe is AA-. The average senior debt rating is A-.
Core Challenges. Downgrades significantly have outnumbered upgrades for Fitchs life rating universe over the past several years. The two core drivers are intense competitive pressure from inside and outside the industry, and a shift in business mix away from traditional life insurance and other protection products to lower margin products such as variable annuities and mutual funds.
The manifestation of these two challenges has resulted in increased earnings volatility, stressed risk-adjusted profit margins, and henceforth declining sustainable earnings and capital growth rates. Fitch believes these long-term negative fundamentals will not dissipate in the near term.
Credit Environment is Improving. During the economic downturn, credit defaults soared and recovery rates plummeted. Fitchs high yield bond default index reached 16% in 2002, a 12-year high. Recovery rates were a weak 22% of par. The timing of this down credit cycle was inopportune as the industrys bond portfolio has trended toward moderately higher credit risk and lower liquidity over the past few years. This has resulted in the industry experiencing higher than expected realized losses and write downs.
In addition, exposure to below-investment-grade bonds has increased to approximately 8% of the bond portfolio as many corporate issuers have been downgraded from investment-grade rating levels. Even within the investment-grade portfolios, there has been downward migration in credit quality for many corporate and some structured finance issuers.
Through the first six months of 2003, Fitchs high yield default bond index fell to 6% annualized. This level is higher than historical averages but a significant improvement from the 2002 levels. Recovery rates improved 50% from 2002 levels to 33% of par. In addition, credit spreads have tightened materially throughout 2003. These factors will translate into improved investment performance for the life insurance industry in 2003.
Other Than Temporary ImpairmentsNot a Rating Issue. Fitch believes that some companies may be too liberal in their definition of other than temporary impairments (OTTI) of investments and that there are broad differences in OTTI standards used by the industry. As a result, Fitch performed a comprehensive "stress-test" analysis of year-end 10(k) disclosures and statutory statements to prospectively judge whether OTTI issues could cause write-downs in the future and the ability of capital to absorb such write-downs.
The stress test adjusted capital and RBC levels for all below-investment-grade securities that had impairments of greater than 20% for six months or more. Additional information was analyzed if an individual companys stress test resulted in a significant migration of capital levels outside of Fitchs current rating expectations.
Overall, very few companies fell materially outside of Fitchs expectations for capital levels with this rather punitive stress test. Therefore, Fitch concluded that the industry does not have a significant rating exposure to large bond write-downs in the pipeline as of year-end 2002. Since Dec. 31, the stress test results have improved due to the significant tightening of credit spreads.
Lowest Interest Rate Environment in 40+ Years. The low interest rate environment has caused profit spreads to narrow for fixed-product writers. Minimum crediting rate guarantees create a floor for what companies can pay to their customers. As the average portfolio yield falls due to declining interest rates, increased prepayments on residential mortgage-backed securities and lost investment income from defaulted bonds, the crediting rate cannot be adjusted to fully reflect the impact of these factors.
The industry is receiving regulatory relief on the 3% mandated minimum-crediting rate from the National Association of Insurance Commissioners and individual states. However, this relief only applies to new products sold and not for the large amount of in-force liabilities.
Another contributing factor to lower portfolio yield is companies selling higher coupon bonds at a gain and reinvesting proceeds in the current low rate environment. Companies have taken this action to mask credit losses on a GAAP basis. Fitch believes this strategy is short-sighted and not emblematic of strong credit fundamentals.
Strategies companies can employ to deal with spread compression include a reach for yield by investing in higher risk assets or increasing asset duration, reducing new premium targets and accepting lower profit margins for a period of time. Fitch expects these trends to continue as long as interest rates remain low. The best case scenario for the industry is for a slow, steady increase in interest rates.
If interest rates were to increase rapidly, then the industry would face significant challenges. Surrender activity would increase as customers trade out of their low yielding policies. Companies would be forced to liquidate bond investments at a loss to fund the surrender requests. The specific liability profile for each company would be a key determinate of how that company weathers a dangerous environment.