Industry Starting To Recover From The Stresses Of Last 3 Years

Equity Markets Looking Up. Historically, equity market performance has not had a major impact on life insurers, from an investment perspective, due to relatively low direct exposure to equity investments. This, however, has changed in recent years as the life industry shifted its business mix to equity-linked products like variable annuities, variable life insurance, equity-indexed annuities and mutual funds.

For companies writing these products, equity markets performance can drive sales mix and levels, fee income tied to assets under management, reserving for minimum death benefit/income guarantees, rate of DAC amortization, surrender activity and allocation of fund balances between the fixed-rate option and equity-linked subaccounts.

The S&P 500 index fell 23% in 2002 after declining 13% in 2001. The adverse environment placed considerable pressure on the industrys earnings and capital levels. Through July 31, 2003, the S&P 500 index rebounded 13% from year-end 2002.

While a sustained improvement in equity market performance would certainly lift some of the pressure on the life insurance industry, Fitch does not believe this would be a "cure all" for the industrys woes. Overall, the industry suffered more in the down market than it benefited in the up market. Competitive pressures and the need for scale with equity-linked products will preclude companies from significantly expanding profit margins and cutting back on some of the more aggressive product features in an improving market.

Consolidation Helps Offset Negative Fundamentals. The skittish capital markets have kept a lid on consolidation activity in the life insurance industry, as well as most sectors. Fitch believes this has been a temporary respite for an industry that requires additional consolidation.

The products sold today by the industry are scale-oriented products. Therefore, size is an increasingly important component of viability. Similarly, diversity of products and distribution is more valued in this difficult environment. Therefore, Fitch expects a material increase in acquisition activity in 2003 and beyond.

The likely form will include current life industry participants buying others of a smaller or equal size. Fitch expects some movement among the small to midsized mutual companies as these participants are challenged by diversification, technological needs and scale issues.

Fitch does not expect significant interest from European insurers in the near term. Those companies that have been most active in recent years–AEGON, AXA, ING and Fortis–are dealing with challenges in their domestic markets. Similarly, Fitch does not expect significant interest from banks. These institutions (with the notable exception of BankOne) have been happy to serve as distributors of insurance products and show little interest in manufacturing these products.

The expectation of increased consolidation activity is a critical component of Fitchs Stable Outlook for the North American life insurance industry. Generally, stronger companies buy their weaker brethren. This often leads to rating upgrades. Recent examples of this phenomenon include Prudentials purchase of American Skandia and Great Wests acquisition of Canada Life. This activity is expected to mitigate the continued negative fundamental operating trends in this business and downgrades that would otherwise result.

Capital Challenges Persist. Fitchs biggest long-term credit concern for the life insurance segment is its ability to grow capital on a sustained basis. In 2002, statutory capital and surplus declined approximately 3%. This decline stemmed primarily from corporate bond losses, reserving for guaranteed minimum death benefits and equity investment declines. Capital raising activity in the second half of 2002 helped stave off even larger declines from earlier in the year. This external capital raising momentum continued into 2003.

Compounding the decline in statutory capital levels is an increase in required capital. The shift back to fixed products and the shift within VAs from equity subaccounts to fixed subaccounts caused higher risk-based capital charges. Therefore, RBC ratios fell measurably in 2002. Fitch estimates the industry aggregate RBC fell from 341% at year-end 2001 to 307% at Sept. 30, 2002, before recovering to 320% by year-end 2002. This represents considerable volatility in risk-adjusted capital levels for the industry.

Capital growth on a GAAP basis has been pressured by acceleration and impairment charges on deferred acquisition costs, refinement of GAAP reserving practices for variable annuity guarantees, spread compression and pension liability charges. GAAP results are the key driver of financial flexibility since capital providers typically focus on these measures.

An industry that was touting its excess capital, share repurchase programs and acquisition opportunities just a few years ago, has shifted its focus to capital preservation. As a result, Fitch expects companies to continue pursuing capital-enhancing strategies such as financial reinsurance, closed block securitizations, selling undervalued assets, divesting noncore businesses, exiting investments with high capital charges and issuing equity-like securities.

Move To/From Offense/Defense. The adverse markets put most companies back on their heels. Fitch expects some of the large companies to take a more offensive stance. These are companies that played defense, while many of the niche-product providers were aggressive in the late 1990s. Now they sense the opportunity to use their balance sheet to gain an advantage over competitors. This may be manifested by some companies starting to offer aggressive product features on VAs for the first time as well as pursuing acquisitions.

Other companies will play defense while they rebuild capital and wait for the environment to settle down. This includes large diversified companies as well as smaller niche companies. These companies may be more willing to put themselves up for sale than they would have been just a few years ago.

Julie A. Burke is a managing director in Fitch Ratings North American Insurance Rating Group, Chicago, Ill. She can be reached via e-mail at [email protected].

Reproduced from National Underwriter Life & Health/Financial Services Edition, August 18, 2003. Copyright 2003 by The National Underwriter Company in the serial publication. All rights reserved.Copyright in this article as an independent work may be held by the author.