U.S. Life/Annuity Rating Outlook Stable

Bests: Economic indicators, along with equities in general, advance

At this time last year, a political stalemate with the potential for an unfavorable resolution of the fiscal cliff threatened to push the U.S. economy back into a recession. Fortunately, cooler heads prevailed, and for the next 11 to 12 months, economic indicators and the equity markets steadily advanced.

Considerable hiring over the August-November period reduced the U.S. unemployment rate to a five-year low of 7%, which is an encouraging sign that the U.S. economy has stabilized. The Dow Jones Industrial Average reached an all-time high at the end of 2013, up 26.5% from year-end 2012. Automobile and home sales are surging, manufacturing is gaining, and the trade deficit is narrowing. Also, gross domestic product (GDP) jumped 3.6% in the third quarter, which was much faster growth than originally reported.

As concerns wane regarding the potential impact of the U.S. economy on insurers, A.M. Best’s rating outlook for the life and annuity sector remains stable. This outlook reflects generally strong risk-adjusted capital, steady GAAP and statutory operating earnings, improved balance sheet fundamentals and enhanced risk-focused decision making by company management. A.M. Best notes that the benign credit environment, combined with significant derisking of life companies’ investment portfolios, has resulted in most insurers reporting relatively modest investment impairments in 2013. Meanwhile, they have maintained net unrealized gains in their fixed income portfolios with only minor pockets of  unrealized losses.

A.M. Best believes the industry has reduced its exposure to poorly underwritten structured securities (i.e., residential and commercial mortgagebacked securities) through sales and book-value adjustments, while at the same time limiting asset/liability mismatches and generally avoiding higher risk asset classes. By and large, life and annuity companies have been proactive in taking asset impairments
as strong capital positions – helped by favorable markets – made investment losses easier to absorb. A.M. Best also has seen life organizations continue to refine their investment strategies, often at the margin, as they seek additional yield.

Some of the strategies employed most recently to improve investment returns have been:

  • allocations to less liquid assets such as private placements, commercial mortgage loans and alternative assets (i.e., hedge funds, private equity, bank loans);
  • reducing turnover in the bond portfolio;
  • increased exposure to “bbb” category bonds as well as high-yield securities (to a much lesser degree); and
  •   lengthening maturities.

These actions, combined with higher new money rates compared with the early part of 2013, should help to mitigate the declining trend in portfolio yields. A.M. Best notes the impact of interest rates on public companies’ reported GAAP shareholders’ equity as of Sept. 30, 2013 as considerable unrealized gains evaporated.

Additionally, life insurance organizations continue to focus on optimizing core businesses and divesting noncore operations. A.M. Best has seen more companies employ a risk-focused approach – shifting to fee-based products, scaling back on secondary/nolapse guarantee universal life (SGUL) and variable annuities (VAs), and de-emphasizing or divesting capital-intensive business through reinsurance or outright sales. Although profitability and risk metrics for VAs have improved substantially through increased fees and benefit reductions for living benefit riders, as well as the use of managed risk funds, some of the larger players recently have controlled sales.

VA Market Opens Up

... the industry has reduced its exposure to poorly underwritten structured securities (i.e., residential and commercial mortgagebacked securities) through sales and book-value adjustments, while at the same time limiting asset/liability mismatches and generally avoiding higher risk asset classes

Together with some downsizing of wholesalers, these tactics appear to have opened the VA market for companies that wish to enhance their presence, as well as for counterparties (e.g., Wells Fargo) looking to add capacity. Nevertheless, the VA market appears to have reached a sort of equilibrium, as sales have remained fairly constant for the past several quarters despite the run-up in the equity markets, which historically has fostered VA sales.

Overall, companies are employing hedging strategies not only to manage the impact of volatile equity markets on capital and earnings, but to minimize the impact of material movements in interest rates. A.M. Best believes these strategies further demonstrate the universally recognized relevance of and focus on enterprise risk management frameworks. In general, life operating companies have maintained or improved risk-adjusted capitalization, even when adjusting for the capital benefit certain companies receive from using domestic and offshore captive structures.

A.M. Best looks through these structures when analyzing insurance enterprises on a consolidated basis, noting that the more prevalent use of these funding vehicles typically translates into higher regulatory
capital ratios but a lower overall quality of capital. Across the industry, new accounting rules for pensions and other post-retirement benefits also have impacted capital. A.M. Best notes that by funding pension plans to expectations of low interest rates, companies position themselves for potential benefits if rates increase. Certainly, companies that have taken significant charges to date have minimized future hits to capital.

A.M. Best recognizes substantial opportunities for U.S. life and annuity companies. Foreign organizations are shifting away from the United States in the face of enhanced capital requirements and a volatile accounting environment. As well, domestic organizations are looking to supplement growth by expanding internationally, both organically and through acquisition. As the United States is viewed as a fairly mature market for retirement, savings and protection products, overseas operations have higher potential for growth with greater margins, and they help to diversify sources of earnings.

In this mature U.S. market, ownership of life insurance is at a 50-year low, and for certain segments of the market (such as Generation X), the insurance gap is even wider. The insurance industry is well-positioned to address America’s unique demographics, namely the underserved middle market, the increasing numbers of baby boomers retiring, and the movement of financial responsibility from government and the private sector to individuals. Although this will be a challenge as producers are aging and ready to retire in record numbers, the consumer-driven economy with advanced technology may profoundly change how life insurance is sold.