Results Still Strong through Nine Months, but Trouble on the Horizon?
(Nine Month 2007 Life Industry Review — 12/4/2007)
A BISM Online contribution from ALIRT Insurance Research, LLC

David Paul and Dan Hausmann are principals of ALIRT Insurance Research, Inc., a Windsor,CT based research firm offering customized credit analytics and competitive intelligence on insurance carriers and the broad insurance industry.

The subprime residential mortgage lending business remained a topic of interest through the second half of 2007. Delinquencies and defaults continue to rise, and a large block of loans with adjustable rates have yet to reach their rate re-set dates, and thus absent special action by government, lenders, and/or investors, many homeowners not presently in default may reach that point in 2008 or 2009.

Ultimately, direct losses from such securities are expected to be manageable for most insurers, though some individual companies may incur larger losses in aggregate or on a relative basis depending on the specific mix of such securities¹. A larger impact could result, however, if subprime woes lead to equity market and/or economic dislocation (a significant contraction in liquidity and available credit has already occurred), which could end the relatively benign operating and investment environment experienced by the insurers for the last several years.

On a more positive note, the life industry meets this issue with its financial house in relatively good order, and any negative effects on insurer financials were muted through the first nine months of 2007. Financial results for the ALIRT Life Industry Composite, which is comprised of the 98² largest U.S. life insurers (ranked by general account invested assets), through September 30, 2007 are detailed in this review.

Highlights for the ALIRT Life Composite in 2007 (through September 30) are as follows:

• Total surplus rose 1.4% in the third quarter, rounding out a 6.0% increase for the first nine months of 2007. The pure capital ratio rose to 11.3%, the highest level in over six years. Solid operating earnings and still sizeable net capital gains exceeded shareholder dividends paid to parent companies in the first nine months of 2007.
• After-tax statutory returns on equity and assets remained below the near-term peak established in 2004, but improved somewhat in the first nine months of 2007 and are still relatively strong by historical standards.
• Premium growth rates eased in the first nine months of 2007, continuing a trend of rising in even-numbered years and falling in odd-numbered years. Sustainable premium growth remains a challenge for the industry and for most companies, despite considerable pressure from insurer management, analysts, rating agencies, parent companies, etc. to improve the top-line.
• Investment returns deteriorated modestly in the first nine months of 2007 from full year 2006 levels, and yield remains depressed by the extended low interest rate environment.
• Investment risks remain manageable, as mortgage loans are only slightly higher than a recently established 15-year low, and bond quality remains high. However, insurers continued to add to schedule BA assets (joint ventures, private equity, hedge funds, limited partnerships, etc.) in recent years, though they still remain relatively small in aggregate.

Capital and Surplus

The third quarter of 2007 was another strong quarter for surplus generation, as equity markets were up through 9/30/07, investment losses remained low, and earnings were close to levels reported over the last few years. Surplus rose 1.4% in the quarter, reaching $282.3 billion, which brought the nine month 2007 increase to 6.0% (8.1% annualized). Surplus growth was made possible by statutory earnings of $21.6 billion and net capital gains of $6.2 billion, which exceeded $13.5 billion of shareholder dividends and capital returned to parent companies.

Aggregate surplus growth for the ALIRT Life Composite over the last fifteen years, shown below, is now more closely linked with equity markets, as net capital gains are boosted when equity markets rise. Also, earnings benefit in bull markets, as insurer fees tied to variable annuities increase, as they are often a fixed percentage of variable annuity account values.

For the first nine months of 2007, surplus increased for 73 of the 98 ALIRT Life Composite insurers. Operating earnings and capital gains were the primary contributors to the higher surplus, as only six companies received capital infusions exceeding $100 million in 2007 (through 9/30).

For the 25 composite insurers that incurred a decline in surplus in the first nine months of 2007, the causes of the reduced surplus were (a company can have more than one cause): Shareholder dividends paid (18 insurers); Operating losses (8); Net capital losses (15); and Other items (20). In total, 35 of the 98 composite insurers incurred capital losses in the first nine months of 2007, up from 20 companies as of 6/30/07.

Overall, the composite insurers paid $13.5 billion of shareholder dividends (and negative surplus paid-in) in the first nine months of 2007, a reduction from the level of dividends paid in both 2005 and 2006. Fifteen of the composite insurers paid shareholder dividends exceeding $400 million in the first nine months of 2007, led by health insurers United Healthcare ($1.5 billion) and Aetna Life ($994 million), as well American Family Life of Georgia ($810 million), Riversource Life ($800 million), Lincoln National Life ($761 million), and SunAmerica Life ($700 million). Prudential Insurance Company of America also paid out $1.3 billion of capital to its parent, most of it accounted for as negative surplus paid-in.

The 6.0% increase in total surplus for the ALIRT Life Composite in the first nine months of 2007 exceeded a 3.2% rise in general account assets, and as a result, the ALIRT Life Composite pure capital ratio (total surplus as a percent of invested assets) edged higher to 11.3% at 9/30/07, the highest level in over six years.

The second graph on the following page exhibits the ALIRT Life Composite pure capital ratio for the last several years, exhibiting not only the significant gains in capitalization over the last five years, but also the industry capital erosion from the equity bear market and higher corporate bond defaults of 2000-2002. Therefore, if the operating environment (which was benign over the last several years) deteriorates, history shows that industry capitalization can decline relatively quickly.

Based upon findings in our recent "Update of Subprime Mortgage Related Losses for Select U.S. Insurers: As of Nine Month 2007 GAAP Reporting", life insurance company exposure to subprime residential mortgage-backed securities and related collateralized debt obligations (CDOs) appears to be manageable for most all individual companies. However, some lost investment income or capital losses are likely for many insurers, and these amounts may become greater in the fourth quarter 2007 and into 2008, depending on the pace of subprime homeowner defaults, rating agency downgrades of securities, and the exact composition of an insurer’s portfolio.

There is still a large volume of subprime mortgages that have yet to fully season, and thus the full impact of this issue is not likely to completely work through until the end of 2008 or the first part of 2009. Any further economic erosion could negatively impact life insurer premium volume, investment income, operating earnings, capital losses, investment returns, and capitalization.

Also, the substantial increase in stock market volatility already observed this year has boosted the cost of equity market derivative instruments (calls, floors, futures, etc.). As these instruments are often critical to the risk mitigation efforts for variable and indexed annuities, those insurers with variable and indexed annuities may experience reduced profit margins, even if markets in aggregate do not move lower for a protracted period of time.

For more detail on life insurers’ variable business, please see our two October 2007 reviews, entitled "Variable Products an Important Business Line, but. . . It’s Variable: Review of U.S. Life Insurer Separate Accounts", and "Embedded Variable Annuity Guarantees: Not Necessarily Secondary for Insurer Risk Management".

For the third quarter 2007, equity market indices posted nice increases despite a considerable increase in volatility (see table below). The higher equity markets in the third quarter led to an increase in industry separate account assets, which may boost insurer account management fees. However, the sharp rise in equity market volatility has boosted the cost of the derivative instruments that are used by many variable annuity writers to hedge the risk of their secondary guarantees (see S&P VIX Index history below). As such, the profitability of variable business is likely to have deteriorated somewhat in the third quarter as compared to the previous few years when equity market volatility was low. This could be especially pronounced for those insurers that priced their secondary guarantees based upon the low market volatility experienced in 2003-2007, especially if those insurers do not have some flexibility to increase the cost of the rider for existing business to reflect higher hedge costs.

For the fourth quarter 2007, the sharply lower equity markets and even higher equity market volatility may put increased pressure on profitability, due to the likely decline in account values and insurer fees, higher required general account reserves as some secondary benefits come increasingly "into the money", and higher cost for derivatives used in insurer risk management for such products.

Premium Growth (Includes Fixed and Variable Premiums, plus Deposit Funds)

Premium growth remains one of the principal challenges facing the life insurance industry, as the mature state of the industry, relatively low demand for traditional life insurance, and a high level of competition all serve as drags on aggregate premium growth.

However, revenue and earnings growth are heavily emphasized by stockholders, analysts, rating agencies, managements, etc. As a result, some companies could feel pressure to take higher risks to generate growth in premiums and earnings, which could take the form of increased product risks (more generous product design and/or crediting rates, higher distributor compensation, etc.), and/or increased investment risks. The continued capital generation of the industry from solid earnings has increased this pressure, at least incrementally. However, consolidation and sizeable capital paid out of insurers in recent years removed some capital from the industry, while higher reserve requirements and the increased cost/reduced availability of reinsurance has boosted capital requirements for direct writers, but at the cost of reduced profitability.

The graphs below show the annual change in total direct and net premiums written and the annual change in direct premiums written by business line. The individual annuity line, the current business focus for many insurers, shows the highest volatility of any of the major business lines, with volume up sharply in 2002, but premiums actually declined for the line in 2003 and 2005. Annuity premium growth rates picked up in 2006 and remained strong in 2007 (through nine months), as variable annuity sales were boosted by the introduction and subsequent consumer/distributor acceptance of some of the new secondary guarantees.

New sales for fixed annuity sales are weak, reflecting low crediting rates relative to alternative investments, and a five-year bull market in equities (through autumn 2007). In addition, the large block of fixed annuities sold in 2001-2003 is at or nearing the end of surrender charge periods. With the product relatively unattractive compared to similar investments, many of these annuities could leave insurers once their surrender charge period is over. Annuity and surrender benefits paid rose 20% in 2006 to $283 billion, and the peak year for fixed annuity sales was 2002, so surrenders may increase again in 2007, before perhaps easing somewhat in 2008. Annuity and surrender benefits totaled $228 billion in the first nine months of 2007 (an 8.2% year-over-year increase).

Individual life sales growth was generally weak for the last few years, one of the principal factors in the industry’s heavy focus on the annuity business. Group life and group health (mostly non-medical lines for the life composite insurers) lines posted significant percentage growth over the last few years, and this trend continued in the first nine months of 2007. However, sales for these types of products are often sensitive to economic conditions, and thus if the economy weakens, sales for group life and group non-medical health products could deteriorate.

Asset Growth

General account asset growth has been remarkably consistent over the last 16 years, averaging around 3-6% per year, with the exception of a spike in 2001-2003 owing to a heightened attractiveness of fixed annuities. For 2006, and the first nine months of 2007, general account assets grew toward the lower end of the historical range, posting growth of 3.1% and 4.3% (annualized), respectively (see graph below).

Changes in separate account assets, on the other hand, vary from large annual increases to actual declines. This is due to the correlation of separate account assets to equity market returns. These trends held true in 2006 and the first nine months of 2007, as separate account assets rose 17.6% and 15.5% (annualized) respectively. However, if the fourth quarter downturn in equity markets is not reversed in December, separate account asset growth may be depressed for the full year 2007.

Operating Earnings

Returns on equity and assets remain below peak levels reported in 2004, but nine-month 2007 returns on assets were improved from full year 2006 levels, and were close to 2005 and 2003 levels. The increase in capitalization has served as somewhat of a drag on returns on equity, though ROEs were higher in the first nine months of 2007 as compared to the full year 2006.

Despite the flat to lower returns, life insurance industry profitability is still substantially higher than 2001-2002 levels, and is at or above profitability metrics reported in the mid and late 1990’s. This is in part due to the benign operating and investment environment of recent years, but also due to a lower level of premium volume (especially for general account products) and the attendant lower level of statutory earnings strain.

Investment Mix

The table below highlights the investment mix for the ALIRT Life Industry Composite over the last few years. The most significant change is a rise in unaffiliated preferred stocks in 2006 and corresponding decline in bonds. This was due to NAIC guidance regarding the classification of hybrid securities, which resulted in many insurers reclassifying hybrid securities from bonds to preferred stocks.

Other trends in investments in the last few years included the following:

• A reversal in the decline of mortgage loans, which actually increased modestly as a percent of invested assets in 2006 and the first nine months of 2007.
• Non-investment grade bonds fell sharply in 2003 and 2004, and continued to decline since then, albeit at a slower rate. However, in light of the considerable rating downgrade activity in the subprime residential mortgage-backed security market, it is possible that this trend may reverse, at least temporarily, in the fourth quarter 2007 or into 2008.
• Schedule BA assets (joint ventures, limited partnerships, private equity, hedge funds, etc.) increased to 3.5% of invested assets at 9/30/07, the highest level in at least the last 15 years³. Though BA assets still remain a relatively small asset class for the life industry and most all insurers, returns and market values for these assets exhibit considerable historical volatility. Additionally, the long-term performance is relatively untested for many of the newer type of "alternative" assets (private equity, hedge funds, etc.) housed in Schedule BA. Insurers with exposure could incur capital losses and/or lower yield if economic conditions and/or equity markets decline.

The table below shows the change in bond quality over the last few years. NAIC Class 3 bonds rose 4.2% in the third quarter 2007, well above the 0.5% rise in total bonds. This may reflect, at least in part, the beginning of the rating downgrades of subprime residential mortgage-backed securities.

Riskier Asset Exposures

The table on the following page shows the 10 composite insurers with the highest surplus exposure to "Higher Risk" Assets (Non-Investment Grade Bonds, Mortgages & Real Estate, Schedule BA assets, and unaffiliated stocks) at 9/30/07.

MetLife Investors USA Ins. Co. had by far the highest exposure relative to surplus, despite only a moderate mix of such assets in the investment portfolio. This is due in large part to an 84% decline in surplus in the first nine months of 2007 (from $609 million to $95 million), resulting from strain from rapid business growth and an absence of capital infusions from its parent. Management stated in late November 2007 that it is evaluating capital alternatives for MetLife Investors USA.

Most of the companies with elevated high risk exposure, as expected, have above average asset leverage (excluding Standard Ins. Co.), while many of the companies also have elevated exposure to mortgage loans and/or real estate holdings. Exposures to non-investment grade bonds, schedule BA assets and unaffiliated stocks were above average for eight, eight, and five of the companies, respectively. Interestingly, only five of the ten insurers with the highest surplus exposure to "Higher Risk" assets achieved above average net investment yield rates for the first nine months of 2007.

Investment Results

Net investment yield remained fairly steady in the third quarter 2007, and is still close to an historical low. The depressed yield reflects the low overall level of interest rates, tight credit spreads on corporate debt, and a fairly conservative fixed income investment strategy for the life insurance industry over the last few years. However, yield rates have stabilized over the last few years, as the steep declines in interest rates observed in the early 2000’s have abated, though the continued low investment returns exert pressure on life company investment performance, crediting rates, and profit margins. Net yield ranged from 5.88% to 5.92% in each year 2004-2006, and was not far from that range, equaling 5.84% (annualized) for the first nine months of 2007.

Net total investment return declined somewhat in the third quarter of 2007, as net capital gains narrowed to $775 million, from an average $2.7 billion for the first and second quarters. Additionally, changes in interest rates impact total return, as the market value of bonds rises (declines) as interest rates fall (climb). However, unlike "marked to market" rules required by GAAP accounting standards, statutory accounting generally records capital gains and losses only upon the sale of a bond or a writedown, as bonds are carried at book value under statutory accounting rules.

Conclusions

The life insurance industry continued a multi-year run of fairly strong financial performance, as the pure capital ratio reached a six-year high, operating earnings and returns remained reasonable, and investment risks are acceptable relative to surplus, even though insurers have increased exposure over the last few years to "alternative" asset classes such as private equity or hedge funds.

However, the very competitive marketplace makes it difficult for insurers to achieve sustainable premium growth. This is especially true as insurers face pressure from rating agencies, stockholders, analysts, and to some degree managements to grow to meet quarterly earnings and/or ROE targets. As a result, some insurers, in an effort to generate growth in premiums and/or earnings, could take on added risks, which may or may not adversely impact future results.

A topic to watch is potential fallout from the difficulties in the subprime mortgage loan market. For the most part, investment portfolio exposures are manageable relative to assets and surplus, as many MBS exposures are in more senior tranches. However, many of these securities experienced rating downgrades in the fourth quarter, and thus it is possible that some insurers will report an increase in below investment grade bonds in the fourth quarter or in 2008. Additionally, the market value of many securities tied to subprime deteriorated in recent months and insurers that sell such bonds could experience capital losses.

Finally, if the subprime woes are the catalyst toward bringing about a downturn in equity markets, weaker U.S. economic performance, and/or tight credit markets over a protracted period of time, insurers could see rising bond defaults, higher reserves for variable annuity secondary guarantees, reduced consumer demand for the industry’s products, and perhaps more difficult conditions to raise capital.

¹ For more on life insurer exposure to subprime residential mortgage-backed securities and CDOs, please see our November 19 release "Update of Subprime Mortgage Related Losses for Select U.S. Insurers: As of Nine Month 2007 GAAP Reporting".
² Lincoln National Life Insurance Company (LNL) merged with affiliates Jefferson-Pilot Life Ins. Co. and Jefferson-Pilot Financiall Ins. Co. in the first half of 2007. As the J-P companies were among the 100 largest life insurers, to keep our composite comparable to 2006, we will use a composite of 98 companies in the 2nd and 3rd quarters of 2007. Note that the J-P companies’ data is still included in our benchmark, as the insurers were amalgamated into a now much larger LNL.
³ For more detail, please see our "Schedule BA Assets: Review of U.S. Insurer Exposures to Schedule BA Assets", issued 11/28/07.