The last thing financial advisors need in the wake of insurance rating company downgrades is to deal with insolvent life insurance companies. Due diligence is key.
The latest cause for concern: Moody’s Investors Service has downgraded its outlook for the U.S. life insurance industry to negative from stable. The downgrade, issued in a September report, “U.S. Life Insurance Industry Outlook,” predicted that low interest rates would continue to depress companies’ earnings and put pressure on reserves to meet obligations over the next few years.
Fitch Ratings, Standard & Poor’s and A.M. Best also have expressed long-term concerns about the insurance industry, but did not immediately follow suit.
“We believe that low rates, along with below-trend economic growth and prolonged volatility in the equity markets, will continue to erode insurers’ earnings and revenues, gradually weakening their financial flexibility,” says Laura Bazer, Moody’s vice president and author of the report.
Write-downs based on generally accepted accounting practices, deferred acquisitions costs, goodwill and other intangibles, she says, will become larger and more frequent. “Persistent high unemployment and fiscal tightening will constrain life insurers’ top- and bottom-line growth,” Bazer adds. “We expect high unemployment, weak consumer confidence and potential sharp tax increases to negatively affect the sales of all life products.”
Other troubles: Variable annuities will underperform because of volatility in the stock markets stemming from the European debt crisis. Reserve swings are expected to become more frequent and depress firms’ earnings and regulatory capital levels.
Fitch, in a report issued last August, says low interest rates make it more expensive for insurers to hedge portfolios. Insurers continue to increase employee pension liabilities and reserve requirements because of reduced expectations for investment returns and future profitability. If low interest rates continue more than three to five years, the amount of capital and/or surplus required by state insurance regulators could rise.
But at least one equity research firm says the industry’s problems are due strictly to the recession.
“Investors should be concerned about earnings,” says John Nadel, managing director of equity research at Sterne Agee & Leach in New York. “Policyholders should not be concerned about solvency.”
Nadel adds that he cut his 2012 and 2013 earnings estimates for the life insurance group 2.5% to 3.5%. And he cut his third-quarter earnings estimates 9%. He points to stock market weakness and volatility, low interest impact on earnings, balance sheet strength and one-time cost write-downs.
Already, insurers are taking on incremental investment risk by increasing allocations to high-yield bank loans and mezzanine debt, says a May 2012 Goldman Sachs Insurance Asset Management Survey. They are also increasing allocations to real estate, emerging market debt and private equity.
However, the survey, which included chief investment officers of 152 insurance companies, also found that insurance companies were limiting fixed-income duration risk through risk-management hedging programs.
Meanwhile, Kurt Karl, chief economist for the reinsurer Swiss Re in New York, believes that insurers must change how they structure their life and annuity products. Insurers need to reprice their guarantees and adjust product offerings to reduce their exposure to interest-rate risk. Under current economic conditions, the guarantees are difficult to hedge.
“For many life insurers, solutions to low interest rates are limited because policy terms for in-force business with generous or rigid guarantees cannot be changed,” Karl says. “However, life insurers can optimize their asset management, hedging and operational costs. They can also offer to exchange existing policies for new products that offer similar benefits, but are easier to hedge. Regulators can facilitate this.”
Given the near collapse of the financial system in 2008, prudence pays off.
The financially strongest companies carry ratings of ‘A++’ to ‘A’ by A.M. Best; ‘A’ to ‘AAA’ by Standard & Poor’s; ‘Aa3’ to ‘Aaa’ by Moody’s; and ‘A to AAA’ by Fitch (see Figures 1 and 2).
Financially weaker companies may carry A.M. Best ratings below ‘B+,’ Fitch ratings below ‘BBB-,’ Moody’s ratings below ‘Baa3’ and S&P ratings below ‘BBB-.’ The weakest companies have A.M. Best ratings of ‘C’ and below; Fitch ratings of ‘B’ and below; Moody’s ratings of ‘Ba1’ and below; and Standard & Poor’s ratings of ‘B’ and below.
Each rating company has its own method for evaluating insurance companies based on public and non-public data, including balance-sheet, off-balance-sheet, reinsurance, capital and reserve measures. But there are similarities in the data and information analyzed.
Nadel of Sterne Agee & Leach says there is not much difference in the way the rating agencies rate insurance companies. But if there are big differences, financial advisors should find out why.
For example, if Standard & Poor’s issues a lower rating, perhaps it is because of concern about the commercial real estate market, and the insurer has large holdings in commercial real estate.
Other variables to scrutinize as a harbinger of insurance company financial problems include inadequate policy pricing, financial problems with affiliates, poor investments and rapid growth, according to A.M. Best.
It is important to keep an eye on these factors because if a company goes belly up, policy owners get limited protection from state guaranty associations, which are funded by insurance companies. State laws vary, but they’ll at least typically cover the following, according to the National Organization of Life and Health Insurance Guaranty Associations, Herndon, Va.:
• $300,000 in life insurance death benefits
• $100,000 in cash surrender or withdrawal value for life insurance
• $100,000 in withdrawal and cash values for annuities
• $100,000 in health insurance policy benefits
Since its inception in 1983, the National Organization of Life and Health Insurance Guaranty Associations has been involved in some 100 multi-state insurance company insolvencies, it reports. Most were during the economic troubles in the early 1990s. During the recession that began in 2008, just nine multi-state companies failed, the organization says.
From 1991 to 2009, on average, life insurance policyholders have recovered just over 96% of their total policy values—including values that exceed state guaranty association limits. Annuitants, according to the National Organization of Life and Health Insurance Guaranty Associations, received just over 94% of total policy values.
Any policy losses, the agency says, would be from policies with benefits that exceed state guaranty association policy limits or from uncovered policies.
In the famed Executive Life Insurance Co. failure in 1991, for example, the company wrote a number of institutional annuity contracts not covered by some guaranty association.
Although the industry is hurting because of low interest rates, both insurers and regulators are taking steps to beef up solvency both here and in Europe. “Guided by the lessons learned from the financial crisis, there is a growing level of activity among regulatory bodies and quasi-regulatory agencies focused on strengthening insurance solvency protection systems,” says Alan Dobbins, analyst at Conning Research and Consulting, Hartford, Conn.