Due to their generally strong capitalization and liquidity, North American life insurers have comprised one of Standard & Poor's highest-rated sectors. However, the sector has experienced incremental credit deterioration for a protracted period. Since 2000, we have taken 159 rating downgrades in the sector compared to just 46 upgrades. This equates to roughly 3.5 downgrades for each upgrade.

The current average financial strength rating, which takes into account quantitative and qualitative factors and future risks, for the life insurers that we rate is 'A+'. This denotes a strong ability to meet policyholder claims. However, in 2000, the average financial strength rating was 'AA'. We believe several factors are behind the deterioration:

• Increased risk acceptance, particularly among firms that converted to investor (or shareholder) ownership from policyholder ownership;
• Changing consumer preferences and product evolution;
• Economic recessions and investment-market volatility; and
• U.S. sovereign credit deterioration.

The Opaqueness Of Long-Term Credit Erosion

A few trends have emerged since 2001 (see charts 1 and 2). First, the net credit deterioration for life insurers has not been smooth and consistent, but rather lumpy. In fact, our 12-month sector outlook, which reflects our expectation for the prospective balance of ratings upgrades and downgrades, has varied between stable and negative with some regularity during the past decade, but has never been positive. Second, the trend in rating actions suggests that the sector's credit profile has little, if any, ability to "bounce back." Lastly, a cursory analysis might indicate a strong correlation between the sector's credit erosion and cyclical economic trends and investment-market volatility; this is only partially true. The fact is a more in-depth look at the sector's trends reveals that there is much more to the ongoing credit deterioration than what first meets the eye.

Chart 1

Chart 2

Increased Risk Acceptance After Demutualization

Demutualization, which is the conversion of policy holder-owned mutual insurers to stock holder-owned insurers, began in earnest in North America in the late 1990s (see table 1). We believe the wave of demutualization activity that occurred from 1998 to 2002 laid the foundation for the sector's greater risk acceptance that has been observed to-date.

Table 1

Demutualization provides several immediate and long-lasting benefits that are attractive to many insurers and their policy holders. Policy holders can typically monetize their ownership interests in mutual companies and receive stock and/or cash. The insurers gain greater financial flexibility with broader access to the equity and debt markets, and greater ability to participate in mergers and acquisitions. These were and continue to be incentives to convert to a stock company.

Despite these benefits, we revised our sector outlook in December 1999 to negative from stable to reflect our credit concern about the impacts of demutualization on the sector's credit and financial strength. The wave of demutualization activity that occurred from 1998 to 2002 resulted in a realignment of stake-holder interests, increased risk-taking, and ultimately greater capital utilization in the U.S. life insurance sector.

A sector once dominated by mutual life insurance companies focused on long-term policyholder interests saw many of its largest mutual companies convert into stock companies, whose interests would now include those of shareholders. Consequently, the sector's business model became tilted toward a shorter-term revenue and profit horizon, which is a model more typical of investor-owned life insurers.

Increased risk taking followed conversions to stock insurance companies including expansion into riskier products, and many mergers and acquisitions whose valuations ultimately fell short of our expectations. The painful lessons learned about the true cost of acquisitions, universal life secondary guarantees, long-term care pricing assumptions, and variable annuity guaranteed living benefits speak volumes about the rapid growth of risk-taking post demutualization. Although there has been some de-risking and recapitalizing since the 2008 recession and global financial crisis, we believe the sector's bias is to revert back to a higher risk profile. We rated mutual life insurers and stock life insurers, on average, 'AA-' and 'A', respectively, as of year-end 2011 (see chart 3).

Chart 3

Changing Consumer Preferences And Product Evolution: The Ongoing Secular Shift Toward Retirement-Oriented Products

Changing consumer preferences and evolving insurer product portfolios continue to weigh on insurer credit quality. Just as many life insurers were demutualizing and getting accustomed to greater quarterly scrutiny from shareholders, the long-standing decline in consumer preference for life insurance products accelerated. Based on National Association of Insurance Commissioners data tabulated by the American Council of Life Insurers, from 1995 to 2000, U.S. consumers purchased on average approximately 13 million new individual life insurance policies annually. By 2010, new policy purchases declined to less than 10 million annually. According to the Life Insurance and Market Research Association, as of 2010, only about 44% of U.S. households had individual life insurance, a 50-year low. Moreover, increasing consumer preference for more commoditized (term and universal life insurance) life insurance products (term and universal life insurance), which began as early as the 1980s, has resulted in thinner margins in this segment of the life insurance business.

Increasing demand for retirement-oriented products, particularly among moderate- to higher-net-worth individuals, intensified during the 1990s and 2000s. This resulted in many insurers placing a greater emphasis on products and services designed to protect and accumulate assets for use during retirement years (specifically immediate and deferred annuities, and wealth-management solutions) rather than products designed to protect against early death. Changing U.S. demographics have been a driving force behind the shifting market demand and we expect this to remain so for some time. In 2011, the leading edge of the baby boom generation turned 65, and based on U.S. Census Bureau data, seniors will increase to about 20% of the U.S. population by 2030 from about 12% currently. Given these dynamics and the declining availability of employer-sponsored defined-benefit plans, it is not surprising that life insurers have shifted their focus toward retirement-oriented products. From 2001 to 2011, U.S. individual annuity production grew at a compound annual growth rate of about 4.55% compared with just 0.84% for U.S. individual life insurance production (see chart 4).

Chart 4

The ongoing secular shift toward retirement-oriented products and wealth-management solutions and away from more stable mortality protection-oriented products remains a significant credit concern. More specifically, permanent life insurance products can often support very strong ('AA' category) and excellent ('AAA' category) ratings, whereas retirement and wealth-management product sets can usually support strong ('A' category) ratings at best.

The primary differences between the often higher-rated life insurance (mortality) business and typically lower-rated retirement-oriented and wealth-management businesses are that the latter have a higher propensity for earnings volatility and calls on capital. The volatility stems largely from greater product sensitivity to interest rates and equity-market performance, particularly for fixed and variable annuities, and fund-management solutions. Historically many insurers have demonstrated a penchant to offer rich and highly market-sensitive variable annuity benefits, notably guaranteed living benefits, while others have had a checkered history in acquiring and effectively managing fund managers.

The good news for the life insurance sector is that it is well positioned to compete with other types of financial services firms in providing retirement and wealth-management solutions as changing demographics increasingly drive up demand. During the past decade, the insurance sector has embraced the opportunity to broaden and deepen its product suites. To the extent a life insurer is able to gain profitable scale in retirement-oriented products and maintain a healthy proportion of traditional life insurance business, the credit implications will likely be neutral. On the other hand, if a highly rated ('AA' category) life insurer shifts its business mix more heavily toward retirement-oriented products, the credit implications are likely to be moderately negative.

Table 2

Economic Recessions And Investment-Market Volatility

Negative rating actions are strongly correlated with severe economic downturns and investment-market volatility. Per our modeling, asset risk (including credit, interest rate, and market risks) is the largest quantifiable risk for most life insurers. Although most life insurers maintain diversified investment portfolios by asset class and credit quality that can weather usual economic cyclicality, no insurer is immune to severe economic deterioration and investment volatility and losses.

The lack of immunity was demonstrated most recently during the 2008 global financial crisis and the resulting recessionary macro environment. In October 2008, we revised our outlook on the U.S. life insurance sector to negative from stable to reflect the turmoil in the credit and equity markets. From 2009 to 2011, we downgraded 56 North American life insurers and upgraded only nine. These rating actions were largely motivated by outsize credit losses in insurers' investment portfolios, the impact of equity-market decline and volatility on their market-sensitive products, and the resulting deterioration in capital adequacy.

Life insurers generally allocate a large portion of their investment portfolio assets to fixed-income securities, primarily corporate bonds and, prior to the aforementioned financial crisis, mortgage-backed securities (MBS). On average, fixed-income securities account for roughly two-thirds of a typical insurer's investment portfolio. During the financial crisis, a limited number of insurers with outsize exposure to mortgage-backed assets--particularly nonagency subprime/Alt-A Residential MBS and certain classes of commercial MBS--experienced elevated credit losses and deterioration. Although life insurers' exposure to corporate bonds tend to be of high credit quality (typically more than 90% investment-grade), many have exposure to speculative-grade investments for the purpose of improving their overall investment yields. As would reasonably be expected, the portfolios with greater exposure to below-investment-grade bonds experienced more credit defaults during the financial crisis. Less expected was the increased number of credit defaults and fallen angels experienced by investment-grade bonds, particularly financial-sector issuances.

Many life insurers offering products with minimum guaranteed death and/or living benefits were particularly hard hit by the sharp equity market decline. These insurers experienced material increases in their reserve requirements as their net amounts at risk increased and lapse rates declined, causing significant capital strain. A secondary impact resulting from the increased equity-market volatility was a marked increase in hedging costs for the above-mentioned benefits, as well as increased cost for options purchased to hedge fixed-indexed annuity participation guarantees. In addition, life insurers with a large proportion of separate accounts to total assets under management had redcued earnings. Lower equity markets reduced account balances and asset-based fees earned from balances on equity-linked products, such as variable annuities. In some cases, the equity market decline also had a secondary impact on insures' earnings through accelerated deferred acquisition cost amortization resulting from downward revisions of future gross profit assumptions.

A lingering consequence of the global financial crisis was a significant slow-down in the capital markets. This, in combination with the impaired and illiquid assets on many insurers' investment portfolios, resulted in an overall reduction in financial flexibility for many insurers, limiting their capacity to fund growth and replenish capital.

We currently assess the risk of another U.S. recession at 20%. The U.S. economy has improved somewhat lately with a better job market and market sentiment. However, sustainability remains in question. We continue to monitor three economic variables that will sway consumer and business confidence and investment volatility: oil prices, fiscal uncertainty in Washington D.C., and the health of the European economy and banking system. Negative developments with one or more of these variables can have a strong correlating influence on U.S. life insurers' operating margins and variability, and capital strength (see U.S. Economic Forecast: An Apple A Day Keeps Recessions Away, published March 15, 2012, on RatingsDirect).

The U.S. Sovereign Credit Influence

On Aug. 5, 2011, we lowered our long-term sovereign credit rating on the U.S. to 'AA+' from 'AAA', with a negative outlook. At the same time, we lowered the counterparty credit and insurer financial strength ratings on five U.S. insurers to 'AA+' from 'AAA'. We did so because of U.S. insurers' direct and--more importantly--indirect exposure to U.S. sovereign credit risk. On a direct basis, U.S. insurers invest moderately, relative to total invested assets, in U.S. debt obligations, though such levels can be significant relative to capital. With respect to indirect exposure, we believe that many U.S. financial institutions, including life insurers, are significantly affected by U.S. monetary, tax, investment, political, and economic conditions---factors that the sovereign influences and that we incorporate into our sovereign credit opinion.

We maintain a negative outlook on the U.S., which remains an issue for highly rated life insurers. A negative outlook indicates that there is at least a one-in-three chance of a rating downgrade. If the rating were lowered to 'AA', we would downgrade at least eight insurance groups currently rated 'AA+' to 'AA'.

A Newer Concern: Interest Rate Risk

A significant sector credit concern is the financial impact of prolonged low interest rates. Although we have yet to take any specific rating action because of low interest rates to-date, the North American life insurance sector's profitability and ability to generate and retain surplus will be eroded if the current low interest rate environment persists. The extent to which prolonged low interest rates will lower our credit opinion on the North American life insurance sector will depend on the direction and magnitude of interest rate movements. At an individual company level, our opinion will vary based on an insurer's particular investment portfolio characteristics and product liabilities, and how effectively insurers are able to mitigate the effects.

Prolonged low interest rates are an issue specifically because life insurers depend on the spread between general account portfolio yields and policy crediting rates for a significant portion of their earnings. Investment return assumptions--in addition to mortality, morbidity, and lapse assumptions--are critical to profitably pricing life insurance, annuities, and long-term care products. If interest rates remain low, we believe that the average life insurer general account portfolio yield could decline by as much as 40 to 50 basis points during the next 36 months, thereby compressing earnings margins. Of course, results will vary across individual companies. The 10-year treasury yield was less than 1.8% as this article was being completed (see chart 5).

Chart 5

The implications of lower investment yield include margin compression of in-force products and new dollars (from premiums, asset maturities, and sales) being reinvested at lower rates. Moreover, prolonged low interest rates can pressure hedging effectiveness for variable annuities, and result in reserve strengthening needs for specific products. Many management teams have already utilized tools available to help mitigate these risks, including lowering credit rates on both general account life and annuity products, reducing guaranteed benefits, lowering policyholder dividends, and even reducing new business writings in the more interest rate-sensitive product lines. Nevertheless, the impact could become more pronounced if low rates persist because insurers will likely be challenged to increase premium rates because of keen competition and lower demand due to slow macroeconomic growth.

Although prolonged low interest rates are an immediate issue, we are also mindful of the risk posed by rapidly rising interest rates. Although they occur infrequently, an interest rate spike of several hundred basis points during a one-year period can result in considerable disintermediation as policyholders seek higher yields and significant unrealized losses in fixed-income portfolios. An interest rate spike is not only less predictable, but it can be more damaging than prolonged low interest rates for many life insurers depending on the extent of the spike and an insurer's asset and liability mix.

Will The Sector's Credit Profile Rebound?

We believe that the North American life insurance sector remains financially strong and continues to exhibit significant flexibility in facing an ever increasing number of pressures, whether rooted in greater competition and increased product risk, changing demographics, investment market volatility, or sovereign credit deterioration. We believe that the sector will likely face some further credit erosion, but expect the average credit quality for rated North American life insurers to remain in the 'A' (strong) rating category during this decade. The sector still has significant opportunities in both the traditional life insurance product space and retirement solutions, and is backed by strong capital.