Fitch's movement to a negative industry outlook implies that over the next 12-18 months, Fitch expects more downgrades than upgrades across the U.S. life insurance industry. However, it does not imply that all, or even a majority, of life insurers' ratings will necessarily be downgraded. Life insurers most exposed to rating pressures include companies with:
- above-average exposure to residential mortgage-related investments or below-investment grade bonds;
- above-average exposure to variable annuities;
- above-average exposure to products or business activities reliant on institutional funding (such as securities lending programs, or products such as guaranteed investment contracts with ratings triggers); and/or
- limited excess capital relative to prior rating expectations.
The dramatic downturn in the U.S. housing market, which has led to significant losses to mortgage-related investments, has prompted a financial crisis among major U.S. financial institutions, market illiquidity, and a wholesale repricing of credit risk. While less exposed to these market issues than many investment banks, commercial banks, or financial guarantors, life insurers are experiencing a significant deterioration in investment results, which are negatively impacted industry earnings and capital.
In the first half of 2008, Fitch's universe of life insurers reported combined statutory net income of $2.2 billion compared to $28.6 billion for full year 2007. Fitch expects statutory earnings to deteriorate further in the second half of 2008 and into 2009 driven by increased investment losses. Likewise, GAAP results have exhibited similar declining trends, which are expect to continue in the second half of 2008 and into 2009. In particular, Fitch projects a significant deterioration in variable annuity results driven by deferred acquisition cost write-downs, declining asset balances, increased reserving for guaranteed benefits, and higher hedging costs.
In addition, Fitch expects the deterioration in industry statutory capital levels, which declined an estimate 4% in the first half of 2008, will accelerate in the second half of 2008. This will be heavily driven by greater recognition of unrealized investment losses as "other than temporary", prompting impairment-related write-downs. Fitch believes a number of life insurers have been slow to recognize investment impairments against statutory capital, and that such recognition will pick up markedly in the second half of 2008.
Despite the above mentioned pressures, Fitch notes that the U.S. life insurance industry is relatively well-positioned to weather an environment of capital markets volatility and market illiquidity. The industry's risk-based capital position was very strong going into 2008, with many companies holding capital at levels close to or above the 'AAA' threshold based on Fitch's economic capital model.
A select number of life insurers have material liquidity exposures via large debt maturities, reliance on commercial paper, short-term bank letters of credit, securities lending programs, short-term funding agreements or ratings triggers on products such as municipal GICs. These insurers are most susceptible to sudden changes in their creditworthiness and financial strength, as well as multi-notch ratings downgrades, should their liquidity pressures heighten.
However, most life insurers have limited liquidity exposures, which should mitigate the impact of current market illiquidity across the industry. In addition, a vast majority of life insurers avoided investments in collateralized debt obligations backed by residential mortgage backed securities, and most have little or no activity in the credit default swap market.
Fitch notes that the U.S. Government has embarked on a broad-based plan to bring stability to the financial markets and provide a market for troubled assets via the establishment of an up to $700 billion fund to support the purchase of troubled assets. It is not clear how effective this program will be and how it will impact the life insurance industry, but a positive outcome could lessen some of the industry pressures discussed above.
