The bear market, a steep decline in mutual fund and variable annuity sales and the strain of product guarantees, will result in widespread downgrades at life insurance and annuity companies, all of the major ratings agencies have announced,

A.M. Best & Co., Fitch Ratings, Moody's Investors Services, Standard & Poor's and Weiss Ratings have stated that the financial stability at many major carriers is threatened by volatility in the equity markets, increased reserve requirements for variable product death benefits and capital strain due to increased sales of fixed products. All have reached the same conclusion: The outlook for life insurers is negative.

Fitch of New York recently announced downgrades at 42% of its covered insurance groups. The mean rating of Fitch insurers has fallen from the low end of AA to the high end of AA-, said Julie Burke, managing director.

These ratings reflect two core challenges faced by all the carriers, she said: competitive pressures and the overall shift to risky portfolios.

Majority in Trouble

S&P of New York has a negative outlook on a third of its insurance groups. At Weiss of Palm Beach Gardens, Fla., 700 out of 1,100 companies have been downgraded based on 2001 reports, and another 30 may be downgraded by the end of the year.

The decline in equity markets is dealing a multiple blow to some carriers, said Rodney Clark, a director with S&P. First, it affects the direct investments that insurers make. "What's happening to companies' investment portfolios is really the major factor," said Michael Cohen, VP of life insurance at A.M. Best of Oldwick, N.J.

Another portfolio risk includes credit defaults, which have reached near-record levels, Clark said. "Life insurers are significant investors in corporate debt, and we've seen near-record corporate defaults," he added.

The shrink in investor assets in products linked to the equity markets is also negatively impacting carriers that generate fees from such products, including mutual funds.

Furthermore, some riders guaranteeing death or income benefits carry a double whammy because new purchases of such guarantees require increasing reserves while carriers are now paying out benefits for existing policies.

Carriers may be caught off balance by this predicament, but analysts have had their eye on it for some time. Arthur Fliegelman, a senior credit officer at Moody's of New York, said that carriers have long underestimated the risks inherent in guarantees. "Long before the equity market began its decline, [insurers] weren't being careful [or] conservative enough [in establishing reserves]," he said.

Although fluctuations in market conditions do not usually affect ratings, Michael Barry, a managing director at Fitch, said that fundamental shifts within the life and annuity industry are driving the downgrades. In particular, he cited the "migration in the industry's product portfolio to lower-margin-type businesses," such as variable annuities and mutual funds.

A larger issue facing carriers is one of distribution, Barry said. As insurers expand to a growing number of distribution channels and models, they also compete with more products and companies outside of the insurance industry. In that competition, he said, "The life industry is at a relative disadvantage."

Equity-Linked a Drag

The loss of revenue from a decline in sales of equity-linked products will continue to be the driving factor affecting financial stability, said Melissa Gannon, VP at Weiss Ratings. Within the VA industry, sales dropped from $7.2 billion in 2000 to $3.3 billion in 2001, she said.

Annuities account for the bulk of the decline in life insurance company revenue. Between 2000 and 2001, individual annuity revenue dropped 58%, from $3.8 billion to $1.6 billion, while individual life revenue declined only 3%, from $8.3 billion to $8.1 billion, according to Weiss.

Deferred acquisition costs (DAC), or the costs of acquiring and starting new policies, are now also weighing heavily on many insurers' balance sheets.

Another important factor is the interest-rate spread, since the rates offered by carriers have become increasingly risky to support as interest rates have remained at record lows. "The problem has the potential for fairly major impact," Clark said. Despite the dire news, Clark said that life insurers are in a fairly strong position, but those strengths are finally being overtaken by market weaknesses.

Rather than looking at market conditions, Fliegelman leveled criticism directly at the carriers, saying, "I don't think it's news that equity markets go down. Companies should not be in a position where their financial stability is at risk."

Taking a broader view, Barry said that the effects of the market downturn act against the backdrop of fundamental changes in the financial services industry that have not yet played out, concluding, "At the end of the day, this industry is just changing rapidly."

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