Insurance May Pay Off -- Eventually
By Catherine Seifert
The long-term picture for the life-insurance industry is promising. With an aging U.S. population's growing need to save for retirement, sales of more popular products -- such as variable annuities -- are well-positioned to benefit in the coming years.
The present tells a different story, though. The equity markets' dismal performance has taken a toll on the results of a number of life insurers. Mediocre sales of variable annuities, variable life insurance, and other equity-linked products (like variable universal life insurance) is hampering revenue growth. Fee income is declining due to a lower level of assets under management from existing annuity and variable life insurance contracts. Hartford Financial Services noted in its third-quarter earnings release that variable-annuity sales had increased -- but that third-quarter variable-annuity account assets under management declined 10% from the previous year.
According to industry association data released in September, 2002, variable-annuity sales for the first six months of 2002 fell 4.8% year-over-year. Although we at S&P anticipate that this trend of lower sales has continued into the third quarter of 2002, we're somewhat surprised by the relative resilience of the variable-annuity market, particularly in light of the steep decline in stock prices.
Investors are apparently still attracted to these hybrid insurance-investment products, in part because of their tax-free status. We forecast variable-annuity sales volume of about $107.5 billion for all of 2002, a 4.7% decline from 2001. Looking ahead to 2003, S&P estimates that variable-annuity sales will climb to about $116 billion, assuming the equity markets recover.
However, we suspect that many companies have sought to counter a hotly competitive industry environment -- and entice wary investors -- by providing minimum death benefit guarantees (MDBGs) on variable-annuity contracts. This strategy, which has likely helped to buoy sales during this difficult period, has proven to be problematic for some companies, especially in light of the sharp equity market downturn during the third quarter.
Some insurers may find it impossible to meet the obligations implied in these guarantee provisions. Indeed, our earnings estimates for a number of life insurers, including Lincoln National (LNC ) and Hartford Financial Services (HIG ), include a higher provision for expenses related to these guarantees.
For many insurers, investment income is a key source of top-line growth, accounting for a third of total revenues in some cases. As interest rates have declined, so too has the growth in investment income. According to A. M. Best, the yield on life insurers' portfolios of fixed-income securities declined 25 basis points in 2001, as the Federal Reserve cut short-term interest rates to reverse a slowdown in the U.S. economy.
To counter the downward pressure on income, and in the hope of recouping some losses in the form of higher investment returns, many insurers took a bit of additional risk in their portfolios, purchasing securities of lower investment grade. This strategy has backfired for some, and published estimates indicate that the life-insurance industry may have an exposure to "problem credits" totaling more than $23 billion (based on yearend 2001 data).
Included in that estimate is an exposure to Enron of approximately $3.9 billion, to Kmart of $715 million, and to WorldCom of $5.3 billion. These write-downs and asset impairments have significantly weakened the capital positions of some players. A number of insurers have forecast future write-downs to their bond portfolios. For example, John Hancock (JHF ), which expects to post net investment losses (due in part to bond defaults) in its third-quarter results, also warned that future results could also be hurt by impairments to its bond portfolio.
Although this exposure to troubled fixed-income securities raises some concerns, it's important to keep it in perspective. Assuming that insurers are unable to recover any amounts from their holdings of debt in bankrupt companies, this $23 billion exposure to "problem credits" represents just over 12% of the industry's capital and surplus of about $185.6 billion at yearend 2001. Most of the industry's capital base remains fairly well-diversified among companies.
Despite these disappointing near-term results, S&P does not expect life insurers to materially alter their investment or asset-allocation strategies. However, the competitive stance of those harder hit by this downturn will likely be altered.
Despite these near-term challenges, we recommend investors with a longer-term time horizon selectively consider investing in life-insurance stocks. Out top pick in the sector is MetLife (MET ), which is ranked 5 STARS, or buy. Hartford Financial Services (HIG ), a multiline insurer, is ranked 4 STARS, or accumulate. Hartford shares have fallen recently amid concerns over the adequacy of asbestos reserves in its property-casualty division. Although this issue has tempered our outlook, we nevertheless view Hartford as a well-managed franchise that's poised for future growth in the retirement-savings marketplace.
Analyst Seifert follows insurance stocks for Standard & Poor's