From a positive perspective, Moody’s believes that the impact of
residential mortgage subprime-related asset write-downs on the US
life insurance industry should be limited and that investment
portfolios, for the most part, should emerge without significant
damage. According to a study published by Moody’s in June 2007,
subprime loans comprise less than 12 percent of the life industry’s
total risk-in-force.

“Excellent capital adequacy and good financial flexibility also
support the industry’s continuing good health,“ said Bazer. She
predicted that the life insurance industry’s earnings “will most
likely remain robust for 2007 results, as well as in 2008”.

Diversified industry

Moody’s also stressed that the US life insurance industry remained
well diversified in 2006 and 2007, in terms of business mix,
earnings and product risk.

“Importantly, most of the industry’s largest, leading players had
at least three or four distinct lines of business, including older
blocks of traditional life insurance policies, which should provide
a stable stream of earnings for many years to come,” said Bazer.
“We believe the industry’s business diversification continues to be
a key strength, cushioning its earnings from shocks to a particular
product or market.”

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Favourable market conditions in recent years have been marked by a
sharp decline in the number of insurers in Moody’s rating universe
subject to downgrades of their long-term financial strength
ratings. Notably, of all re-ratings between 2004 and 2007, five
were downgrades and 12 were upgrades. As at 31 December 2007, 83
percent of insurers rated by Moody’s were regarded as having a
“stable” outlook, 7 percent a “positive” outlook and 7 percent a
“negative” outlook, while 3 percent were under review for up- or
downgrades.

The US life insurance industry has on average been assigned an A1
long-term insurance financial strength rating by Moody’s. A1 is the
fifth highest of the rating agency’s investment grade ratings, the
highest being Aaa, a status enjoyed by two US insurers, New York
Life and the Teachers Insurance and Annuity Association.

Necessary developments

Moody’s highlighted two developments that would be required to
result in an upgrade of the US life insurance industry’s average
rating. Both are of a long-term nature.

The first, explained Bazer, would require consistent improvement in
risk-adjusted profitability on new business over the long term and
would likely require greater pricing discipline and significant
additional industry consolidation. The second would require a net
reduction in product risk resulting from, for example, more
effective product design, distribution management and hedging. The
use of capital markets solutions to offload risk could provide a
viable solution over the long term, said Bazer.

Bazer also pointed to factors that could put downward pressure on
the life industry’s rating:

• a sharp decline in sales and premiums, driven by an economic
  slowdown/recession and low interest rates, particularly affecting
  investment and savings products, such as individual annuities,
  institutional investment products and pensions. This was a
  possibility if current economic indicators continue to turn
  negative, said Bazer;

• deteriorating asset quality, resulting in unexpectedly high
  write-downs, realised and unrealised losses similar to levels
  experienced between 2001 and 2003; and

• a significant equity market downturn – depressing revenues,
  earnings and capital as well as hindering financial flexibility –
  accompanied by reduced availability of capital markets financing
  solutions because of continued credit market disruption. This has a
  moderate probability of occurring should the current market
  disruption continue and if the economy experiences a recession,
  said Bazer.

  Overall, Bazer said Moody’s believes that the solid performance of
  the life industry over the past few years has benefited from a
  strong economy, reasonably stable and favourable equity market, and
  a very benign credit market. “We see unstable capital market and
  economic conditions potentially pressuring companies’ investment
  portfolios and operating results if the current situation worsens
  and/or continues for a prolonged period,” said Bazer.

  Greater risk

  Bazer also emphasised that life insurers’ products have become
  increasingly complex in recent years, with product features
  affording what she termed “greater optionality” to policyholders,
  resulting in greater risk to insurers. “Greater product optionality
  weakens the credit profile of life insurers, to the extent that it
  puts the decision-making about if and when to exercise the option
  in the hands of policyholders – a risk that, to date, life insurers
  have had uncertainty in quantifying, pricing for and managing,”
  said Bazer.

  In this context, she continued, key risks faced by insurers
  are:

• equity market risk, which affect variable annuity performance,
  assets under management and sales;

• interest rate risk, which impacts on spreads on fixed rate
  products such as fixed annuities, traditional life insurance and
  structured settlement annuities; and

• rollover and reinvestment risk, which can affect institutional
  investment products, such as funding agreement-backed notes and
  guaranteed interest contracts.

  In addition, said Bazer, the now-ubiquitous benefit guarantees such
  as death, income and withdrawal benefits on variable annuities, and
  premium guarantees on certain term and universal life policies,
  create pricing and profit uncertainties, as they place increasingly
  valuable options in the hands of policy

  holders who may be influenced by their distributors and/or
  independent third parties for longer periods of time.

  She added that new products introduced in 2006 and 2007 offered
  policyholders even greater optionality, in terms of liquidity
  (annuities with guaranteed stop-and-start withdrawal and
  accumulation benefits) and longevity protection with an equity
  component (guaranteed variable immediate annuities).

  Bazer also noted that markets for many of the new annuity and life
  insurance products are volume driven and often exhibit intense
  competition and a lack of pricing discipline, something that holds
  particularly true for products sold in the brokerage producer
  channel.

  Role of equity market

  The key role played by the equity market in the fortunes of US life
  insurers is of significance in the light of both current equity
  market volatility and a decline of about 15 percent in the US
  S&P500 equity index since October 2007. Indeed, Bazer noted:
  “Behind the industry’s recent profitability, of course, has been a
  rising equity market – at least until the second half of
  2007.”

  Moody’s pointed out that about 40 percent of the life industry’s
  total assets now support equity-based products, resulting in life
  insurers’ profitability becoming increasingly linked with the
  health of the equity market. According to Moody’s, the equity
  market has appreciated by about 14 percent a year since its last
  major cyclical low in September 2002. Since that time, said Bazer,
  generally robust and rising equity market values have boosted
  industry sales of variable annuities, pension annuities, variable
  life insurance and mutual funds, and buoyed assets under management
  and related fees.

  A well-conceived hedging programme can provide insurers with needed
  protection in a down equity market, said Bazer. However, she added:
  “The extent of that protection in the next bear market is still
  open to question. Moreover, time will tell if insurers that
  dynamically hedge have been whipsawed getting in and out of hedge
  positions [at the wrong time] in today’s extremely volatile equity
  market conditions.”