BEST S SPECIAL REPORT

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1 BEST S SPECIAL REPORT Our Insight, Your Advantage. Financial Review August 20, 2015 Life/Annuity performance consistent with prior years but change is on the horizon. Low Interest Rates Continue to Restrain Life/Annuity Results Introduction The /Health Industry performed favorably during the first quarter of However, the headwinds that have challenged the marketplace have not changed much in recent years, such as continued low interest rates, a slow-growth economy, changing regulatory climate and general competitive pressures tied to the evolving marketplace. These factors have resulted in a trend of positive but tapering earnings in recent quarters. One of the top challenges facing the life/health industry continues to be improving top-line growth. One positive note is that despite low interest rates, the industry has managed to limit the effects of spread compression on interest-sensitive products so far. The ability of insurers to lower crediting rates somewhat mitigates the effect of lower investment yields, making the risk of spread compression manageable. However, A.M. Best expects that earnings from insurers that market annuities or other interest-sensitive products will decline if low interest rates persist. One of the major transactions that impacted industry results during first quarter 2015 was Prudential Insurance Company ceding its closed block of participating life business into a newly established statutory separate account managed by an affiliate. If this transaction was included in industry totals, invested assets and separate account assets would have increased modestly. It also would have impacted realized gains and net income. The scope of this report on the /Health Industry is limited to all statutory blue book filers and excludes pure health insurance companies filing as an orange book. Analytical Contact Analytical Contact: Frank J. Walko, Oldwick +1 (908) Ext 5072 Frank.Walko@ambest.com SR Premiums Good Start for got off to a good start as overall Direct Premiums Written (DPW) increased to USD billion at first quarter 2015, up from USD billion at first quarter, 2014, representing a 5.8% increase. About a quarter of the industry DPW is from Individual Annuities, followed by Ordinary & Group Life at 22%, Deposit-Type Contracts (for example, Guaranteed Investment Contracts) at 16%, Group Annuities at 15%, Group A&H at 13% and Individual A&H at 9%. (see Exhibit 1) Deposit-type contracts increased to USD 31.5 billion at first quarter, 2015, from USD 24.2 million at first quarter 2014, led by an increase in deposit-type revenues from Metropolitan Life. According to A.M. Best data, deposit-type contract premium is highly Exhibit 1 /Health Direct Premiums Written by Line (1Q 2015) Individual A&H 8.8% Group A&H 13.1% Contracts Deposit Type 16.1% Group Annuity 15.3% Ordinary & Group Life 21.8% Individual Annuity 24.9% Copyright 2015 by A.M. Best Company, Inc. ALL RIGHTS RESERVED. No part of this report or document may be distributed in any electronic form or by any means, or stored in a database or retrieval system, without the prior written permission of the A.M. Best Company. For additional details, refer to our Terms of Use available at the A.M. Best Company website:

2 concentrated, with the top ten life & annuity carriers making up 90% of Direct Written Premium. Group A&H DPW increased to USD 25.6 billion at first quarter 2015, from USD 22.5 million in first quarter 2014, an increase of USD 3.1 billion. Some of this change is due to rate increases in recent periods to offset anticipated margin contraction as mandated by the Patient Protection and Affordable Care Act (PPACA). These rate increases help offset the reduced profit margins on business received from the exchanges. Individual annuities decreased to USD 48.6 billion in first quarter, 2015, down from USD 51.5 billion in first quarter, Low interest rates continue to impact fixed annuity sales and companies continue to moderate their risk exposure to annuities. Per LIMRA data, all annuity lines of business experienced declining premiums, with the exception of fixed indexed annuities. Variable annuity sales declined in first quarter 2015 due to continued moderation of the risk profile of this product and competition from fixed indexed annuities with guaranteed minimum withdrawal benefit riders. Potential buyers may also be concerned about the nearterm future of the equity markets, given the recent strength and high valuations. Ordinary life DPW at first quarter 2015 increased 3.4%. Per LIMRA, universal life and whole life comprised over two-thirds of total life sales. While individual life sales were robust in the first quarter of 2015 following a lackluster 2% growth rate for full-year 2014, the industry continues to fight the headwinds of low interest rates, pricing competition, higher financing costs and relatively lower consumer interest. Although data is limited to one calendar quarter, initial results suggest that the implementation of Actuarial Guideline 48, which places significant limitations around the structure of XXX and AXXX captives, has not had a measurable negative impact on life sales. Net income amounted to USD 12.6 billion in first quarter 2015, relative to USD 8.2 billion for the same prior-year period, an increase of USD 4.4 billion or 54%. (see Exhibit 2). The primary driver of the growth in earnings was a USD 4.6 billion swing in realized capital gains/losses improving from a realized capital loss of more than USD 1.5 billion in first quarter 2014 to a USD 3.1 billion realized capital gain in first quarter The improvement in realized capital gains was mainly driven by a large reinsurance transaction. The single large reinsurance transaction is driven by Prudential, in which closed block participating life business was recaptured and moved into the separate account of an affiliate. Outside of this single large transaction, the Exhibit 2 /Health Pretax Operating Gains (1Q Q 2015) Millions Q 2Q 3Q 4Q 1Q 2Q 3Q 4Q 1Q 2Q 3Q 4Q 1Q life/annuity industry would have recorded a modest amount of realized capital losses. A.M. Best notes that there is continued focus on strategic de-risking of product portfolios and increased diversification. Underwriting results have improved modestly across the industry relative to the prior year. Additionally, there is continued moderation in the fixed annuity marketplace as companies seek to minimize their exposure to interest rate risk by limiting sales and decreasing crediting rates. Pre-tax operating gains totaled USD 12.1B for 1Q15, up from USD 11.8B in 1Q14, an increase of 1.9%. Net premiums increased modestly in first quarter 2015 as the increase in DPW was partially offset by increased use of reinsurance. Investment Income declined in first quarter 2

3 2015 primarily due to lower yields as interest rates remained low. Total revenue was partially offset by an increase in mortality experience, where death benefits were USD 19.1B in first quarter 2015, compared to USD 17.5 billion over the same period last year. Surrender benefits increased from USD 65.9 billion in first quarter 2014, to USD 68.6 billion in first quarter Investments -- Investment Approach More of the Same General account invested assets declined modestly from USD trillion at year-end 2014 to USD trillion at first quarter Partially offsetting factors include new life and annuity sales and investment income. If the assets from the aforementioned single large transaction were included in the aggregate total, assets would have increased in the first quarter 2015 by 1.4% to USD trillion. Investment allocations for first quarter 2015 were generally in line with allocations at year-end Interest rates as measured by the 10-year U.S. Treasury Bond hovered around 2% throughout the quarter. Allocations by asset type were fairly consistent with year-end results, as bonds comprised 74% of invested assets, followed by mortgage loans (10%), other invested assets at (7%), policy loans (3%), cash & short-term assets (3%), common & preferred stocks (2%), and real estate (1%). (see Exhibit 5) Exhibit 5 /Health Invested Assets by Class Mortgage Loans 10.2% Common & Preferred Stock 2.4% Other Invested Assets 6.7% Cash & Short-Term Assets 2.7% Policy Loans 3.4% Real Estate 0.6% New money rates continue to remain lower than overall net investment yields, which presents challenges to the industry as it aims to maximize yield while ensuring that assets and liabilities are properly matched. As mentioned earlier, the low interest rates have resulted in lower yields and investment income. Bonds comprised the largest category of General Account Invested Assets, at 74.0% in first quarter Of note is the increase in the percentage of below investment grade bonds, which were 6.3% of total bonds in first quarter 2015, up from 6.0% at year-end The life industry data suggests that current below investment grade holdings are primarily investment grade bonds that were recently downgraded, as fewer below investment grade bonds were purchased and a modestly higher amount were sold. Companies also appeared to purchase more NAIC class 1 bonds, which is reversing a trend of purchasing lower-rated investment grade bonds to gain yield. Mortgage loan holdings remained flat at first quarter Mortgage loans generally provide higher returns compared to investment grade corporate bonds. Due to the appeal of higher yields, more companies and businesses have entered the commercial mortgage loan market, increasing the competition and forcing yields down. Many insurance companies refuse to compromise their underwriting standards to acquire this business, and have chosen not to write as much. In addition, the decline in mortgage loans also reflects the paydowns of existing mortgages. Other invested assets recorded the biggest change, where holdings increased to 6.7% of total general account invested assets in first quarter 2015, up from 6.4% at year-end, As interest rates continued to remain low, companies have been investing at the Bonds 74.0% 3

4 Exhibit 3 /Health Net Investment Income (1Q Q 2015) ($ Billions) Q 12 2Q 12 3Q 12 4Q 12 1Q 13 2Q 13 3Q 13 4Q 13 1Q 14 2Q 14 3Q 14 4Q 14 1Q 15 Source: Best s Statement File L/H, U.S Exhibit 4 U.S. Treasury Rate Curve (2Q Q 2014) Q 2004 YE Q 2014 Percent mo 3 mo 6 mo 1 yr 2 yr 3 yr 5 yr 7 yr 10 yr 20 yr 30 yr Source: US Treasury Department and Bloomberg margins to gain yield at the expense of liquidity. This asset class is typically comprised of Schedule BA assets, where these securities typically offer the potential for relatively higher yields but are often not publicly traded, which makes them less liquid. Many insurers use these holdings, which often have long-dated maturities to match their long-dated liabilities, and maintain that the liquidity provided by these holdings are not needed in the near-term. Preferred stock allocations remained constant in first quarter 2015 at 0.3% as did common stock holdings at 2.1%, as companies continue to limit their exposure to equity market risk. Capital and Surplus Shows Consistent Improvement Capital and Surplus increased by USD 6.7 billion at first quarter 2015, to USD billion, from year-end 2014, an increase of 1.8%. Adjusted capital and surplus, which includes the asset valuation reserve, increased from USD 418 billion at year-end 2014 to USD billion in first quarter There has been a continued trend of increases in capital and surplus since the financial crisis. (see Exhibits 6 & 7), but the additions to surplus have been at a decreasing rate, partially as a result of lower interest rates. Also, dividends paid to shareholders in recent years have been higher, and may also have been used to fund share repurchases, which both have contributed to decreasing growth in surplus. The main drivers of the increase in surplus are statutory net income of USD 12.6 billion and unrealized gains of USD 1.6 billion, partially offset by stockholder dividends of USD 4.8 billion and unrealized foreign exchange losses of USD.9 billion. Change in unrealized gains decreased in the first quarter 2015 compared to the same period prior year as equity markets became more volatile and interest rates were rangebound. 4

5 Changes in unrealized gains/losses can be volatile, as this line item is impacted by certain product, risk management and hedging activities. Exhibit 6 /Health Capital & Surplus (4Q Q 2015) ($ Billions) Q 09 4Q 10 4Q 11 4Q 12 4Q 13 1Q 14 2Q 14 3Q 14 4Q 14 1Q 15 Exhibit 7 /Health Total Adjusted Capital (4Q Q 2015) Q 09 4Q 10 4Q 11 4Q 12 4Q 13 1Q 14 2Q 14 3Q 14 4Q 14 1Q 15 ($ Billions) Conclusion Despite the low interest rate environment, the life/health industry has been able to generate positive but declining earnings in recent years. Direct written premium growth has been positive but modest, and will remain one of the top issues facing the industry. While individual life and annuity premium growth continues to be a challenge for the industry as a whole, the pension risk transfer market, although not without its challenges, represents an area of potential premium growth going forward. This business is somewhat unpredictable as to when premiums are received, although they tend to be generally high dollar amounts, which can have a significant impact on direct written premiums. Over the past few years, Prudential has been the largest U.S. writer of pension risk transfer business. When interest rates rise, A.M. Best expects that there could be increased volatility in this market. However, other companies have recently entered the pension risk transfer marketplace, mainly in the small- to medium-size case market. A.M. Best will continue to monitor this evolving market, which can be appealing to companies with substantial resources interested in hedging large existing mortality books with longevity risk. Interest rates have been projected to rise for some time, but there is increasing sentiment that the Federal Reserve may raise interest rates as early as September In addition, one of the 5

6 main unresolved questions is that when interest rates rise, will it be a slow, steady increase, or a rapid rise in interest rates. A predictable, steady rise in interest rates will allow insurers to invest proceeds into higher yielding securities, which will help increase spreads between investment yields and interest rates credited on interest-sensitive products. A rapid rise in interest rates may lead to some unpredictability in the markets, and could expose insurers to disintermediation risk as investors seek to move money into higher yielding investments. Higher yields may also decrease market values of publicly traded bonds, which would impact unrealized capital gains, which may make them more difficult to sell without booking large realized losses. Rate hikes also may cause market volatility, which could impact separate account sales and management fees associated with those products. A.M. Best will also continue to monitor industry performance as the life/health insurance marketplace evolves in response to legislative, regulatory and economic developments. Among the most significant legislative and regulatory developments are the new NAIC Actuarial Guideline 48 governing domestic captive reinsurers, the ongoing impact of PPACA on health insurers and the Department of Labor s Conflicts of Interest Proposed Rule, which would expand the definition of fiduciary under ERISA. 6

7 Published by A.M. Best Company Special Report CHAIRMAN & PRESIDENT Arthur Snyder III EXECUTIVE VICE PRESIDENT Larry G. Mayewski EXECUTIVE VICE PRESIDENT Paul C. Tinnirello SENIOR VICE PRESIDENTS Douglas A. Collett, Karen B. Heine, Matthew C. Mosher, Rita L. Tedesco A.M. BEST COMPANY WORLD HEADQUARTERS Ambest Road, Oldwick, NJ Phone: +1 (908) WASHINGTON OFFICE 830 National Press Building th Street N.W., Washington, DC Phone: +1 (202) A.M. BEST AMÉRICA LATINA, S.A. de C.V. Paseo de la Reforma 412 Piso 23 Mexico City, Mexico Phone: A.M. BEST EUROPE RATING SERVICES LTD. A.M. BEST EUROPE INFORMATION SERVICES LTD. 12 Arthur Street, 6th Floor, London, UK EC4R 9AB Phone: +44 (0) A.M. BEST ASIA-PACIFIC LTD. Unit 4004 Central Plaza, 18 Harbour Road, Wanchai, Hong Kong Phone: A.M. BEST ASIA-PACIFIC (SINGAPORE) PTE. LTD. 6 Battery Road, #40-02B, Singapore Phone: DUBAI OFFICE* (MENA, SOUTH & CENTRAL ASIA) Office 102, Tower 2 Currency House, DIFC PO Box , Dubai, UAE Phone: *Regulated by the DFSA as a Representative Office A Best s Financial Strength Rating is an independent opinion of an insurer s financial strength and ability to meet its ongoing insurance policy and contract obligations. It is based on a comprehensive quantitative and qualitative evaluation of a company s balance sheet strength, operating performance and business profile. The Financial Strength Rating opinion addresses the relative ability of an insurer to meet its ongoing insurance policy and contract obligations. These ratings are not a warranty of an insurer s current or future ability to meet contractual obligations. The rating is not assigned to specific insurance policies or contracts and does not address any other risk, including, but not limited to, an insurer s claims-payment policies or procedures; the ability of the insurer to dispute or deny claims payment on grounds of misrepresentation or fraud; or any specific liability contractually borne by the policy or contract holder. A Financial Strength Rating is not a recommendation to purchase, hold or terminate any insurance policy, contract or any other financial obligation issued by an insurer, nor does it address the suitability of any particular policy or contract for a specific purpose or purchaser. A Best s Debt/Issuer Credit Rating is an opinion regarding the relative future credit risk of an entity, a credit commitment or a debt or debt-like security. It is based on a comprehensive quantitative and qualitative evaluation of a company s balance sheet strength, operating performance and business profile and, where appropriate, the specific nature and details of a rated debt security. Credit risk is the risk that an entity may not meet its contractual, financial obligations as they come due. These credit ratings do not address any other risk, including but not limited to liquidity risk, market value risk or price volatility of rated securities. The rating is not a recommendation to buy, sell or hold any securities, insurance policies, contracts or any other financial obligations, nor does it address the suitability of any particular financial obligation for a specific purpose or purchaser. Any and all ratings, opinions and information contained herein are provided as is, without any expressed or implied warranty. A rating may be changed, suspended or withdrawn at any time for any reason at the sole discretion of A.M. Best. In arriving at a rating decision, A.M. Best relies on third-party audited financial data and/or other information provided to it. While this information is believed to be reliable, A.M. Best does not independently verify the accuracy or reliability of the information. A.M. Best does not offer consulting or advisory services. A.M. Best is not an Investment Adviser and does not offer investment advice of any kind, nor does the company or its Rating Analysts offer any form of structuring or financial advice. A.M. Best does not sell securities. A.M. Best is compensated for its interactive rating services. These rating fees can vary from US$ 5,000 to US$ 500,000. In addition, A.M. Best may receive compensation from rated entities for non-rating related services or products offered. Data sourced from the BestLink system is retrieved around the time of the report creation and is subject to revision. A.M. Best s Special Reports and any associated spreadsheet data are available, free of charge, to all Best s Insurance News & Analysis subscribers. Nonsubscribers can purchase the full report and spreadsheet data. Special Reports are available through our Web site at or by calling Customer Service at (908) , ext Briefings and some Special Reports are offered to the general public at no cost. For press inquiries or to contact the authors, please contact James Peavy at (908) , ext