Reader Response to August 2011 Ratings: Consequences of US Downgrade

Last week, we wrote about the impact of the US Downgrade on the ratings of insurance companies.  However, we inadvertently approached this Ratings e-Alert issue like any other.  Clearly, the downgrade of US debt is an unprecedented event, and as such, last week’s Ratings e-Alert issue should have considered those matters unique to this unprecedented event.  Fortunately, a good friend of THEInsuranceAdvisor.COM – Dick Weber of Ethical Edge – brought this to our attention and was kind enough to author a “response” to the "August 2011 Ratings: Consequences of the US Downgrade" .  

In his response, Dick provides a well-reasoned explanation for how financial strength and claims-paying ability ratings are ONLY one of the major elements to consider as part of determining the overall suitability of a life insurance product, and cautions against comparing illustrations of HYPOTHETICAL policy values to determine whether a “new” policy can do a better job than the “old,” in-force policy.  Thanks to Dick for his willingness to contribute to the emerging, higher standard-of-care for life insurance product selection and portfolio management. 

For those of you not yet familiar with Dick's presence in the industry, he is a 45-year life insurance veteran (yes, he was a child agent!).  For 25 years a successful life insurance agent and 20-year life member of the Million Dollar Round Table, Dick and his firm now provide fee-only analytics and consulting services to family offices and high net worth individuals.

An academic in his spare time, his most recent publication, co-written with Christopher Hause, FSA, MAAA, is Life Insurance as an Asset Class - A Value-added Component of an Asset Allocation, was honored with a 2008 Best Paper Award from the Academy of Financial Services.  Hause and Weber published a second volume in the Asset Class series - Managing a Valuable Asset - in December 2010.  In addition to these two ground-breaking research papers, the two authors are best known for their unique process of applying Monte Carlo and industry standard expenses to the assessment and remediation of in-force variable universal life.

Dick's firm is located in Northern California, and he can be reached by email at Dick@EthicalEdgeConsulting.com.  The firm's website can be accessed at www.EthicalEdgeConsulting.com.

Lastly, if you are interested in also contributing to and/or participating in the dialogue about the emerging, higher standard-of-care for life insurance product selection and portfolio management, please contact Sarah Riedel at sriedel@theinsuranceadvisor.com with your ideas for an e-news article. 

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For all the respect I have for The Insurance Advisor’s efforts to bring rationality to the understanding of the underlying pricing of life insurance, I must take issue with the suggestion in your most recent headline that 5 of our best life insurance companies will likely begin to raise their fees and expenses in order to "make up" lost profitability due to S&P's policy to not rate a holder of a bond higher than the sovereign that issued it.

The conditions precipitating S&Ps carrier downgrades on August 5, 2011 results from a completely different situation than might typically characterize a rating downgrade as you suggested in your headline article.  Also, I must point out that the other major rating agencies did not follow suit.

Income and profitability has not changed one bit for Northwestern Mutual, New York Life, Knights of Columbus, TIAA-CREF and USAA.  California’s Insurance Commissioner Dave Jones said on August 10 that the downgrade does not reflect the insurers’ financial health, and further “... S&P’s downgrade to AA+ has no impact on insurers’ claims paying abilities.”  S&P itself commented that these five companies have “...very strong financial profiles and favorable business profiles ... maintaining very strong capital and liquidity.”  S&P also stated “ … in addition, we believe that the significant retail insurance liabilities -- such as whole life insurance and deferred annuities -- that some of these companies are less prone to withdrawals or surrenders than institutional liabilities.” 

The NAIC has affirmed the continued strength of downgraded carriers.  Susan Voss, NAIC president and Iowa insurance commissioner, stated "There is no impact on insurer investments in U.S. government and government-related securities from the actions recently taken by the rating agencies (sic).”

Neither Moody’s nor Fitch have taken the “no rating higher than the sovereign” approach to life insurers.  On August 2, 2011, Fitch stated that with the debt ceiling increase signed into law and “... commensurate with its ‘AAA’ rating [of the U.S.], the risk of sovereign default remains extremely low.”

According to one resource I follow (and a matter of public record), the five downgraded insurance groups have significant holdings of U.S. Treasury and government agency securities—between 60–200 percent of total adjusted capital for each of the five companies at the end of calendar 2010.  That said, the downgrade of U. S. debt obligations is not expected to affect a life insurance company’s Risk Based Capital ratio, as RBC does not assign a credit risk charge for instruments that are backed by the full faith and credit of the U.S. government. 

In a report issued following S&P’s downgrades, Colin Devine of Citi Investment Research & Analysis, stated: “Japanese life insurers adapted to that country losing its ‘AAA’ rating and continue to hold large levels of government bonds. We see no reason why U.S. insurers won’t do so as well.”

Of additional interest is that S&P affirmed the ‘AA+’ ratings on five other insurance groups—Assured Guaranty, Berkshire Hathaway, Guardian, Massachusetts Mutual, and Western & Southern.  While at the same time S&P revised the rating outlooks on these companies to negative from stable - it nonetheless stated that this group of carriers maintains very strong capital and liquidity.

Ironically, and against financial pundit predictions, S&P’s downgrade of U. S. debt did not result in a sudden rise in interest rates.  In fact, as of this writing on September 9th, there has been ~75 basis point drop in the interest rate on 10-year U. S. Bonds since the debt ceiling debacle.  And, that drop has, in turn, actually increased the value of those bonds on behalf of all bondholders (although, of course, it's a zero-sum game with respect to portfolio income and asset valuation).

Notwithstanding all of my chest-thumping about the continued financial integrity of these ten insurance companies - and indeed most of the top carriers in our industry - there is a problem with declining portfolio income, brought about by the fiscal, economic, and political issues that currently plague our country.  Let’s not kid ourselves - no-lapse policies are not meeting their targeted shadow account returns, and real policy crediting rates and dividends are declining as a result of lower income on new investments made with premium income.  Of similar negative consequence is the turnover of matured bonds whose redemption proceeds must be reinvested at today’s substantially lower coupon rates.

It appears that the Great Recession isn’t over, and there could even be a “double dip.”  Most economists believe we’re in an economic phase that doesn’t have easy fixes.  An extremely volatile stock market combined with historically low interest rates has devastated retirement plans and is producing lower-than-illustrated results for performance-dependent life insurance policies.

But I caution advisors and consumers alike: the recent modest downgrade from one rating agency with respect to the financial strength ratings of some our most venerable and financially secure financial institutions is unique and does not suggest a problem with carriers themselves.  If an agent suggests that the downgrade warrants the exploration of a different policy from a different carrier, don’t compare illustrations of non-guaranteed policy values to determine whether a “new” policy can do a better job than the “old,” in-force policy.  The near-zero short-term rates and historically low mid and long-term interest rates are affecting all insurance companies.  A disappointing crediting rate or somewhat lower dividend scale does not in and of itself change the suitability of a current policy.  The prudent thing to do (as defined by the Prudent Investor Act) is to measure: 

1)      what the insurer expects to charge for cost of insurance charges (COIs), fixed administration expenses (FAEs), cash-value based “wrap fees” (e.g., VUL M&Es) and premiums loads, and

2)      actual historical performance of invested assets underlying policy cash values. 

If policy costs are competitive relative to peer-group and performance is reasonable for the asset classes into which cash values are invested, then the solution is to revise expectations - not shop for the appearance of a better deal (but which, in fact, isn’t guaranteed by the insurance company).

If policy costs appear non-competitive relative to peer-group – and if tempted to recommend or pursue a replacement – then it is imperative to complete and discuss with the client the Society of Financial Service Professional’s “Replacement Questionnaire” (RQ).  The RQ addresses:

• the potential loss of important guarantees (e.g. 4% versus 2.5% guaranteed crediting rates);
• the amount of surrender charges in the “old” policy and the new contingent surrender charges associated with the “new policy (and a justification for why this is to the client’s advantage);
• the beginning of a new 2-year contestable period (make certain that each and every answer in the application is unequivocally correct);
• and that the projections in the “new” illustration are reasonable insofar as can be reasonably determined today. 

Richard M. Weber, MBA, CLU®, AEP

President

The Ethical Edge, Inc.

Pleasant Hill, CA