Industry Ratings Outlook

The performance of Japan's insurers was split along industry lines in fiscal 2018 (ended March 31, 2019). The results for major life insurers were rosier than S&P Global Ratings expected, while those of major non-life insurance groups were in line with our expectations.

Japan's four major life insurers increased their total unconsolidated core insurance profit by 3.8% year on year, mainly due to better interest margins.

Consolidated net income lifted for Japan's three major non-life insurers despite heavy losses stemming from primarily from a string of natural disasters in Japan in 2018. Total consolidated net income rose 6.2% year on year as the groups drew down on their catastrophe loss reserves, accelerated sales of shareholdings, and staged a recovery in their overseas businesses.

The four major life insurers we rate are Nippon Life Insurance Co., The Dai-ichi Life Insurance Co. Ltd., Sumitomo Life Insurance Co., and Meiji Yasuda Life Insurance Co. The three non-life insurance groups are Tokio Marine Group, MS&AD Insurance Group, and Sompo Holdings Group.

For fiscal 2019, the insurance-related profit of the four life insurers is likely to continue to underpin solid core insurance profit. However, interest spread volatility might increase alongside the growing proportion of foreign currency-denominated coupons and dividend proceeds relative to overall coupon and dividend proceeds.

We expect the three major non-life insurance groups to beat the combined total of consolidated net profit for fiscal 2018. This is because the groups expect losses related to natural catastrophes in Japan to normalize and to boost profit contributions from their overseas businesses. Shareholders' expectations for better capital efficiency are likely to lead to continued strong pressure for higher returns. This factor keeps our analysis focused on how each non-life insurance group balances retained earnings and shareholder returns, and on any developments involving large acquisitions.

Japan's Four Major Life Insurers

The four major life insurers' aggregate core insurance profit on an unconsolidated basis grew 3.8% year on year to ¥2.154 trillion in fiscal 2018 (see charts 1a and 1b). Core profit increased because positive spreads improved. First, on the revenue side, there was an increase in interest and dividend income from foreign securities and in dividend income from domestic stocks. On the cost side, average guaranteed rates of interest declined as policies with high guaranteed rates matured and insurers set aside additional reserves. Insurance-related earnings, which are the sum of mortality and morbidity gains and expense margins, were nearly flat from the previous fiscal year. This is despite an increased burden in provisions set aside for underwriting reserves related to new contracts (particularly group life insurance contracts renewed every year), mainly due to the impact from revision to the standard life table. The standard life table is the data summary of death rate by age and gender released by The Institute of Actuaries of Japan; it is used to calculate policy reserve.

Accumulation of retained earnings and issuances of subordinated debt helped the four major life insurers improve their capital bases more than we expected for fiscal 2018. They continued to accumulate reserves that count as retained earnings and earned surpluses, thanks in part to large core insurance profits. Furthermore, some of the four insurers issued subordinated debt that met our criteria for intermediate equity content. Latent gains on domestic equities shrank, reflecting an approximately 7% decline in Tokyo's TOPIX stock index from March 31, 2018, through March 2019. But our credit analysis of each life insurer incorporates a degree of negative impact. To some extent, our assessment of capital takes into account a potential fall in such latent gains on the assumption that stock prices might lose some ground.

As the two charts below show, total core insurance profit at the four life insurers has increased, mainly because of positive investment spreads.

Chart 1a

Chart 1b

To secure yields in a low interest rate environment, the four major life insurers have been shifting their weightings toward foreign and other securities. In turn, their weightings in domestic government and corporate bonds have shrunk (see chart 2a). The decline in the proportion of domestic stocks is likely attributable mainly to the slump in market value, given that the book value is nearly flat.

Insurers expect unconsolidated core insurance profit to decline in fiscal 2019 because they anticipate that positive interest spreads will shrink. While the average guaranteed rates of interest have been declining, the low interest rates in the domestic market are likely to persist, and insurers are making conservative assumptions about the financial markets this fiscal year. The maturation of domestic government and corporate bonds with relatively high yields should continue to draw life insurers' focus to several constraints as they reinvest funds: management of assets and liabilities, maintaining yields, foreign currency risk, and hedging costs.

We expect insurance-related earnings to remain either flat or be a tad lower year on year for some time. An increase in third-sector business (which includes policies for matters such as nursing care and medical treatment) is likely to enable mortality and morbidity gains to provide support to insurance-related earnings. But the issue over when to recognize expenses and revenue in accounting terms may cause some temporary volatility. That said, we expect a decline in in-force policies, mainly for death protection, to pull down earnings.

The charts below show the market sensitivity of interest and coupon income has increased. The share of foreign securities in the general account at the four life insurers has risen.

Chart 2a

Chart 2b

The main risks that the four major life insurers face for now are interest rate risk and risk from domestic stock price volatility. The companies are exposed to currency risk in their income statements because they receive most of the interest income from foreign securities in foreign currencies. Interest and dividend income from foreign securities and dividend income from domestic stocks account for a growing proportion (see charts 2a and 2b). Furthermore, interest spreads have become more volatile than before because of wide variations in dividends on domestic and foreign stocks and in dividend and redemption gains on other securities.

We do not expect interest rate risk to diminish substantially over the next 12 months. While some life insurers resumed sales of yen-denominated savings-type insurance products, the insurers continue to curb fresh underwritings of these insurance products by lowering their guaranteed rates of interest or suspending sales of such products. We see two reasons why this type of risk is unlikely to subside. First, in order to maintain yields, the insurers have no option other than to target foreign-currency-denominated bonds with short durations when reinvesting a portion of repayments and dividend and coupon incomes received on yen-denominated interest-bearing assets in their existing portfolios. Second, a lower surrender-and-lapse ratio for residual debt insurance policies could lengthen the duration of their liabilities.

Risk concerning domestic stock price volatility has waned because the market settled down in fiscal 2018. Thus far, there has only been a limited increase in risk stemming from additional stock purchases. The downward pressure on yields fueled by persistent low interest rates and stock market volatility risk suggest to us that the life insurers are unlikely to materially reduce or increase their exposures.

Foreign currency risk is likely to vary by life insurer, with each enacting its own flexible policy on such risk based on its market expectations. Hedging costs, though, have been on the rise or remained at elevated levels in recent years owing to a climb in U.S. interest rates. In response, life insurers are implementing a combination of measures such as increasing open positions; allocating more funds to euro-denominated bonds, which tend to have relatively low hedging costs; reducing risk by diversifying investments into various regions; and utilizing currency options to control foreign currency risk (see charts 3a and 3b).

To keep fees on currency options in check, we think life insurers might be setting strike prices at levels far off actual market prices. Their disclosures suggest that they might be engaging in trading, whereby they offset premium payments to buy put options with premium income for selling call options. While the scale of this trade is not large now, it could grow. Also, this method of option trading might help reduce risk volume, but it is not clear how well it would curb volatility of the bottom line. We have not seen any meaningful increase in the insurers' holdings of alternative assets so as to affect the insurers' credit quality. Alternative assets include bonds rated 'BB+' or below, investments in infrastructure funds, securitized products such as collateralized loan obligations, and bank loans, and real estate.

The charts below show how the insurers have diversified geographically and in terms of currency options to handle the trade-off between foreign exchange risk and hedge costs.

Chart 3a

Chart 3b

Japan's Three Major Non-Life Insurance Groups

The three major non-life insurance groups weathered ballooning losses related to natural disasters in Japan, marking a 6.2% increase year on year in total consolidated net income to ¥613.8 billion in fiscal 2018. Factors that lifted income include a step-up in stock sales (which exceeded a total of ¥400 billion on the sales price), drawing down of catastrophe loss reserves, and a recovery in overseas businesses.

However, we believe substantive sources of accumulated earnings shrank. We base this on two factors. First, insurers drew down a large amount of catastrophe loss reserves. Second, booking gains from securities sales means latent stock gains were merely realized, which does not significantly boost capital. We estimate that the substantive accumulation of retained earnings as of the end of fiscal 2018 was either up by a limited amount or even down (see charts 4a and 4b). This is because the insurers have said they plan to maintain shareholder returns at the previous year's levels.

For fiscal 2019, the three major non-life insurers expect to increase their total consolidated net income by 12.9% to ¥693 billion. They assume a normalization of losses related to natural disasters in Japan, and a recovery and growth of their overseas businesses.

One factor that could weigh on profit is an expected rise in reinsurance cost. This is because reinsurance premium rates have increased in response to the massive losses related to the natural disasters in Japan in fiscal 2018. Also, the two insurance groups excluding Tokio Marine expect net incurred losses from disasters in Japan to grow about 10% year on year in fiscal 2019. In addition, the three insurance groups expect a rise in costs stemming from the scheduled increase in the consumption tax and a decline in gains from securities sales.

Meanwhile, the insurance groups' assumed normalization of losses related to natural disasters in Japan might support their profit. They are also likely to gradually reap the benefits from industry body General Insurance Rating Organization of Japan's plan to hike its advisory rate for fire insurance premium rates in fiscal 2019 by more than 5.5%. Furthermore, new types of insurance products are likely to continue experiencing strong growth.

Domestic non-life and life insurance businesses should still support Japan's three major insurance groups' profit. This is mainly because in-force policies should steadily grow in the domestic life insurance business, too. Overseas businesses are generally likely to make increased contributions to group profit thanks to an assumed normalization of losses related to natural disasters. The degree of contribution may differ among the groups, though.

Regional and business diversification should help the non-life insurance groups maintain their capability to generate accumulated earnings, despite temporary fluctuations over the course of a single fiscal year. The governance regime of the acquired overseas units, underwriting management, and risk management are focal points in our analysis. This is because we have seen cases in which the operating performance of acquired overseas subsidiaries has worsened on factors other than natural disasters. Goodwill impairment related to acquisitions do not directly affect our analysis because we completely deduct goodwill from our calculation of total adjusted capital (TAC). However, we may lower our expectation of the earnings contribution the acquired overseas entity might make, thereby potentially hurting our credit assessment.

As the charts below show, there is a chance retained earnings at the non-life insurance groups declined in fiscal 2018.

Chart 4a

Chart 4b

Each insurance group's economic solvency ratio remains stronger than the level each group considers necessary (see chart 5). This is partially because risk related to stocks have been shrinking, offsetting the negative effects of a reduction in catastrophe loss reserves and latent stock gains and a decline in interest rates. Shareholder expectations for better capital efficiency are likely to lead to continued strong pressure for higher returns. Therefore, our analysis will continue to focus on how each non-life insurance group balances retained earnings and shareholder returns and on any cumulative effects of large acquisitions and their minor investments in overseas insurance companies.

Chart 5

Domestic equities and natural disasters are likely to remain the main risk factors the three non-life insurance groups face. Selling strategically held stocks might help improve the quality of capital and reduce risk, in our view. As such, our base-case scenarios incorporate the groups' plans to continue selling strategically held stocks; and our assessment of each insurance group's capital and earnings reflect them to a degree. In fiscal 2019, the groups have said they plan to sell strategically held stocks in amounts upward of ¥100 billion; actual sales will depend on market conditions. This would follow a year of accelerated sales of strategically held stocks, by which the groups steadily turned to less risky assets and realized latent gains.

The insurers are likely to continue to reduce exposure to domestic stocks, which tend to have low returns relative to the risk, while reallocating more resources to overseas businesses in the longer term to achieve higher returns relative to risk. Expanding overseas operations remains a basic policy of the insurance groups. Indeed, fiscal 2018 saw sporadic cases of bolt-on acquisitions (acquiring and growing smaller businesses) to complement existing lines of business and equity-method investments by the groups in their pursuit of expanding their overseas insurance businesses. They also have the discipline to sell any overseas units that don't meet profit expectations or whose business overlaps with their own. For example, the Sompo group sold Sompo Canopius AG in fiscal 2017, and the Tokio Marine group sold two reinsurance subsidiaries (two Tokio Millennium Re companies) in fiscal 2018.

Domestic risk associated with natural catastrophes is unlikely to increase materially. This is because of prudent underwriting practices; and because insurers assumed larger losses than before from natural disasters in Japan and have bolstered reinsurance coverage. Risk associated with natural catastrophes overseas is likely to continue to increase due to major non-life insurers' organic growth and expansion outside Japan through M&A. Nevertheless, the insurers are likely to somewhat curb growth of overall risk after considering diversification effect. We base this view on their efforts to increase the geographic and business diversity and to continue developing more sophisticated risk management systems.

Issuer Review

Table 1

Related Research

• Japan Insurer Outlook Stable For 2019; Groups Seek Strength Through Diversification, Jan. 20, 2019
• Japanese Insurer Solvency Momentum May Slow, Dec. 7, 2018
• Disasters Defined Japan's Major Insurer Performance In FY2017, June 26, 2018