The COVID-19 pandemic has escalated risks for North American life insurers--namely asset risk, equity market volatility, near-zero interest rates, and heightened mortality risk. Nevertheless, our outlook for the sector remains stable. We believe that the majority of North American life insurers are well-positioned to handle the immediate impact of COVID-19--particularly from the increase in corporate bond downgrades and moderate pandemic risk--given their buildup of solid capital buffers and liquidity.

We do not expect significant reserve increases in response to near-zero interest rates, rather we expect assumption updates to generally be moderate. We also believe hedging programs are generally effective. Likewise, we are not expecting a "race to the bottom" in an effort to find growth, but rather the sector will focus on conserving capital during the market dislocation.

Given the deterioration in credit quality in corporate bonds and the significant losses in equity markets, we believe asset risk is the most immediate risk factor for the sector. North American life insurers tend to have relatively low exposure to equities in their investment portfolios since most heavily invest in fixed-income securities to match asset and liability durations within a relatively short range. While there is some risk to capital adequacy from other-than-temporary impairments and fallen angels--particularly as insurers have significantly increased their exposure to 'BBB' rated bonds--we believe most insurers are well-positioned.

The sector has reduced its equity market risk exposure over the last decade through more risk sharing with policyholders, repricing and moderating guarantee benefits. Also, the rising popularity of adding macro hedges on top of dynamic hedges should better protect financial strength in times of stress, though these strategies vary widely by insurer.

The unprecedented drop in key benchmark interest rates (such as the 10-year U.S. Treasury yield) is also a risk for the industry, though life insurers have been effectively navigating declining rates for over a decade. The recent widening of credit spreads has also softened the blow somewhat. We anticipate only moderate increases to reserves following insurers' annual asset adequacy tests this year. But for insurers with longer-tail liability profiles, such as long-term care, a moderate interest rate assumption change could translate into a larger reserve increase.

Furthermore, we recently conducted a hypothetical mortality stress test to estimate the potential impact of a pandemic event on the U.S. life insurance sector (see "Amid Coronavirus Outbreak, S&P Global Ratings Looks At How A Hypothetical Pandemic Could Affect U.S. Life Insurers"). In our moderate pandemic scenario, we anticipate current capital buffers will generally absorb additional excess net mortality claims.

We view life insurers' ability to take a longer-term view of their liabilities as a key differentiator relative to other players in the financial markets value chain. As such, life insurers should remain a stable supplier of retirement solutions and mortality protection when the market needs these the most. Nevertheless, we can anticipate repricing and redesign of products that are more prone to interest rate sensitivity. And we wouldn't rule out a slowdown or a complete halt in new sales for interest-sensitive products.

Asset Risk: Most Significant And Immediate Risk, But Life Insurers Are Well-Positioned With Capital Buffers

U.S. life insurers tend to have high asset leverage, with about $8 of invested assets for every dollar of capital in the industry. Given this, and the fact that investment/credit risk (C-1 per NAIC risk-based capital) tends to make up more than half of the required capital for our rated insurers, we see several key areas to monitor as COVID-19's impact continues to roil the U.S. economy.

First, other-than-temporary impairments could weigh on both earnings and capital. Our assessment of adjusted earnings typically excludes realized gains, but we could view more negatively the risk tolerance of an insurer that experiences outsize losses relative to peers. Fallen angels and downgrade risk could also heighten capital requirements for insurers.

We assessed both of these risks last year and found that most insurers are well-positioned today, with capital buffers that are substantially larger than in 2008 (see "When The Cycle Turns: Investment Impairments Will Bend But Not Break U.S. Life Insurers' Financial Strength"). We have since updated our analysis to include some assumptions around other asset classes, particularly exposure to sectors most affected by social distancing, as well as to energy given its own crisis. However, to the extent we see a wider range of effects--such as significant defaults in commercial mortgage whole loans, which we did not see in 2008--the hit may be worse than anticipated.

According to our economists, the impact of social distancing on consumer spending activity and a knockdown effect on business investment, together with depressed oil prices, likely means a large contraction of around 12.0% for U.S. GDP growth in the second quarter. A slow U-shaped recovery in the second half of the year largely depends on governments' policy response and the path of the virus. To date, S&P Global Ratings has taken almost 300 rating actions on nonfinancial corporate borrowers that were at least partially related to the outbreak's effects. We now expect the U.S. speculative-grade corporate default rate to rise to 10% in the next 12 months from 3.1% in December 2019.

Finally, the recent changes in rates--including the substantial decline in the 10-year Treasury rate, somewhat offset by an increase in corporate spreads--may reduce insurers' new money yields. Many insurers have been experiencing a decline in new money yields for over a decade given low rates and spreads, causing a slow bleed in overall portfolio yields as existing assets mature.

Depending on an insurer's investment strategy and the amount of risk it is willing to take, a volatile market like today's could be an exciting opportunity to find underpriced risk, or could be a strong incentive to step back and invest more safely at historically low yields. We think U.S. and Canadian life insurers will take a variety of approaches.

Interest Rates: Reserving Assumption Updates Are On The Horizon

Interest rates also play a key role in setting up insurance reserves since insurers need to make long-term interest rate assumptions to set up their GAAP reserves. Under U.S. GAAP accounting, most insurers generally assume mean reversion, meaning rates will gradually increase over time, say 10 years, to higher than current levels. But as rates have remained lower for longer, insurers have sequentially lowered their long-term rate assumptions and endured earnings hits from related reserve updates.

This key GAAP reserve assumption differs among insurers (see table). In 2019, some insurers updated these assumptions, but actual rates have declined further since then. Therefore, we believe it's likely that in 2020, during the annual actuarial assumption reviews (usually in the second or third quarter), several insurers will further lower the long-term rate or extend the amount of time it will take to reach their assumed mean reversion levels.

Table 1

How will that change affect GAAP earnings and capital? Historically, insurers have lowered their assumption by 25 basis points-50 basis points at a time. This gradual shift has somewhat muted the impact on earnings rather than hurt capital. If insurers maintain a gradual approach and assume long-term rates will revert to higher levels, we wouldn't expect a meaningful impact on earnings and capital.

Lower interest rates will also result in spread compression, which is a negative for operating performance. Liabilities with relatively high guarantees are staying on the books longer than expected, compressing spreads as the reinvestment rates are now lower than at issuance. For some insurers, new business at lower rates is helping to offset the older guarantees, and investment yields (though declining) remain above guaranteed levels. But, as we revert back to lower for much longer--and new sales are expected to slow and investment yields to decline further--spread compression will once again be a pressure point for the industry.

Equity Risk: Effective Hedging

The U.S. equity market's 30% drop this month marks an abrupt end of the 10-year bull market. Furthermore, it is unclear when equity markets will bottom out amid an economic shutdown propelled by increasing cases of the coronavirus, along with an energy crisis. Among the life insurance sector's products, there is more of a bias toward assuming interest rate- and mortality-related risks than equity market volatility as a fallout of the financial crisis.

After the financial crisis, many variable annuity (VA) players reduced the richness of the guarantees offered on their products, mandated the use of risk-managed funds, and increased the fees charged for these types of products. Despite the sector's efforts to reduce risk over the last decade, some market-sensitive legacy blocks, as well as some blocks sold in the post-2009 era, still contain guarantees that would be exposed to the equity market downturn, and insurers with increased exposure to asset-management businesses should see lower fees.

We expect hedging to be effective for most insurers, though hedging strategies vary widely among the life insurers we rate. Ultimately, we take a balanced view--putting into perspective the appropriateness of hedging strategies (spectrum of dynamic hedges "at the money" to macro hedges to cover tail risk) relative to capital buffers. From a risk management perspective, we view favorably a combination of large capital buffers, dynamically hedging the first dollar of loss, and instituting macro hedges to cover any residual equity risk across the enterprises.

Generally, as equity market volatility increases, hedging costs rise, which will dampen earnings even further. Lastly, increased equity risk accelerates amortization of GAAP deferred acquisition costs as future gross profit assumptions are dwarfed.

The effects of equity market volatility on life insurers are not linear--the biggest unknown is policyholder behavior, which isn't always economically aligned with the relative moneyness of embedded guarantees (or the difference between account values and guarantee levels). Even the best actuaries cannot predict with certainty policyholders' behaviors, including lapse rates and income utilization for VAs with embedded guarantees. The same is true for some fixed indexed annuity writers who have increasingly been offering living benefits outside the dominant Insurance Marketing Organization distribution channel. Moreover, even though most VA writers actively hedge the impact of equity markets and interest rates, it is impossible to hedge against changes in policyholder behaviors.

Generally, we expect greater persistency as in-force guarantees are more "in-the-money." However, in the last financial crisis, we also saw a spike in GLWB (guaranteed living withdrawal benefits) shock lapses for "at-the-money" contracts. Given the current market volatility and the average age of policyholders, we anticipate annuityholder preferences to shift to income from accumulation, more so than during the financial crisis. As such, we could see greater utilization of income riders, perhaps higher than original actuarial assumptions.

Mortality: Stress Test Shows The Impact Of A Hypothetical Pandemic

As of this writing, the reported cases of COVID-19 total over 416,000 across 196 countries, according to the World Health Organization. About 5%, or at least 18,589, of the reported cases have died from it. This case fatality rate (CFR)--the proportion of those infected who subsequently die--varies across countries and ages. The actual mortality rate may be lower since the CFR is only based on reported cases of individuals having COVID-19. But, even if the actual mortality rate is lower, there is no denying that a spike in the mortality rate can negatively affect insurers with life insurance business.

We aren't epidemiologists, and we don't model the potential spread of the coronavirus. So, we undertook a mortality stress test based on historic pandemics to assess the impact on insurers' in-force life insurance business (see "Amid Coronavirus Outbreak, S&P Global Ratings Looks At How A Hypothetical Pandemic Could Affect U.S. Life Insurers").

Our moderate pandemic event stress (based on the 1957 "Asian flu" pandemic) showed $7 billion of additional excess net mortality claims (aftertax). This represents about 2% of outstanding industry capital and would have a limited impact on the industry's financial strength. A more extreme pandemic event (based on the 1918 "Spanish flu" event) would result in about $52 billion of excess net mortality claims (aftertax)--about 12% of the aggregate U.S. life insurance industry capital--and would likely have a negative impact on insurers' credit quality (see chart).

At current levels in the U.S., "excess deaths"--or deaths reported as a result of COVID-19--remain well below our moderate stress scenario. But, we also recognize that a vaccine is still almost a year away, and no proven treatment has been approved by the World Health Organization. This puts the emphasis on containment measures to slow the spread and keep mortality levels in check.

Several states have taken steps--such as shelter in place orders, school closures, and limits on the size of gatherings--in an attempt to contain the spread of COVID-19. But, several states remain open to business with limited actions that encourage social distancing. The lack of cohesive action does increase morbidity and mortality risks. We continue to closely track the spread of this virus and containment actions local, state, and federal governments are taking.

Unique Dynamics For Canadian Life Insurers

While the Canadian life insurers we rate face many of the same risks as U.S. insurers from an asset perspective, the Canadian accounting and regulatory frameworks are significantly different from the U.S. and have some unique considerations.

As both sides of the balance sheet in Canada are mark to market, we expect to see immediate effects on the liability side as a result of declines in interest rates. However, this should be offset by corresponding gains on the asset side through the available-for-sale bonds, in many cases resulting in an increase in overall shareholders' equity and improved LICAT ratios.

Canadian insurers, like their U.S. counterparts, also do not hold significant equity investments in their portfolios, but their capital and earnings will be affected by the decline in equity markets to varying degrees based on exposures to various product types. Many of the Canadian insurers we rate also have asset and wealth management businesses, so we could see some weakening in earnings as assets under management fees go down.

More generally, the decline in oil prices may pressure the general health of the Canadian economy more so than better-diversified economies, with knock-on effects to Canadian sales as well as potential impairments, defaults, or downgrades in Canadian corporate bonds.

A few important factors are offsetting these headwinds. The top three insurers in Canada are well-diversified, both geographically and across lines of business. This diversification will serve them well--particularly as their reporting currency, the Canadian dollar, weakens relative to some of the other geographies in which they operate, boosting reported earnings. Several insurers have also been deleveraging their balance sheets and reducing the risk on their liability and asset portfolios for the past few years. Finally, overall capital buffers, including PfADS (provisions for adverse deviations), remain strong relative to rating levels, so we expect stability in the sector while continuing to monitor second-order effects from COVID-19.

Most Life Insurer Ratings Likely Can Withstand The Impact Of COVID-19

As North American life insurers face fourfold risks amid the COVID-19 pandemic--namely asset, equity market, interest rate, and mortality--we think most companies are well-positioned given their buildup of capital buffers and liquidity. Our sector outlook indicates anticipated credit trends over the next 12 months, informed by existing outlook distributions and sector risks, as well as any emerging risks that may dominate rating actions. Just over 90% of our rated life insurers currently have stable outlooks, which indicates the low likelihood of negative rating actions in the next 12 months.

While we do not envision significant rating activity, the tendency is toward a moderately negative trend, particularly for insurers that are more prone to the identified risks or that were already facing ratings pressure prior to the coronavirus.

What would cause the North American life insurance industry outlook to become negative?

A prolonged recession, beyond our current revised base case, could have broader implications. Potential downside scenarios that would cause us to revise our sector outlook to negative include scenarios that would materially reduce capital cushions:

• Higher-than-expected corporate bond downgrades or defaults;
• Substantial reserve increases, which could occur due to persistently near-zero or declining interest rates; or
• Higher-than-anticipated losses due to hedge breakage from equity market volatility.

Likewise, we may revise our outlook if the mortality rate increases significantly over the next few weeks or months.

A sustained COVID-19 pandemic may also constrain some insurers' ability to access the capital markets, which we would view as credit negative. Nonetheless, strong holding company liquidity and limited upcoming maturities somewhat offset this concern.

S&P Global Ratings acknowledges a high degree of uncertainty about the rate of spread and peak of the coronavirus outbreak. Some government authorities estimate the pandemic will peak about midyear, and we are using this assumption in assessing the economic and credit implications. We believe the measures adopted to contain COVID-19 have pushed the global economy into recession (see our macroeconomic and credit updates here: www.spglobal.com/ratings). As the situation evolves, we will update our assumptions and estimates accordingly.

Appendix: Ratings, Financial Risk Profile Assessments, And Capital Scores And Levels

Table 2 provides a list of our life insurers' current capital and earnings scores, financial risk profile assessments (which take into consideration funding structure and risk exposure), and capital model redundancy. For a hypothetical issuer that holds 'AAA' capital with a '2' capital and earnings score and an overall very strong financial risk profile, it's likely that the insurer has a substantial capital buffer at the current ratings level.

Table 2