While the COVID-19 vaccination program in the U.S. offers some hope, the U.S. economy is far from being out of the woods. We may be looking at a lengthy recovery or even another downturn, albeit not as severe as in 2020, if restrictions and shutdowns drag down the economy. Neither of these scenarios is particularly appealing for life insurers.

In S&P Global Ratings' view, U.S. life insurers will continue to deal with stresses on their investment portfolios; muted earnings due to low interest rates; challenges to distribution; and, sadly, elevated mortality claims. Balancing these headwinds, at least somewhat, are:

• The strong capital positions that most life insurers have built over the last decade;
• The capital markets, which continue to offer life insurers relatively cheap capital to further bolster their balance sheets;
• Active mergers and acquisitions (M&A); and
• Healthy demand for life and retirement products, or even higher demand for some products (such as term life insurance).

In 2021, we expect about an equal number of rating actions up and down for our rated U.S. life insurers. About 97% of our ratings have stable outlooks, none have positive outlooks, and the balance either has negative outlooks or ratings on CreditWatch negative or developing (see chart 5).

We believe 2021 might be a tough year for the companies we rate in the sector, but we expect they'll be able to navigate through the difficulties without a significant negative impact on their credit quality. Beyond the next few years, we do see threats for the life insurance industry, particularly from sustained low interest rates and technological changes to the marketplace. That said, these threats will take years to unfold, and the industry may very well adapt to successfully tackle them, and indeed most companies have begun taking steps to do so.

Chart 1

Sales Are Expected To Recover For Some Products Amid Renewed Appreciation For Life Insurance

The unexpected onset of the global pandemic and the lockdowns and other restrictions caused an unprecedented disruption in sales and distribution of life and annuity products. The industry was quick to get its bearings--minimizing operational challenges, navigating market volatility, and maintaining balance sheet strength. Both life and annuity sales took a hit in the first half of 2020 and then gradually improved in the second half as some restrictions were lifted and as the fragmented distribution networks adapted to the new online-only reality.

We expect life insurers to focus on improving sales in 2021, although renewed restrictions amid a surge in COVID-19 cases across the U.S. may hamper these efforts, at least until the vaccination program begins to reduce the spread of COVID-19. At the same time, we expect companies to reevaluate product features and focus on simpler and more flexible product designs as they contend with sustained low interest rates, changing consumer preferences, and evolving distribution.

Chart 2

Life insurance products

Amid the operational issues that plagued the industry, 2020 reinstated the need for life insurance protection products. After a chaotic first half, we saw increased demand for simple term and whole life insurance. The gruesome death toll of the pandemic forced potential life insurance consumers to reassess their protection needs, increasing demand. We expect this momentum to continue well into 2021. This will likely increase sales of simpler and smaller face value policies, perhaps sold through digital platforms, as opposed to the more complex and high face-value policies, which are typically driven by high-net-worth individuals' financial planning needs.

Demand for long-term care (LTC) combo products will also likely remain strong as consumers look for solutions to LTC expenses bundled with traditional life insurance. Indexed universal life (IUL) sales will likely pick up, but will remain below historical highs, as insurers absorb amended Actuarial Guideline 49 that further limits some sales practices. Despite gradual recovery, employment and economic conditions will likely still hurt group life and employee benefit players--particularly companies exposed to small to midsize businesses. We view this as an additional obstacle given that there have been several acquisitions in group insurance in the past couple of years and companies are already contending with integration-related distractions.

Chart 3

Variable annuities

Traditional variable annuity (VA) sales have been declining since 2011 (barring a slight uptick in 2018), and we expect this trend to last as companies limit and even discontinue selling VA with living-benefit guarantees. At the same time, we are seeing an increased emphasis on selling indexed VAs, also known as registered index-linked annuities (RILAs), structured VAs, or buffered VAs, which limit market risk.

Currently, RILAs represent 22% of the VA market and 10% of the total annuity market. With many large traditional VA insurers entering the market, we expect this product to eat into some of fixed-indexed annuities (FIAs) and traditional VAs' market share. To reduce the risk in their overall VA books, we expect insurers to continue to pivot toward limited benefit or investment-only VA offerings. Moreover, as insurers vie for economic solutions, we expect they'll try to balance managing legacy VA blocks and looking for alternatives, like policy buyback/surrender options and block reinsurance, to name a few.

Fixed-indexed annuities

After a strong run since 2012 (barring 2017), tough market conditions coupled with insurers' pricing actions (like reducing caps and participation rates) dampened FIA sales in 2020. Sales were also affected by a decline in disposable income stemming from the recession and stay-at-home orders. Historically, FIA sales are highly dependent on independent marketing organizations (per LIMRA data, approximately 59% FIAs were sold through IMOs in 2020 through the 3rd quarter). And we are seeing an increasing presence of banks and broker-dealers (15% and 19%, respectively, per LIMRA). While guaranteed-income products (primarily sold through IMOs) continue to dominate the FIA market, we expect to see growth in accumulation market and fee-based solutions that are predominantly sold through banks and broker-dealers--which are a preferred choice in the current economic conditions.

We expect FIA sales to gradually recover in 2021 after the slowdown in 2020. FIAs account for 26% of total annuity sales, and we believe in the next few years they may surpass traditional VAs' market share (which now account for 34% of total annuity sales).

Pension risk transfer

COVID-19-related factors certainly affected pension risk transfer (PRT) sales in 2020, but we expect modest recovery in 2021, despite PRT sales generally being uneven. Both demand and supply fundamentals should remain healthy in this market.

While only a handful of players dominate the large-plan market, the small-to-midsize plan market has attracted many competitors. Regulatory changes, the cost of managing and funding pension plans, and capital market volatility will continue to propel employers to offload their pension liabilities. Considering insurers are well-positioned to manage this long-tail risk, we think this market will remain attractive. As competition intensifies, we expect companies to consider risk-sharing, such as through reinsurance or collaborating with other insurance companies for larger deals.

Remote selling

Over the past couple of years, insurers have been investing in technology, but 2020 truly tested the industry's digital prowess. Although traditional distribution (career/independent agents, banks, broker/dealer channels etc.) isn't going away, enhancing remote-selling capabilities will be a major area of focus. Face-to-face sales are likely to remain difficult in the first half of 2021, and we could see more consolidations as independent agencies/broker-dealers navigate through these new operating conditions, which may require an additional technology expense. We further expect insurers to continue to invest in automation, simplified underwriting that does not require blood tests and other labs, and legacy administration platform upgrades.

Capital Buffer Resiliency Is Key To Ratings Stability

Over the past few years, our annual U.S. life insurance sector outlooks have often stated that aggregate capitalization was strong for the sector and would likely stay strong. We also thought it would not get any stronger, as insurers use what they deem as excess capital for dividends, share buybacks, M&A, and reinvestment in their business. We were of the opinion that the strong capital levels, supported by robust risk management, would position insurers well for a stress scenario--especially compared with the industry's capital level entering the 2008 Great Recession. However, we did not have specific real-world evidence to support this view, since no crisis had occurred. Then came 2020.

Early on in the pandemic, we conducted testing to determine how stresses such as asset risk, equity market volatility, near-zero interest rates, and heightened mortality risk would affect capital adequacy. We found capital buffers at U.S. life insurers were generally resilient to our assumed stresses (see "Assessing The Top Risks COVID-19 Poses To North American Life Insurers" and "Down But Not Out: Insurers' Capital Buffers Are Proving Resilient In The Face Of COVID-19"). Meanwhile, capital adequacy proved to be vital and the main reason for the sector's stability.

Companies' risk-management practices, which include large capital buffers and hedges to protect both capital and earnings, proved largely effective throughout 2020. While hedging strategies vary widely among life insurers we rate, they could be used more as insurers look to address the effects of multiple risks or stresses occurring at the same time. While companies certainly did see some capital declines from economic fallout of the COVID-19 recession (and, to a much lesser extent, from elevated mortality claims), these were more modest than initially anticipated. Moreover, capital markets remained open during the crisis and enabled insurers to raise debt and hybrid capital, and most companies took actions to conserve capital.

In addition to debt and hybrids, issuance of funding agreement-backed notes (FABNs) increased significantly last year. In 2020, S&P Global Ratings rated close to $34 billion of FABNs, compared with $24 billion in 2019 and just $8.4 in 2018. The FABN market is off to a strong start in 2021, and we expect this momentum to continue as issuers look to diversify their financing options.

All of these factors put life insurers in a position of strength as we enter 2021, and we expect capital adequacy in the aggregate to remain stronger than historical trends.

We anticipate that insurers will be prudent in their capital structures and how they are managed until, at a minimum, the effects of uncertainty caused by the COVID-19 pandemic and macroeconomic pressures subside. We expect dividend payments to persist at the subsidiary operating company level, though we think insurers will generally hold capital levels at either the high end or above management targets. At the holding company levels, we believe discretionary spending will be tightly controlled and project greater cash and liquid assets to be held to support multiple annual fixed charges as well.

We anticipate the market will remain open and favorable for new issuance. Multiple issuers accessed the public (or private) markets at the time of heightened volatility, and we continue to view refinancing risk as no cause for alarm for U.S Life insurers.

We also expect life insurers to maintain financial leverage within reasonable levels, generally similar to current profiles. Capital deployment in the form of share buybacks is likely to resume more broadly through the year, though be more muted than in prior years. We think management teams will be prudent and tactical with share repurchases for at least the short term. We deem this to be a cautious posture and a first line of defense in the ongoing uncertainty, particularly in case of any sudden deterioration in capital markets or spike in virus-related claims.

M&A Activity Will Endure

During 2020 we witnessed fairly solid activity on block M&A as companies looked to dispose of blocks of policies that were no longer integral to their strategies or that may have lower profitability and/or higher capital requirements. Companies also looked to dispose of blocks of policies that they thought investors saw as overly complex (such as legacy VA) and weigh on insurers' stock prices.

Buyers--generally run-off specialists, reinsurers, or alternative capital investors--are looking to add scale, expand their core business, and generate higher margins by benefiting from their regulatory jurisdiction or investment expertise. We expect this trend to continue and potentially even accelerate in 2021 as insurers reevaluate their business as the interest rate remains low and sales focus shifts.

Table 1

Most transactions in 2020 were supportive of our business risk and financial risk profile assessments, and, therefore, we did not take any rating actions as a result. While this is typically the case for block M&A, and we see no reason it would not be so in 2021, it's impossible to predict the nature of future deals and their potential impact on ratings. We see no reason to believe M&A will lead to downgrades or upgrades in the life sector this year. Although, we note that an active M&A market may slightly support credit quality because it affords flexibility to the sellers and is a growth channel for the buyers. We will continue to assess each deal on a case-by-case basis, analyzing risk tolerance, pricing discipline, business concentrations, leverage, capital and earnings impact, and other factors to determine the rating impact, if any.

Investment Risk Remains Prominent For Life Insurers

Asset or investment risk remains the prominent risk to U.S. life insurers' balance sheets as we enter the new year. While the low interest rate continues to compress portfolio yields, we have seen a longer-term trend in increased 'BBB' allocation and growing allocation to private bonds, mortgages, and alternatives as a liquidity trade-off to combat the spread compression of traditional corporate bonds and to seek a more favorable risk-reward balance. Supporting this trend has been a growing number of partnerships and M&A in the life insurance industry--namely, large asset managers and private equity supporting insurers with a steady pipeline of investments, including alternatives, infrastructure, and real estate to support their liabilities and margins.

Differences in investment allocation vary across the sector, and will result in variances in capital requirements, investment performance, and potential impairments in 2021.

The average credit quality of life insurers' bond portfolios has drifted lower over time as 'BBB' rated bonds account for about 35% of the fixed-income portfolio, compared with about 25% heading into the 2008 financial crisis. While we could see additional fallen angels (bonds downgraded to speculative grade from investment grade), our view is that the risk of potential fallen angels ('BBB-' rated issuers with negative outlooks or ratings on CreditWatch negative) falling into speculative-grade territory is lower as we enter 2021 given the current corporate bonds ratings distribution. Potential fallen angels account for only about 5.7% of the $5.16 trillion total outstanding 'BBB' nonfinancial debt in the U.S. and EMEA as of Oct. 31 (see "Global Credit Outlook 2021"). Market stability provided by the Fed is expected to continue and should aid 'BBB' rated issuers with financial flexibility should economic lockdowns reemerge in early 2021.

The industry has experienced manageable levels of impairments and downgrades of the bonds insurers hold in their investment portfolios, to date primarily concentrated in corporate sectors hurt by pandemic-related economic shutdowns. The life sector has been prudent in maintaining higher capital, substantially greater than levels heading into the 2008 financial crisis, leaving the industry in a much better position to manage elevated stress on investment portfolios. Additionally, equity market performance, impairments, and downgrades of bonds have been less severe than the scenarios outlined in our internal stress test earlier in 2020 and give us further comfort in capital resiliency heading into 2021. COVID-19 cases continue to surge, but optimism of a widely distributable vaccine and hope for further Fed stimulus have buoyed equity markets to pre-pandemic levels, and the 10-year Treasury yield has rebounded off the summer lows of around 0.50%.

As vaccine rollouts in several countries continue, S&P Global Ratings believes there remains a high degree of uncertainty about the evolution of the coronavirus pandemic and its economic effects. Widespread immunization, which certain countries might achieve by midyear, will help pave the way for a return to more normal levels of social and economic activity. We use this assumption about vaccine timing in assessing the economic and credit implications associated with the pandemic (see our research here: www.spglobal.com/ratings). As the situation evolves, we will update our assumptions and estimates accordingly.

Commercial Mortgage Exposure Remains In Focus

Commercial mortgages account for about 14% of the life insurance sector's invested assets and have been an important asset class for insurers to pick up additional yield. While many of the insurers we rate have been successful in underwriting commercial mortgage loans, the pandemic has placed added pressure on certain areas of their retail, lodging, and potentially longer-term office sector exposure. While larger retailers, with support from a strong online sales presence, have performed well through the pandemic, we highlight ongoing risk for midsize and smaller retailers as well as hotel/lodging as occupancy levels remain muted.

Longer term we may see insurers pivot to reduce allocation of office exposure in their commercial mortgage loans portfolios. The question remains whether after months of work-from-home whether employers will look to reduce their real-estate footprints. This will likely play out over the next few years as long-term leases renew.

Additionally, we could see pressure in the multifamily sector for similar reasons, if there is a longer-term population shift away from densely populated cities and prices reset in those markets. While we have anecdotally seen an increase in insurers providing forbearance and loan modifications, impairments have been manageable thus far, and it remains an asset class that we are keenly focused on in 2021.

Beyond 2021

Life insurers have an extra year to implement the GAAP accounting update on long-duration contracts, with the option of early adoption

The Financial Accounting Standards Board has given the life insurance industry an extra year to implement the new guidance with the effective date now Jan. 1, 2023. Companies spent a large part of 2020 managing the operational disruptions stemming from the pandemic, which could have adversely affected their ability to implement the new rules in 2022. There is an option to adopt the standards beginning Jan. 1, 2022, but we believe life insurers need the extra time for implementation because the new rules apply to both new business and in-force blocks.

We expect these long-duration targeted improvements to have a significant impact on the U.S. life insurance industry. In particular, they could lead many insurers to shift their strategies as a result of increased volatility of reported generally accepted accounting principles (GAAP) capital and earnings (see table 2 for the four proposed changes). For more details, see "Credit FAQ: GAAP Accounting Standard Changes Could Propel Long-Term Shifts In Life Insurers' Strategies," published Oct. 28, 2019.

Table 2

We expect most life insurers will assume the modified retrospective approach (also known as the pivot method), with a more detrimental impact on GAAP balance sheets on day one compared with the full retrospective method. Under both approaches, we anticipate greater volatility for both earnings and GAAP equity for each reporting period.

In general, we don't change our ratings based on revisions to accounting standards because accounting does not necessarily reflect the true economics of a business. These changes will also not affect statutory capital, which is our basis for most life insurers' capital assessments. That said, if the increased disclosures reveal deficiencies in a company's financial risk profile, we could change our ratings. Likewise, rating changes may follow longer-term shifts in insurers' strategies in response to these new rules.

The low interest rate will present challenges and potential balance sheet charges beyond 2021

The life insurance industry has been managing through low interest rates for the past decade, and we have seen the corresponding decline in companies' investment yields. We think low interest rates will weigh on earnings beyond 2021 as net earnings spreads continue to narrow. Further, low interest rates, which are a factor in the discount rate and reinvestment yields for cash flow testing purposes, could cause some scenarios to result in reserve strengthening on statutory balance sheets--particularly as companies perform, for example, the New York 7 deterministic interest rate scenarios or their state mandated cash flow testing scenarios on an annual basis.

The impact will vary by issuer, product suite, capital position, and overall net earnings spread. Companies that hold annuities with guarantees would be the most sensitive to low interest rates. Nevertheless, we think, life insurance companies will be able to withstand such headwinds in the coming few years. We looked at the difference between tabular interest rates on annuity reserves as a proxy for the crediting rates and compared it with the investment yields, 10-year Treasury rates, and 'A' rating level credit spreads (see chart 4). Companies are still in a position where they are earning an investment spread over their minimum guarantees, though that is declining.

Chart 4

Asset-liability management (ALM) becomes key in managing prolonged low interest rates as insurance companies seek to match their asset and liability cash flows. Some have strived to increase the duration of their assets to ensure better matching between asset and liabilities. But, depending on the steepness of the yield curve, this strategy may not compensate a life insurer for the additional duration risk (specifically, when rates are rising, the value of these assets will correspondingly be more sensitive). As a result, some insurance companies have chosen to invest in more illiquid assets, such as private debt, mortgages, or alternatives, which might weigh on liquidity.

We believe most life companies have done well in managing their liquidity and will continue to do so. None of the life insurers we rate had any negative ratings impact due to liquidity. So it boils down to a delicate balance between ALM and managing investment profiles. We expect companies to:

• Continue to employ prudent ALM,
• Invest in interest rate hedging strategies,
• Reduce crediting interest rates,
• Lower dividends on whole life policies,
• Reinsure some older annuity blocks with higher guarantees, and/or
• Change their sales mix into products that are less interest sensitive to combat persistently low interest rates.

Insurtech will continue to modernize the life insurance value chain, but disruption risk will be kept at bay

We expect life insurance companies to innovate and partner with insurtech companies beyond 2021. But we think that complex regulation, the industry's capital-intensive nature, and the propensity of policyholders to stick with their original carriers will remain barriers for life insurtech (lifetech) start-ups to significantly disrupt the industry. We are seeing relevant lifetechs making their imprint on the industry. In fact, such partnerships or investments in lifetech through life insurers venture portfolios will be imperative to remain competitive in a post-COVID-19 world. We believe these lifetech companies will partner with carriers and modernize the way life insurers operate, instead of directly competing with carriers and leaving life insurers obsolete.

The life insurance industry has generally lagged its property/casualty and health insurance counterparts in terms of technology and innovation, but as the pandemic has proven, companies had already invested in technology solutions that enabled them to sell in a stay-at-home environment. Arguably, this is just the start. The overall life insurance business model is highly complicated, which is probably why it has lagged the other sectors in terms of technology. We expect tech investment to continue and more partnerships to emerge as they focus on accelerating capabilities across the business model, including how products are priced and distributed, the customer user experience, and how claims are processed.

Beyond 2021, we see disruption from technology as a threat, but the life industry appears to be headed down the route of some industries, such as banking, where the established players are adapting to the shifting technological landscape, rather than being displaced by new entrants. It's too soon to tell whether this is definitely the case, and we will monitor this threat as it unfolds over the next few years.

Key for the life insurance industry will be managing the unknown longer-term impact of COVID-19 on morbidity and mortality

It is possible that life insurers will see negative physical health conditions from those who have recovered from COVID-19 that could affect morbidity or mortality. The Centers for Disease Control and Prevention (CDC) has noted that while most COVID-19 survivors return to normal health, some have shown symptoms that persist for weeks or months after recovery. The CDC has initiated multiyear studies to examine whether there are longer-term implications of these effects and whether they will be permanent. With almost 20.6 million cases identified in the U.S. as of Jan. 6. 2021 based on World Health Organization statistics, there is still a high level of uncertainty about the overall health conditions of COVID-19 survivors. We will continue to monitor any negative morbidity or mortality trends that emerge over the long term.

The virus has also been associated with adversely affecting mental health. With reduced activities and socialization and increased unemployment resulting from the pandemic, the CDC reported elevated adverse mental health conditions, such as individual depression and/or anxiety, substance use, and thoughts of suicide. This backdrop could lead to increased morbidity claims as people seek mental health benefits, or could unfortunately even lead to suicide claims.

We recognize that COVID-19 is a health crisis for which there is still a great deal of unknowns regarding the longer-term morbidity (which could affect long-term disability and long-term care businesses) and mortality impact on the overall U.S. insured population, and we will continue to monitor any meaningful trends.

What Could Weaken The Industry Outlook?

The following are potential downside scenarios.

Capital drain.  Capitalization levels decline because insurers significantly reduce their strong capital buffers either via an unexpected increase in shareholder returns or from unexpected organic or inorganic expansionary moves.

Race to the bottom.  However unlikely, insurers increase their risk tolerances via increased product or pricing or asset risk, such as greater use of richer guarantees or aggressive underwriting assumptions related to rates or lapsation, or a deterioration of investment portfolios.

Market displacement.  Dislocation in the capital markets from higher-than-expected corporate bond defaults resulting in more credit losses and worsening capital levels. Also, a significant spike in rates--such as 300 basis points over a short period of time--could increase disintermediation risk. Additionally, a severe drop in the equity markets could hurt insurers with meaningful market-exposed guarantees.

Prolonged low interest rates and excessive reserve strengthening.  If low interest rates persist and that causes companies to post reserves that lead to a reduction in our view of capital adequacy relative to the current rating levels, then we could see insurance companies' credit quality deteriorate.

Rating And Outlook Distributions

Chart 5

Despite the pandemic, life insurer rating actions were rare in 2020. We only took four: one upgrade and three downgrades, all of which were driven by company-specific issues rather than by the pandemic and its economic fallout. These changes were specific to the credit quality of each insurer and not related to any specific industry-level changes.

Chart 6

We expect the current rating distribution to persist, with close to 94% of rated life insurers in the 'A' and 'AA' categories (see chart 7). We view the industry as relatively well-positioned to withstand the challenges it faces, primarily through its focus on retaining strong levels of capital and liquidity.

Chart 7