A fiscal 2021 bonanza does not mean Japan's major insurers can rest on their laurels. This fiscal year, risks abound.

Japan's four major life insurers' aggregate core insurance profit on an unconsolidated basis in fiscal 2021 (ended March 31, 2022) increased about 11% from the previous year. Meanwhile, the three major non-life insurance groups' consolidated net income in aggregate soared more than 100% from the previous year. After adjusting for various reserves that are substantive sources of accumulated earnings, non-life insurers' consolidated net income grew about 70% year on year. Results at all groups we rate exceeded our expectations.

S&P Global Ratings believes, however, downside risk for Japan's major life and non-life insurers has increased in fiscal 2022. Turmoil induced by COVID-19 was waning in fiscal 2021. Now, economic and financial uncertainty is back. Inflation rates are way above where major central banks in the U.S. and Europe expected, and wanted, them to be. Meanwhile, geopolitical risk has risen.

Central bankers, including at the European Central Bank, the Bank of England, and the Federal Reserve in the U.S., are pushing up interest rates. This is shaking up an environment used to the ultra-loose monetary policy ushered in by the pandemic. Global equity corrections and a deteriorating funding environment in the U.S. and other countries have followed.

Even in this context, we expect major life and non-life insurers to maintain somewhat healthy financial performances in fiscal 2022. This is thanks to profits from their insurance businesses. Nevertheless, major life insurers' aggregate core insurance profit will likely decrease at a steady pace from fiscal 2022. This is mainly because of a decline in death coverage policies. Furthermore, the proportion of interest margins (before adjusting for hedging and other costs) in core insurance profit has been rising. We therefore believe structural pressure on the four life insurers' ability to secure accumulated earnings is mounting.

Meanwhile, Japan's three major non-life insurance groups' consolidated net income in aggregate is likely to remain favorable, in our view. Their overseas insurance business will likely expand. In addition, their domestic non-life insurance business will also likely further grow as long as losses related to natural disasters in Japan normalize. Still, the groups must properly manage the impact of natural disaster risk on profits and capital. Their underwriting profit remains greatly susceptible to the size and frequency of natural disasters in Japan. However, the groups' diverse sources of earnings should underpin profit stability.

Life insurers are improving their economic solvency ratios (ESRs). They originally placed emphasis on enhancing capitalization through issuance of subordinated bonds and accumulation of retained earnings. Now they are focused on reducing interest rate risk, in our view. This has led to them issuing fewer subordinated bonds.

The non-life insurance groups take different approaches to economic solvency risk, based on their sensitivity to market movements. This has led to variation in the degree to which the three groups work to reduce market risk. While the groups are likely to continue to take measures to hedge against natural disasters overseas, they continue to be exposed to major risk in this area domestically, in our view. We believe a major challenge for the groups is to maintain ESRs within the ranges they have set by carefully balancing retained earnings and shareholder returns.

The four major Japan-based 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. Japan's three non-life insurance groups we rate are Tokio Marine Group, MS&AD Insurance Group, and Sompo Holdings Group.

Table 1

Table 2

Life Insurers: Structural Challenges Of Existential Proportions?

In fiscal 2021, the four major life insurers' aggregate core insurance profit on an unconsolidated basis increased about 11% from the previous year (see chart 1). We attribute the increase to a number of factors. Dividends on equity and through investment trusts rose. Return on investment (ROI) of core insurance profit improved thanks to increased foreign currency-denominated interest dividend income. Interest margins also grew substantially on the back of continuous decline in the average guaranteed rate of interest. On the other hand, insurance-related earnings at the groups decreased, mainly because of a rise in pandemic-related insurance claims. Despite this, aggregate annualized new premium income bottomed out, mainly because marketing activity was adapted to cope with impediments brought about by the pandemic (see chart 2).

Chart 1a

Chart 1b

Chart 2

We expect, as well as a steady decline in aggregate core insurance profit, to see insurance-related earnings also keep falling on an aggregated basis. The compound average growth rate of such earning at life insurers from fiscal 2011 to fiscal 2021 was minus 3.7%. If this pace continues, insurance-related earnings will be halved in 18-19 years. Although mortality and morbidity margins remain stable for now, given the trend of premium income from policies in-force and claims payments from policy cohorts, we expect such margins to continue a structural decline in the long run. Policies in-force are decreasing. In addition, the competitive environment remains difficult for life insurers in Japan. Overseas rivals and life insurance companies from groups operating mainly in the non-life sector are expanding their shares in Japan, backed by consulting know-how, their parent companies' brand power, and effective sales channels. Meanwhile, third-sector business (which includes policies for matters such as nursing care and medical treatment) is likely to increase to a degree that allows mortality and morbidity gains to mitigate the impact of decreasing insurance-related earnings. However, the profit margin of third-sector business could decline if the competitive environment worsens due to, for instance, more pricing pressure.

In the insurers' interest margins, contributions from Japanese government, and corporate bonds will likely continue to fall, in our view. Meanwhile, foreign securities with relatively high yields, other securities, and equities will likely contribute more. Revenue from domestic government and corporate bonds decreased even though the outstanding amount of such bonds rose. This was mainly because bonds with relatively high yields were redeemed while the ongoing low interest rate environment meant those remaining had lower yields. This suggests sensitivity to changes in the stock and foreign exchange markets and the economic and financial environment will rise. Although a continuous decline in the average guaranteed rate of interest could be a buffer, we have an eye on growing volatility of interest margins.

We expect the four major life insurers to continue working to improve their ESRs (see chart 3). Insurers were emphasizing stronger capitalization through the issuance of subordinated bonds and accumulation of retained earnings, amid the low interest rate environment in Japan. In recent years, however, they are shifting their focus to reduction in interest rate risk from issuance of subordinated bonds. At the same time, they continue to accumulate retained earnings.

Reducing the high susceptibility of their ESRs to interest rates is the most difficult challenge for life insurers. Meanwhile, they have been increasing other types of market risk through credit investments and other means. This is because they are working to maintain investment returns in the low interest rate environment. However, we believe the life insurers' ESRs are unlikely to deteriorate. This is because the groups continue to carefully control risk volume to keep it within levels that do not increase overall market risk after considering diversification effects.

Chart 3

Major life insurers considerably increased their holdings of outstanding domestic government and corporate bonds in fiscal 2021, as they did in fiscal 2020. This contrasts with a slow pace of purchases of such bonds until fiscal 2019 amid a prolonged low interest rate environment (see chart 4). We believe the life insurers prioritized reducing interest rate risk by capitalizing on opportunities in Japan afforded by increases in interest rates whenever they arose. They did so because the introduction of economic-based capital requirement regulations in Japan looks increasingly likely to happen. We expect the life insurers to aggressively purchase Japanese government and corporate bonds whenever interest rates are within the permissible ranges they have set to do so. To reduce interest rate risk, they are buying super-long-term bonds by using funds raised through repos as a financial source. They are also utilizing interest rate swaps and reinsurance.

Chart 4a

Chart 4b

As of March-end 2022, the aggregate outstanding balance of four life insurers' domestic stocks dropped from the previous year in line with a decline in the value of the overall market. Despite ongoing pressure on investment yields, we do not believe life insurers would willingly increase domestic equities, considering their maintenance of ESRs and risk control. However, some insurers have reduced risk through futures and other instruments.

Major life insurers' outstanding foreign public and corporate bonds started to decrease at the end of fiscal 2021. This is mainly for two reasons. First, some insurers sold their bonds when overseas interest rates rose. Second, the market value of such bonds fell because of rising interest rates. The outstanding balance of the insurers' foreign public and corporate bonds will likely increase only moderately, in our view. This is because of a substantial increase in hedging costs and the relatively high level of yields on domestic super-long-term bonds.

Foreign equities and other securities leaped at the end of fiscal 2021. Foreign equities and other securities include foreign stocks, credit, and private equity funds, that have a variety of risk attributes. The breakdown of foreign investment by region shows an increase in investment in Latin America (see chart 5). One reason for this is that many private funds are based in the Cayman Islands. The four life insurers are likely to continue to shift their funds to this kind of asset class due to persistently low interest rates in Japan. Accordingly, we will pay close attention to the impact of this on each insurers' credit quality.

Chart 5a

Chart 5b

Major life insurers are likely to continue to work to avoid foreign currency risk, in our view. Nonetheless, their risk appetite may have risen a little, in our view, as hedging costs have increased considerably. Their main hedging instruments remain forward exchange contracts, but they are using others. For instance, some life insurers are hedging bonds denominated in foreign currencies through currency swaps. We believe they are doing so to profit from credit spreads by hedging foreign exchange risk to maturity. Moreover, they frequently use currency options to hedge risk at low cost in a flexible manner. We think that although option trading might help reduce risk volume, its ability to constrain earnings volatility depends on undisclosed exercise prices. We therefore view the impact of such trading for insurers as limited.

Non-Life Insurers: Profit Supercharged By A Catastrophe Lull

In fiscal 2021, the three major non-life insurance groups' consolidated net income in aggregate increased over 100% to ¥908.1 billion (see chart 6) from the previous year. Substantive sources of accumulated earnings also increased greatly, in our view. On a reserve-adjusted basis, the groups' consolidated net income grew 67.5% year on year to ¥1,101.7 billion, mainly because of substantially excessive provisions of catastrophe loss reserves and price fluctuation reserves on a net basis. Consolidated net income of the groups' domestic non-life insurance business improved substantially.

There were fewer catastrophes in Japan than we expected at the beginning of fiscal 2021. This boosted the balance of fire insurance. These positive factors made up for increased losses in automobile insurance as people got back in their cars as the pandemic's impact diminished. The overseas businesses of some non-life insurers felt the impact of large natural disasters. However, these businesses improved because of decreased losses due to a pandemic rebound, a sharp rise in premium rates, and expansion of underwriting. The non-life insurance groups' investment businesses also performed well thanks to increased interest and dividend income.

Chart 6a

Chart 6b

We anticipate the three major non-life insurance groups' consolidated net income will likely remain high in fiscal 2022. Overseas insurance business is likely to improve for them and domestic non-life insurance business could too if losses related to natural disasters in Japan normalize. Although the groups' underwriting profits remain greatly susceptible to the size and frequency of domestic natural disasters, we believe the groups' earnings sources, which are diversified into domestic non-life, domestic life, and overseas insurance businesses, will underpin profit stability.

Domestic non-life insurance business at the groups is likely to remain generally strong, in our view. Incurred losses from automobile insurance will likely continue to increase alongside the number of traffic accidents as pandemic effects wane. The groups reduced voluntary automobile insurance premium rates in January 2022, responding to a General Insurance Rating Organization of Japan (GIROJ) announcement. GIROJ disclosed a 3.9 percentage point reduction on average in reference rates for voluntary automobile insurance, reflecting in part fewer traffic accidents thanks to proliferation of advanced safety technology. Even in these circumstances, the combined ratio of the three groups' voluntary automobile insurance is likely to remain way below 100%, in our view. We expect premiums of new types of insurance products to continue to grow. The three groups still have room to sell more insurance products to small- and medium-size enterprises as well as new types of insurance. In addition, societal and environmental changes are likely to lead to opportunities for the groups to innovate new products.

Profit from fire insurance will likely continue improving, in our view. Given the intensity of natural disasters in recent years, GIROJ in October 2019 raised by an average of 4.9 percentage points reference rates for fire insurance (householders' comprehensive insurance). This followed an average 5.5 percentage point rise in May 2018. Furthermore, GIROJ in June 2021 announced a 10.9 percentage point increase in the rates, together with its plan to shorten the contract term to a maximum of five years from the current maximum of 10 years.

We predict non-life insurers will respond to GIROJ by raising fire insurance premium rates for home and content policies in 2022. They will also likely abolish 10-year insurance policies and, instead, develop products that require policy renewals within a maximum of five years. Although major non-life insurers will be able to reflect most recent natural disaster trends on fire insurance premium rates in a timelier manner, this will not improve revenue or profit anytime soon, in our view. However, we expect the non-life insurance groups to generate underwriting profits of around ¥50 billion to more than ¥100 billion on a pre-tax basis by fiscal 2023. The cumulative effects of various measures, including premium rate revisions, should help generate this profit.

Improving profit for fire insurance, meanwhile, could be tough. The intensity of domestic natural disasters could become stronger than anticipated. Major non-life insurance groups' payments of net incurred losses exceeded initial annual budgets for a few years through to fiscal 2020. Since fiscal 2021, payments have been below initial annual forecasts (see chart 7). The groups' fiscal 2022 budgets for domestic natural disasters leveled off from the previous year. They had previously been on an upward trend. The leveling off mainly reflects lower net incurred losses over the past two years, in our view. However, on the medium-to-long term, we assume net incurred losses from domestic natural catastrophes will continue to rise. Extreme weather events that look likely to have climate change behind them are occurring globally. As a result, more serious natural disasters may be inevitable.

Chart 7

Reinsurance premium rates related to typhoon and flood damage in Japan rose by double digits for three consecutive years through 2021. In April 2019, they rose 15%-25%, in 2020 30%-50% and in 2021 15%-20%. At the time of renewals in April 2022, however, the rates rose only modestly, according to Arthur J. Gallagher & Co., the new owner of Willis Re. Nevertheless, reinsurance premium rates themselves remain high. Also, typhoon and flood risk in Japan has been increasing in recent years.

We consider a substantial drop in reinsurance premium rates unlikely, given the above. Based on this, we believe the groups are striving to avert the impact of the increase in ceded reinsurance premiums by refining reinsurance schemes and contractual coverage for in-force reinsurance policies. Specifically, the groups are increasing higher layers of reinsurance that have relatively low costs. Meanwhile, in terms of cover when premium rates are substantially rising, the groups accept a degree of profit volatility in line with their risk appetites.

Profit in the non-life insurers' domestic life insurance businesses will be underpinned by three factors, in our view. First, the groups have high brand power. Second, they can cross-sell alongside non-life insurance products through agent networks. And third, there are prospects for a continued increase in in-force policies.

We believe premium rate increases, which are appropriate given rising risks in recent years, are likely to continue to contribute to profits from overseas businesses. In addition, an increase in insurance policies in which quality is maintained through disciplined insurance underwriting should also contribute. Meanwhile, the decline of the yen against other currencies has been another benefit. This is because foreign currencies are now worth more when the profit of the U.S. and European subsidiaries of Japanese non-life insurers are consolidated onto group books (see table 3). If this situation does not change, the profit contributions from the three groups' overseas insurance businesses will likely increase, in our view.

Table 3

Risks associated with natural catastrophes overseas assumed by major non-life insurance groups are likely to remain manageable, in our view. Even though the three groups' risk appetite for natural catastrophes overseas was not high originally, some have aggressively looked to reduce such risk. Meanwhile, we think the groups have exposure to Russia and Ukraine through overseas direct insurance and reinsurance. Nonetheless, we think this exposure will be of a size that can be absorbed by periodic income. In Europe and the U.S., inflation may worsen the groups' combined ratios. However, we think the groups can handle this through premium rate hikes at the time of renewals, even if there is a slight time lag.

Non-life insurers' investment businesses face high uncertainty and downside risk. Their equity holdings have decreased because of continued stock sales. Prospects for the performances of investees are uncertain. These factors could pressure dividends. In addition, monetary tightening by major central banks in Europe and the U.S. brings risks. First, the insurers could see a rise in foreign exchange hedging costs due to widening gap between domestic and foreign short-term interest rates. Second, credit spreads could widen as funding environments deteriorate and economies slow down. Third, default rates among corporations with speculative grade ratings could rise.

We believe exposure to corporations with speculative grade ratings will have a notable impact on our assessments of the credit quality of non-life insurance groups. We assume default rates of speculative grade companies will climb within the next 12 months (see table 4). Some groups have increased investments in such companies' bonds in the search for yield, mainly in the U.S., in recent years. Accordingly, those groups that have high exposure to such bonds could see declines in value because of widening credit spreads. If the non-life insurers intend to hold such investments to maturity, they will unlikely incur losses on their profit and loss statements, unless it is as impairment losses on credit investments. From the perspective of balance sheet and ESR, however, investing in the bonds of speculative grade companies could have an effect, depending on the degree of exposure and the sensitivity of ESRs to credit spreads.

Table 4

The three non-life insurance groups' ESRs have shown different patterns by sensitivity, depending on group-specific factors (see chart 8). Higher domestic interest rates, depreciation of the yen, and an increase in each group's retained earnings affected ESRs positively. Conversely, there were five negative factors for ESRs: (1) a decline in stock prices; (2) widening credit spreads; (3) redemption of groups' subordinated bonds; (4) review and tightening of risk models; and (5) an increase in insurance underwriting risk.

Chart 8a

Chart 8b

The three non-life insurance groups take different approaches to economic solvency risk, such as reduction in equity and interest rate risk, based on their sensitivity to market movements. A major challenge for the groups is carefully staying within the target ranges for their ESRs, which the group set themselves. To do this, they have to make subtle changes when needed to balance retained earnings and shareholder returns. As shareholders demand higher capital efficiency, strong pressure for returns endures.

We expect major non-life insurance groups to continue to improve capital quality and reduce market risk through sales of strategically held stocks. The groups sold such stocks in fiscal 2021, which resulted in further risk reduction and realization of latent profit on their securities holdings. Future policies about strategically held stocks differ between the groups. We believe this is because the groups decided the policies after comprehensively considering their ESRs, including these ratios' susceptibility to the stock market and relative risk volume. We incorporate prospects for the groups' sales of strategically held stocks, based on their records, into our assessments of their capital and profitability in our base-case scenarios.

The non-life insurance groups have an increasing appetite for credit risk and overseas insurance business with high returns relative to risk. Their aim here is to limit declines in yields caused by efforts to reduce equity risk. This is likely to continue, in our view. In fiscal 2021, there were further cases of bolt-on acquisitions (acquiring and growing smaller businesses) and equity-method investments by the groups as they work to expand overseas. This gels with the groups' business portfolio strategies. Meanwhile, we think the groups might buy at high prices. This is because of the persistently high stock prices of potential large acquisition targets, depreciation of the yen, and increased funding costs stemming from interest rate rises.

In addition, the three major non-life insurance groups diverge on interest rate risk reduction. Two groups have completed their interest rate risk reduction measures and are now risk monitoring. The other is likely to continue reducing interest rate risk for the foreseeable future, in our view, given the high susceptibility of its ESR to interest rates and other factors.

We believe domestic natural disasters remain a major risk factor for the non-life insurance groups. The groups have fully hedged risk through reinsurance of upper layers, reflecting their continued low risk appetite. Some non-life insurers have increased catastrophe cover in preparation for tail events to bolster risk volume control in ESR.

We take the view that the non-life insurers are likely to continue to somewhat curb growth of risk associated with natural catastrophes overseas in consideration of diversification effects. Some increase in overseas natural catastrophe risk by means of major non-life insurers' organic growth and expansion outside Japan through acquisitions is unavoidable. We expect the non-life insurers to work to increase geographic and business diversity and to continue developing more sophisticated risk management systems to cope with overseas catastrophe risk.

Issuer Review

Table 5

Note

Net short positions in forward contracts may include hedges against minimum guarantees in special account but we consider the impact to be minor. Under the low interest rate environment, life insurers continue to limit or suspend sales of yen-denominated savings-type insurance products either as a risk control measure or because of economic analysis on profit/loss management. Against this backdrop, major traditional life insurers have entered one after another the market for foreign currency-denominated savings-type products. These are the investments relative to foreign currency-denominated policy reserves, and therefore, would not lead to an increase in foreign exchange risk. However, the hedge ratios above do not incorporate the foreign currency-denominated policy reserves for calculation because the amount of such reserves are not disclosed. If such reserves are incorporated, we think the hedge ratios in fiscal 2017 and beyond would be higher than the ratios shown in chart 5a.

Related Research

• Default, Transition, and Recovery: The U.S. Speculative-Grade Corporate Default Rate Could Reach 3% By 2023 As Risks Continue To Increase, May 19, 2022
• The European Speculative-Grade Corporate Default Rate Could Rise To 3% By March 2023, May 18, 2022
• Economic Research: Global Macro Update: Growth Forecasts Lowered On Longer Russia-Ukraine Conflict And Rising Inflation, May 17, 2022
• Global Credit Conditions Special Update: Inflation, War, And COVID Drag On, May 17, 2022
• Japan Insurer Outlook: New Year, Old Trends, Jan. 11, 2022
• ESG Credit Indicator Report Card: Asia-Pacific Insurance, Nov. 29, 2021
• ESG Credit Indicator Report Card: EMEA Insurance, Nov. 29, 2021
• ESG Credit Indicator Report Card: North And Latin America Insurance, Nov. 29, 2021