The U.S. and Canadian life insurance sectors are facing a mix of good news and bad news at the start of the new year. Factors that could affect life insurers include rising rates, choppy equity markets, global geopolitical uncertainty, and above all the looming threat of a recession sometime this year. Meanwhile, changes to financial reporting standards in the U.S. might cause more confusion than clarity, and COVID-19, while seemingly on the decline, still carries meaningful uncertainty. We believe these conflicting forces will largely balance each other out, and we do not anticipate a significant number of upgrades or downgrades for life insurers in 2023.

A Recession Will Stress Investment Portfolios, But Capital Buffers Will Likely Absorb It

S&P Global economists' baseline scenario assumes a shallow recession in the first half of this year (see "Economic Outlook U.S. Q1 2023: Tipping Toward Recession"). While the negative effects of a coming recession (such as slower sales, inflation, and higher labor costs) could hit life insurers in a variety of ways, the most immediate impact will likely be to the corporate bonds and loans in their investment portfolios. Declines in GDP and the stock market, and tougher financing conditions could cause an increase in corporate defaults and--more importantly for life insurers--downgrades of corporate bonds.

Life insurance portfolios contain large exposures to investment-grade corporate debt, particularly to 'BBB' rated bonds and loans, which made up approximately 27% of total investments as of year-end 2021. Any downgrades of these bonds and loans will require companies to hold additional capital against the increased credit risk, which, in turn, could hurt some life insurers' credit quality. During the most recent recession in 2020, approximately 5% of all 'BBB' corporate bonds in the U.S. were downgraded to 'BB+' or below (see "2020 Annual U.S. Corporate Default And Rating Transition Study"). The only year in recent history with a higher percentage of 'BBB' downgrades was 2009, when approximately 7.5% of 'BBB' corporate bonds were downgraded to speculative grade.

In anything but an extreme recession (which we are not expecting), corporate defaults are typically limited to speculative-grade companies, which life insurers have limited exposure to (on average 4.2% of total investments as of year-end 2021). The speculative-grade default rate in 2020 was 6.7%, only surpassed by the 2009 rate of 11.8%. Life insurers have some indirect exposure to speculative-grade corporate debt through their holdings of collateralized loan obligations (CLOs). These are securitizations of speculative-grade loans, and defaults of the underlying companies can cause stress to some tranches CLOs. Not all life insurers invest in CLOs, and those that do typically focus on the 'AAA' and 'AA' rated tranches, which can withstand significant stress of the underlying collateral. Some insurers also have exposure to 'A' and 'BBB' rated CLOs, which still offer meaningful protection and can withstand stress of the underlying collateral, albeit not as much as the higher-rated tranches.

S&P Global Ratings recently ran stress tests to assess the resiliency of CLO ratings (see "How The Next Downturn Could Affect U.S. BSL CLO Ratings (2022 Update)"). In a scenario in which, among other factors, 5% of the underlying loans in broadly syndicate CLOs defaulted, nearly 29% of 'BBB' rated CLO tranches were downgraded to 'BB+' or below, but tranches rated 'A' or above had no rating movement into speculative grade. In a more stressful scenario where 10% of the underlying loans default, nearly 85% of 'BBB' CLO tranches and 0.9% of 'A' tranches were downgraded to speculative grade, but 'AA' and above were not. In both these stress scenarios, there were effectively no defaults of CLO tranches rated 'BBB' or higher.

To assess how a recession could affect life insurers' capital buffers, we ran a hypothetical stress test on the U.S. and Canadian life insurers we rate. We assumed 5% of all 'BBB' rated bonds and loans, other than CLOs, were downgraded to 'BB' (similar to the experience in 2020). And to simulate a roughly 6%-7% default rate on the speculative-grade loans, we assumed 50% of 'BBB' rated CLOs were downgraded to 'BB'. We focused on the transition to 'BB' from 'BBB' since that is where our capital model has the most meaningful increase in additional capital. Also, historically the majority of downgrades of 'BBB' rated bonds are to the 'BB' category.

We found that, on average, the additional capital required to account for the added credit risk represented 2.5% of a given insurer's available capital (total adjusted capital or TAC), ranging from close to 0% foe some issuers to up to 10% for others. Out of the 68 life insurers we examined, the stress test indicated that we would not change our capital and earnings assessment for 59. Of the nine companies whose stress tests indicated they may fall to a lower capital and earnings assessment, the potential changes in capitalization were not meaningful enough to change the ratings. Further, while capitalization may be affected in the current year, insurers would likely be able to return capital and earnings to their previous level in our two-year forecast horizon via retained earnings.

The average insurer saw its capital redundancy, per our capital model, drop by slightly more than 2 percentage points owing to the added capital requirements given the downgrades of bonds, loans, and CLOs. PE-affiliated insurers saw a bigger drop of nearly 4 percentage points, while insurers in other categories were closer to the 2-percentage-point average (see charts 1-5).

The key takeaway is that the capital buffers of U.S. and Canadian life insurers are likely to be able to absorb a 2020-like recession with minimal to no impact on ratings. Our economists' baseline assumption for this year presumes a shallower recession than the one experienced in 2020. A deeper recession, though not expected, may have a more severe impact. We note that our stress test assumed no management action to raise or conserve capital.

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The prospect of an upcoming recession, or of slow growth if the U.S. manages to avoid an outright recession, is likely already affecting life insurers' investment decisions. Anecdotally, many of the life insurers we rate have told us they are making defensive movements in their portfolios, avoiding sectors they anticipate being more vulnerable (such as the office sector of commercial real estate) and generally investing higher up in the credit spectrum. They're making these changes on the margin, primarily with securities bought with incoming premium dollars and proceeds from maturing bonds. Insurers' asset-liability matching policies and unrealized losses on bond portfolios make it difficult to sell securities backing current liabilities. Some life companies are also increasing their "dry powder" cash holdings in anticipation of opportunities to buy good credit assets on the cheap if a recession does occur.

Higher Interest Rates Are A Breath Of Fresh Air, But Beware The Spike

For much of the period prior to 2020, life insurers faced ever-decreasing interest rates, culminating in the uber-low rates of the early months of the COVID-19 pandemic. Low rates made it tougher to sell, manage, and make a profit on most life insurance and annuity products, particularly spread-based business such as fixed annuities and universal life insurance. Spread compression ruled the day. But in the middle of 2020, the tides turned, and interest rates have markedly increased since then. Sales of fixed annuities and insurance policies began to rise, and the potential profit margins on these new sales were higher than insurers have seen in years.

This all sounds like good news to insurers, and it generally is. The big wrinkle is that these higher rates are prompted by high inflation, geopolitical instability, and lingering supply chain issues--all of which are raising the risk of a recession. That said, if insurers can weather the storm--as we expect--they'll benefit if rates continue to climb, or even if they persist at current levels.

During the last few quarters, sales have largely shifted toward fixed products, such as indexed universal life and fixed-rate annuities, and away from traditional variable annuities and whole life, reflecting the rise in rates. We expect this trend to continue as rates either continue to increase or stabilize. That said, changes to the macroeconomic conditions can affect life insurance sales.

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Also, the threat of an even more dramatic spike in rates than we've seen does merit some attention. If rates rise too high too fast, policyholders might be tempted (or prompted by insurance agents) to pull their money out of their annuity accounts and cash-value life insurance policies to invest them in higher-yielding products.

This is known as disintermediation risk, and it could create a liquidity crunch and subsequent losses for the insurers. To be sure, it would have to be a large enough increase in rates to justify the penalties policyholders would pay in the form of surrender charges and market-value adjustments, which serve as deterrents for early withdrawals and also compensate the insurance companies for losses they may incur. About 70% of annuity liabilities in the U.S. are not subject to discretionary withdrawal or include these types of protections. Those that are not, such as annuities outside of their surrender-charge period, can be withdrawn without penalty. Life insurers typically back these products with shorter term, more liquid assets as part of their asset-liability matching policies.

How high and how fast do rates need to climb for that to happen? That's unclear. It has been over 40 years since the last large spike in rates, when the 10-year Treasury rose to 14.6% in 1982 from about 7.2% in 1977. There is little to no evidence on policyholder behavior in rate spikes from more recent history. The current rise in rates of roughly 350 basis points in the 24 months between mid-2020 to mid-2022 hasn't thus far caused a wave of early withdrawals from annuity and insurance products.

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Earnings Dynamics Are The Opposite Of The Pre-Pandemic Era

In the decade before the pandemic, life insurers' earnings faced two opposite forces. On one hand, spread compression slowly decreased earnings as interest rates dropped. On the other, rising equity markets were increasing fee-based earnings, particularly in businesses such as asset-management and retirement services, which are driven by assets under management (AUM). Life insurers spent most of the decade pivoting toward fee-based businesses to balance the spread compression. Since mid-2020, the reverse has been true: Rising rates have been causing spread-expansion, and as AUMs have fallen, fee-based earnings are suffering.

Companies realize profits of spread-based products slowly over their lifetime, so it might take a few years for this higher profitability to appear in earnings. AUM drops are immediate, so the impact on fee-based earnings is quick to show up on the income statement. This means that we are likely to see some pressure on earnings this year, which may slowly ease if interest rates do not start dropping. Life insurers' earnings have also benefited from the decline in COVID-19 death claims, as the pandemic has eased in the U.S. and Canada.

We've already seen some of these dynamics in the first three quarters of 2022. Although, it is difficult to compare 2022 to the previous year, since 2021 was a record earnings year for the life industry, in no small part owing to outsize returns on alternative investments, which were not sustainable.

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Private Equity And Private Credit Pick Up In The Life Insurance Sector

While private ownership of life insurers is nothing new, the involvement, in one form or another, of private equity (PE) companies in the life sector has increased over the last few years. As a result of mergers and acquisitions (M&A) over the last decade or so, more life insurers today are either fully or partially owned by PE companies, have all or part of their investment portfolio managed by a PE company, or some combination of the two, than in any period in the past. We refer to these insurers as PE-affiliated.

While the pace of M&A slowed in 2022 from the prior two years, we think M&A is likely to continue. There is no shortage of capital on the PE side and no shortage of interested sellers on the mutual and publicly traded side.

We're also seeing a growing trend of life insurers investing in private credit, meaning bond and loan deals that are made between the insurers and borrowing companies directly, as opposed to bonds that are widely traded in the bond market. Privately placed bonds for the entire life industry increased to nearly 40% of bonds in 2021 from 26% in 2011. This trend reflects, among other things, insurers' search for higher yields in the form of an illiquidity premium as interest rates dropped.

We don't necessarily expect the share of private credit to drop now that rates have increased, since life insurers see additional benefits to private placements beyond higher yields. While some PE-affiliated insurers lean more into private credit, nearly all life insurers have exposure to it. The numbers vary among companies. Being PE-affiliated doesn't necessarily mean a company has more exposure to private credit, and being a mutual or publicly traded insurer doesn't necessarily mean less exposure.

Our analysis does not differentiate between PE-affiliated and non-affiliated insurers. Rather, we focus on the rating factors outlined in our methodology, such as capital and earnings and competitive position (see "Insurers Rating Methodology"). We also do not believe that there is anything inherently good or bad with private credit. We examine the nature of the assets and the risks they bring onto the balance sheet regardless of the how they are traded.

Other Issues In The Life Insurance Industry

Long-duration targeted improvements (LDTI)

Later this year, publicly traded insurers will publish their first-quarter reports under the long-awaited LDTI update to U.S. generally accepted accounting principles (GAAP), as well as publish restatements of 2021 and 2022. As we have said over the past few years, we do not believe that the change in accounting standards, in itself, will have a material impact on life insurers' creditworthiness (see "GAAP Accounting Standard Changes Could Propel Long-Term Shifts In Life Insurers' Strategies").

Many insurers have already disclosed initial estimates of the impact, some including multi-billion-dollar changes to GAAP equity, and the market reaction has been largely benign.

The most material impact on balance sheets tends to stem from the current interest rate environment. The newly standardized discount rates used for liabilities can be lower than the historical discount rates used to value liabilities. This causes liabilities under LDTI to be larger and reduces GAAP equity. The recent rise in rates will likely dampen the magnitude of this effect compared with year-end 2020. Nevertheless, we'll be closely analyzing any idiosyncratic changes, such as to actuarial assumptions that need to be unlocked and reset or to deferred acquisition costs amortization or hedging strategies, that could reveal outliers.

LDTI will only change GAAP financials. Statutory accounting--which we use for most of our capital analyses of U.S. life insurers, and which governs cash flow out of regulated insurance companies--is not changing. We do use our adjusted assessment of GAAP equity in our debt-funded double leverage calculations, which can affect our view of statutory capital adequacy.

COVID-19

Although it seems COVID-19 is waning and its impact on mortality and the economy are more manageable and predictable, there is still significant uncertainty. Large surges appear to be less likely but are not out of the question, and the longer impact of COVID-19 on mortality is still largely unknown. We will continue to monitor companies' results and any associated changes to underwriting as more information emerges.

Distortions to financial leverage and GAAP return on equity

Another result of the rising rates is that, under current GAAP standards, life insurers' bond portfolios have swung from the large unrealized gains to sizable unrealized loss positions. We believe companies' asset-liability matching policies and track record of holding investments to maturity typically ensure that these unrealized losses, which are usually reported in accumulated other comprehensive income (AOCI), are highly unlikely to be realized. These unrealized losses distort the value of reported equity under GAAP. As a result, metrics like financial leverage and return on equity are less comparable with previous years' metrics. As part of our assessment of any understatement or overstatement of total shareholders' equity, we look at financial leverage excluding unrealized losses and return on assets, which are less sensitive to changes in rates.

Growth in offshore reinsurance entities

In the last couple of years, we have seen growth in offshore reinsurance entities, or sidecars, being set up in the U.S. life sector. The ownership structures for these entities vary: some are fully or partially owned by the sponsoring insurer, while for others the sponsor has no equity stake at all. However, these sidecars have similar goals of transferring a portion of the risk from the sponsor's balance sheet to an offshore entity for capital relief, additional competitive capacity, and possibly some regulatory or tax benefit. The non-sponsor-owned portions of the sidecars are typically financed by third-party private investors, which allows the sponsor access to additional capital without directly diluting current equityholders. These structures have a limited track record, and our analysis focuses on evaluating:

• The level of control the sponsor has over the sidecar;
• The counterparty risk exposure;
• Whether there is a true transfer of risk; and
• The level of capitalization and regulatory supervision that the sidecar operates under.

Absent any track record and/or detailed financial information, we typically take a conservative approach and capture this exposure in our overall financial risk assessment.

The slowing pace of M&A

Similar to other sectors beyond insurance, the pace of life and annuity M&A slowed significantly in 2022, especially relative to the period between mid-2020 and the end of 2021, which was active for the life sector. Although it is hard to pin down the exact reasons, global geopolitical unrest and the uncertainty around the economy likely contributed to the slowdown. We do not expect this to change until the economic environment becomes clearer, though some life and annuity blocks will still change hands, as they have in 2022 and in prior years when M&A was sluggish.

What Could Weaken Our Life Sector View?

Deeper- or longer-than-expected recession

If corporate and CLO downgrades significantly outpace the levels in our stress test, the impact on portfolios may cause bigger capital shortfalls and ultimately make a large enough dent in life insurers' creditworthiness to affect ratings.

Race to the bottom

However unlikely, insurers could 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 quality.

Disintermediation

If a large interest rate spike, bigger than what's already occurred, causes policyholders to withdraw funds from insurance products en masse, despite surrender charge and market-value adjustment penalties, insurers might experience a liquidity crunch that could cause losses and affect ratings.

Rating And Outlook Distributions

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