US Life/Annuity Industry Weathers the Pandemic Well in 2020 AM Best’S Outlook for the US Life/Annuity Market Segment Remains at Negative

BEST’S MARKET SEGMENT REPORT March 8, 2021 US Life/Annuity Industry Weathers the Pandemic Well in 2020 AM Best’s outlook for the US life/annuity market segment remains at Negative. Most of the Most of the US companies in the L/A insurance industry maintain solid balance sheets, owing largely to healthy risk-adjusted capitalization and liquidity, but the segment faces a number of challenges L/A companies and threats. Some of the issues the industry is grappling with existed well before the COVID-19 maintain solid pandemic, including ongoing challenges to top-line growth, margin compression due to the prolonged low interest rate environment, the need to leverage technology to improve efficiency balance sheets, and better align the business model with customer needs, as well as the need to further owing largely enhance enterprise risk management (ERM) frameworks. to healthy The emergence of COVID-19 during the first quarter of 2020 added new challenges to the list, risk-adjusted such as a further decline in interest rates, the potential for substantial deterioration in mortality and morbidity experience, a sharp drop in the equity markets, and a significant widening capitalization of credit spreads. Furthermore, a number of fixed-income rating downgrades suggested the and liquidity, potential for considerable deterioration in the credit markets—particularly for the sectors most impacted by the pandemic, such as hotels, airlines, travel, energy, and real estate. but the segment faces Recognizing the threat posed by the pandemic, AM Best immediately ran conservative stress tests on the balance sheets of the rated insurance companies to identify those that could be a number of at risk of higher loss ratios, declining equity values, and deteriorating credit fundamentals. Working closely with the rated companies, we monitored both the markets and individual challenges and company performance closely throughout the balance of 2020 and continue to do so. Still, threats given the immediate impact of the pandemic, as well as the many challenges and unknowns, in March 2020 we revised our outlook for the segment to Negative from Stable.

The impact of the pandemic to date on mortality experience has been better than originally anticipated—and manageable. Morbidity experience has also held up well and, in certain product lines, has actually improved, although such improvements are likely to be temporary. Analytical Contact: Additionally, the equity markets have more than recovered, while credit impairments remain Thomas Rosendale, Oldwick +1 (908) 439-2200 Ext. 5201 surprisingly low. Most companies in the segment transitioned rather seamlessly to a work from Thomas.Rosendale home environment, at least for home office employees. The sales process has been more of a @ambest.com challenge, as few distribution channels were well equipped for a remote sales model. However, digitization and technology initiatives to support remote selling were accelerated, and sales Contributors: volumes began to improve in the second half of 2020. Michael Adams Igor Bass Bruno Caron Although it has weathered the pandemic well to date, the US L/A segment remains vulnerable George Hansen to its effects. Credit impairments to date have been limited, but we’re not out of the woods Jason Hopper Edward Kohlberg yet—loss recognition for asset classes such as commercial mortgages and certain structured Christopher Lewis securities can take time to emerge. It’s still too early for investment portfolios to declare Anthony McSwieney victory. Likewise, the impact of the decline in interest rates has yet to be fully recognized on Rosemarie Mirabella the liability side of the balance sheet. We started to see the impact vis-à-vis GAAP assumption Michael Porcelli Thomas Rosendale changes following the third quarter of 2020, as well as some statutory reserve charges at year- Frank Walko end, and are likely to see more of the same. This could also include additional block or legal 2021-031 entity transactions, as companies may look to diminish their exposure to interest rate risk.

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The pandemic has served as a real life test of companies’ ERM frameworks. Although certain aspects of these frameworks remain under development (including stress and scenario testing capabilities), most companies in the segment have earned passing grades to date. Furthermore, insurers quickly raised capital and curtailed share repurchases during the early phase of the pandemic, to bolster liquidity and capital as part of their overall ERM governance.

The impact of COVID-19 was seen early on as more of a challenge to the asset side than to excess mortality for the insured population. Hence, the life reinsurers’ business model, which relies less on asset portfolios, was less likely to be impacted—which is not to say that COVID mortality didn’t affect life reinsurers, but that the large dominant players entered 2020 with capitalization levels that were sized to handle an even more extreme mortality event.

With rising case counts and new strains of COVID-19 appearing, there is still economic risk despite the growing availability of highly effective vaccines, which have yet to have a meaningful impact. However, we remain cautiously optimistic for 2021 and beyond.

Balance Sheets Weathering the Pandemic … for Now The US L/A segment remains well capitalized despite the impact of the pandemic on operations, mortality, investments, and sales. Absolute capital and surplus grew about 5.0% through September 30, 2020, from the prior period, benefiting primarily from positive—albeit significantly lower—earnings and a change in unrealized capital gains (Exhibits 1 and 2). (All figures in this report are as of September 30, 2020.)

C&S growth leveled off for individual annuity companies, but group annuity companies continued to show moderate growth through September 30, 2020. Capital growth has been otherwise generally consistent across all lines of business (Exhibit 3).

Median BCAR (Best’s Capital Adequacy Ratio) scores have generally risen, as companies maintained their investment-grade allocations, and their absolute statutory capital levels rose Exhibit 1 US Life/Annuity – Capital & Surplus, 2015-3Q20

500

450 456 462 440 442 400 410 416 395 350 380

300

250 ($ billions)($ 200

150

100

0 2015 2016 2017 2018 2019 1Q20 2Q20 3Q20

Source: AM Best data and research

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(Exhibit 4). Based on AM Best’s criteria (according to which a risk-adjusted capital score greater than zero at VaR 99.5 and equal to or less than 10 at VaR 99.6 is considered Strong), nearly 90% of the rated entities have a Strong or better BCAR.

As noted, insurers raised capital in 2020 and limited share repurchases during the first three quarters of the year, which will benefit year-end BCAR scores, although dividends and share repurchases started increasing in the fourth quarter. Overall capitalization in 2020 fared much better than anticipated from the results of AM Best’s April stress testing, due to lower- than-expected mortality, modest levels of impairments in commercial real estate, and buoyant equity market valuations, despite Exhibit 2 credit rating downgrades. US Life/Annuity – Capital & Surplus, 2019-2020 Data as of February 17, 2021 Low interest rates and L/A carriers’ ($ billions) desire to hold more liquidity during the pandemic drove an 9 Months 9 Months YoY % increase in debt issuance, as 2019 2020 Change companies took advantage of the Prior Year-End Capital & Surplus 416.3 438.7 5.7 opportunity to refinance older Net Income 29.4 13.2 -54.9 issues that had been priced at Change in Unrealized Gains/Losses 26.1 14.3 -45.3 higher interest rates. Debt issuance Change in Asset Valuation Reserves -8.9 -0.7 -92.2 for the L/A carriers amounted Other Changes in Surplus 1.9 6.3 238.7 to nearly $35 billion through Contributed Capital -3.2 5.6 -276.5 September 2020, significantly Stockholder Dividends -19.8 -15.4 -22.2 higher than the approximately Ending Capital & Surplus 442.9 462.4 4.4 $20 billion through September Change in C&S from Prier Year-End ($) 26.5 22.2 2019. About three-quarters of all Change in C&S from Prier Year-End (%) 6.4 5.1 debt issued was senior unsecured. Note: NM = Not meaningful. Figures may not add up due to rounding. The issuance of surplus notes Source: AM Best data and research

Exhibit 3 US Life/Annuity – Capital & Surplus by Rating Unit Composite, 2015-3Q20

140

120

100

($ billions)($ 60

0 2015 2016 2017 2018 2019 1Q20 2Q20 3Q20

Individual Annuity Individual Life Group Annuity Multiple Lines

Source: AM Best data and research

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Exhibit 4 US Life/Annuity – Median BCAR Scores by Balance Sheet Strength

100

-20

Median BCAR Score -40

-60

-80

-100 VaR 95% VaR 99% VaR 99.5% VaR 99.6%

Strongest Very Strong Strong Adequate Weak Very Weak

Source: AM Best data and research

also increased from the prior year, but accounted for only about $5 billion of debt issued. Unadjusted debt to capital ratios have risen but remain at manageable levels. Interest coverage ratios remain adequate despite a decline in 2020 due to a drop in earnings. Of those issuers that had access to contingent capital facilities, only a few drew down these facilities early in the pandemic,

Most companies showed a net increase in GAAP equity through the third quarter, with OCI (Other Comprehensive Income) improving due to the recovery of the financial markets after the downturn in the first quarter. Asset valuations have improved as credit spreads narrowed, but shareholders’ equity growth has been constrained due partly to revisions to DAC (deferred acquisition costs) asset balances—insurers have had to lower their long-term interest rate assumptions and lengthen the duration of their grade-in periods in response to the decline in interest rates in 2020.

Investment Stability Continues to Buttress Balance Sheets In early 2020, despite low interest rates and declining portfolio yields, investment trends were stable owing to favorable equity market conditions, moderate GDP growth, and stable credit spreads, all of which benefited from the Federal Reserve’s accommodative monetary policy. The capital markets took a decided turn in March, with equity market declines of 32% and the benchmark ten-year Treasury sliding almost 150 basis points (touching an intraday low of 32 basis points in early March) in response to the accelerating growth in COVID-19 cases worldwide. This caused massive spread widening from March to April, prompting insurers to immediately raise liquidity both in their investment portfolios and on their balance sheets. Insurers quickly identified the major sectors most at risk—commercial real estate, energy, hospitality, airlines, retail, and entertainment—of the severely decelerating US economy, which saw a decrease in GDP and a historic and unprecedented spike in unemployment as the country embarked on a temporary shutdown.

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Minimal Changes in Asset Allocations Overall trends in asset allocation (Exhibit 5) remained roughly in line with the familiar theme of higher allocations to alternatives (Schedule BA) and an increased preference for private over public asset classes, along with a continued preference for structured securitized asset classes. These tactical asset allocation shifts have been offset by a decrease in public bonds. This reflects the ongoing and notable shift toward structured asset classes and private debt as insurers’ search for liquidity premiums to offset compressed portfolio yields. They also reflect insurers’ views that these asset classes offer a better risk/return than the public corporate bond market, which is characterized by higher—and unsecured—issuer leverage. The growth in private placements also continued, with the life industry almost doubling its allocation since 2009.

Asset-liability matching has played a role as insurers adjust to a prolonged low interest rate environment and lengthen duration using private assets—namely, private equity, private debt, real estate, and other alternative assets. The considerable growth in this market, with assets under management at an all-time high of $6.5 trillion, has made the shift possible, as insurers and other investors trade liquidity for illiquid risk premium. Declining portfolio yields and the need to support embedded product guarantees will likely continue to drive the growth in these holdings. Although insurers are likely to remain largely buy-and-hold investors, they must become more tactical, to take advantage of temporary market dislocations on the margin and thus improve performance, as insurers with deep investment capabilities have been able to do during the pandemic.

The trend toward private placements continued, with the life industry almost doubling its allocation since 2009.

Securitized credit remains an attractive asset class for many insurers, as yields have typically been higher than corporate bonds due to their structural complexity and liquidity premiums. CLO (collateralized loan obligations) holdings continue to grow, but the overall allocation of 4%

Exhibit 5 US Life/Annuity – Invested Assets, 2015 vs. 2019

Schedule BA & Other Invested Assets

Cash & Short Term

Policy Loans

Real Estate

Mortgages

Total Stock

Public Bonds

Private Bonds

0 10 20 30 40 50 60 2019 2015 % of Invested Assets

Source: AM Best data and research

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remains moderate. Furthermore, Exhibit 6 insurers have consistently remained US Life/Annuity – Corporate Bond Portfolio in the higher-credit tranches, (%) Basic typically at the “a-” or higher level, Technology, Materials/Cyclicals/ with very limited exposure to below 3.7 Manufacturing, 9.9 investment grade CLOs or equity tranches. Consumer Staples/Retail, Services, 8.5 In recent years, some insurers 12.0 have securitized their BA assets Public and sold them off to institutional Utilities, investors, a trend that continues, 10.0 Energy, 9.5 with some insurers now packaging BA commitments into structured Other, 13.7 special purpose vehicles and Financials, 25.1 using capital provided by other Pharmaceutical/ asset managers to fund existing Chemical, 5.0 commitments while seeking outside minority investors. Another Health, 2.5 noteworthy trend is traditional insurers who typically had outside Source: AM Best data and research managers or internal traditional asset management capabilities starting their own asset management companies as a way to originate private assets for themselves and external clients, while realizing fee income to augment their investment returns. We expect this trend to continue, although whether insurers will achieve these objectives remains to be seen.

Insurers Continue to De-Risk Portfolios The bond sector has not seen a material change in allocations as Exhibit 6 shows. However, there has been an ongoing de-risking in insurers’ portfolios, specifically of energy and retail holdings, the last five years. A growing number of insurers are adopting an ESG (environmental, social, and governance) framework for major asset classes. Some larger insurers have issued green bonds, but overall industry purchases of these bonds remain modest, although we do note an increased commitment by larger insurers. We expect that sustainability investing will continue to grow, although it remains relatively modest.

Credit spreads blew out quickly late in first quarter 2020, which led to unrealized losses, but started recovering in the second quarter (Exhibit 7).

Shift in Commercial Mortgage Loan Allocations Insurers’ CML allocations continue to grow, but with an underlying sector rotation. The shift from office and retail is being offset by generally stable allocations to industrial properties and an increase in multifamily housing (Exhibit 8).

These multiyear trends have diminished the industry’s exposure to the COVID-19 -sensitive sectors—namely retail, hotels, and to some degree office, which proved beneficial in 2020. Understanding how office space needs will change post-pandemic will take some time, as companies adapt to a hybrid work from home/office strategy, and the need for safer work environments, along with larger workspaces, may offset some of the potential vacancy contraction. The economic impact on the sales function and the ability of many industries, including the life insurance industry, to pivot to a work-from-home strategy will also play a role

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Exhibit 7 US Life/Annuity – Bond and Stock Unrealized Gains/Losses, 4Q15-3Q20

15,000 1,600

1,400 10,000 8 - 1,200 Average Rolling Quarter 5,000 1,000

0 800

($ millions)($ 600 -5,000 400 -10,000 200

-15,000 0

Unrealized Stocks & Bonds YTD 8-Quarter Rolling Average

Source: AM Best data and research

Exhibit 8 US Life/Annuity – Commercial Mortgage Loan Breakdown, 2015-2019

100 5.9 5.8 6.9 6.7 7.2 90 20.9 21.4 22.8 24.1 80 27.6

70 4.1 4.1 4.3 4.3 3.6 60 14.1 13.9 14.1 14.3 14.4 (%) 50 23.8 23.5 40 22.7 20.9 19.2 30

20 31.2 31.3 29.2 29.7 27.9 10

0 2015 2016 2017 2018 2019 Other Apartments Hotels/Motels Industrial Retail Office

Source: AM Best data and research

in the office market. Retail will remain under pressure although the impact will be felt mostly in large commercial shopping malls, in which the industry has minimal investment, having de-risked this allocation over the last decade. Most of the industry’s holdings are in strip malls, with a focus on essential services (grocery, drugstore, etc.), but these locations will still feel pressure as online shopping continues to accelerate. A geographic shift is currently under way from large major cities to suburban and medium-sized cities; whether this trend is permanent

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Exhibit 9 US Life/Annuity – Commercial Mortgage Loan Impairments, 2013-3Q20

3.5

3.0 0.8 0.3 0.6 2.5 0.5 0.5 0.4 0.5 0.6 0.4 2.0 1.3 1.1 1.4 1.3 1.5 1.3 1.4 1.1 ($ billions)($ 1.7 1.7 1.0 0.6 0.3 0.4 0.4 0.3 1.4 0.5 1.1 0.3 0.7 0.1 0.4 0.6 0.5 0.6 0.2 0.0 0.2 2013 2014 2015 2016 2017 2018 2019 2Q20 3Q20

Foreclosed Restructured In Foreclosure 90 Days Delinquent

Source: AM Best data and research

or if there will be a reverse migration in a normalized post COVID-19 world is difficult to ascertain. Exhibit 9 shows that the CML market is beginning to see some delinquencies and restructured and foreclosed loans, a trend likely to continue but to remain manageable for insurers.

The commercial mortgage-backed securities (CMBS) market is also showing some early signs of distress in the large multifamily, non-agency market, as occupancy numbers have declined and the number of borrowers considering deed surrender in lieu of foreclosure is rising. The retail CMBS sector is also showing signs of stress.

Affiliated DA & BA Investments Affiliated Schedule DA (short-term loans) holdings continue to decline, which has been offset by an increase in both affiliated and total Schedule BA (other long-term invested assets) over the last five years (Exhibit 10a). The decrease in affiliated DA holdings is due partly to their structure, as they are short duration maturities (less than 365 days), which do not fit well from an ALM standpoint owing to the pressure from short-term yield environment. The increase in affiliated BA holdings is notable, as they now account for 47% of all BA holdings (Exhibit 10b).

Total BA exposure (affiliated and non-affiliated) increased 10% in 2019, which not only reflects the increase in allocations to privately originated asset classes but is also strategic, with additional investments in technology to support business innovation. Both joint ventures/ partnerships and surplus notes/capital notes/loans have been increasing, to account for almost 90% of BA assets in 2019. JV/partnerships make up just over 75%, which have held steady as a percentage of the total. The surplus notes/capital notes/loans growth has exceeded JV growth, with its share rising from 8% of BA surplus/capital notes in 2015 to 11% in 2019.

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Exhibit 10a US Life/Annuity – Affiliated DA Growth, 2015-2019 5.0 14

4.5 12 4.0

3.5 10

3.0 8 (%) 2.5 6 ($ billions)($ 2.0

1.5 4

1.0 2 0.5

0.0 0 2015 2016 2017 2018 2019 Total Affiliated DA % of Total DA

Source: AM Best data and research

Exhibit 10b US Life/Annuity – Affiliated BA Growth, 2015-2019 120 49

100 48

80 47 (%) 60

($ billions)($ 46 40

45 20

0 44 2015 2016 2017 2018 2019 Total Affiliated BA % of Total BA

Source: AM Best data and research

Quality per NAIC Designation The credit quality of insurers’ investment-grade bond portfolios continued to decline through 2019 but stabilized last year. The increase in Class 2 bonds has been offset by a decline in below investment grade bonds (Exhibit 11). The shift from NAIC Class 1 to Class 2 is a result

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Exhibit 11 US Life/Annuity – Quality per NAIC Designation, 2010-2019 (%)

Total Bonds 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 Class1 65.8 65.0 62.9 62.6 63.4 62.4 62.3 62.0 60.3 60.5 Class 2 27.3 28.4 30.8 31.7 30.8 31.7 31.6 32.4 34.3 34.3 Below Investment Grade 6.9 6.6 6.2 5.8 5.8 5.9 6.0 5.7 5.3 5.2

Total Publicly Traded Bonds 74.7 74.4 72.8 73.2 72.1 71.0 70.3 68.9 66.6 64.5 Class1 72.0 71.4 69.6 69.1 69.4 68.2 67.8 67.6 65.2 65.8 Class 2 22.8 23.4 25.5 26.6 26.2 27.6 28.0 28.5 31.1 30.9 Below Investment Grade 5.2 5.2 4.9 4.4 4.4 4.2 4.3 3.9 3.8 3.4

Total Privately Traded Bonds 25.3 25.6 27.2 26.8 27.9 29.0 29.7 31.1 33.4 35.5 Class1 47.5 46.5 45.0 44.7 47.7 48.4 49.5 49.5 50.7 51.0 Class 2 40.6 43.0 45.1 45.7 42.7 41.7 40.4 40.8 40.8 40.6 Below Investment Grade 11.9 10.5 9.9 9.6 9.6 9.9 10.2 9.6 8.5 8.5 Percentages may not add up to 100 due to rounding. Source: AM Best data and research

of structural changes in the corporate bond market, given an increase in debt issued at the bbb- level. However, we expect that 2020 will show an increase in below investment grade bonds, in addition to some ratings migration from NAIC 1 to NAIC 2 due to the pandemic, as the number of fallen angels has already exceeded levels experienced during the 2008-2009 financial crisis.

Overall Portfolio Yields Continue to Decline Insurers’ portfolio yields have declined by roughly 85 basis points since 2010 and will likely continue to do so. Net investment income has held steady, driven by a higher asset base but this will likely level off, given a decline in sales during most of 2020. Investment yields were most negatively impacted in the first and second quarters from lower alternative asset income, but the third quarter showed significant improvement. Most of the public companies that have reported believe alternative asset income will normalize by the fourth quarter, with expected returns in the 7% to 10% range. Common stock returns remain more volatile but were favorable at year-end (Exhibit 12).

Another round of stimulus in the works in Congress could lead to a rebound of economic growth in the second half of 2021. However, the benefits of any stimulus may prove short-lived, given the growing likelihood for higher taxes and increased regulation. We think the potential for massive changes in policy and stimulus are somewhat limited. We remain cautious, as credit migration has already exceeded levels experienced during the financial crisis and has the potential to worsen if we are unable to control the spread of the virus. Nevertheless, we believe that actual impairments will remain manageable, given the industry’s sufficiently capitalized balance sheets, which should benefit from ongoing net cash flow generation to weather 2021.

Impact of LIBOR Companies continue to assess the impact on their financial statements of the upcoming transition from the London Interbank Offered Rate (LIBOR). LIBOR is used to set interest rates on a plethora of financial assets, including mortgages, loans, corporate bonds, and derivatives. In the US, the Alternative Reference Rates Committee (ARRC) has identified the Secured Overnight Financing Rate (SOFR), as the replacement for USD-based LIBOR rates. The transition from LIBOR can impact both assets and liabilities on insurers’ balance sheets,

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Exhibit 12 US Life/Annuity – Portfolio Yields, 2010-2019

200 5.4

195 5.2 190 5.0

185 Net Yield (%) 4.8 180 4.6 175 ($ billions)($ 4.4 170 4.2 165

160 4.0

155 3.8 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019

Net Investment Income ($ billions) Net Yield (%)

Source: AM Best data and research

as many invested assets have LIBOR provisions. Some reserve valuation rates may also be based on LIBOR. In addition, insurers’ debt structures may be affected, especially those with floating rate obligations currently tied to LIBOR. One of the largest risks that may emerge after transitioning to other reference rates is the potential litigation regarding fallback provisions for the use of alternative reference rates. The Fed recently announced that the administrator of dollar LIBOR, the ICE Benchmark Administration, is set to extend the key tenors on LIBOR until mid-2023, which would allow most legacy USD LIBOR contracts to mature before they expire. AM Best does not expect the transition from LIBOR to have an impact on ratings but will continue to monitor companies on their preparedness for the event.

Reserves at Risk in Intensifying Interest Rate Environment Principle-Based Reserves The decade-long effort to “right-size” reserves led to principle-based reserving (PBR), which became effective at the start of 2020. Some companies were early adopters, starting in 2017. PBR implementation is expected to affect the level of reserves for some products and the use of captives for reserve relief, as well as operating costs. Small carriers that do not qualify for the small company exemption PBR requirements for disclosures, methodologies, and reporting may be particularly impacted. Reserve patterns, and consequently earnings patterns, will vary by line of business, carrier, and in-force blocks. For example, some unusual patterns may emerge in term blocks, as older vintage XXX reserves continue to ramp up and carry more weight in the short term. Over the long term, PBR may smooth out earnings patterns, as one of the PBR goals is to diminish redundancies and inadequacies in reserves; in the short term, unexpected patterns may emerge, as formula-based and principal-based approaches coalesce.

Mortality and Underwriting On the mortality front, companies have characterized COVID-19 as having an earnings impact as opposed to a balance sheet impact, suggesting fluctuations in benefits but no significant changes to reserves. Some carriers experienced slightly higher mortality rates than usual,

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which resulted in slightly favorable developments for long-term care. Some carriers playing both sides of the equation also benefited from the mortality and longevity impact. However, the short- and the long-term implications of COVID-19 mortality on liabilities and future pricing assumptions remain to be seen. The pandemic also brings new questions with regard to its impact on mortality from other causes, illnesses, and conditions, including mental health. COVID-19 has forced carriers to use a more digitized approach to underwriting—big data in the L/A segment continues to improve, leading to better underwriting standards. AM Best expects more granularity and underwriting capabilities on the mortality front, for both life and longevity insurance.

Long-Duration Targeted Improvements (LDTI) The effective target date for ASU-2018-12 was once again postponed to January 1, 2023 for SEC filers (January 1, 2025 for all others). COVID-19 and all of its ripple effects can be blamed for this shift in priorities. Like PBR, this initiative requires significant resources, but the accounting standard is likely to bring more transparency to reporting on company’s obligations.

Modeling Actuaries typically benefit from large data sets that have withstood the test of time. Although historical data is by no means the sole predictor of the future, it does help actuaries frame a problem, to understand the order of magnitude and sense of direction of a certain situation. Modeling can help make informed decisions. COVID-19 brought another dimension to modeling as the type, quality, and timeliness of data used to model pose a real challenge to modelers and decision makers.

Margin Compression Impedes Capital Growth The industry’s statutory pre-tax operating earnings were favorable through third quarter 2020, but was about half as much as in the same period in 2019 (Exhibit 13). This was driven primarily by derivative positions used to hedge interest rate exposures, the market- driven impacts on variable annuity blocks, and lower premiums during the year. Although the pandemic underscored the importance of life insurance, life insurance premium was down about 1% through third quarter 2020. Annuity premium was down further, about 11%, as some companies looked to de-risk their liability profiles due to spread compression.

Sales of fixed-indexed annuities (FIAs) were down but remained the highest selling annuity product through 2020, despite a moderation of sales for some companies. However, even with a falling equity market, FIAs still offer an attractive choice among competing products, which could stem any large-scale outflows for insurers.

The ongoing drag from the low interest rate environment continues to impact margins and stifle earnings growth, evident from the industry’s weakened investment yield trends (Exhibit 14). Partly offsetting lower yields was the continued growth in absolute invested assets, which reached a record $4.78 trillion as of September 30, 2020. The low interest rate environment is likely to continue to create a drag on margins until longer-term interest rates and credit spreads return to more historical levels. Companies have been looking to offset this somewhat through expense efficiencies. Although the ratio of general expense to net premiums written declined from 11.1% as of third quarter 2018, to 9.9% at third quarter 2019, it increased as of third quarter 2020 to 10.3%, as a result of increased technology spending due to the pandemic and remote reworking environment. We expect that general expenses will decline in the coming years, as companies look to minimize their office footprint and generate greater technology efficiencies.

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Exhibit 13 US Life/Annuity – Statutory Quarterly Results, 2013-3Q20 ($ billions) 3Q19 4Q19 1Q20 2Q20 3Q20 Premium & Annuity Considerations 515.6 689.7 183.3 313.9 481.0 Increase in Reserves 101.6 114.5 97.5 69.4 91.8 Net Income 29.4 45.6 -23.1 6.1 13.2 Pretax Operating Gain 38.7 61.8 -50.5 -4.2 16.7 Insurance Assets 4,719.8 4,733.6 4,971.9 4,989.0 5,029.0 Separate Accounts – Assets 2,729.6 2,833.4 2,460.3 2,738.2 2,846.1 Capital & Surplus 442.9 440.1 442.3 455.7 462.4 Source: AM Best data and research

Exhibit 14 US Life/Annuity – Yield by Asset Class, 2010-2019 10

5 (%)

0 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019

Net Yield Bonds Common Stock Mortgages BA Assets

Source: AM Best data and research

Some offsets to the ongoing macroeconomic challenges the L/A insurers face are favorable underwriting and evolving risk management practices, including the use of hedges, adjustments to crediting and discount rates, and a focus on technology to improve sales. These factors have resulted in favorable statutory and GAAP operating profitability for most companies. The industry continues to use hedging to help mitigate earnings and capital volatility and to manage risks in embedded product guarantees on legacy blocks of business.

Third quarter 2020 pre-tax operating income was down for a little over half the statutory companies, and pretax operating income for the rating unit groups was down from third quarter 2019. The ten groups with the largest drops in earnings accounted for a decline of about $22 billion in total. In addition, because of statutory accounting, material changes in the equity markets and interest rates often result in a mismatch between changes in the value of the asset (derivatives used for hedging) and the associated changes in liability (reserves), which distorts operating income trends. For example, as of third quarter 2020, large insurers with sizeable annuity blocks (such as Prudential, Brighthouse, Equitable Life, and Ameriprise)

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recorded pre-tax statutory operating losses driven by derivative accounting, increases in reserves reflecting primarily lower interest rates, variable annuity accounting, and reserve refinements. However, this income statement distortion is generally offset by direct changes to statutory capital and is therefore capital-neutral—hence, the diminished statutory pre-tax operating income as of third quarter 2020, even as capital continued to grow.

Benefits paid and commission expenses were down about 2% for the first three quarters of 2020 compared to the same period in 2019 owing mainly to lower sales. Operating results for private equity companies are also more volatile. Stock companies aim for earnings consistency and look to deploy capital to fund earnings growth. Mutual and fraternal companies tend to hold on to more capital and provide policyholder dividends or fraternal benefits, which dampen ROE results (Exhibit 15).

The industry’s C&S showed solid growth through third quarter 2020, up $22.2 billion, to $462.3 billion and is projected to end the year at $458.1 billion (Exhibit 16). (During the same period in 2019, capital increased by $24 billion.) The growth was driven mainly by a $14.2 billion increase in unrealized capital gains. In addition, dividend payouts declined in 2020, as insurers looked to build up their capital bases in light of the pandemic. Although operating income trends have been tough to follow due to hedging and market impacts, capital growth has slowed due to narrowing margins resulting from the pandemic and lower interest rates.

At the holding company level, financial flexibility remained sound, with moderate but growing levels of financial and operating leverage and solid interest expense coverage levels. In addition, overall liquidity remains positive and has grown, as companies looked to expand credit facilities as a prudent risk approach to the pandemic. Many companies with excess capitalization remain somewhat cautious with respect to using it.

Insurers Seek New Avenues for Growth Intense competition in the fixed-annuity space has also forced insurers to search for new distribution channels or to seek other avenues for growth. The influx into the market of direct annuity writers backed by private equity offering generous crediting rates has put some pressure on more established companies. In addition, fixed-indexed annuities that offer guaranteed living benefit riders had in recent years become necessary for fixed annuity writers to remain competitive. However, several prominent insurers have recently announced that they would no longer offer these riders due to their higher capital requirements, volatility, and growing costs. Some insurers have also experienced unfavorable utilization, which, combined with low interest rates, has made it difficult to justify new sales. Many L/A insurers have been gravitating to registered index-linked variable annuities (RILAs), which have been the primary driver of growth in the variable annuity product segment the past two years. Unlike regular variable annuities, RILAs share the downside risk with the policyholder. In addition, these products have generally been sold without any secondary guarantees, although a small number of carriers have recently begun offering them.

Well-established insurers have focused more on growing the bank and broker/dealer channels, as they require a higher rating, which many of the new entrants have not obtained. According to the Secure Retirement Institute, bank sales accounted for 41% of fixed-rate deferred annuity sales in third quarter 2020, up 85% from prior year period. Some insurers that have established direct-to-consumer (DTC) distribution capabilities and have experienced a noticeable increase in sales, although from a relatively low base, as the share of new business in the DTC channel has historically accounted for a modest amount of overall sales.

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Exhibit 15 US Life/Annuity – ROE by Organizational Structure, 2015-2019 20

10 (%) 8

0 2015 2016 2017 2018 2019

Stocks Mutuals Private Equity-Owned

Source: AM Best data and research

Exhibit 16 US Life/Annuity – Statutory Financial Trends, 2015-2021e

Profitability 2015 2016 2017 2018 2019 2020e 2021e Return on Assets (%) 0.7 0.8 0.7 0.6 0.7 0.4 0.6 Return on Equity (%) 12.0 13.2 12.8 10.6 12.2 7.4 10.5 Return on Revenue (%) 5.2 5.9 6.0 4.8 5.6 3.7 5.2 Change in Net Investment Income (%) -0.5 1.0 5.5 2.8 -0.2 4.8 1.7 Pretax Operating Gain ($ billions) 55.2 67.2 63.7 47.4 61.8 34.8 66.2 Net Operating Gain ($ billions) 44.7 51.2 51.3 43.9 52.4 26.3 50.0 Realized Capital Gain/Loss ($ billions) -3.5 -12.5 -8.4 -4.4 -6.7 7.7 - Net Income ($ billions) 41.2 38.6 43.0 39.5 45.6 33.9 50.0

Capital Change in NPW & Deposits (%) 1.2 -3.7 1.2 2.7 13.8 -2.6 3.2 Change in Capital & Surplus(%) 4.0 3.9 3.7 1.6 5.7 4.1 3.6 Change in Net Unrealized Capital Gains/Losses-11.7 ($ billions)-4.7 7.2 0.8 19.5 13.2 - C&S/Liabilities (%) 11.9 11.7 11.8 11.7 12.1 6.2 6.2 Capital & Surplus ($ billions) 380.4 395.3 409.7 416.3 440.1 458.1 474.6 Asset Valuation Reserve ($ billions) 49.5 51.5 57.4 56.3 71.9 67.6 67.6 Total Adjusted Capital ($ billions) 429.9 446.8 467.1 472.7 512.0 525.7 542.2 Source: AM Best data and research

The increased DTC sales were also primarily for more simplified products—consumers would still rather speak with a live financial representative for more complex retirement type products.

Given the stiff competition in the individual annuity segment, a growing number of insurers have identified the pension risk transfer (PRT) market as an area for potential growth. Although interest rates remain low and US single premium buy-out sales declined 32% in

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the first nine months of 2020 from prior year period (according to the Secure Retirement Institute), many medium-sized players feel that this product is a good fit for them as it can also provide a partial hedge to their mortality books of business. PRT has historically been dominated by a handful of large insurers, with the UK the most mature market, but many medium-sized US companies are eying this growing market—they believe they have the capacity on their balance sheets to handle smaller to medium-sized transactions, perhaps partnering with a reinsurer on larger deals.

Company Business Profiles Being Reshaped by Low Interest Rates Given the prolonged low interest rate environment, pressure continues to mount as insurers lose the levers they can pull without worsening their company risk profiles. Spread compression and declining investment yields have been a concern for some time, and market volatility and uncertainty suggest the problem will only get worse, as guaranteed rates on many older blocks of business remain a burden for many insurers. However, based on data from the AM Best-rated population (via the Supplemental Rating Questionnaire [SRQ]), account values with a guaranteed minimum interest rate (GMIR) of 5% or higher declined from 6% in 2012 to just 3.1% in 2019 (Exhibit 17).

Products guaranteeing anything higher than 3% have also declined; lower rate guarantees are becoming more prevalent, as companies try to manage spread compression. Additionally, the percentage of companies with more than half their account values in products with a GMIR higher than 4% has declined to roughly 37% over the last four years, down from more than half in 2011 (Exhibit 18). However, the net yield of these companies has declined 99 basis points on average, from 5.09% in 2010 to 4.10% in 2019 (Exhibit 19), highlighting the issue of spread compression for those with concentrations in products with higher GMIRs.

Exhibit 17 US Life/Annuity – Statutory Account Values for Contracts with Guaranteed Minimum Interest Rates 2012-2019 100 6.0 6.0 5.3 5.2 4.6 4.1 3.9 3.1 90 17.2 16.4 15.9 19.6 18.5 17.4 22.9 80 24.5 6.0 5.0 5.0 5.7 4.9 4.4 70 4.0 5.0 60 30.1 31.2 30.8 29.9 32.8 35.4 50 (%) 36.9 34.9 5.7 40 6.7 6.8 7.1 6.3 9.2 8.9 30 6.1 8.0 9.1 5.9 8.0 4.4 6.0 7.9 5.8 5.1 5.6 8.4 5.8 20 8.4 4.9 4.2 5.9 10 21.4 21.9 22.4 24.0 16.0 18.9 9.8 12.7 0 2012 2013 2014 2015 2016 2017 2018 2019

<1.5% 1.5%-2% 2%-2.5% 2.5%-3% 3%-3.5% 3.5%-4% 4%-5% =>5%

Source: AM Best data and research

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As a result, insurers are under intense pressure to continue to cut expenses while investing in digital capabilities. Historically, insurers have been able to mitigate this pressure through

Exhibit 18 US Life/Annuity – % of Rating Units with More than 50% of Account Values with Minimum Guaranteed Interest Rates Higher than 4%, 2011- 2019 60

55.7 50

40 44.6 43.6 42.3 39.5

Based Capital (%) 37.2 37.8

- 36.9 30 35.2

20 Average Risk

0 2011 2012 2013 2014 2015 2016 2017 2018 2019

Source: AM Best data and research

Exhibit 19 US Life/Annuity – Average Net Yield by Business Profile Exposure, 2010-2019

5.19 5.06 4.78 5 4.69 4.54 4.46 4.30 4.25 4.27 4.19

(%) 3.61 3 3.48 3.38 3.42 3.24 3.24 3.12 3.16 3.16 3.20

0 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019

Interest-Sensitive Non-Interest-Sensitive

Source: AM Best data and research

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new product pricing on the liability side of the balance sheet, including lowering cap rates for indexed products, scaling back pricing on variable annuity living benefit riders, and lowering crediting rates and dividend scales. For over a decade now, L/A insurers have been transitioning away from more volatile lines of business and have cut back or discontinued sales of universal life products with secondary guarantees, divested in-force legacy annuity blocks, and completely ceased sales of new variable annuities (VA) with living benefits. These actions have been further supported by ongoing expense savings through automation and the elimination of redundant processes. As a result, insurers have generally been able to maintain target return ratios while unlocking some capital from insurance operations, which they have either returned to shareholders or used to support growing operations. However, many of these actions have also made these de-risked products less attractive to consumers and more difficult for insurance agents and financial representatives to sell.

Higher market volatility has resulted in higher hedging costs for products such as fixed indexed annuities, indexed universal life, and variable annuities with living benefits. As a result, many insurers began to re-evaluate their overall business strategies and were forced to make bold strategic decisions to best position themselves in this rapidly evolving business climate. For the most part, insurers have chosen to narrow their strategic focus to core product lines while simplifying and streamlining their corporate structures. High-profile examples include Ameriprise and MetLife selling their P/C business, Allstate and AFG selling their life operations, Jackson National spinning off from its parent Prudential plc, and Aegon announcing that it would cease selling fixed annuities and variable annuities with living benefits. The general theme has been to shift from more capital-intensive and interest- sensitive businesses toward businesses such as asset management, which provides more fee income, and shorter-duration group insurance business, that relies more on underwriting income.

Despite a notable disruption at the beginning of the pandemic, sales rebounded for many insurers, especially for L/A insurers that had already been digitizing and streamlining their sales, underwriting, and administrative processes for a number of years. Many L/A insurers made changes to their life underwriting processes to address the diminished access to paramedical suppliers and to simplify the sales process, which will likely lead to a temporary increase in mortality and anti-selection risk.

Real World Test for Enterprise Risk Management Frameworks COVID-19 provided a unique test for companies’ ERM. Of particular note was capital planning based on multi-risk stress testing that combined several challenges at once. In 2020, we saw falling interest rates, deteriorating credit quality, a shrinking asset base from which to draw fee income, declining life and annuity sales, and excess mortality—all at the same time.

Many companies successfully implemented work from home initiatives, which tested their operational risk management process, as most companies experienced an increase in hacking attempts. Companies expect that, with more people working from home, even greater vigilance will be required.

Another aspect of ERM that was put to the test was the ability to report risks and exposures in real time. Risk reporting has always been an essential element of ERM. As the COVID-19 crisis emerged, companies were being asked to provide daily updates to senior management, risk committees, and their boards of directors. Several companies were well positioned to do so after years of investing in the required infrastructure. Those companies already had risk dashboards to handle the need to provide rapid and concise information to decision makers

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and leadership. Less-prepared companies were forced to respond to senior management on an ad hoc basis, making do with an infrastructure set up for quarterly reporting.

Some companies used the disruption caused by COVID-19 to accelerate a move to “fluid-less underwriting,” by taking advantage of advanced analytics underwriting techniques in a social distancing environment. Although such an approach is a positive for compressing the time to issue a policy, insurers will need to closely monitor this new underwriting strategy.

Many companies are still using legacy systems, which can create a natural drag for innovation or the implementation of ERM initiatives. Still, the industry is in a better place today, for a variety of reasons. Established carriers have been able to rationalize capital expenditures on IT modernization to better compete with new entrants that are not burdened by legacy systems and can leverage third-party technologies to improve ERM capabilities. The larger top-tier insurers, along with newer entrants led by experienced managers and backed by fresh capital, have shown an ability to conduct quantitative modeling and risk pool analysis better than the smaller, regional insurers that lack the required scale to properly invest in ERM.

The need to integrate new organizational roles such as chief digital officer as part of an integrated ERM process has accelerated over the past year. Many companies have already embarked on this strategic initiative, and the ones that were further along at the start of 2020 were able to react more quickly and capitalize on the market dislocation.

Another factor attracting more and more attention is the move towards ESG programs and policies, which have increasingly become a part of ERM discussions. In the US, a handful of states (California, Connecticut, New York, Washington, Minnesota, and New Mexico) now require that insurers with more than $100 million of premium in these states participate in an annual survey on climate change. Insurers have also been addressing the issue of governance, making it a more formalized process—and improving it—over the past decade, especially as ERM is a component in both the AM Best rating process and the Own Risk Solvency Assessment (ORSA).

Innovation Focuses on Business Continuity AM Best observed a recalibration of priorities by innovation teams during 2020, which often included pausing major initiatives that weren’t deemed essential to manage regulatory hurdles, direct competition, or general business continuity. Many innovative projects have apparently been put on the back burner until macro-economic conditions improve or at least return to some semblance of the pre-COVID-19 world. Because of companies’ temporary halt to ventures deemed to be higher-risk, AM Best innovation scores are slightly lower than initial projections, prior to the release of the criteria.

However, not all companies have paused their initiatives. Those that continued to implement innovative strategies throughout the pandemic—beyond the digitization forced upon them by the current environment—have largely focused on automating time-consuming manual processes, furthering their data analytics capabilities, and selectively investing in insurtech firms with potential. With further automation, companies are more likely to provide more effective customer service, improving customer satisfaction and retention.

L/A organizations have made efforts to better analyze distribution channels down to the individual level, to determine where the best quality business is being sourced from. Finally, those entities with capital substantial enough to do so continue to offer resources to start-ups and other growing insurtech firms in the hope that these third party initiatives can be later integrated into their own operations.

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On the Regulatory Front…. Regulatory issues were not at the forefront in 2020, but there were a few regulatory developments. The SEC passed its “best interest” regulation (Reg BI), requiring broker-dealers to not put their financial interests ahead of those of their retail customers. The regulations covers disclosure, care, and conflict of interest obligations that might hurt sales for broker- dealers. Firms were required to comply starting June 30, 2020. The NAIC adopted a similar best interest model law that would apply to insurance agents.

The department of Labor (DOL) also recently released final regulation on its new DOL fiduciary rule, which includes a prohibited transaction exemption. The new rule replaces a more stringent regulation that was promulgated during the Obama administration but was vacated by a federal appeals court in 2018. The DOL has tried to make its new Impartial Conduct Standards proposal compatible with the SEC’s Reg BI.

Reg BI makes it clear that financial professionals can collect commissions for selling individual life insurance and individual annuities and need not act as a fiduciary. In addition, financial advisers to a retirement plan or to someone with an individual retirement account would have more compensation flexibility, so long as they act in the best interest of their clients, charge reasonable compensation, and do not make misleading statements. The department’s ruling also brings back an old “five-part test” for determining when a financial professional should act as an investment advice fiduciary. Industry officials believe that the Biden administration will likely replace the ruling once again, with more stringent regulations. Although L/A writers may face some compliance headaches, companies in general have been preparing for best interest regulations for some time, and we do not expect significant disruptions.

In December, the NAIC also voted to reduce the minimum non-forfeiture rate for individual annuities from 1% to 0.15%, which will alleviate some concerns about interest rate risk for companies writing new individual fixed deferred annuity business. Also in late December, the NAIC made a revision to Section 7702 (the definition of life insurance) in recognition of the current interest rate environment, lowering the valuation rate used for the cash value accumulation test from 4% to 2%, effective January 1, 2021. For new business, this will allow for higher premiums and larger cash values on a life policy’s death benefit. This change will be of particular interest to affluent segments of the market focused on using life insurance for cash accumulation.

Mergers & Acquisitions Higher unemployment, tightening consumer spending, and lower investor confidence all served to impede M&A throughout the year. These conditions made accurately valuing targets more difficult.

Shutdowns prevented face-to-face meetings among executives, which led to a lull in new M&A, although many deals were able to proceed after the shutdowns, with several notable transactions, including New York Life’s acquisition of Cigna’s life and disability unit; the sale of F&G Re to Aspida Holdings; American Equity’s partnership with Brookfield Asset Management; MassMutual’s planned acquisition of Great American Life; Allstate’s planned divestiture of its life operations to Blackstone; MetLife’s acquisition of Versant Health; and MassMutual’s sale of its retirement business to Empower Retirement. Several deals were strategic in nature, as companies sought to maximize shareholder value by exiting lower-margin life and annuity lines, while others sought to diversify earnings by entering the asset management and reinsurance marketplace. We expect insurers to continue to expand operations in both asset management and reinsurance to mitigate declining interest margins in their life and annuity business.

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Not all deals made it to the finish line, such as the acquisition of Genworth by China Oceanwide Holdings. After several years of delays and extension waivers, the two parties agreed in January 2021 to extend a new waiver. The likelihood of this deal finally happening seems remote. Acquisitions of complex books of business such as long-term care will always be a challenge.

One of the biggest hotbeds for M&A for US life insurers in 2020 was Asia, which offers a rapidly growing middle class and aging populations. Furthermore, the global environment underscores the importance of wealth management, retirement income, and insurability needs, factors that have led many US life insurers to further expand their business on the continent. In addition, China recently removed restrictions on foreign funded life insurance, which has resulted in some overseas entities consolidating with their US counterparts. Noteworthy transactions in Asia the past year include HSBC acquiring the remainder of its life operations in China and Prudential exploring a joint venture for life products in Thailand.

Looking Ahead…. The flurry of M&A announcements in early 2021—including Blackstone’s acquisition of Allstate’s life insurance business, MassMutual’s acquisition of AFG’s annuity business, and the planned de-merger of Jackson National and Prudential plc—reinforces our expectations that the US L/A segment will remain heavily focused on interest rate risk. Interest rate concerns can manifest in a number of ways, including additional M&A, reinsurance transactions to cede higher risk blocks, or temporary or permanent exits from interest-sensitive product lines, including fixed annuities, variable annuities, and even certain individual life insurance products.

AM Best will also be closely monitoring the US L/A company investment portfolios for signs of credit deterioration in asset classes that are particularly at risk to the pandemic, and where loss recognition may be slow to emerge. This will include sub-segments of the commercial mortgage market, sectors of the corporate bond market, as well as structured securities backed by such assets. Although impairments in these asset classes have been quite manageable to date, the longer the pandemic persists, the higher the likelihood of a significant increase in realized investment losses.

Last, although companies in the segment will out of necessity need to focus a significant amount of attention to mitigating the risks we have discussed here, they can ill afford to allocate resources to strictly defensive initiatives if they are to survive and grow over the long term. As we move forward into 2021, leveraging the capabilities developed to support remote work and sales environments during the pandemic in order to better position their business models for top-line growth will be critical.

Growth has been a challenge for some time—particularly in the middle market for individual life insurance products—but there may be a silver lining to what has otherwise been a long and drawn-out catastrophic event. In responding to the needs of both employees and distributors to work remotely, many companies have effectively accelerated certain aspects of their planned technology initiatives. In doing so, they may be better positioning themselves to grow and to take advantage of what appears to be heightened interest on the part of consumers in life insurance and other financial security products.

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Best’s Market Segment Report

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