Standard & Poor’s says that it continues to expect more downgrades than upgrades in the North American life insurance sector.

The ratings agency says that the U.S. life insurance industry continues to recover from the wounds inflicted in the past four years from a combination of a weak equity market, low interest rates, and a weak corporate credit environment. Yet, in spite of this cautious optimism, reduced capital positions and earnings following significant investment losses, increased cost of variable product guarantees and pension benefits, and reduced asset-based fee income remain real challenges for the industry.

“It is during this recovery period that the strength of management teams is being tested as never before,” S&P says. “A clear trend underlying near-term rating actions is unlikely to emerge, as company-specific responses to the improved industry fundamentals will contribute to either lagging or leading performance.”

The rating agency says that the changing dynamics of the North American life insurance industry have made consolidation once again a powerful mechanism for achieving scale and diversifying risk. “Given a stabilizing sector environment and improving market valuations, acquirers are more willing to do a deal now than during down years. Joining forces with other life insurers can be a powerful mechanism both to achieve scale and to diversify risk,” it says.

“Standard & Poor’s believes that for acquirers, most transactions will have neutral credit implications in the near term and may also have a positive effect on credit quality in the long term if the synergies between the two companies improve economies of scale and overall market position. There are caveats: M&A activity can damage financial strength if the acquirer lacks adequate capital, if the transaction involves substantial leverage, or if the target is significantly impaired.”

S&P also says that future upward rate movements should improve the earnings outlook for life insurers. But, the possibility of a rapid spike in interest rates, while considered unlikely, presents potential problems for the industry if it should cause policy surrenders to rise or reduce the attractiveness of insurance products relative to bank deposits or other financial products. “Such uncertainty and the likelihood of rate volatility underscore the vital importance of asset/liability management—an area of strength for most companies in the industry, although some gaps exist,” it says.

“Finally, corporate credit quality has begun to show material improvement, although the trend of credit deterioration appears to have abated in 2003, with more modest downgrade and default activity. Credit default experience in 2004 is now projected to be well below industry averages, although some leading indicators predict that default risk might be on the rise again by 2006,” S&P comments.

“In the past few years, the deterioration in corporate credit quality has had a negative effect on investment portfolios and has eroded capitalization, which was once a great strength of the industry. Despite that the default rate is improving in 2004, there still may be hidden credit losses in insurer portfolios.”