The U.S. life and health insurance industry experienced improved operating earnings and balance sheet strength in 2004, says ratings agency A.M. Best Co in a special report on rating trends.

The firm says rating upgrades outnumbering downgrades by a slight margin, and it’s year-end ratings outlook for the industry was stable.

As 2005 gets under way, A.M. Best says the life and health industry appears to be at a crossroads. Key challenges facing the industry are: the ongoing shift in the industry’s product mix; the more aggressive competitive stance being taken by major players in key market segments; and the the increasing diligence demanded to comply with accounting and regulatory requirements.

A.M. Best says it does not expect these factors to adversely impact ratings in the near term. However, the ratings agency believes that the industry will be challenged over the long term to sustain earnings and consistently accumulate capital—factors that are expected to pressure ratings over time.

The continued stability in equity markets and relatively benign credit environment have enabled life companies to maintain asset-management fee levels and attain solid investment returns. Still, insurers that are dependent on fixed annuities remain challenged by low interest rates and ongoing spread compression.

Another looming challenge for annuity writers is the possibility that U.S. President Bush’s administration will reinstate its plans to introduce legislation for new, tax-exempt savings plans later in the year. If enacted, these plans could hurt annuity companies by providing an alternative savings mechanism to annuities.

The health insurance industry has experienced a more positive operating environment than the life and annuity carriers, largely driven by a highly favorable pricing environment and a moderating medical cost trend that has resulted in several years of strong earnings. Nevertheless, it is highly unlikely that these robust earnings will be sustainable in 2005.

In 2004, rating activity included 40 upgrades and 35 downgrades for the life and health industry. These 75 rating actions reflected rating changes on approximately 8% of the life and health rating units followed by A.M. Best. Life and annuity company downgrades totalled 24, compared with 21 upgrades. Health company upgrades totalled 19, compared with 11 downgrades.