Q&A: Five Years After The Credit Crisis, U.S.

Insurers Tackle Risk And Reforms

Primary Credit Analyst: Rodney A Clark, FSA, New York (1) 212-438-7245; rodney.clark@standardandpoors.com Secondary Contacts: Ron A Joas, CPA, New York (1) 212-438-3131; ron.joas@standardandpoors.com John Iten, New York (1) 212-438-1757; john.iten@standardandpoors.com Gregory S Gaskel, Hightstown (1) 212-438-2787; greg.gaskel@standardandpoors.com

Table Of Contents
Questions And Answers

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Q&A: Five Years After The Credit Crisis, U.S. Insurers Tackle Risk And Reforms
(Editor's Note: The following is one of a series of question-and-answer articles in which Standard & Poor's Ratings Services analysts assess changes in the financial industry in the five years since the economic and credit crisis that began in September 2008 with the collapse of Lehman Brothers.) Just after Lehman Brothers' bankruptcy, the U.S. insurance giant AIG Group began to suffer a liquidity crisis of its own, after incurring significant losses on credit protection it had sold through its financial products unit. The Federal Reserve soon stepped in to prevent the company's collapse in what remains the biggest government bailout of a private entity in U.S. history.

Questions And Answers

What's been the most significant development with regards to regulation of the industry in the five years since onset of the credit crisis?
While changes in the regulatory environment are still evolving, there have been some significant developments in the past five years. In this light, it's important to remember that U.S. insurers are primarily regulated at the state level, not by the federal government. It's also important to remember that AIG's most significant troubles weren't related to its insurance business per se, but rather to its financial products unit and a securities lending vehicle, both of which operated outside of insurance regulation. At any rate, the view of industry participants and regulators is that the state regulatory system can still work, but can be improved--and many state agencies have broadened their regulatory scope. The National Association of Insurance Commissioners (NAIC) designed the Insurance Holding Company System Regulatory Act as a piece of model legislation for states, to help establish rules and reporting requirements for insurance holding companies--including with regard to their non-insurance activities. Several states have already passed the legislation and adopted related regulations. Meanwhile, much of the debate centers on whether or not the U.S. should adopt the standards of the EU's Solvency II Directive of 2009, which determines how much capital insurers must set aside in support of their risk. One aspect similar to Solvency II that is expected to take effect in the U.S. in 2015 is the Own Risk and Solvency Assessment (ORSA), which will require insurers to maintain a risk-management framework appropriate to their risk, conduct internal capital assessments, and regularly report to regulators. More narrowly, under the Dodd-Frank Wall Street Reform and Consumer Protection Act, which Congress enacted in July 2010, AIG and Prudential have been named as systemically important financial institutions. This could mean they are subjected to more intensive oversight, including additional regulation from the Fed with regard to their solvency requirements and how they need to capitalize. The final rules haven't yet been written with respect to these requirements for non-banks, so it remains to be seen what impact they may have on the companies and their business and financial strategies. Indeed, if the requirements are seen as onerous, it is possible that companies may adapt their

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Q&A: Five Years After The Credit Crisis, U.S. Insurers Tackle Risk And Reforms

own strategies or jettison businesses in order to avoid the designation. Dodd-Frank also established the Federal Insurance Office (FIO) within the Department of Treasury. The FIO is charged with monitoring and reporting on the domestic insurance industry as well as representing the U.S. in international insurance matters, including with the International Association of Insurance Supervisors. Although FIO has no direct regulatory oversight authority, its formation creates some uncertainty as to the future balance of authority over the industry between the states and the federal government.

How has the behavior of U.S. insurers changed in the past five years?
In 2009-2010, we saw increased risk-aversion in the industry, with insurers de-risking their balance sheets in earnest--as well as a better balancing of asset holdings so as to avoid getting caught overweight in a particular asset class. However, since the financial crisis ebbed, persistent low interest rates have pushed companies to add incremental risk in their investment portfolios in the past couple of years. For the most part, these changes have added incremental risk, but with only moderate pick-up in investment yields as a result. In addition to de-risking the investment portfolios, many companies also worked to de-risk their product offerings during the period. Variable annuities, in particular, offer equity market returns with protection on the downside, which caused significant volatility to insurers' results in 2008 and 2009. As a result, by 2010 many insurers repriced those products, cut back on the level of guarantees, and imposed limits on the underlying investment options to those that could be more easily hedged. Companies also increased their focus on hedging the risk in these product guarantees in order to avoid potential earnings and capital volatility in the future. Companies have also renewed their emphasis on enterprise risk management (ERM). Following some of the lessons learned, many companies are more skeptical of models than before, and have recalibrated those models to reflect the unusual series of events in 2008 and 2009. Companies have also added components to their ERM outside of the models, particularly with heightened focus on risk concentrations and hedging techniques to mitigate outsized risks.

What are some of the most significant ways in which Standard & Poor's has changed its approach to rating this industry?
In 2013, we released new criteria (following a request for comment in 2012) for how we rate insurance companies. Although few insurance companies experienced distress during the financial crisis, we did make changes to reflect lessons learned. Some of these changes included new metrics for investment concentrations by sector, other mechanisms to overlay model outcomes with qualitative judgment, and new liquidity metrics. These are in addition to incremental changes over recent years in how we evaluate the risk of commercial mortgages and structured securities, using a more granular approach to differentiate risk and to better reflect both default and recovery characteristics.

How have insurer ratings performed during this period?

Beyond the downgrade of AIG that was concurrent with its liquidity crisis, a number of U.S. insurers suffered subsequent declines in credit quality--typically resulting in one- to two-notch downgrades--especially with investment losses affecting capital positions. However, the economic recovery taking hold in the past three years has brought significant ratings stability in the sector, as companies have generally reduced risk and performed reasonably well. Potential upgrades, however, have been constrained by low interest rates and the effect on insurers' profitability, somewhat compounded by the slow economic recovery.

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Q&A: Five Years After The Credit Crisis, U.S. Insurers Tackle Risk And Reforms

What is Standard & Poor's outlook for the industry?

Our outlook for the U.S. life and property/casualty insurance sectors is currently stable. The sector is well-capitalized, and earnings are adequate, despite the headwinds of global economic risk and historically low interest rates. The still-fragile economy continues to restrain revenue growth and earnings, but we expect both of these effects to moderate in the next 12-24 months, depending on the rate of improvement in the economy broadly.

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