MORGAN
NORTH
STANLEY
RESEARCH
AMERICA
Morgan Stanley & Co. LLC
Nigel Dally
[email protected]
+1 212 761 4132
Hayley Locker, CFA
[email protected]
+1 212 761 6271
August 15, 2012
Insurance - Life /Annuity
Assessing Who is at Risk of
Higher Required Life
Reserves Under AG38
Regulators are looking at potentially changing
reserving requirements for some life insurance
policies, which may result in a large increase in
reserves for some players. Based on our review,
Lincoln, Manulife and Genworth are the companies
that appear most at risk.
What are the changes? The National Association of
Insurance Commissions (NAIC) is in the process of
updating the reserving requirements for various
secondary guarantee universal life policies that fall
under Actuarial Guideline 38. For policies with variable
cost of insurance charges, this could result in a
substantial increase in the amount of required reserves,
especially if the NAIC decides on retrospective
application and uses an early look-back date.
Reserves at Risk to Potential Changes in AG38
350
YE 2011 Reserves as % Equity ex-AOCI
Industry View
In-Line
Total Interest-Sensitive
300
Other Interest-Sensitive
250
AG38 Impacted
200
150
100
50
0
LNC
MFC
GNW
PFG
HIG
Source: Statutory Filings
How much would required reserves increase? The
impact on required reserves varies significantly
depending on product design, although some industry
experts believe the level of reserves could increase as
much as two to seven times their current level.
Which companies are potentially at risk? Lincoln,
Manulife and Genworth are companies that appear to
have the most secondary guarantee life insurance
policies in force. Principal and Hartford also highlight this
as a potential risk in their recent financial statements.
Implications: The charge to reserves would be a hit to
the statutory capital and negatively impact risk-based
capital ratios. Large charges could potentially diminish
available capital for other purposes including dividends
and stock repurchases. To avoid these charges, we
suspect various companies may look to increase the use
of captive reinsurance, although as we have discussed
in recent research (“Fed Actions Suggest Limited
Capital Maneuverability”, dated June 28, 2012), the
capacity to use these vehicles could be limited.
Morgan Stanley does and seeks to do business with
companies covered in Morgan Stanley Research. As
a result, investors should be aware that the firm may
have a conflict of interest that could affect the
objectivity of Morgan Stanley Research. Investors
should consider Morgan Stanley Research as only a
single factor in making their investment decision.
For analyst certification and other important
disclosures, refer to the Disclosure Section,
located at the end of this report.
MORGAN
STANLEY
RESEARCH
August 15, 2012
Insurance - Life /Annuity
Investment Case
Summary & Conclusions
Universal Life Basics
We view the proposed changes to reserving for various types
of life insurance policies to be a meaningful risk factor that
deserves close attention for several companies in the industry.
While most domestic US life companies have been
downplaying the risk, there is the potential that some of the
changes in how reserves are calculated for secondary
guarantee universal life policies could have a meaningful
impact on capital if the changes were to be applied retroactively.
Manulife has already warned this could have a material impact
on the statutory capital position of their US subsidiary, John
Hancock, while our work suggests other companies including
Lincoln and Genworth could also be impacted.
• How a Regular UL Policy Works: With a regular universal life
policy, policyholders pay premiums typically monthly, with the
excess of premium payments above the current cost of insurance
credited to the cash value of the policy. The cash value is credited
each month with interest, and the policy is debited each month by a
cost of insurance (COI) charge, as well as any other policy charges
and fees, even if no premium payment is made that month. Interest
credited to the account is determined by the insurer, but has a
contractual minimum rate of between 2% and 4%. The policy
lapses if no premiums are paid and the cash value of the policy falls
to zero.
Types of Products Could Potentially be Impacted
The key issue surrounds the level of reserves that companies
are establishing against universal life insurance policies with
second guarantees (SGUL – see text box for additional
explanation). For these products, the amount charged for the
insurance coverage (the cost of insurance or COI) can vary
depending on factors including the balance of funds in the
shadow accounts. In calculating the required reserves, it
appears some companies have been using the highest
potential COI charges. This results in lower reserves, even
though the probability of these higher charges being applied is
relatively low. This ultimately leads to significantly lower
reserves than if the more conservative charges had been used.
While the potential for the use of higher assumed premium
charges exists for all products with secondary guarantees that
have variable insurance charges, the issue has become
increasingly important as various companies have been
coming out with products such as “Term UL”. These
products are designed to have little to no cash build up. Many
of these policies are being marketed as a direct comparison to
traditional term insurance, leading some regulators to be
concerned that the only reason they are written on a universal
life chassis is to avoid/mitigate various reserving requirements.
Essentially by using the higher assumed policy charges in
calculating reserves, there is concern among some regulators
that companies may be establishing reserves below what was
originally intended by the NAIC Valuation of Life Insurance
Policies Model Regulation. Accordingly, the Life Actuarial Task
Force has been investigating this issue, with the goal of
introducing new rules effective January 1, 2013.
• How a Secondary Guarantee UL Policy Works: Under a
non-lapse guarantee policy, as long as certain minimum premium
payments are made for a given period, the policy will remain in
force for the guarantee period even if the cash value drops to zero.
This essentially makes the policy significantly more interest
sensitive as the probably of the cash value declining to zero
increases as the crediting rate on the cash value declines.
• What is a Shadow Account? A shadow account is a phantom
account value, which is established with more generous
assumptions. On some products, there may be multiple shadow
accounts related to different policy years. Shadow accounts use
unique credited rates, cost of insurance factors and loads.
Essentially it is a guarantee to policyholders that regardless of what
has happened with their true cash accounts, if their phantom
accounts that use more favorable charges and higher crediting
balances still have funds, the policy will remain in-force.
• The issue with multiple Cost of Insurance Charges: With many
of the SGUL policies, the cost of insurance charged to the
consumer will vary based on the balance of funds in the shadow
accounts. This raises the question as to which minimum cost of
insurance charges to use in determining the appropriate level of
reserves. In many cases, insurers have been using the higher cost
of insurance charges, which they believe is in accordance with the
rules. However, these rules are likely to be changed, not only for
new policies, but also for potentially for various in-force policies
depending on the date chosen as the effective “look-back effective
date”.
The impact on required reserves could be substantial.
Based on a article published by KPMG in the January issue of
their “Life Actuarial Insights”, the required reserves if the
insurers are forced to use the lower policy charges could rise
by as much as two to seven times. Further, as most of the
additional reserves would fall into the deficiency reserve
category, which typically is not tax deductable, meaning there
would be no tax offset to the higher reserve requirements.
2
MORGAN
STANLEY
RESEARCH
August 15, 2012
Insurance - Life /Annuity
To date, many of the insurers have downplayed the issue,
reflecting their optimism that any proposed rule changes would
likely only be applied on a prospective basis, similar to what we
have seen on other recently adopted changes in accounting.
However, recent developments seem to suggest retrospective
adoption is becoming increasingly likely. According to the
latest proposals, the regulators now appear to be considering
one of three potential “look back effective dates” – January 1,
2003, July 1, 2005, and January 1, 2007.
companies included MetLife and Prudential. Other companies,
including CNO Financial, write more basic universal life policies,
which would also not be impacted by any change in the
regulations.
Exhibit 1
Which Companies have Highlighted AG38 as a Risk
Highlighted in
10K and Qs as Risk
Comment
Lettter to NAIC
Aflac
It comes as little surprise that companies have been pushing
for the latest possible look back date. Lincoln Financial, in a
letter dated August 3, 2012, urged regulators to use 2007 as
the effective look back date, or 2005 as a reasonable
compromise. Based on their comments, they are concerned
the earlier look back issue would be very problematic, stating “it
is a much more significant issue when these assumptions are
applied retroactively to existing business that cannot be
re-priced”. Other regulators, such as the New York State
Department of Financial Services, prefer the earlier adoption
date of January 1, 2003, as per their comment letter dated
August 2, 2012.
Assessing Who Is Potentially at Risk
To assess who is potentially at risk, we have examined
exposures both from a qualitative and quantitative perspective.
First, from a qualitative perspective, we reviewed the various
10Ks and 10Qs to determine whether universal life reserving
practices have been raised as a risk factor. We have also
looked to see whether the companies have provided a
comment letter to the NAIC, which could also be a sign that the
company views the outcome of the rule changes as potentially
a risk to their financial position.
The results of this first screen are shown in Exhibit 1. Among
the various companies we follow, Genworth, Hartford, Lincoln,
Manulife and Principal have highlighted the issue as a risk
factor in their recent SEC filings. Lincoln, Genworth and
Principal also provided comment letters on the proposed
changes to the Life and Annuity working committee working on
AG38.
Further, we followed up with the individual companies to learn
more about their reserving practices, in order to determine if
they were potentially at risk. What we learned in doing so, was
that while several companies do actively write UL policies, their
reserving is not based on the use of multiple shadow accounts
and they do not use the higher COI assumption when setting
their reserves, and therefore they would not expect to be
impacted by any changes in the actuarial guidelines. Such
Ameriprise
CNO Financial
Genworth
Hartford
Lincoln
MetLife
Manulife
Principal
Prudential
RGA
Stancorp
Sun Life Financial
Torchmark
Unum Group
Source: Company Data, Morgan Stanley Research
Second, we looked to gauge each company’s exposure to
secondary guarantee universal life policies. The results of our
analysis are shown on Exhibit 2. Unfortunately not all
companies provide details of their secondary guarantee
reserves. Accordingly, we show the break-down between
traditional and secondary guarantee interest sensitive reserves
where available, and total interest sensitive reserves for those
companies who do not provide the split.
What we found is that companies with larger balances of
secondary guarantee relative to equity (excluding FAS115)
include Genworth and Lincoln. While Manulife also has a
relatively higher exposure to interest-sensitive individual life
insurance reserves, given limited disclosures, it remains
unclear what portion is actually falls under AG38.
3
MORGAN
STANLEY
RESEARCH
August 15, 2012
Insurance - Life /Annuity
Exhibit 2
Exhibit 3
Interest-Sensitive Individual Life Reserves
Cumulative UL Sales Since 2003
6
Total Interest-Sensitive
300
Other Interest-Sensitive
250
AG38 Impacted
2008-2012 YTD
5
VUL/ UL Sales ($B)
YE 2011 Reserves as % Equity ex-AOCI
350
200
150
100
50
2006-2007
2003-2005
4
3
2
1
0
LNC
MFC
GNW
PFG
0
HIG
*PFG AG38 impacted estimated based on management comments that 50% of SGUL in-force
will potentially be impacted by changes to regulations
Source: Statutory Filings, Morgan Stanley Research
Last, we also looked at the amount of universal life sales made
by each company expected to be impacted since 2003, which
is the earliest expected “look-back date”. As previously
discussed, not all universal life insurance will be impacted by
the changes. Nonetheless, it provides some perspective into
who has written more recent vintage business that potentially
could be impacted by the rule changes. The results are shown
in Exhibit 3. Among the various companies, Lincoln, Principal
and Manulife stand out as having sold a significant amount of
UL policies. A significant portion of Lincoln’s sales (roughly a
third) occurred in the time frame of 2003-2005, which
potentially explains why the compact is pushing regulators to
chose a later look-back effective date. Based on company
disclosures, it appears that roughly 35-40% of these universal
life sales contained secondary guarantees, making them more
likely to be at risk from any changes in the guidelines.
Similarly, we would expect only a portion of the sales of the
other companies shown would be impacted if the changes
were to be adopted retrospectively. Specifically, Genworth
would most likely to see the greatest impact on its
term-universal life business, which it began selling in 2010, and
through the second quarter of 2012 accounted for $291 million
of their total universal life sales. Likewise, Principal only began
selling products it expects may be impacted in 2006.
According to the company, of the roughly $35 billion of
secondary-guarantee universal life currently in-force,
approximately 50% is reserved using the methodology
currently in question.
LNC
MFC
PFG
GNW
HIG
HIG includes whole life sales; Source: Company Data, Morgan Stanley Research
In aggregate, the results of our analysis suggest that among
the companies we follow, Lincoln, Manulife and Genworth are
the company’s potentially most at risk from the proposed
changes. Genworth in particular has been a large seller of
Term UL policies, while Lincoln is one of the larger players in
the secondary guarantee universal life space. Lincoln is better
positioned to absorb any potential changes to their required
reserves, given a robust current RBC ratio of roughly 500%.
For Genworth, while their RBC ratio is solid at 405%, the
company also has significant long term care exposure, where
we remain concerned over reserve adequacy. For Manulife,
any charges would not impact their primary Canadian MCCSR
ratio, but would likely results in the reallocation of capital from
Canada to the US.
Implications
From our perspective, we see three implications of these
pending changes:
1.
Increased use of captive insurers: First, we believe
insurers will look towards means in which to avoid any
charges. This potentially could include greater use of both
external and internal captive reinsurance relationships. In
a captive reinsurer, reserves are established under a
modified GAAP accounting method, and accordingly we
do not believe they would be subject to the potential rule
changes. The problem, however, is that the ability to rely
on these alternatives may be limited. As we discussed in
our earlier research piece “Fed Actions Suggest Limited
Capital Maneuverability”, dated June 28, 2012, insurers
4
MORGAN
STANLEY
RESEARCH
August 15, 2012
Insurance - Life /Annuity
have already been significantly increasing the use of
captive insurance relationships, while the capacity of
banks and others to finance these relationships through
letters of credit has become more restrictive.
2.
Statutory capital hits impacting capital management:
Second, to the extent the insurers cannot avoid the
increased reserve requirement due to the retroactive
application of the new rules, they will need to increase
current reserves, potentially leading to large hits to their
statutory capital positions. Arriving at a precise impact is
challenging given the very limited disclosures regarding
the exposure of each companies to the various products
that could be impacted. That said, any reserve charges
would directly impact their statutory surplus and limit their
flexibility to make dividends to the parent company,
potentially negatively impacting various capital
management alternatives, including share repurchases.
3.
Changes in future product design: Regardless of
whether the changes are prospective or retroactive in
nature, the higher reserve requirements will likely spur
another round of product redesign and/or price increases.
While this would be an industry-wide issue, we could likely
see an outsized negative impact on sales prospects for
those companies whose recent sales have been
dominated by these types of policies, including Lincoln and
Genworth. We would expect sales at Manulife to be less
impacted given the company has already de-emphasized
this product in the US.
Accordingly, at a minimum, we believe the issue has emerged
as a risk factor that deserves close attention for the industry.
While most companies currently have robust capital ratio that
suggest ample room to absorb some level of charges, the
developments nonetheless add a level of risk around capital
management flexibility, depending on the rules ultimately
determined by the NAIC and state regulators.
5
MORGAN
STANLEY
RESEARCH
August 15, 2012
Insurance - Life /Annuity
Exhibit 4
Life Insurance Valuation Summary
Rating
Price ($)
14-Aug
Mkt Cap
($M)
Price to Book ex-AOCI
2011
2012E
2013E
2011
AFL
E
45.23
21,334
6.28
33.22
1.79
1.58
1.36
26.5
24.1
22.3
AMP
E
54.34
11,447
36.19
38.53
1.58
1.50
1.41
16.0
16.1
17.8
CNO
E
8.81
13.87
16.19
19.08
0.64
0.54
0.46
7.4
8.2
7.8
GNW
E
5.1
22.45
22.91
23.93
0.22
0.21
0.20
1.1
2.2
4.1
HIG
5.5
5.2
41.73
41.97
48.27
0.41
0.41
0.36
4.6
7.0
7.4
5.9
5.6
5.2
36.22
40.70
44.85
0.65
0.58
0.53
10.4
10.8
10.6
5.60
7.8
6.6
6.2
46.69
48.82
53.32
0.75
0.72
0.66
10.9
11.1
11.0
0.50
1.30
NM
NM
8.7
12.44
12.48
13.08
0.91
0.91
0.87
0.2
4.0
10.2
2.66
2.95
3.30
9.9
8.9
8.0
27.29
29.22
31.64
0.97
0.90
0.83
10.0
10.6
10.9
25,080
6.11
6.55
7.70
8.8
8.2
7.0
58.02
63.29
68.98
0.92
0.85
0.78
11.1
11.0
11.6
56.05
4,149
6.55
6.85
7.40
8.6
8.2
7.6
57.25
64.11
69.17
0.98
0.87
0.81
12.1
11.4
11.2
E
30.18
1,346
3.13
3.00
3.30
9.6
10.1
9.1
39.65
41.38
43.31
0.76
0.73
0.70
8.1
7.3
7.8
SLF
E
22.53
15,692
0.18
2.65
2.50
NM
8.5
9.0
22.29
19.19
20.30
1.01
1.17
1.11
0.8
11.6
10.4
TMK
U
50.32
4,816
4.49
5.15
5.65
11.2
9.8
8.9
32.89
34.99
37.93
1.53
1.44
1.33
14.4
15.6
15.6
UNM
E
19.40
5,432
0.94
3.05
3.20
NM
6.4
6.1
26.33
29.11
32.21
0.74
0.67
0.60
3.5
11.1
10.6
Ticker
Operating EPS
2011
2012E
P/ E Ratio
2012E
2013E
Book Value ex-AOCI
2011
2012E
2013E
2013E
2011
6.52
6.85
7.2
6.9
6.6
25.29
28.71
5.17
5.55
6.55
10.5
9.8
8.3
34.31
2,089
0.61
0.76
0.88
14.4
11.6
10.0
4.89
2,375
0.26
0.50
0.95
NM
9.8
E
17.28
8,002
1.96
3.15
3.35
8.8
LNC
E
23.59
6,553
4.00
4.22
4.55
MET
O
34.98
39,282
4.46
5.30
MFC
E
11.36
23,110
0.02
PFG
U
26.37
7,791
PRU
O
53.54
RGA
O
SFG
Source: Company Data, Morgan Stanley Research
6
ROE (%)
2012E
2013E
MORGAN
STANLEY
RESEARCH
August 15, 2012
Insurance - Life /Annuity
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7
MORGAN
STANLEY
RESEARCH
August 15, 2012
Insurance - Life /Annuity
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Within the last 12 months, Morgan Stanley managed or co-managed a public offering (or 144A offering) of securities of Aflac, Lincoln National Corp,
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Financial Group Inc., Genworth Financial, Inc., Hancock Holding, Hartford Fin. Services Grp., Lincoln National Corp, Manulife Financial Corp., MetLife
Inc., Primerica, Inc., Prudential Financial, Reinsurance Group of America, Sun Life Financial Inc., Unum Group.
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8
MORGAN
STANLEY
RESEARCH
August 15, 2012
Insurance - Life /Annuity
Stock Rating Category
Coverage Universe
Investment Banking Clients (IBC)
% of
% of % of Rating
Total
Count
Count Total IBC Category
Overweight/Buy
Equal-weight/Hold
Not-Rated/Hold
Underweight/Sell
Total
1133
1260
109
454
2,956
38%
43%
4%
15%
457
489
32
114
1092
42%
45%
3%
10%
40%
39%
29%
25%
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Stanley received investment banking compensation in the last 12 months.
Analyst Stock Ratings
Overweight (O). The stock's total return is expected to exceed the average total return of the analyst's industry (or industry team's) coverage universe,
on a risk-adjusted basis, over the next 12-18 months.
Equal-weight (E). The stock's total return is expected to be in line with the average total return of the analyst's industry (or industry team's) coverage
universe, on a risk-adjusted basis, over the next 12-18 months.
Not-Rated (NR). Currently the analyst does not have adequate conviction about the stock's total return relative to the average total return of the
analyst's industry (or industry team's) coverage universe, on a risk-adjusted basis, over the next 12-18 months.
Underweight (U). The stock's total return is expected to be below the average total return of the analyst's industry (or industry team's) coverage
universe, on a risk-adjusted basis, over the next 12-18 months.
Unless otherwise specified, the time frame for price targets included in Morgan Stanley Research is 12 to 18 months.
Analyst Industry Views
Attractive (A): The analyst expects the performance of his or her industry coverage universe over the next 12-18 months to be attractive vs. the
relevant broad market benchmark, as indicated below.
In-Line (I): The analyst expects the performance of his or her industry coverage universe over the next 12-18 months to be in line with the relevant
broad market benchmark, as indicated below.
Cautious (C): The analyst views the performance of his or her industry coverage universe over the next 12-18 months with caution vs. the relevant
broad market benchmark, as indicated below.
Benchmarks for each region are as follows: North America - S&P 500; Latin America - relevant MSCI country index or MSCI Latin America Index;
Europe - MSCI Europe; Japan - TOPIX; Asia - relevant MSCI country index.
.
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9
MORGAN
STANLEY
RESEARCH
August 15, 2012
Insurance - Life /Annuity
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10
MORGAN
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Industry Coverage:Insurance - Life/Annuity
Company (Ticker)
Nigel Dally
Aflac (AFL.N)
Ameriprise Financial, Inc. (AMP.N)
Genworth Financial, Inc. (GNW.N)
Hartford Fin. Services Grp. (HIG.N)
Lincoln National Corp (LNC.N)
MetLife Inc. (MET.N)
Principal Financial Group (PFG.N)
Prudential Financial (PRU.N)
Reinsurance Group of America
(RGA.N)
StanCorp Financial Group (SFG.N)
Torchmark Corp. (TMK.N)
Unum Group (UNM.N)
Hayley Locker, CFA
CNO Financial Group Inc. (CNO.N)
Manulife Financial Corp. (MFC.TO)
Primerica, Inc. (PRI.N)
Sun Life Financial Inc. (SLF.TO)
Rating (as of) Price* (08/14/2012)
E (05/27/2011)
E (10/06/2005)
E (11/12/2010)
E (02/08/2012)
E (01/28/2011)
O (03/03/2011)
U (11/09/2011)
O (05/10/2012)
O (11/12/2010)
$45.23
$54.34
$4.89
$17.28
$23.59
$34.98
$26.37
$53.54
$56.05
E (08/09/2012)
U (07/13/2006)
E (02/17/2010)
$30.18
$50.32
$19.4
E (01/24/2011)
E (05/25/2012)
E (09/08/2010)
E (05/25/2012)
$8.81
C$11.36
$28.88
C$22.53
Stock Ratings are subject to change. Please see latest research for each company.
* Historical prices are not split adjusted.
© 2012 Morgan Stanley
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