(By Mani) Efforts by regulators to impose new rules on the life insurance industry could potentially cause problems for the sector as investors will find it less attractive to invest in insurers.
On one hand, higher capital levels provide more stability and lead to better ratings,but, on the other hand, regulatory mandating to hold capital deemed in excess of what is need, is a potential headwind as it could impact valuation of stocks and thus the insurers' financial flexibility.
"New proposed regulations and rules could pose risks to the industry that could potentially more than offset the efforts undertaken to make life insurers better suited to withstand economic downturns," RBCCapital Markets analyst Erin Berg wrote in a note to clients.
[Related -American International Group Inc (AIG): Current Weakness Offers A Buying Opportunity]
Ratings agency Fitch is certain that 3 life insurers that will end up being regulated by the Federal Reserve as these insurers will be deemed non- bank SIFI(Systemically Important Financial Institution) by the FSOC (Financial Stability Oversight Counsel), namely, MetLife (NYSE:MET), AIG(NYSE:AIG) and Prudential Financial (NYSE:PRU).
"We, on the other hand,believe that there is a possibility that Hartford and even Lincoln National could join the ranks as these insurers took TARP money during the financial crisis. This is certainly not what these companies would like to hear as capital deployment is an important lever in improving returns," the analyst added.
[Related -American International Group Inc (AIG): Buy This 'Hated' Company While It's Still An Incredible Bargain]
In addition, the convergence of IFRS and US GAAP could negatively impact insurers. The biggest criticism was that the balance sheet will become more opaque as insurers will have more lee way in setting up their reserves.Another criticism was that marking liabilities to market will create earnings volatility. Combining these two will ultimately lead to increased cost of capital.
"The fear is that less transparency and higher earnings volatility will drive investors out of the sector in search for other investment opportunities. Lower multiples would mean less financial flexibility," Berg noted.
In addition, overly complicated variable annuity product designs could haunt life insurers for a long period. Companies have been making changes to their offering, reducing the richness of their guarantees and limiting investment options. The latest trend of offering protected portfolios, wherein a limited number of investment options are offered that are easy to hedge, is being perceived as the right approach by many consultants as well as rating agencies.
However, legacy blocks will remain on the insurers' balance sheet for years to come, up to 20 plus years. To be sure, companies have improved their hedging programs and are now hedging statutory capital and more Greeks than before. However, the products had become so complicated that experts including rating agencies have a hard time determining whether the hedges are effective.
Meanwhile, rating agencies do not like when a company has big exposure to variable annuities,which is probably one of the reasons MetLife decided to curb its sales. Thus, despite recent product modifications, the analyst said rating agencies will continue to feel uncomfortable with companies' balance sheets that have a large exposure to variable annuities and they include Hartford Financial (NYSE:HIG), MetLife and Prudential.
Consequently, large share buybacks could be very hard to do. Insurers would have to increase returns by changing their products and underwriting standards.Pricing can be adjusted to reflect the requirement of having to hold additional capital.
However, given the long tail nature of liabilities in the industry, it could take a long time before return on equities could move up to the 12 percent to 13 percent range as legacy blocks of business would be a drag to returns for years to come.
"After all, while insurers have the ability to deal with these challenges, having long-tailed liabilities makes this as low process," the analyst noted.