Business Week

From Standard & Poor's RatingsDirect

The second half of 2006 promises many rewards for the U.S. life-insurance industry. Higher interest rates, coupled with moderately positive equity market movements, create the potential for double-digit increases in operating profits -- admittedly from a fairly low base. Standard & Poor's Ratings Services believes that life companies with strong capabilities in product innovation, distribution, and enterprise risk management will do well. Those that lack these key strengths will find themselves in compromised positions.

Overall, the outlook on the U.S. life-insurance sector remains stable, with positive and negative rating movements over the next six to 12 months about equal, generally reflecting company-specific circumstances rather than macroeconomic or industrywide factors.

Unfortunately, the near-term period could be the calm before the storm. Over the long haul -- the next three or so years -- we expect low growth for the life-insurance market, compounded by an ultracompetitive environment that will make higher profits hard to achieve.

M&A INDULGENCE. To satisfy shareholders' desire for greater returns, some U.S. life insurers are turning to mergers and international expansion. Historically, M&A has been a high-risk strategy that has often destroyed shareholder value. Recent transactions, however, appear to have more potential.

For one thing, the prices of acquisitions have become more rational than in the late 1990s. Second, companies have tended to place greater importance on strategic fit than on growth for growth's sake. Third, and in part related to more rational purchase prices, recent deals have generally involved less debt financing than in the past.

As a result of these developments, we expect M&A generally to be a positive factor for life-insurer credit quality in the short term. However, we think that over the long term, M&A is likely to hurt credit quality as companies return to the undisciplined behavior of years past.

Indeed, European firms are rumored to be looking at U.S. acquisitions to expand their reach. If they become more active, this could heat up bidding for hot properties and lead to the type of irrational M&A behavior that we saw in the late 1990s. For now, the trend is benign, but by 2007 the dynamic could change.

Major recent acquisitions include:

-- In 2005, MetLife (MET) [S operating subsidiaries: AA] purchased Travelers Life & Annuity from Citigroup (C) [AA-/Positive/A-1 ], signaling the end of the Citigroup experiment in merging a major bank with a large insurer.

-- In April, 2006, Lincoln National (LNC) [A ; operating subsidiaries: AA], a major seller of both individual life insurance and variable annuities, completed its acquisition of Jefferson-Pilot, a significant seller of individual life insurance and fixed annuities.

-- Prudential Financial (PRU) [A; operating subsidiaries: AA-] has made a series of recent acquisitions that move the company from the second tier to a leading provider of group and individual retirement products with significant economies of scale. In 2003, the company acquired American Skandia Life Assurance, which gave it variable-annuity product expertise and access to the independent financial-planner market.

In 2004, Prudential acquired the retirement business of CIGNA (CI) [BBB; operating subsidiaries: A-], greatly expanding its scale in that market. Prudential's recently announced acquisition of Allstate's (ALL) variable-annuity business will broaden that unit's heretofore proprietary distribution.

-- In February, 2006, Protective Life (PL) [A; operating subsidiaries: AA] announced its intention to acquire Chase Insurance from J.P. Morgan Chase (JPM) [A ], marking yet another bank exit from the insurance business.

LOOKING OVERSEAS.

Another way for life insurers to grow is to expand abroad. The mature markets of Europe are already well-penetrated by companies there, but Asia and -- to a lesser extent -- Latin America offer fertile ground for U.S. life insurers to grow or to set up new businesses. American International Group (AIG) [AA], to cite one example, has pursued an international life-insurance strategy for decades in dozens of countries, but still manages to show strong growth by expanding in existing markets and into emerging ones.

Other companies that have successfully expanded abroad include Prudential in Japan and Korea, MetLife in Mexico and Korea, the American Family Life Assurance unit of AFLAC (AFL) [A; operating subsidiaries: AA] in Japan, and New York Life Insurance [AA ] in Mexico and Taiwan. Those successes notwithstanding, however, many of those same companies have set up green-field operations or made acquisitions that have failed or produced disappointing results.

Many risks come with an international strategy:

-- Poor knowledge of the market. Cultural dynamics differ around the world, and many companies have stumbled trying to sell U.S.-style products in markets where non-U.S.-style products are the norm.

-- Partnership difficulties. Many companies use joint-venture partners to enter a country, either because governments require it or as a way to obtain local market knowledge or access to distribution. However, such relationships can stagnate or dissolve when partners do not share a common goal.

-- Economic difficulties. As many U.S. companies discovered during Argentina's default crisis, developing markets pose challenges that do not exist in the U.S., such as the risk of currency devaluation, default on government debt, or restriction on cross-border movement of funds. Economic risk assessment is key to choosing the right markets and managing exposure once there.

"International expansion can be a strong outlet for growth for companies that understand and manage the risks and plan well," says Standard & Poor's credit analyst Rodney Clark. "But management of those risks is absolutely crucial, and you have to expect at least one or two failures along the way."

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Copyright © 2006 Earl G. Graves, Ltd. All Rights Reserved.