Back in August, holders of insurance policies and annuities issued by London Pacific Life & Annuity Co. got a shock when state regulators took over control of the North Carolina-based insurer.
London Pacific had bet heavily on investing premiums in high-tech and communication industry stocks and bonds, whose value had declined so much "that there is concern about London Pacific's ability to meet its obligations," regulators said. To preserve assets, state insurance chief James E. Long's office ordered the company to limit payouts to normal policy benefits. Tapping a policy for cash, such as a loan, would be allowed only in hardship cases, a "moratorium" that could last as long as three years.
The travails of London Pacific are an extreme example of a recent dose of bad news facing life insurers.
Nearly 70 percent of American families are covered by some type of life insurance and the industry's 1,200 companies have happily invested their $125 billion in annual premiums in stocks, bonds and other investments. The industry's success has long been tied to strong investment performance and favored regulatory and tax treatment.
But the end of the stock market boom and some recent events in Congress has put life insurance under siege on both fronts.
One bright spot has been a spurt in the sales of traditional life insurance, spurred by consumerconcerns about mortality after the Sept. 11, 2001, terrorist attacks. But the industry's premium, investment and other income dropped more than 10 percent last year, according to the American Council of Life Insurers (ACLI), a Washington-based trade group. As a result, experts expect companies to raise premiums on many kinds of life policies and they believe a number of weaker companies will be forced to merge or go out of business.
"Our view on the industry right now is negative," said Rodney Clark, director of financial service ratings at Standard & Poor's Corp. He cited the regulatory, tax and product issues facing the industry, as well as "issues of asset quality and the corporate default rate on bonds." All these, he said, "mean reduced capital bases and reduced earnings and that causes us a good deal of concern."
S&P doesn't expect "a significant number of failures" of life insurance companies, he added, but a weakening of the industry's financial strength. Life insurance is still a "very highly rated industry, but it's going to be less strong coming out of this cycle than it was going in."
Of most immediate concern is the impact of the declining stock market on variable life insurance, which provides an investment component as well as a death benefit, and variable annuities.
During the 1990s, insurers plunged heavily into these products, in which benefits are tied to an investment account, usually a mutual fund or something resembling one, chosen by the customer from a menu of offerings by the company.
"Variable products were the primary growth products" of the insurance industry in the 1990s, said Eric Speer of financial services consultants Tillinghast-Towers Perrin. "Variable life grew substantially year over year throughout the decade" until it reached "40 percent of life premiums in 2000, up from very low numbers at the beginning of the decade."
"Variable annuities followed a similar trajectory," he said.
Variable annuities and life policies typically carry a guaranteed minimum benefit, but both the customer and the company assume that the investment account will provide much more. When that assumption is correct, the guaranteed benefit is rarely paid and is of little cost to the company. For years, companies could count on investment gains of 8 to 9 percent a year, according to industry experts. But two years of a bear market have undermined both ends of that calculation.
The operating assumption was "that in times of increasing equity returns these guarantees had little value. Now that's seen as a quite valuable benefit that may have been substantially underpriced" during the 1990s, said Clark.
In addition, Clark said, companies assumed they would have large and growing sums under management as years passed and many have restructured themselves accordingly. Thus when the value of assets shrank, so did the companies' revenue streams.
In addition to the market problems, insurers have also been caught up in various legal reforms in ways that sometimes blindsided them.
For example, as the corporate governance reforms moved through Congress, Sen. Charles E. Schumer (D-N.Y.) added an amendment that forbade corporations from making loans to executives. The provision was aimed at preventing huge loans by companies to senior officers, such as the ones WorldCom Inc. made to chief executive Bernard J. Ebbers. But the broad wording also seems to cover a certain kind of life insurance perk that firms often provide to executives.
This is called "split-dollar" life insurance. It is often structured so that the company pays part or all of the premiums on a large policy benefiting an executive or his family and then recovers those payments out of the death benefit or cash value of the policy. Such deals are deemed to be loans by the company to the executive, and apparently would be barred by the Schumer amendment.
The industry is arguing strongly that they are not covered, but the matter remains unresolved. And meanwhile, the uncertainty has clouded sales of a very profitable niche product.
Similarly, adverse publicity surrounding some companies' use of corporate-owned life insurance (COLI) covering rank-and-file employees to dodge taxes has raised another threat.
Firms have long been allowed to buy what used to be called "key man" insurance on certain executives or employees on the grounds that the death of such an employee would hurt the firm. More recently, however, companies have been buying "broad-based COLI" covering all workers. This is often used to fund worker-benefit programs, but some companies have tried to turn it into a tax shelter as well, and that has caught the attention of the Internal Revenue Service and some lawmakers.
The IRS has won several court cases against broad-based COLI tax shelters, making the coverage less appealing to some potential purchasers.
sssThen in September word reached the industry that Sen. Jeff Bingaman (D-N.M.) was considering a measure that would have ended the favorable tax treatment of COLI -- life insurance death benefits are exempt from income tax.
The ACLI launched an advertising campaign arguing that such a measure would wipe out needed business insurance. The campaign, along with efforts by agents' groups, generated some 50,000 letters to Capitol Hill. Congress adjourned without acting on the bill to which Bingaman's proposal would have been attached.
Just as that threat receded, another emerged: The Republicans' election victory giving them control of both houses of Congress in addition to the White House raised the possibility that the estate tax might be repealed permanently. That would take away a major incentive for people who buy life insurance in estate planning.
Life insurance's very generous tax treatment gives it wide appeal to the wealthy. Death benefits are not only exempt from income tax, they also escape estate taxes if the policy is not part of the dead person's estate -- something that can be accomplished by putting a policy into an irrevocable trust.
This opens up to insurers a large market among people who wish to pass on to heirs large sums tax-free, or who have large but illiquid estates and fear their heirs will be forced to sell unless there is cash to pay the taxes.
"We estimate that about 25 percent of variable life policies and a similar amount of universal policies [a form of insurance in which premiums and coverage can vary] are estate-planning-related," Speer said. "So complete repeal . . . would be a pretty significant event for the industry."