Tokyo: The business contraction and deteriorating financial strength due to low interest rates impacting investment income, and weak equity market has made Standard & Poors (S&P) to give negative outlook for the Japanese life insurance industry.

The global credit rating agency has come to this conclusion after studying the fiscal 2001 results of major Japanese life insurers.

S&P expects the Japanese life insurers to continue cost cutting exercise, reduce the level of risk assets in their investment portfolio, and shift their resources to business areas with greater profit and growth opportunities.

However, given their shrinking business in force and the severe domestic investment environment, the near-term benefits from such efforts will be limited.

"We expect the gap between Japanese life insurance companies to widen, with most players experiencing some weakening in their credit quality, and we do not rule out the possibility of additional failures in 2002," says Tatsuo Kurogi, a credit analyst at S&P.

"Continued flight to quality among increasingly credit-savvy policyholders may also precipitate the exit of marginal players from the market and lead to further consolidation," he adds.

Shrinking business, weak stocks
According to S&P, fiscal 2001 results from the 10 largest Japanese life insurers reveal a continued contraction of business in force, led by declines in new business and high surrender and lapse rates, as consumer scepticism over the health of the industry persisted.

Total new business and business in force for the 10 largest insurers decreased by 2.5 per cent and 3.9 per cent, respectively. Only two of the largest 10 companies Fukoku Mutual Life Insurance and Taiyo Mutual Life Insurance registered increases in individual business in force, despite the fact that six companies Asahi Mutual Life Insurance, Sumitomo Life insurance, Daido Life Insurance, Mitsui Mutual Life Insurance, Fukoku, and Taiyo-recorded modest year-on-year growth in individual new business.

The drop in consumer confidence hit Asahi and Mitsui particularly hard, forcing them to record year-on-year declines in total assets of 31.3 per cent and 15.5 per cent, respectively, mainly from increased surrenders in the individual and corporate pension businesses, states S&P.

According to S&P, these ills were compounded by the negative impact of falling stock prices and new accounting rules on how life insurers value their investment portfolios. At the end of fiscal 2001, the Nikkei average had fallen by about 15 per cent from the previous fiscal year. As a result, mandatory evaluation losses on securities and realised losses on securities-both mostly related to domestic stock holdings-amounted to approximately JPY1.5 trillion and JPY0.9 trillion, respectively, in fiscal 2001.

These losses were large enough to wipe out domestic life insurers still ample underwriting profits, or kiso rieki, which totalled about JPY2.1 trillion at fiscal year end. Thus, in order to cover remaining losses and to create distributable profits to pay policyholders' dividends, domestic life insurers were forced to realise hidden gains on securities (mostly on bond holdings), and several companies had to go so far as to dip into their price fluctuation and contingency reserves, states S&P.

Total realised gains on securities and reduction of reserves for the industry amounted to around JPY1.2 trillion and JPY0.5 trillion, respectively, in fiscal 2001, revealing the severe impact the falling domestic stock market had on local life insurers. Asahi was the worst hit, recording a net loss of JPY149.5 billion even after using nearly all of its price fluctuation and contingency reserves.

Continued pressures on earnings, capitalisation
S&P predicts Japanese life insurers to face continued pressure on their underwriting profits amid sluggish business prospects and still high negative spreads-which occur when the guaranteed yields promised to policyholders exceed the actual investment returns earned by life insurers.

Life insurers are expected to cut into their still somewhat bloated operating costs in an effort to improve earnings, but such efforts are not likely to be sufficient to offset deteriorating profitability, states S&P.

The capitalisation of life insurers has been severely eroded by falling stock prices since the introduction of mandatory mark-to-market treatment of financial assets in fiscal 2001. While many insurers are actively trying to sell off their stock holdings, it is unlikely that they will be able to reduce their levels of risk assets drastically enough to fully isolate themselves from stock market volatility in the near term. While Japanese insurers have made a dramatic shift to fixed-interest assets-mainly bonds-from risk assets, even these are exposed to price fluctuation risk (in the case of an interest rate hike) depending on how they are classified.

To cope with capital pressures, many Japanese insurers have sought out subordinated lending, including kikin funding, a type of subordinated debt uniquely available to Japanese mutual life insurers that can be treated as capital. While the Financial Services Agency (FSA) treats kikin instruments as regulatory capital, S&P considers kikin as a weak form of capital because of features such as ongoing servicing requirements that are inherently debt-like, and liken kikin to subordinated loans.

In March 2002, Mitsui received JPY100 billion in kikin funding from Mitsui group companies, including Sumitomo Mitsui Banking Corporation (SMBC), and Sumitomo Life received JPY150 billion in subordinated loans from several banks. Also in March 2002, Asahi replaced JPY150 billion in existing subordinated loans with kikin funding from the former Dai-Ichi Kangyo Bank (now part of the Mizuho Financial Group), Daiwa Bank, and Asahi Bank, to increase its regulatory adjusted net worth (subordinated loans are treated as capital under the FSA's solvency margin calculation, but not under the FSA's adjusted net worth calculation.

In contrast, kikin funding is treated as capital under both calculations. Both the FSA's solvency margin calculation and its adjusted net worth calculation can trigger regulatory seizures if the results fall below certain limits.) In addition to these moves, Nippon, Dai-Ichi Mutual Life Insurance, and Meiji Life Insurance have already announced plans to secure kikin funding in fiscal 2002.

Accelerating industry consolidation
In January 2002, Meiji and Yasuda Mutual Life Insurance announced plans to merge without demutualising by April 2004, marking a new phase in industry consolidation distinct from the previous trend of acquisitions of failed insurers by foreign insurers and loose business alliances between local insurers.

Despite the failure of early integration talks between Asahi and Tokio Marine Life Insurance in January 2002, other signs of a shift in the merger trend are apparent: GE Edison Life Insurance completed its full acquisition of shares in Saison Life Insurance in April 2002, with the aim of completing a full merger within this fiscal year; and Sony Corporation has announced that it is in discussions with foreign insurers over creating a capital alliance with its subsidiary, Sony Life Insurance.

"We expect the consolidation of the life insurance industry to accelerate in the next few years as companies be they mutual or stock, large or small-seek to survive," says Kurogi.

While S&P believes it is possible that such mergers will lead to cost reductions and improved economies of scale, it would like to maintain realistic stance. Most mergers fail to produce the hoped-for synergies, and we would wait to see concrete improvements in credit quality after a merger before reviewing our ratings on an insurer, says S&P.

New business opportunities crowded, unproven
With the traditional death protection market experiencing limited growth-attributable to Japan's rapidly aging society-local life insurers have been aggressively marketing "third sector" products such as medical and long-term care insurance, which were fully liberalised in 2001. While this area offers good opportunities for growth, it is already the focus of many players in the industry.

S&P expect competition among domestic and foreign insurers in the third sector to intensify in coming years, which will exert pressure on profit margins in this segment.

Another potential area of new business growth-the variable annuity market-remains very small, reflecting the sluggish local investment environment. Despite this, new players continue to enter the market in anticipation of future growth. Many life insurers have already allied with local brokerage firms as main distribution channels for variable annuity products, and the industry as a whole should benefit from wider distribution when banks are allowed to enter the market starting from this fall, feels S&P.

Still, this market is largely unproven, and its success will depend not only on perceptions about future stock market performance in Japan but also on whether life insurers, brokerage firms, and banks can successfully provide customer-driven products.

S&P expects the consolidation and divergence of credit quality in the Japanese life sector to accelerate in coming years, with most players experiencing some weakening in their credit quality. In addition it does not rule out the possibility of additional failures of already marginal players-particularly if a weakening stock market serves to stoke retail investor nervousness.