Rating agencies� appraisal of life insurance investments played an important role in the markets of the 1990s for three main reasons. First, the raters themselves have emerged from an industry-only interest to key players in the course of a single decade. The only traditional rating service, A.M. Best, even though it had a monopoly, languished in the shadows till the mid-1980s. The other three current leaders�Standard & Poor�s, Moody�s, and Duff and Phelps�all began their insurance-industry-specific services during the 1980s. (Weiss Research is a fourth and even more recent�and controversial�arrival.)

Second, the very fact of insurers� and raters� broadening interest in the ratings is directly related to the growing integration of insurers with the financial markets as both borrowers and lenders. The need for insurance companies to have the ability to issue commercial paper and to obtain bank credit lines was caused by periodic disintermediation problems, by the shortening of liability maturities, and perhaps most important for the future, by the need for access to capital through public equity and bond markets. Insurance companies suddenly needed ratings, a fact the raters correctly perceived as a profit opportunity.

Third, the vagaries of the business cycle�with special emphasis on the downside of commercial real estate and junk bonds in a recession�played a key role in the rise of life insurance defaults. Therefore investment portfolios immediately became a challenge to rating agencies. Once educated in facts and regulations, rating agencies soon began to produce elaborate tests, models and analyses on all the factors relevant to portfolio management�liquidity, asset/liability matching (including cash-flow testing), bond and real estate quality, and actual and possible delinquencies and defaults, as already discussed. The rating agencies had the ability and incentive to go beyond insurance supervisors� rules and regulations. In particular, the leading raters coming from the securities industry (Standard & Poor�s and Moody�s) brought criteria from outside institutional and market finance to bear upon the insurance industry, thereby educating their new clients in turn.

Controversy began almost as soon as the number of raters and their published ratings began to rise in the mid-1980s. The element of judgment, common to most raters, opened the door to disagreements among equally qualified appraisers in much the same way in which investment portfolios differ even among managers with identical objectives. When the rating agencies used strictly quantitative tests to evaluate investments (and other factors) in their analysis, the very lack of supplementary qualitative judgment became a source of criticism. Ratings thus became publicity items at the exact time (1986-1991) when life insurance failures became significant.

The ratings services scrambled as junk bond and real estate problems multiplied. Downgradings typically followed a company�s disclosure of extra reserving for investment problems, of outright writedowns, or of poor quarterly or annual results often associated with investment problems. Competition among insurance company field sales forces quickly spread the bad (or good) news, raising sharply the importance of high ratings in attracting new funds. The cause and effect of downgradings were sometimes indistinguishable since downgradings themselves, even if justified in the eyes of the rating agencies by mounting portfolio problems, could trigger runs on a company and force asset sales at distress prices.

By the early 1990s it was clear that the importance of ratings reinforced the return to conservatism in investment policy and supervision. But several questions have yet to be answered.

The most important of these questions is whether the insurance industry needs a source of liquidity to tide a company over a temporary market and/or ratings-induced rough spot. Might Executive Life have survived had it been able to participate in the recovery of the junk-bond market after new supplies abruptly ceased in 1991? Would Mutual Benefit Life�s real estate have come into its own in the mid-1990s? Might a conditional liquidity arrangement be preferable to impairment and liquidation proceedings or to forced mergers and/or the activation of guarantee funds? As an analogy, Federal Reserve credit is one of the options available to banking entities judged to be capable of recovering, and its quantity and terms have occasionally been stretched to help banks through crises.

The longer-term nature of nearly all life insurance portfolios leaves them vulnerable to a threatened run on an insurance company. Insurers have no safety net, no source of funds to help them through a crisis. The guarantee funds in each state kick in only after the regulators have taken control of a troubled insurer. Therefore the influence of published ratings and their changes will remain a major force in an insurer�s survival. It has been proved that capital-strong companies can survive a downgrading, especially at or near the top of the rating grades. Weaker companies, however, may have to adopt new and possibly severe restraints on their investment portfolios in order to avoid potentially ruinous asset squeezes. Marketing considerations reinforced by regulatory developments and rating pressures will continue to move the industry in the direction of investment conservatism.

Few people would have dared predict the dramatic events of the late 1970s and the 1980s, especially the elevation of the investment function to its current importance, as a consequence of the product revolution. Clearly, caution is in order with respect to predictions for the future. Nevertheless, several trends are clear enough that they will probably continue to be major factors until the close of the century.

The most important of these trends is the swing toward investment conservatism in reaction to the swinging 1980s. Capital standards and the Model Investment Law will require such conservatism; continuous attention to ratings and their influence on marketing will reinforce it. There is a distinct possibility, however, that the combination of these factors will carry a trend that in itself is logical and desirable too far. As a result, the important role that life insurance investments has played in the long-term capital markets and in support of emerging companies may be diminished, to the detriment of national economic growth�especially if life insurers shift all of their assets to top-quality issues and abandon the intermediate-quality assets they have typically financed in recent decades.

In fact, the industry might have to raise so much outside capital to satisfy the new standards being imposed by insurance regulators that its historical net contribution to national investment might fall sharply in the 1990s, along with the change toward high-grade investments. The acceleration of the previously snail-like process of demutualization because of the need for outside capital was a sign of the times in 1992 when the Equitable, one of the largest companies, joined the demutualization parade, primarily to help cure a serious capital deficiency. Other mutuals have also demutualized in order to augment internal retained capital by going public. One mutual insurer (Prudential) was able to raise $300 million by issuing a new form of notes to institutional investors in mid-1993. This indicates that at least some of the strongest mutual insurers may raise capital on Wall Street without having to demutualize. By 1998, even Prudential was pursuing demutualization.

One consequence of the new conservatism was that the recovery of commercial real estate was delayed by insurer investment officers� reluctance or inability to renew their commitment to a sector subject to high capital requirements and asset reserves. The 20 percent average vacancy rate for office space in the early 1990s is unlikely to be cut soon to a more normal 8 percent to 10 percent. Other substantial real estate surpluses existed in hotel and shopping center space. Overbuilding of the 1980s, partly because of weakened underwriting standards, had come home to roost. Thus life insurers had to emphasize defensive management of the existing mortgage and equity real estate portfolio. While in the early 1990s supply and demand pressures to liberalize new financing were minimal, when construction again becomes a leading business investment, the new conservatism will be tested.

Similar considerations, although less extreme, could arise in the relation of corporate financing to life insurance investments. As leading life insurers curbed their appetite for risky loans in response to regulatory and marketing forces, the interest rate margins available on well-secured loans to stable businesses shrank sharply, regardless of whether these margins were measured against the cost of funds or against the alternative of government (or government-backed) securities. Conservatism itself thus increased the squeeze on life insurance earnings, and this conservatism will have to run its course to purge the excesses of the 1980s.

A second important trend for the 1990s is further life insurance diversification into money management per se. The enormous progress of investment skills among insurance officers and of the investment selection aspects of life insurance products can be readily extended into the noninsurance field. A key incentive is the relatively low capital requirements in fee-for-service operations. A great number of leading insurers have acquired mutual fund affiliates and/or independent pension management firms to utilize the sophisticated investment skills of their employees more fully. The field forces of numerous insurers have also developed more refined financial planning knowledge and skills. In effect, many life insurance agents have become financial planners with full portfolio capability, including securities licenses.

The integration of this diversification and expansion into traditional life insurance marketing operations presents major problems in both home office and field force organization and management. The differences in marketing tactics and commission structure�indeed in corporate culture�cannot be bridged easily. One clearly emerging development in home office organization is to establish semi-independent investment subsidiaries; in effect, money market and securities portfolio management is declared another segment of investment operations, often more distinct organizationally than general account segments or separate accounts among themselves.

A third trend for the 1990s is the increasing overlap of investment operations among different types of institutions. This trend is part of the larger issue of broadening franchises and direct competition among previously unassociated groups of institutions. But while the 1990s produced much consolidation in banking, the distinction between banking and insurance was under congressional attack in 1998. No doubt the removal of legal and regulatory barriers would bring a quick end to this separation, but significant public policy concerns and private turf considerations are likely to produce a spirited battle to keep the basic barriers intact. On the other hand, the marriage of investment banking and brokerage with life insurance proceeded forward in the 1990s�a logical development, given the trend toward broad-service financial management within the insurance industry. The legal obstacles appear somewhat more surmountable than for banks seeking to expand into the securities business; nevertheless, management skills to make the disciplines compatible are proving difficult to acquire.

A fourth important trend is the further internationalization of the investment business. Leeway provisions of existing laws or the new Model Investment Law are likely to be used increasingly to take advantage of investment opportunities in the European common market, the developing North American common market, and in dynamic Asian economies. Newly acquired portfolio management skills are also being marketed by several leading United States insurers to generate United States real estate and securities portfolios for foreign institutional investors. Last but not least, the imposition of more stringent United States capital standards for life insurers is certain to be followed by a search for new sources of capital. Leading foreign capital markets are a likely source, and foreign insurers might perceive new opportunities for combinations with United States firms. (Again, the demutualization experience of the Equitable in 1992 may point the way�more than two-thirds of the total additional capital raised in 1991-1992 came from a foreign source, the French AXA insurance group.)

In sum, new challenges and opportunities in life insurance investment management are readily apparent in the late 1990s, notwithstanding the conservative reaction to the 1980s. Consolidation and expansion alternate with the business cycle, more so on the investment side than on the product side of life insurance. Thus it appears that the retrenchment of the early 1990s will be followed by further enhancement of the relative importance of the investment function of life insurance in the remainder of 1990s.