jpm - insurance primer

North American Equity ResearchNew York 14 January 2004

Life Insurance Industry PrimerA Useful Guide to a Complex Sector**CORRECTED REPORT; supersedes any pervious versions ** This report provides an overview of the life insurance sector and key issues. We discuss earnings drivers, success factors in life insurance businesses, distribution, products, capital, and valuation. In addition, we highlight investment issues, regulation, consolidation, and insurance accounting issues. The life insurance sector is a mature, highly regulated, competitive industry, filled with product manufacturers generating significant cash flow and offering commodity-like products that are essentially pushed through distribution channels. Companies that are best positioned are those with significant scale and efficiencies, a service orientation, broad-based and diverse distribution, and a solid brand name. Life stocks continue to trade in a narrow band. In 2004, we believe companies with strong franchises should be awarded premium valuations. For this reason, our Focus List picks HIG and PRU (with six-month price targets of $65 and $45, respectively), industry leader AIG, and LNC are our favorite names in the sector. HIG and AIG are two premier companies with scale, efficiency, and stronger than average earnings growth that we believe are likely to be awarded with premium multiples. See page 7 for a guide on how to navigate this report.Table 1: JPMorgan U.S. Life Insurance CoverageOverweight Rated Stocks01/13/2004 Ticker Company AIG HIG LNC PRU AIG Hartford Financial Lincoln Financial Prudential Financial Price 69.49 62.41 40.92 42.17 EPS '03E $3.87 $5.16 $3.17 $2.55 EPS '04E $4.50 $5.85 $3.53 $3.15 EPS Growth 02-03E 14.5% 11.0% 24.8% 20.3% 03-04E 16.3% 13.4% 11.4% 23.5% P/E 2003E 18.0 12.1 12.9 16.5 P/E 2004E 15.4 10.7 11.6 13.4 P/BV 2.7 1.6 1.3 1.1 NTM ROE 16.6% 14.3% 11.0% 7.6%

United States Life Insurance Michelle Giordano(1-212) 622-6468 [email protected]

Jimmy S. Bhullar(1-212) 622-6397 [email protected]

Scott Woodcock, CFA1-212-622-6652 [email protected]

Source: Company reports and JPMorgan estimates. NTM ROE = Next 12 months estimated earnings divided by 9/30/03 book value per share including unrealized gains or losses. Note: Data in this table reflect 1/13/04 closing prices; all other data in this report reflect 1/12/04 prices.

http://mm.jpmorgan.com See last two pages for analyst certification and important disclosures, including investment banking relationships. JPMorgan does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision.

Michelle Giordano (1-212) 622-6468 [email protected]

North American Equity Research New York 14 January 2004

Table of ContentsInvestment Thesis: Back on Track ...........................................................................3 Primer Summary .......................................................................................................7 Macro Earnings Drivers............................................................................................8 How to Make Money in the Sector .........................................................................10 Life Insurance Success Factors...............................................................................12 Distribution...............................................................................................................15 Historical Perspective ..............................................................................................18 Key Industry Valuation Metrics.............................................................................19 Product Capsule: Variable Annuities.....................................................................23 Product Capsule: Fixed Annuities..........................................................................29 Product Capsule: Equity-Indexed Annuities.........................................................33 Product Capsule: GICs, Funding Agreements (FA) .............................................36 Product Capsule: Universal Life ............................................................................39 Product Capsule: Whole Life..................................................................................41 Product Capsule: Term Life ...................................................................................43 Product Capsule: Variable Life ..............................................................................45 Product Capsule: Group Life..................................................................................49 Product Capsule: Disability Insurance ..................................................................52 Product Capsule: Long-Term Care........................................................................56 Product Capsule: Supplemental Health.................................................................59 Capital and Ratings .................................................................................................61 Life Industry Invested Assets..................................................................................64 Industry Consolidation............................................................................................72 Mutual Insurers and Demutualization...................................................................77 Regulatory Issues .....................................................................................................79 Earnings Model Mechanics .....................................................................................83 Statutory Accounting...............................................................................................85

We would like to thank Patrick Biladeau for his contribution to this report.

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Investment Thesis: Back on TrackWith industry earnings growth and valuations in line with historical averages, we think premier companies will be awarded premium multiples. The strengthening of the equity market has driven earnings growth and valuations for the industry toward historical averages. In addition, lower investment losses and stronger earnings have increased capital flexibility for most companies. We think ratings agencies are likely to become less negative on the sector, which should allow companies to resume share buybacks and drive a more robust acquisition environment. As a result of stronger earnings and increased capital flexibility, we think valuations for the industry should expand modestly, although we think valuations for the companies with scale and efficiencies in key businesses that are best positioned to take advantage of the improved economy and equity market are likely to pull away from the rest of the industry as they are awarded for their higher growth potential and better than average franchises. Focus List picks HIG and PRU (with six-month price targets of $65 and $45, respectively) and industry leader AIG are our favorite names in the sector. HIG and AIG are two premier companies with scale and efficiency that we believe are likely to be awarded premium multiples. Both companies are among the best positioned variable annuity companies, which should increasingly benefit from their scale in this business, and higher interest rates should benefit earnings for their property casualty businesses. PRU should benefit from continued strong momentum in its international business, a turnaround in its equity market sensitive businesses, ongoing expense saves, share buybacks, and accretion from the Wachovia and CIGNA deals. Among other Overweight-rated names in the sector, LNC should also benefit from improvement in the equity market given its presence in the variable annuity market. We are less enthusiastic about defensive names such as AFL, JP, and PL given their lack of significant exposure to improving equity markets.

Key Investment PointsThe stronger equity market is likely to continue to drive better variable annuity earnings. The stronger earnings contribution from equity market sensitive products such as variable annuities should continue to drive stronger earnings for the sector into 2004. The recovery in the equity market (with the S&P up 26% in 2003) has resulted in better investment performance and stronger sales, both of which have boosted VA asset growth, which should continue to drive stronger earnings into next year. This should benefit companies such as HIG, LNC, NFS, PRU, and AIG, which generate a substantial part of their earnings from variable products. Companies with little exposure to the equity market, such as AFLAC, Protective Life, Jefferson Pilot, and UnumProvident, are likely to underperform in the event of continued equity market strength. A gradual rise in interest rates with a continued steep yield curve (i.e., a parallel shift higher in the yield curve) could help earnings for life insurers, relieving downward pressure on portfolio yields (but result in a drop in book value). New money yields available in the market remain below overall portfolio yields for most companies, suggesting portfolio yields are likely to continue to fall in the near term. We think most companies have factored this into their guidance, so earnings are unlikely to fall short of expectations if rates remain flat. If rates rise, it could benefit earnings momentum for business lines such as whole and term life insurance, property casualty insurance and disability, LTC, and reinsurance. AIG and HIG would both3



likely benefit from a soft rise in rates due to their exposure to the property casualty business. Book values are likely to decline if rates rise due to the negative impact this would have on unrealized investment gains included in book value. In most cases this would not have a negative economic impact, however. Companies remain vulnerable to a flattening of the yield curve, which would hurt earnings for spread products such as GICs, fixed annuities, and UL. While spreads may benefit from a gradual rise in rates (or a parallel shift higher in the yield curve), which would further reduce pressure on minimum crediting rates, a rise in short-term rates resulting in a flatter yield curve would exert downward pressure on spreads. This would hurt companies with significant earnings exposure to spread products such as fixed annuities and GICs, particularly companies lacking an offsetting exposure to improving equity market trends. We think PL, JP, JHF, and MET would be most at risk in the event of a flattening of the yield curve. Pressure from ratings agencies is likely to abate in 2004, increasing capital flexibility, bringing back share buybacks. Lower investment losses and stronger earnings have allowed companies to strengthen their capital position and, in many cases, accumulate excess capital. As a result, we think ratings agencies are likely to become less negative on the sector and could even revise their negative outlook on the sector to neutral in 2004. We think this could benefit the sector in the form of additional share buybacks, ratings upgrades, or the removal of negative outlooks from certain names. Companies we think would benefit most from this include MET, LNC, and PRU. However, capital flexibility could be hurt by higher reserve requirements for no-lapse UL (AXXX) and guaranteed life products, although it appears that these are likely to have a greater impact on reinsurers in the near term. As capital continues to build and trends return to normal, we think companies should reconsider modest dividends and raise yields and payouts. A number of companies have raised their dividend payouts as a result of the reduction in the dividend tax rate in 2003. Still, dividend yields on average for the sector are 1.44% and payout ratios are 22.6% on average, below comparable financials such as banks and thrifts. We think companies should consider further dividend increases as capital flexibility builds to increase their appeal with investors. We expect life insurance industry consolidation to continue to heat up in 2004 as operating trends improve, rating agency pressures lift, and capital pressures diminish. We expect greater capital flexibility in 2004, driven by lower levels of realized investment losses and continued improvements in VA earnings and reduced death benefit expenses. The forces driving consolidation should gradually pressure companies to sell non-core businesses, sell their company, or participate in a merger of equals. We view this as a buyers market and prefer potential buyers to potential sellers, as we expect continued modest premiums awarded to sellers. The combination of buying properties at reasonable prices, gaining scale, and potentially creating better efficiencies should benefit better-positioned buyers over the long term. We think the premier companies in the industry are likely to be awarded with premium valuations as operating conditions continue to improve. While industry P/E and P/BV multiples have recovered from the lows seen in 2002, valuations remain in a tight range. The median life insurer trades at 11.7 times 2004E earnings, with 14 out of 24 companies with P/Es roughly in the 10-12 range. In our view, the best positioned companies are likely to pull away from the pack as they continue to deliver stronger than average sales, earnings, and returns. In particular, companies that we4



believe will receive premium valuations due to their strong market position, scale, and efficiencies include AIG and HIG.

Risks to Our ThesisA downturn in the equity market could hurt equity market sensitive names and cause more defensive names to outperform. Most companies in the sector have some exposure to the equity market, and renewed weakness in the equity market would likely weigh on valuations in the sector. Stocks with limited or no exposure to the equity market, such as AFL, JP, and PL, would likely outperform in such a scenario since their earnings should not be affected by a potential market decline. A slow turnaround in the economy could benefit more defensive names. While recent data suggest the economy is now on surer footing, a slowdown in the pace of economic recovery and in consumer confidence could make investors more cautious and cause them to more defensive names.

Valuation & Ratings AnalysisHartfordWe reiterate our Overweight rating on Focus List pick HIG with a $65 six-month target. HIG is one of the best operators and most attractive franchises in the life insurance industry. The stock is currently trading at 10.7 times our 2004 estimate, a discount to the life group median of 11.7 times, which we believe is unwarranted. We continue to think HIG should trade at least in line with the group on a P/E basis or roughly 11 times 2004 earnings, implying a 6 month price target of $65. On a P/BV basis, this represents a slightly lower multiple than HIG's current P/BV multiple of 1.77 times (using BV excluding FASB 115 gains) to 1.68 times projected 6/30/04 BV excluding 115 gains of $38.74.

Risks to Our Rating and Price TargetHartfordWe estimate that about 40% of HIG's earnings are linked to movements in the equity market. Should the equity market deteriorate materially from here, it is likely that HIG will not outperform the comparable group average or meet our price target. Further, it is unlikely in this case that the stock would reach our price target in the six-month time frame, as the multiple is not likely to expand and the acceleration in variable annuity earnings would be delayed. Additionally, while we believe HIG's asbestos reserves are adequate, the stock may be sensitive to developments in asbestos litigation and legislation.

Valuation & Ratings AnalysisPrudentialWe reiterate our Overweight rating and maintain PRU on our Focus List. We also maintain our $45 price target and believe that PRU's P/BV multiple should expand as the company's ROE improves. Our price target assumes that PRU's P/BV excluding the effect of FASB 115 will expand to 1.4 times our projected BV of $32 from about 1.2 times current BV of $33.88. This P/BV multiple expansion is consistent with our expectation that ROE improves to 9.5% by 2Q04 and PRUs 12 month's forward prospective ROE is 11.5% by 2Q04. We are expecting a decline in book value over the next six months due to the deployment of $2.1 billion of capital associated with the CIGNA acquisition. One of the primary reasons for PRU's lower than comparable average ROE is due to its significant excess capital. The deployment of this capital into a higher return business should be one of a number of issues driving the higher return, and the subsequent expansion in the P/BV multiple.5



Risks to Our Rating and Price TargetPrudentialWhile PRU's earnings have a reasonable amount of exposure to the equity market, there are other stocks in the life group that are more heavily levered to the improvement in the equity market and, should the equity market continue to improve significantly, PRU may not perform as well as those that are more levered to the equity market. PRU could also underperform the group if there are additional negative developments in the issues surrounding its trading practices in mutual funds. Further, PRU may not outperform the comparable group and could fail to reach our price target if the improvement in ROE takes longer than expected or the ROE stays below our estimate.Table 2: JPMorgan Life Insurance Coverage UniverseTicker Company AFL AFLAC AIG HIG JP JHF LNC MFC MET NFP NFS PFG PL PNX PRU RGA TMK UNM AIG Hartford Financial Jefferson-Pilot John Hancock Lincoln Financial Manulife Financial MetLife National Financial Partners Nationwide Principal Financial Protective Life Phoenix Cos. Prudential Financial Reinsurance Group Torchmark UnumProvident 1/12/03 Price $35.39 70.50 62.69 49.38 39.44 41.33 33.83 32.63 30.25 34.43 32.32 33.97 13.04 42.26 38.34 45.45 15.75 JPM Rating UW OW OW UW N OW N N N N N UW UW OW N N UW EPS 03E $1.88 $3.87 $5.16 $3.57 $3.13 $3.17 $2.34 $3.01 $1.68 $2.88 $2.26 $2.74 $0.57 $2.55 $3.24 $3.86 $1.70 EPS 04E $2.15 $4.50 $5.85 $3.83 $3.37 $3.53 $2.65 $3.10 $1.86 $3.15 $2.67 $2.97 $0.69 $3.15 $3.65 $4.25 $1.78 EPS Growth '03-04E 14.4% 16.3% 13.4% 7.3% 7.7% 11.4% 13.2% 3.0% 10.7% 9.4% 18.1% 8.4% 21.1% 23.5% 12.7% 10.1% 4.7% P/E 2003E 18.8 18.2 12.1 13.8 12.6 13.0 14.5 10.8 18.0 12.0 14.3 12.4 22.9 16.6 11.8 11.8 9.3 P/E 2004E 16.5 15.7 10.7 12.9 11.7 11.7 12.8 10.5 16.3 10.9 12.1 11.4 18.9 13.4 10.5 10.7 8.8 P/BV 2.7 2.7 1.6 1.8 1.4 1.3 2.4 1.2 2.1 1.1 1.4 1.2 0.6 1.1 1.3 1.6 0.6 NTM ROE 16.0% 16.6% 14.3% 13.8% 11.7% 11.0% 18.3% 11.0% 12.0% 9.3% 9.9% 10.1% 3.1% 7.6% 12.2% 14.9% 6.5%

Source: Company reports and JPMorgan estimates. NTM ROE = Next 12 months estimated earnings divided by 9/30/03 book value per share including unrealized gains or losses. JPMorgan ratings: OW=Overweight, N=Neutral, UW=Underweight.

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Primer SummaryThis primer provides an overview of the life insurance sector and key issues facing the sector. We discuss macro and earnings drivers, success factors, distribution; products, capital, and valuation. Further, the primer addresses investment issues, regulation, consolidation, and sector-specific modeling and accounting issues.

A Top-Down Sector View (Pages 8-11)These two sections illustrate some key macroeconomic factors affecting the industry and how to invest in light of these. Macro Earnings Drivers (pages 8-10) explains how earnings for the sector are affected by the equity market, the shape of the yield curve, and the level of interest rates; mortality and morbidity experience; and the credit environment. How to Make Money in the Sector (pages 10-11) separates companies in the sector into three broad groups and illustrates when it has historically been time to buy each group.

Key Industry Fundamentals (Pages 12-22)This section explains other important life insurance fundamentals needed to evaluate individual companies, including Life Insurance Success Factors (pages 12-14), Distribution (pages 15-17), a Historical Perspective on products and distribution (page 18), and Key Industry Valuation Metrics (pages 19-22).

Product Capsules (Pages 23-60)The product capsules explain common products sold by life insurers. The capsules cover variable, fixed and equity-indexed annuities, GICs, funding agreements, universal, whole, term and variable life, group life, disability insurance, long-term care (LTC), and supplemental health. Each capsule offers key product statistics, a brief description of the product, an explanation of the products economics, distribution, leading players and market size and an outlook for product.

Capital and Industry Structure (Pages 61-82)These sections deal with capital and asset quality, the evolving structure of the industry. Capital and Ratings (pages 61-64) explains how to look at capital for the life insurance sector, while Life Industry Invested Assets explores key issues associated with industry assets and the composition of investment portfolios. Industry Consolidation (pages 72-76) offers our outlook for merger and acquisition activity in the life industry and describes past deals in the sector. Regulatory Issues (pages 79-82) highlights some key regulatory factors facing the industry.

Modeling and Accounting Issues (Pages 83-86)These sections illustrate some of the more technical aspects regarding the life insurance sector. Earnings Model Mechanics (pages 83-85) describes key line items in a life insurance model and Statutory Accounting briefly describes statutory accounting principles for the life insurance industry.

Resource ToolsIn the appendices of the report, we have created valuable resource tools covering earnings, distribution, products, and key insurance terms.7



Macro Earnings DriversInterest rates and the performance of the equity and credit markets are three of the major earnings drivers for life insurers. Variable products such as variable annuities and variable life expose earnings for life insurers to the equity market because assets are typically invested in equity-type funds. The level of interest rates affects earnings for traditional insurance products such as whole and term life, supplemental medical, disability, and long-term care insurance products and life reinsurance. The shape of the yield curve affects earnings for spread products such as fixed annuities, GICs, and a portion of universal life earnings. The credit market is another key driver of realized losses and, thus, net income for the sector (although credit losses do not generally have a material impact on operating income). Another, but a subtler driver of the sector is the health of the economy, which has an impact on sales, disability claims trends, and investment experience. A portion of life insurers earnings is also generated through risk or underwriting income, one source of income that does not strictly depend on these macro drivers but rather is based on the underwriting or pricing of the product..

Equity Market SensitivityWe estimate about 30% of industry earnings are linked to the equity market through variable products.

Life insurers have significant exposure to the equity market through their variable annuity and variable life businesses because assets are invested in equitytype funds. The performance of the equity market affects both revenues and expenses for variable products, and affects them in four ways. Fees: Investment performance for the underlying account balances, which are typically invested in equity mutual funds, depends on the performance of the equity market and is a key driver of fee revenues for variable products. Sales: Sales of variable annuities are generally positively correlated in the equity market. Sales are generally weak in a weak equity market, while a recovery in the equity market results in stronger sales (although there is usually a one to two quarter lag before sales pick up following a recovery or slow following an economic downturn). Deferred acquisition costs (DAC): Broker commissions (acquisition costs) are deferred at the time variable annuities are sold, and amortized over the profitable life of the policy. If profitability is weaker than expected due to weakness in the equity market, DAC amortization must be accelerated, resulting in higher expenses. Better than expected equity market experience can result in a positive unlocking or a reduction in DAC expenses, which would benefit earnings. Guaranteed Minimum Death Benefit (GMDB): GMDBs guarantee the policyholder a minimum benefit at death, regardless of the performance of the underlying variable annuity account. Death benefit expenses are higher when customers die and accounts balances are in the money, or below the guaranteed death benefit. Statutory reserves associated with GMDB also need to be increased when account balances decline (due to a weak equity market), which can strain capital. Conversely, GMDB expenses and reserve requirements are lower when the equity market is strong, since fewer accounts are in the money. Companies will be required to establish GAAP GMDB reserves in the beginning of 2004.

See page 24 for an extensive discussion of DAC and GMDB.

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Interest Rate SensitivityApproximately 15-20% of industry earnings are generated through these types of products, which are dependent on the level of interest rates.

The level of interest rates is an important earnings driver for long-tailed products that have embedded interest rates. Long-tailed products that are sensitive to the level of interest rates include whole and term life, life reinsurance, long-term care, supplemental medical, and disability. Investment income for these products tends to be stronger when yields are higher, and lower interest rates generally pressures investment income and profitability for these products.

Exposure to the Yield CurveSpread products such as fixed annuities, universal life, and GICs generate about 35-40% of life industry earnings.

Spread product earnings generally depend more on the shape of the yield curve than on the absolute level of interest rates. Since assets for spread products are generally tightly matched with liabilities, the absolute level of interest rates does not generally affect earnings for these products, unless rates are so low that it becomes difficult to generate reasonable spreads because investment yields are too low, backing up against minimum crediting rates. However, most states recently approved reductions in minimum crediting rates for newly sold fixed annuities. The shape of the yield curve is more important to spread product earnings since crediting rates generally track short-term rates while investment yields move more closely with intermediateterm rates. In general, the most favorable environment for spread products is rapidly declining interest rates combined with a steep yields curve as crediting rates decline faster than yields. Conversely, the worst environment is a rapidly rising rate environment where the yield curve flattens as crediting rates rise faster than portfolio yields.

Risk IncomeRisk income generates about 20% of industry earnings.

Life insurers generate risk or underwriting income by assuming mortality and morbidity risks from individuals. Risk income is generated on life insurance, longterm care, disability, supplemental medical insurance, and reinsurance. The level of benefits that needs to be paid in a given period and the reserves established for future losses determine the benefits ratio (benefits divided by premium income) and drives the underwriting income for the product in that period. Companies use historical data, mortality tables, and loss experience to price risks for these products. Unlike other life insurance products, risk income generally does not depend on macroeconomic factors (although disability claims experience is influenced by the economic climate).

Credit Market SensitivityInsurers have exposure to the credit market through their investment portfolios, although credit generally affects net, not operating income. Due to their extensive holdings of corporate bonds, life insurers have substantial exposure to the credit market and can suffer substantial investment losses in times of major economic weakness. Losses due to credit defaults negatively impact net income, but realized investment losses are not included in operating income. Credit losses can have an indirect impact on operating income, since the insurer loses the coupon income on bonds that default, which hurts net investment income (an operating income item). Credit losses also have an impact on capital.

See page 64 for a discussion of life insurance industry investment exposures and page 61 for the impact of credit losses on capital.

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How to Make Money in the SectorUnderstanding the key exposures of the stocks in the group and owning them at the right time are key to making money in the life sector. Key macro earnings drivers of life insurance stocks include the equity market (due to variable product earnings), the credit market (due to life company corporate bond investment holdings), and interest rates (also due to large bond holdings). However, as exposure to variable annuities has risen (now 30% of industry earnings, up from 10% 15 years ago), stocks have increasingly traded with moves in the equity market than previously. Generally, investors should buy equity and credit sensitive life insurance stocks when the equity or credit markets are improving and reduce exposure when they are deteriorating. Life insurance stocks should be thought of as laggards on the equity improvement story and improving credit defaults. Brokers and asset managers are higher-beta ways to take advantage of equity market improvement (with greater upside and downside), while banks are more levered to an improving credit environment (again, with greater upside and downside). Still, life insurers with these exposures should outperform other stocks in the sector in the event of a sustained equity or credit market recovery. Conversely, these stocks may underperform as equity and credit markets weaken, as earnings from variable products are likely to come under pressure and credit defaults are likely to rise as a result of economic or equity market weakness putting pressure on capital. Other names in the sector are seen as defensive and are likely to outperform in the event of equity and credit market weakness. Generally, investors should consider owning companies with little earnings exposure to the equity market (because of a lack of variable product exposure) or credit market (because of conservative investment portfolios) when the economy is deteriorating or when the equity market outlook is negative. These stocks are likely to outperform when the equity market is weak, since their earnings do not depend on the performance of the equity market, and are less vulnerable to credit defaults in the case of a weak equity market. However, these stocks may underperform in the event of a recovery given their lack of exposure to improving trends associated with a stronger economy and equity market.

Equity Market Sensitive NamesHIG, LNC, AIG, PRU, NFS, PFG, and PNX are equity market sensitive stocks.

We recommend buying equity-market sensitive stocks when the equity market shows signs of improvement: HIG, LNC, AIG, PRU, NFS, PFG, and PNX. These stocks are sensitive to the performance of the equity market due to their earnings from equity-linked businesses such as variable annuity, variable life, brokerage, and asset management. While these companies also have exposure to earnings from other products such as spread products, property/casualty, and health insurance, earnings from equity-linked products often accelerate and decelerate more quickly than other businesses. As a result, improvement or deterioration in the equity market has a major impact on earnings growth and thus valuation and stock price performance. AIG, HIG, NFS, and LNC have considerable exposure to the equity market (roughly 20-40% of earnings exposed to the equity market) through variable products such as variable annuities and variable life. PFG is exposed to the equity market (25% of earnings) through its full-service accumulation pension and asset management businesses.

See page 8 for more detail on the sensitivity of life insurers earnings to the equity market.

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Industry valuations are discussed in fuller detail beginning on page 19.

PRU has exposure to the equity market (almost 30% of earnings) through its variable products, asset management, and brokerage businesses.

Several equity market sensitive names appear attractively valued relative to their near-term growth prospects, in our view. Multiples for equity market sensitive names compressed substantially as a result of the 2001 and 2002 equity market declines, although they have recently rallied from their lows. The valuations look attractive in light of their near-term earnings growth relative to their peers.

Credit Sensitive NamesJHF, MET, MFC, and UNM are credit-sensitive names.

See page 64 for a fuller discussion of investment losses and other investment related issues.

uy stocks with higher than average credit exposure when credit defaults are improving. Companies such as JHF, MET, MFC, and UNM are seen as credit sensitive due to their large holdings of below investment grade bonds or other risky investments. Heavy realized losses suffered on these riskier investments when the credit market deteriorates reduce net income and can negatively impact capital for these companies. Reduced capital flexibility can result in share buyback programs being put on hold (which reduces EPS growth) or, in extreme cases, issuance of additional equity or other dilutive securities. As credit defaults improve, companies that had suffered substantial investment losses should benefit from increasing capital flexibility and should be able to increase repurchase activity. This should result in a multiple expansion for these companies.

Defensive NamesAFL, JP, PL, RGA, and TMK are defensive names.

Buy stocks with conservative investment strategies and little equity market exposure when markets are troubled and the sector is out of favor. Companies such as AFL, JP, PL, RGA, and TMK generate earnings that are not meaningfully linked to the performance of the equity market, and as such, are likely to deliver relatively strong earnings when the equity market is weak. Similarly, these companies tend to have more conservative than average investment portfolios, characterized by low exposure to below investment grade bonds and riskier asset classes such as equities and partnerships, and have suffered lower levels of realized losses in tough credit markets. While earnings for these companies do not benefit from lower interest rates, defensive companies generally have stronger relative earnings when the economy is weak. While multiples for these names also tend to come under pressure when the equity market is weak, their valuations often do not compress to the same extent as for stocks with credit or equity market exposure. Similarly, valuations for these stocks are not likely to expand as much in the event of a recovery. Currently, we think the defensive names probably do not have as much upside potential as stocks more levered to improving trends. While earnings and valuations for this group held up relatively well in the face of the multi-year equity market decline and severe credit market turmoil, the stocks are likely to underperform other stocks in the group that should benefit from improvements in the equity and credit markets. With the exception of AFLAC, these companies generally have lower than average earnings growth prospects.

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Life Insurance Success FactorsCompanies possessing many of what we consider to be life insurance success factors are more likely to produce solid, consistent and higher than average earnings growth and are generally better investments. Aside from macro factors such as the credit cycle and equity market performance (described above) that are important drivers of the performance of life companies, there are a number of characteristics that drive long-term earnings growth and profitability. These success factors can be broadly classified as helping increase top-line growth (distribution, brand name), reducing risk (prudent investment strategy, diverse business mix), or increasing returns (scale and efficiencies and effective use of capital). Service and brand name are the most difficult attributes to replicate. Over time, companies that have these attributes should generate above-average earnings growth and stock price performance.

Broad-Based DistributionDistribution is critical for generating sales, particularly due to intense competition for sales of most life insurance products. Many insurance products are commodity-like, with dozens of companies offering similar products. In order to drive sales in this environment and access the target market, it is important for companies to have superior access to broad-based and multiple distribution channels. Service provided to distributors and wholesalers through the use of technology in-house, such as support personnel, web sites with product information, quick underwriting time and payment of commissions, is also critical.See page 15 for additional details about life insurance distribution. Also see Appendix VIII for more detail on distribution capabilities of individual companies.

AIG, HIG, NFS, AFL, and LNC have the strongest distribution capabilities, with a solid presence in multiple channels. JHF, MET, and PRU have among the largest captive forces of publicly traded companies and have made progress recently in enhancing this channel, but still have some work to do.

Strong Brand NameA well known brand name is another important driver of sales in a crowded insurance market. In addition to being an important driver of sales to individuals, a strong brand name is also important for securing shelf space with distributors. Maintaining a brand name can be expensive, however, as advertising and other brand expenses can be a large part of operating expenses. PRU, MET, AFL, HIG, NFS, AIG, and JHF have the best-recognized brand names in the sector.

Prudent Investment StrategyCompany investment exposure by class is discussed in the invested assets section on page 65.

Balancing risk and return in the investment portfolio an important competency for insurers. Since investment income is a key driver of earnings for life insurers, it is important for companies to be able to generate suitable investment yields. However, while taking on additional risk in the investment portfolio is one way to boost returns, investment losses (which are recognized through net income, not net investment income or operating income) can impact earnings and put stress on statutory capital. It is important for insurers to be skilled at taking prudent risks and avoiding substantial investment losses.

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Product mix is an important determinant of investment strategy, as most companies seek to minimize the mismatch between invested assets and product liabilities. The ability to maximize yields is an important competency for many products (such as traditional life, disability and reinsurance), while spread management is important for other products (fixed annuities, GICs and universal life). While its aggressive investment style led to high levels of realized investment losses in 2001 and 2002, JHF is one of the savvier investors, generating higher than industry average yields over the long term. AFL, one of the most conservative investors in the industry, has generally had the best loss experience. AFL does not generally invest in below investment grade securities and also has limited exposure to equities or other riskier asset classes.

Diverse Business MixA diverse business mix allows a company to generate sales and earnings growth regardless of the environment. Efficiencies allow companies to maintain low unit costs, provide better service to distributors and customers, provide greater flexibility to pay higher commissions, and, ultimately, could drive better top line and earnings growth. This has been particularly important in the recent troubled market, where earnings on some products (particularly equity-linked products) declined sharply. The ability to offer fixed-return alternatives (such as fixed annuities and universal life) to the variable products helped offset weakness in variable product earnings. Among our coverage companies, AIG, HIG, JHF, PRU, and MET have the most diverse business mixes. AIG, HIG, and MET all have exposure to the property casualty business, and JHF and PRU both have a mix of protection, accumulation and asset management businesses.

Scale and EfficienciesDue to the modest top-line growth for many insurance products, an insurers ability to achieve low expenses through scale and efficiencies is critical for earnings growth. Achieving scale for companies is typically easier than achieving efficiency. Efficiencies and the ability to keep expense ratios low are critical to bottom-line growth. Companies that are efficient are able to provide higher levels of service. Service, in turn, can lead to greater top- and bottom-line growth. When companies are efficient, they have more flexibility to invest in technology, which allows speedier claims processing, policy applications, and payment of commissions, which essentially makes it easier for distributors to sell products and also provides them with incentive to sell the products. AIG, AFL, HIG, and TMK are the most efficient insurers, as demonstrated by lower than average expense ratios, which gives them a competitive edge. PRU and MET, on the other hand, have the most low hanging fruit in terms of expense saves, which will likely be a meaningful driver of earnings growth for each company in the medium term.

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Effective Use of CapitalUsing capital effectively allows companies to maximize returns. Companies that deploy their capital effectively, through investments in their own business or through acquisitions, or by returning capital to shareholders if needed, typically generate better returns and earnings growth than the average company in the sector. AIG has been among the most effective users of capital and has achieved rapid earnings growth and high returns. LNC has recently done a good job of re-allocating its capital and improving returns. While TMK generates modest earnings growth, the company achieves among the highest returns in the industry through effective management of its capital.

Table 3: Summary of Life Insurance Industry Success Factors--Company ScorecardEfficiency OVERWEIGHT American International Group Hartford Financial Lincoln National Prudential NEUTRAL John Hancock Manulife MetLife National Financial Partners Nationwide Principal Reinsurance Group Torchmark UNDERWEIGHT AFLAC Jefferson-Pilot Phoenix Protective UnumProvident Legend Best Above average Average Weak Effective use of Capital Prudent Investors Broad-based distribution Diverse business mix Brand name Valuation

Source: JPMorgan estimates. Note: Ratings are relative to other companies in our coverage universe.

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DistributionHighly saturated markets and commoditization of insurance products have made distribution a crucial success factor in the life market. Competition in most insurance markets is highly intense, with a large number of companies offering similar products. While having the right products is important, product design has become less important than distribution since new product features can be easily copied. Companies need to have superior access to multiple distribution channels in order to drive sales in this environment, but distribution channels have become increasingly cluttered and difficult to penetrate. Distribution focus over the past 20 years has been broadened to include broker dealers and banks, in addition to the more traditional agent channel. In conjunction with the shift in product focus to retirement savings from protection products, the greatest growth opportunities exist in the broker/dealer (a growing channel) and bank (less penetrated) channels. Wholesalers (intermediaries between insurers and distributors) have become increasingly important in penetrating these alternative channels.See Appendix VIII on page 94 for detailed information regarding distribution capabilities for individual companies.

Investment Dealer ChannelsInvestment dealers have become a key sales channel for growth of many products and offer continued solid growth potential, but they have become increasingly competitive and expensive. Investment dealers are wirehouses, regional broker/dealers, and independent financial planning firms. Sales growth through investment dealers has accelerated as growth has slowed through agent-led channels. At the same time, however, distribution through investment dealers has become increasingly competitive and expensive, as market participants have crowded into this channel and start up and access fees for the channel have climbed. Variable annuities and variable life are most common products sold through this channel (because an NASD license in needed to sell these products). Investment dealers sell a limited amount of products requiring an insurance license to sell, such as whole, term, survivorship life, fixed annuities and long-term care, disability and supplementary insurance. Insurance products face competition from other investment products in this channel as brokers often focus on maximizing commissions and selling products that are quick and easy to sell, like stocks and mutual funds. Wirehouses: The largest wholesale brokers and dealers of financial products, including Dean Witter, Paine Webber, Smith Barney, and Merrill Lynch, are often referred to as wirehouses. The development of this channel has been held back by licensing requirements on selling life insurance and brokers hesitance to sell complex life products over other financial products. Regional broker/dealers: Regional broker/dealers are similar to wirehouses but focus on more concentrated geographic regions and markets (although some are now national in scope). Regional broker/dealers sell the same suite of insurance products as wirehouses, primarily variable annuities and variable life policies. Some of the largest regional broker dealers include Raymond James, Edward D. Jones, A.G. Edwards, and Wheat First Union.15



Independent Financial Planners: Independent financial planners are small independent advisory firms that sell a full range of investment and insurance products. This channel typically receives the most aggressive commissions and generally focuses on selling products with some form of guarantee.

Hartford has been particularly successful in the investment dealer channel, ranking first in the sale of variable annuities, benefiting from its strong brand name, service orientation, and extensive wholesaler operation. Other companies that have had success in penetrating this channel include AIG, National Financial Partners, American Skandia/Prudential (in the financial planner channel), and Manulife.

BanksBanks are less penetrated and offer solid growth prospects, but offer challenges in training and motivating distributors. A key challenge in penetrating the bank channel is that life insurers, rather than banks, must train bank employees to sell their products. Annuities are the most widely sold life insurance product through banks because fixed annuities are simple products (like a tax-deferred CD) that are relatively easy to train people to sell. Variable annuities are typically sold through the broker/dealer subsidiaries of banks, as the relative complexity of the product makes it more difficult to motivate bank tellers to sell. Life insurance is also difficult to sell through banks due to its complexity and the need for a life insurance license. The bank channel accounts for roughly 20% of total annuity industry sales, up from 16% three years ago. Total annuities sold through banks in 2002 grew 29% from 2001 to $49.1 million. Major banks offering insurance include BankOne and Citigroup. AIG, Nationwide, and Hartford have had success in selling products through the bank channel.Figure 1: Banks Represent an Increasingly Important Distribution Channel for Annuities$ in billions

$60 $50 $40 ($ billions) $31.0 $30 $20 $10 $0 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 9M02 9M03Source: The Kehrer Report and JPMorgan calculations.

$49.1 $38.1 $26.4 $18.1 $12.3 $13.5 $14.2 $17.2 $19.3 $19.7 $37.1 $38.5

Smaller insurers often rely on third-party marketers to drive sales through banks. Companies that do not have direct relationships with banks typically use third-party marketers such as Independent Financial, Essex (owned by John Hancock), and Talbot. Relationships typically are not exclusive, and third-party marketers usually represent several insurance companies. Most of the largest life insurance company sellers through banks primarily sell directly rather than using third-party marketers. Sales of16



fixed annuities through third-party marketers in 2002 (up 32.7%) experienced significant growth (slightly less than the overall market, which grew 34.1%). Sales of annuities through third-party marketers represent about 40% of fixed annuity sales.

Agent-Led ChannelsCaptive and independent agents remain important for distribution of insurance products, although they are relatively mature and growing slower. Captive agents are full-time employees, compensated primarily with sales commissions and certain employment benefits and cannot sell the products of other insurance companies. Mutual insurers often rely on captive agents to distribute their products. The channel can be expensive due to salary costs, benefit payments, and frequent agent turnover, although companies have driven down costs for captive agents by consolidating sales offices and revising compensation practices. Independent agents are able sell the products of more than one insurance company, or different types of insurance, ranging from life to auto insurance. They are not employees of the firms whose products they sell. Compensation is determined on the basis of sales commissions, and employee benefits (health care, pensions) are not typically provided to these agents. This channel is a major seller of many products, including whole, term and universal life, fixed and variable annuities, group life, disability insurance, and long-term care. Since agents sell products from multiple insurers, having a compelling product offering and excellent service (through broker general agents or BGAs) is essential to succeed in this channel. Competitive commissions and quick turnaround of policies are also important in this channel.

Direct ChannelsThe arrival of the Internet has increased the potential of the direct channel, but the high touch nature of insurance products presents a challenge. Highly commoditized and inexpensive life insurance products are more frequently being sold directly to consumers by direct mail, telephone, and the Internet. Products like term life and supplemental insurance are among the most frequently sold. While annuities are marketed and sold over the Internet, the channel has yet to realize significant sales, partially due to the products complexity and substantial investment requirements. As consumers become more familiar with shopping online, the Internet channel is expected to grow. However, given the importance of direct contact and advice in the sale of insurance products, sales through the direct channel are likely to remain relatively small.Table 4: Summary: Distribution Channel MatrixProducts Channel Sold Agent Led Life, Annuities, Supplemental Investment Dealer Annuities, GICSs Bank Fixed Annuities Direct Term Life, SupplementalSource: JPMorgan.

Market Penetration High Moderate Low Low

Development Stage Mature Developing Nascent Nascent

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Historical PerspectiveChanges in business mix and distribution strategies have fundamentally changed the life insurance industry over the past decade. The shift from protection-oriented products to investment-oriented products has made insurers modestly less interest rate sensitive and more exposed to the equity market (with roughly 30% of life insurance exposed to the equity market).

Products: Shift to Investment Products from ProtectionInsurance products have shifted in focus from simple death protection to retirement savings. In the past, life insurance products were protection-oriented products, primarily insuring against death. Although a product such as whole life accumulated a cash balance, its primary purpose was death protection. Over time, insurers seeking growth focused more on capturing part of the growing market for retirement savings products, and products such as universal life became more popular. Additionally, customers seeking death protection are increasingly favoring term life, a cheaper insurance product that does not have a savings component. The increasing popularity of mutual funds and the hot equity market in the 1990s fueled the rise of variable annuities and variable life. Companies offered variable annuities and variable life in the 1980s, but these products did not reach their full potential until the mid 1990s, when they became the central driver of industry sales and earnings. This product shift fundamentally changed the risk profile of the insurance industry, changing it from an interest rate driven to equity market driven.

Distribution: Move to Alternative ChannelsTraditionally, reliance on agent-led distribution gave advantage to companies with extensive agent networks. In the past, captive agents were the primary distribution channel for distribution of insurance products. Competing in this environment was relatively straightforward, as companies only needed to focus on growing their agent network and increasing the productivity of their agents. Captive agents gradually became a liability, however, due to the cost of maintaining such a network and the opening of competing channels that made it less important to have a captive sales force. Additionally, a wave of demutualizations increased insurers focus on growth and achieving higher returns, which pushed them to seek out new ways to sell their products. The increasing importance of investment-oriented products now necessitates diversified distribution strategy. Having shifted toward investment-oriented products, insurance companies made new distribution channels such as broker/dealers available to life insurers. While both channels offer significant growth opportunities, they also present challenges traditional agent-led channels did not, such as licensing requirements and competition against a wide array of products. Companies that have superior access to a variety of distribution channels have been able to achieve aboveaverage growth and returns, and we expect this trend to continue.

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Key Industry Valuation MetricsWhen valuing stocks in the life insurance sector, we recommend looking at P/E and P/BV as key valuation metrics. It is important to compare valuation metrics not only with historical levels for a given company, but also with the outlook for earnings growth and returns.

Price to Earnings Ratio (P/E) vs. Earnings GrowthThe life industrys P/E has become increasingly correlated with the equity market due to its increased reliance on variable product earnings. In absolute terms, life insurance P/Es have averaged about 13 times forward earnings, and the median life insurance stock is currently trading at a 11.7 P/E. While we think the group could see further multiple expansion, we think it is more likely that multiples for selected stocks levered to improving equity market trends continue to rise while those lacking such exposure are likely to remain relatively flat. The industry reached its trough multiple at the height of the technology bubble in the beginning of 2000, when the group was neglected by investors and traded at an average P/E of 8.7 times earnings. This was only shortly after the group reached a peak multiple of 18.4 in late 1998 due to a flurry of acquisition activity and the robust equity market.Figure 2: Historical P/E for Life Insurance Sector2 0 .0

1 8 .0 A v e ra g e = 1 3 .9 1 6 .0

1 4 .0

1 2 .0

1 0 .0

8 .0

6 .0 1 /9 4 1 /9 5 1 /9 6 1 /9 7 1 /9 8 1 /9 9 1 /0 0 1 /0 1 1 /0 2 1 /0 3 1 /0 4

A c tu a l P /E

Source: FactSet.

Life insurance P/E ratios generally move in line with the outlook for earnings growth for the sector. In general, the higher the earnings growth prospects for the company, the higher P/E ratio it will be awarded by investors. This relationship between P/E and earnings growth has been solid over time, with P/Es expanding as earnings growth improves and contracting as earnings growth slows. Companies should generally trade at a P/E roughly in line with earnings growth (or a slight premium), and companies with consistently high earnings growth should be awarded a premium P/E valuation.

19



Figure 3: P/E vs. Growth Rate21.0 AFL

19.0 Price / Earnings Ratio 2003 AIG NFP 15.0 PL JHF NFS 11.0 (-1.1%, 11.5) UNM (-14.1%, 9.5) TMK PFG JP 13.0 DFG RGA SFG MET HIG

17.0

PRU SCT MFC SLF LNC

9.0

7.0 5.0%

9.0%

13.0%

17.0%

21.0%

25.0%

Average 2 Year Projected Growth (2003-2004)

Source: Company reports and JPMorgan estimates.

The life insurance industrys correlation with interest rates, once strong, has declined over time. From 1994 to 1999, the industry had a relatively strong correlation with rates, with valuations contracting when interest rates rose. This relationship appears to have begun to break down after 1999, and after 2001 there appears to be little remaining correlation between life industry valuations and interest rates.Figure 4: Life Industry's Correlation with Interest Rates Declining20.0

18.0

Period 3 Period 1R =0.692

R2=0.36

Period 4R2=0.11

16.0

14.0

12.0

10.0

Period 2R2=0.81

8.0 1/94 1/95 1/96 1/97 1/98 1/99 1/00 1/01 1/02 1/03 1/04

Actual P/E

Predicted P/E

Source: FactSet.

Industry P/BV multiples have also recovered from their lows. The life industry currently trades at 1.37 times book value (excluding FASB 115), a discount to the long-term average multiple of 1.8 times. Multiples of book values excluding FASB 115 (which marks to market gains on investment securities) are more representative, we believe, since they exclude large interest-rate related gains on investments that have inflated BVs and thus understated P/BV multiples for many insurers. We expect multiples for the industry to approach historical averages as ROEs improve due to better performance of equity-linked products and as realized investment losses remain low.20



Figure 5: Life Industry P/BV Ratio Has Averaged 1.8 Times2.6 2.4 2.2 2.0 1.8 Average = 1.8 1.6 1.4 1.2 1.0 1/94 1/95 1/96 1/97 1/98 P/BV 1/99 1/00 P/BV ex. 115 1/01 1/02 1/03 12/03

P/BV ex. FASB115


Price to Book Value Relative to ROELife industry P/BV multiples generally correlate closely with returns. Companies with higher returns on equity are typically rewarded by the market with a higher price to book value multiple. Empirically, there is a high correlation between P/BV and ROE for life insurers, a relationship that has held up well over time.Figure 6: Strong Correlation Between P/BV and ROE2.7 AFL AIG MFC 2.3 NFP JP

Price / Book Value

1.9 SLF 1.5 PRU 1.1 PLFE 0.7 MNY PNX UNM NFS PL MET AMH PFG SFG

DFG JHF RGA LNC SCT

HIG TMK

0.3 0.5%

2.5%

4.5%

6.5%

8.5%

10.5%

12.5%

14.5%

16.5%

18.5%

Next Twelve Months Return on Equity


Embedded ValueWhile generally not used by U.S. insurers, embedded value is a widely followed insurance valuation metric outside of the United States. To estimate embedded value, companies add an estimate for the value of in-force insurance business (present value of future profits) to adjusted shareholders equity. The value of in-force insurance business is estimated by valuing the stream of profits expected from the life insurance21



business in the future, adjusted for the regulatory capital required to back the business. Key inputs into the value of in force business include the regulatory capital required for the business, an appropriate discount rate (usually a government bond yield plus a risk premium), and a tax rate. Embedded value is difficult to calculate for U.S. companies, since the companies do not typically provide much of the information needed to do the calculation. A large number of inputs are needed to estimate the present value of future profits, including a risk discount rate, investment return assumption, surrender and lapse experience, taxes, mortality/morbidity experience, and other items. Embedded values are also difficult to compare from company to company since they rely on a large number of assumptions that may differ from company to company.

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Product Capsule: Variable AnnuitiesOverviewIn a normal market, variable annuities are among the fastest growing and highest return insurance products. While their growth and returns were dented by the down equity market, over the long term, variable annuities are likely to grow faster than other life insurance products. ROEs for variable annuities are also higher than for traditional insurance products, since the insurer does not bear the risk for the product driving minimal capital requirements and a low level of reserves.See below for a further discussion of DAC and GMDB.

Variable annuity earnings are largely tied to the performance of the equity market. Earnings are driven by fees on policyholder account balances, most of which is invested in equity-type mutual funds, so that account balances and fees generally rise with the equity market. Sales also tend to be stronger when equity market performance is strong although sales have historically tended to lag movements of the market by almost a quarter. In addition to higher revenues, strength in the equity market also results in lower deferred acquisition cost (DAC) and guaranteed minimum death benefit (GMDB) expenses for variable annuities.

Key StatisticsReturn on Equity: 15% or higher in normal environment, depending on scale and efficiencies Forecast Long-Term Earnings Growth Rate: 10-12% Typical Commission Structure: 7% on new sales

Product DescriptionThe recent reduction in dividend taxes potentially reduces the appeal of variable annuities relative to mutual funds, although the tax cut does not appear to have had a major impact on sales in the near term. See page 81 for further discussion.

Variable annuities are insurance contracts that function as tax-deferred mutual funds with a death benefit, and many products offer living benefits. Variable annuities offer a range of options that invest in mutual funds (stocks, bonds or money market funds) or a fixed rate option. The value of the annuity depends on the performance of the investment options chosen. The customer does not pay taxes on the income and investment gains on the invested assets until the contract is annuitized or withdrawn, at which point income is taxed at the ordinary rate. Customers must typically pay a surrender charge, which generally begins at 7% and declines over time, if funds are withdrawn before the seventh year. Customers use VAs as the primary source of retirement savings (in the case of qualified VAs, typically 403(b)s or 457 plans in the case of teachers and hospital employees or government employees, respectively) or to supplement retirement savings or 401(k) plans (non-qualified). The IRS assesses a 10% penalty, in addition to tax, if funds are withdrawn from a variable annuity before age 59 .

Economics: Equity Market Drives ProfitsRevenues and expenses for variable annuities are both driven by the performance of the equity market. Most (about 60% as of the end of the third quarter of 2003) variable annuity assets are invested in equity-type mutual funds, so that the performance of the equity market has a large impact on account balances. The company charges a mortality and expense (M&E) and distribution fee of 100-150 basis points on assets under management, and additional fees for optional features such as guaranteed withdrawal benefits or GMIBs (which generally cost 40-60 basis points), guaranteed minimum accumulation benefits (GMABs), or guaranteed minimum23



accumulation benefits (GMWBs). Customers must also pay fees for the underlying mutual funds in which the assets are invested (40-150 basis points), although these fees flow through to the asset manager managing the funds. The performance of the equity market is an important determinant of the level of assets under management and fee revenue. The customer bears the investment risk on the assets, so the business can be supported with a lower reserve level than for fixed products (where the insurer bears the risk), generating a higher ROE. DAC and GMDB expenses, both affected by the performance of the equity market, are two key drivers of VA profitability. DAC represents acquisition costs (primarily commissions) that are capitalized when an annuity is sold and amortized over time. With the equity market declines of 2001 and 2002, higher DAC expenses have hurt earnings for VAs because actual profits fell short of original expectations requiring DAC to be accelerated. The stronger equity market has helped to relieve DAC pressures, as product profitability has been improving as the equity market has climbed. GMDBs guarantee the policyholder a minimum benefit at death, regardless of the performance of the underlying variable annuity account. Death benefit expenses are higher when customers die and accounts balances are in the money, or below the guaranteed death benefit. Statutory reserves associated with GMDB also need to be increased when account balances decline (due to a weak equity market), which can strain capital. Conversely, GMDB expenses and reserve requirements are lower when the equity market is strong, since fewer accounts are in the money. GMDB has more of an ongoing effect on earnings and affect SAP and GAAP results. The key issues with GMDB are (1) amount of assets in the money, or account balances that are below the guaranteed minimum death benefit; (2) reinsurance purchased; and (3) statutory reserves established. NAR, net amount at risk, is an indicator used to quantify the portion of variable annuity assets covered by a guaranteed minimum death benefit that is "in the money," and retained NAR is the amount of exposure, which reinsurance is not able to cover. Retained NAR, the risk retained after reinsurance, is the key metric of an insurers exposure to GMDB. GMDB expenses are incurred when policyholders holding a GMDB die with their account value below the guaranteed value. Charges to establish GAAP reserves for VA GMDB in early 2004 are expected to have a modest impact on net earnings and a minimal ongoing impact. The AICPA statement of position (SOP) regarding reserves for GMDB is on track for adoption in the beginning of 2004. The SOP requires companies to establish GAAP reserves against GMDB exposure (where many companies previously only maintained statutory reserves), and companies will likely take charges early in 2004 to establish these reserves. The net impact should be relatively modest, and the charges will not be included in operating income.

Distribution: Key Driver of SuccessThe breadth and depth of the distribution network is a key driver of a companys success in generating VA sales. Channels have become increasingly cluttered and more expensive. Substantial wholesaler capabilities and providing excellent service to distributors has become vital to drive sales. 24

Sales of VAs through investment dealers have grown quickly, although this channel is becoming increasingly cluttered and competitive. Larger



players dominate the wirehouse (large securities firms, generally based in New York) and regional broker dealer (Edward D. Jones, A.G. Edwards) channel, with smaller players struggling to gain shelf space due to competition, high cost, and high quality of service required to effectively compete in this channel. Independent financial planners represent a less centralized channel, and generally offer products with more specialized features and have the most aggressive commissions.See page 15 for a full discussion of distribution for the life insurance industry.

Banks represent a channel with good growth potential, but have proven difficult for VA companies to penetrate. A few companies have had considerable success in generating sales of variable annuities through banks, although sales through this channel remain challenged by the lack of in depth product knowledge from bank personnel. Captive agents remain an important distribution channel, although it is losing ground to alternative channels. Although captive agents remain an important channel for distribution of variable annuities, it is not growing as quickly as alternative distribution channels. The direct channel, while inexpensive, is likely to remain a relatively small contributor to sales. Direct sales have not been a channel that has performed well relative to the other VA distribution channels, due to the complex nature of the product and the need for it to be actively sold.

Figure 7: VA Distribution: Independent NASD Channel Gaining in Importance40% 35% 30% 25% 20% 15% 10% 5% 0%Direct response Bank/credit union NY wirehouse Regional firms Independent NASD Captive Agency

1996 3Q03

Source: VARDS.

Concentrated MarketThe level of sales and assets are both relevant measures of a companys standing in the VA market. New sales indicate the companys near-term business momentum, and are key to building a solid base of VA assets in the long term. The level of assets, however, is a more important determinant of VA earnings power. Despite the large number of players, the VA market is becoming increasingly concentrated. While there are over 50 companies writing variable annuities, the top 10 VA companies account for over half of VA sales, and the top 25 companies account for close to 90% of industry sales. The largest sellers of VAs with the strongest distribution networks have been winning market share, increasing the concentration of25



See page 98 for an explanation of GMWBs.

the market. Hartford, the top seller of variable annuities, has enjoyed market share gains recently due to strong sales of its Principal First feature, a guaranteed minimum withdrawal benefit (GMWB).

Table 5: Individual Variable Annuity New Sales (Gross Sales Less Internal Transfers)$ in millions 3Q02 3Q03 Rank Rank Company 2 1 6 5 3 10 7 8 11 13 1 2 3 4 5 6 7 8 9 10 Hartford Financial TIAA-CREF AXA Group MetLife/NEF/Gen Am AIG/American General/SunAmerica Pacific Life Insurance Company ING Group of Companies Prudential/Skandia Lincoln National Manulife Financial Top 10 Companies Top 25 Companies Total CompaniesSource: VARDS and JPMorgan calculations.

3Q02 2,404.8 3,350.8 1,481.2 1,505.6 1,844.5 1,032.9 1,388.3 1,257.8 1,006.0 883.0 16,154.9 24,710.1 28,095.5

3Q03 3,974.4 3,056.8 2,894.3 2,518.5 2,326.7 1,566.9 1,550.9 1,257.8 1,057.7 981.4 21,185.4 29,376.6 31,339.9

% Change 65.3% -8.8% 95.4% 67.3% 26.1% 51.7% 11.7% 0.0% 5.1% 11.1% 31.1% 18.9% 11.5%

3Q02 Mkl. Sh. 8.56% 11.93% 5.27% 5.36% 6.57% 3.68% 4.94% 4.48% 3.58% 3.14% 57.50% 87.95% 100.00%

3Q03 Mkt. Sh. 12.68% 9.75% 9.24% 8.04% 7.42% 5.00% 4.95% 4.01% 3.37% 3.13% 67.60% 93.74% 100.00%

bp Change 412 (217) 396 268 86 132 1 (46) (21) (1) 1,010 579 0

9M02 6,902.5 9,301.6 4,408.9 4,499.4 5,808.8 3,034.9 4,248.4 3,738.3 3,071.3 2,898.0 47,912.1 72,543.2 82,901.3

9M03 11,655.9 9,583.4 8,129.4 7,269.2 5,949.4 4,626.3 4,335.2 3,771.2 2,771.8 3,062.2 61,154.0 87,470.8 93,109.6

% Change 68.9% 3.0% 84.4% 61.6% 2.4% 52.4% 2.0% 0.9% -9.8% 5.7% 27.6% 20.6% 12.3%

Top variable annuity companies also have been increasing their share of industry assets. The largest 10 VA companies have over 70% of industry assets, and the largest 25 companies control 94% of industry assets. Companies with a larger base of assets have the advantage of economies of scale and lower expenses, so the increasing concentration of industry assets is likely to benefit the larger players at the expense of more marginal competitors. TIAA-CREF, which sells primarily qualified annuities, has a significant 28.8% share of the industry assets with and $253 billion in assets at the end of the second quarter of 2003. Among non-qualified annuity players, Hartford and AIG have the largest market shares with 8.2% and 6.2% of industry assets, respectively.Table 6: Individual Variable Annuity Assets Under Management$ in millions 9/30/02 Rank 1 2 3 5 7 4 6 8 9 10 9/30/03 Rank Company 1 2 3 5 4 6 7 9 8 10 TIAA-CREF Hartford Financial AIG/Amer. Gen./SunAmerica Lincoln National AXA Group Prudential/Skandia ING Group/ReliaStar/Aetna Nationwide MetLife/NEF/Cova/GenAm IDS Life Top 10 Companies Top 25 Companies Total Industry AssetsSource: VARDS and JPMorgan calculations.

9/30/02 Assets 225,088 59,135 48,353 34,385 29,417 34,918 32,487 29,145 22,695 22,057 537,682 701,419 756,734

9/30/03 Assets 260,725 76,894 58,671 39,972 40,831 38,877 38,737 35,161 36,684 27,666 654,217 856,416 909,761

% Change 15.8% 30.0% 21.3% 16.2% 38.8% 11.3% 19.2% 20.6% 61.6% 25.4% 21.7% 22.1% 20.2%

9/30/02 Mkt. Sh. 29.74% 7.81% 6.39% 4.54% 3.89% 4.61% 4.29% 3.85% 3.00% 2.91% 71.05% 92.69% 100.00%

9/30/03 Mkt. Sh. 28.66% 8.45% 6.45% 4.39% 4.49% 4.27% 4.26% 3.86% 4.03% 3.04% 71.91% 94.14% 100.00%

bp Change (109) 64 6 (15) 60 (34) (4) 1 103 13 86 145 0

6/30/03 Assets 253,580 72,184 54,946 38,869 37,931 37,854 37,563 34,359 34,262 26,700 628,247 822,137 880,091

Seq % Change 2.8% 6.5% 6.8% 2.8% 7.6% 2.7% 3.1% 2.3% 7.1% 3.6% 4.1% 4.2% 3.4%

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Market Size: Recent Growth Held Back by Equity MarketSharp declines in the equity market in 2001 and 2002 temporarily hurt sales and assets for the variable annuity market. During this difficult period, sales and assets were helped by the fixed return option offered by many companies, and withdrawals were lower than for products such as mutual funds due to the higher persistency of variable annuity assets. Still, weakness in the equity market took its toll on both sales and assets. However, we anticipate sales and assets will begin to approach peak levels as the equity market stabilizes. At the end of the third quarter of 2003 variable annuity assets stood at $911.0 billion, down 6.3% from a peak of $972.5 billion reached in 1999 but up from $796 billion at the end of 2002. After rapid growth from 1996-2000, sales dropped off in line with the decline in the equity market. Industry sales of $113.9 billion in 2002 are also down from their peak of $137.2 billion in 2000. Still, VA sales for the full year 2003 are likely to be up 12-14%.Figure 8: VA Industry Assets$ in billions$130 1,600

Table 7: Historical Variable Annuity Gross Sales - Annual$ in billions Year 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 9M2003 Total Industry Sales 12.0 17.3 28.5 46.6 50.2 51.3 74.3 88.2 99.8 122.9 137.2 113.0 113.9 93.1 Growth 22.4% 44.2% 64.7% 63.5% 7.7% 2.2% 44.8% 18.7% 13.2% 23.2% 11.6% -17.7% 0.8%

$110

1,400

$90 (Variable Annuity Sales)

1,200

1,000 '(S&P 500) $70 800 $50 600 $30

400

$10

200

-$101991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003E

0 Total Industry Sales S&P 500

Source: VARDS and JPMorgan.

Source: VARDS and JPMorgan calculations.

Industry fund flows deteriorated with the weak equity market but appear to be recovering along with the equity market. Fund flows are an important indicator of the underlying health of the VA business. VA fund flows, defined as new deposits less withdrawals, declined to $19.4 billion in 2002 from their peak of $52.1 billion in 1999. This is due both the weaker sales and an increase in withdrawals, both driven by consumer concerns about the equity market. Fund flows appear to be back on track in the second quarter of 2003, nearly tripling from second quarter 2002 levels to $13.9 billion, boosted by the stronger equity market.Figure 9: Fund Flows: Down from Peak Years, but Getting Stronger$ in billions60.0 50.041.4 49.1 52.8 52.1

40.0 30.0 20.0 10.0 0.0 1994

32.8

35.3

38.7 32.7 22.5

19.4 15.5

1995

1996

1997

1998

1999

2000

2001

2002

9M02

9M03

Source: VARDS and JPMorgan. 27



Outlook: Stronger Sales and EarningsWhile the VA industry has suffered recently due to the multi-year decline in the equity market, the rebound in the market in 2003 should translate into stronger VA sales and earnings. Companies with strong brands, service, and distribution should continue to be successful in winning market sales and asset market share. We expect variable annuity sales to grow 8-10% to roughly $137-143 billion in 2004. In the fourth quarter of 2003, we expect sales to increase roughly 5-6% sequentially from the seasonally weak third quarter and 12% from the fourth quarter of 2002 to $33.5 billion. For full-year 2003, we expect VA sales to grow 12-14% to roughly $127-130 billion following 0.7% sales growth in 2002. VA assets should also grow 10-12% in 2004, assuming 7-8% market appreciation for the full year. We expect VA assets to rise 20-25% in 2003, following a 10.9% decline in 2002, driven largely by the strong rise in the equity market in 2003. VA earnings should remain strong in the fourth quarter of 2003 and into 2004. The equity market advanced further in the fourth quarter, with the S&P 500 Index up 11.6% in the quarter following its robust performance earlier in the year, which should continue to drive higher account balances and fees. DAC expenses are likely to continue to decline, and GMDB expenses are also likely continue to decline, although new GAAP reserving requirements for GMDBs could result in a modest rise in GMDB expenses. VA earnings should continue to see double-digit growth in 2004, assuming a 7-8% rise in the S&P 500. The reduction in the dividend tax rate does not appear to be having a substantial negative impact on the VA industry. The reduction in the dividend tax rate introduced in 2003 makes VAs less appealing relative to mutual funds because many of the tax benefits of VAs are more muted. Despite the negative implications of the tax cut, it does not appear to have had a materially negative impact on the market for variable annuities. We expect agents and brokers to continue to aggressively market variable annuities because of the high commissions they receive for VA sales, as well as the products other tax deferral features and death benefits. Product innovation will remain important in light of the current, potentially damaging regulatory changes. As a result of the flurry of recent legislation, the VA industry may begin to concentrate on developing new products like long-term care or immediate annuities, as well as wrap products for savings plan products and/or encourage consumers to put variable annuities in these savings plan products to get a death benefit, principal protection, or guaranteed returns.

See page 79 for further discussion of regulatory issues affecting the life insurance sector.

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Product Capsule: Fixed AnnuitiesOverviewFixed annuities are an important source of earnings for many insurers, although longer term growth is likely to be modest. We estimate fixed annuities generate close to 30% of industry earnings. Sales of fixed annuities grew substantially as a result of weakness in the equity market in 2002, as consumers came to prefer a guaranteed fixed return to equity market exposure. In general, however, the market for fixed annuities is relatively mature and earnings and sales growth are not likely to be much greater than upper single digits. Companies decide whether or not to be in this market depending on their appetite for new business at given market rates. The ability for companies to generate acceptable spreads is the major factor driving sales for companies participating in this market. A companys ability to generate spreads is a function of the interest rate environment (primarily the shape of the yield curve) and the companys investment prowess. Companies set their crediting rates based on their desired spreads, which in turn drives what level of sale they generate.

Key StatisticsReturn on Equity: 8-13% Forecast Long-Term Earnings Growth Rate: 9-11% Typical Commission Structure: 7% of deposits

Product DescriptionFixed annuities are an investment vehicle that guarantees a fixed crediting rate on the account balance (either an annual rate or a fixed rate for the duration of the contract). Traditional annuities guaranteed a rate for one year, but insurers more recently have been emphasizing multi-year products (3-,5-, 7- or 10-years), which guarantee a set rate for multiple years and which are easier to manage from an asset/liability perspective. Customers use FAs as the primary source of retirement savings (in the case of qualified FAs) or to supplement retirement savings (non-qualified). The IRS assesses a 10% penalty, in addition to tax, if funds are withdrawn from a fixed annuity before age 59 . Retirees seeking stable income from their investment portfolio are the primary buyers of fixed annuities. Insurers protect themselves from early withdrawals through surrender charges, which customers must pay if they withdraw their funds before five to seven years and typically begin at 5-7% and decline over time. Fixed annuities also have a market value adjustment (MVA) feature that also protects companies against early withdrawals by adjusting the value of a withdrawal or surrender according to changes in interest rates. The MVA may have a positive or negative impact on the value of the withdrawal amount depending on the level of interest rates. Fixed annuities can be compared to a higher yielding, less liquid CD.

Economics: Profitability Driven by Yield CurveThe shape of the yield curve is a primary driver of earnings for fixed annuities. Insurers target a spread (usually about 150-225 basis points) between the rate credited to customers and the yield generated on assets backing the contract. Since assets for spread products are generally tightly matched with liabilities, the absolute level of29



interest rates does not generally affect earnings for fixed annuities. The shape of the yield curve is more important to spread product earnings since crediting rates generally track short-term rates while investment yields move more closely with intermediateterm rates. The absolute level of interest rates is only relevant for spread products when investment yields approach state-mandated minimum crediting rates on a given product. However, most states recently approved reductions in minimum crediting rates for fixed annuities (to 1.5-2% from 3%), the main insurance product with minimum rates. Persistency is another key driver of fixed annuity profitability. Insurers are exposed to rising withdrawals when interest rates are climbing, as policyholders withdraw their funds to seek higher-yielding alternatives. MVAs protect insurers against heavier withdrawals, although low persistency generally still hurts FA profitability. In the case of much heavier than expected withdrawals, companies may be forced to unlock DAC (deferred acquisition costs) associated with FAs to reflect the lower profitability. Companies are partially protected against early withdrawals by surrender charges and MVA features.

Distribution: Relationships and Crediting Rates KeyBank distribution has become increasingly important for fixed annuities, but also increasingly competitive. Because fixed annuities are relatively simple products, they have sold relatively well through banks, where salespeople are relatively unfamiliar with insurance products. Their conservative customer base also makes them an attractive target for FA sales. However, getting shelf space in the channel has become increasingly difficult and expensive, as more and more companies have entered the market. The bank channel accounted for 36% of fixed annuity sales in 2002, up from 21% in 1995. Approximately 40% of all fixed annuities are sold through independent agents, which continue to account for the largest portion of fixed annuity sales. Other FA distribution channels include stockbrokers (7%), other channels

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