JPM - Insurance Primer

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North American Equity Research New York 14 January 2004

Life Insurance Industry Primer A 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.

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

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

Scott Woodcock, CFA 1-212-622-6652 [email protected]

• 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 Coverage—Overweight Rated Stocks 01/13/2004

EPS

EPS

P/E

P/E

Ticker Company

Price

'03E

'04E

02-03E

03-04E

2003E

2004E

P/BV

ROE

AIG

69.49

$3.87

$4.50

14.5%

16.3%

18.0

15.4

2.7

16.6%

AIG

EPS Growth

NTM

HIG

Hartford Financial

62.41

$5.16

$5.85

11.0%

13.4%

12.1

10.7

1.6

14.3%

LNC

Lincoln Financial

40.92

$3.17

$3.53

24.8%

11.4%

12.9

11.6

1.3

11.0%

PRU

Prudential Financial

42.17

$2.55

$3.15

20.3%

23.5%

16.5

13.4

1.1

7.6%

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 Contents Investment 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.

2

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

North American Equity Research New York 14 January 2004

Investment Thesis: Back on Track With 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 Points The 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 both 3

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

North American Equity Research New York 14 January 2004

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 we 4

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

North American Equity Research New York 14 January 2004

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

Risks to Our Thesis A 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 Analysis—Hartford We 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 Target—Hartford We 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 Analysis—Prudential We 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 PRU’s 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

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

North American Equity Research New York 14 January 2004

Risks to Our Rating and Price Target—Prudential While 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 Universe Ticker Company AFL AFLAC

1/12/03 Price $35.39

JPM Rating UW

EPS 03E $1.88

EPS 04E $2.15

EPS Growth '03-04E 14.4%

P/E 2003E 18.8

P/E 2004E 16.5

P/BV 2.7

NTM ROE 16.0% 16.6%

AIG

AIG

70.50

OW

$3.87

$4.50

16.3%

18.2

15.7

2.7

HIG

Hartford Financial

62.69

OW

$5.16

$5.85

13.4%

12.1

10.7

1.6

14.3%

JP

Jefferson-Pilot

49.38

UW

$3.57

$3.83

7.3%

13.8

12.9

1.8

13.8%

JHF

John Hancock

39.44

N

$3.13

$3.37

7.7%

12.6

11.7

1.4

11.7%

LNC

Lincoln Financial

41.33

OW

$3.17

$3.53

11.4%

13.0

11.7

1.3

11.0%

MFC

Manulife Financial

33.83

N

$2.34

$2.65

13.2%

14.5

12.8

2.4

18.3%

MET

MetLife

32.63

N

$3.01

$3.10

3.0%

10.8

10.5

1.2

11.0%

NFP

National Financial Partners

30.25

N

$1.68

$1.86

10.7%

18.0

16.3

2.1

12.0%

NFS

Nationwide

34.43

N

$2.88

$3.15

9.4%

12.0

10.9

1.1

9.3%

PFG

Principal Financial

32.32

N

$2.26

$2.67

18.1%

14.3

12.1

1.4

9.9%

PL

Protective Life

33.97

UW

$2.74

$2.97

8.4%

12.4

11.4

1.2

10.1%

PNX

Phoenix Cos.

13.04

UW

$0.57

$0.69

21.1%

22.9

18.9

0.6

3.1%

PRU

Prudential Financial

42.26

OW

$2.55

$3.15

23.5%

16.6

13.4

1.1

7.6%

RGA

Reinsurance Group

38.34

N

$3.24

$3.65

12.7%

11.8

10.5

1.3

12.2%

TMK

Torchmark

45.45

N

$3.86

$4.25

10.1%

11.8

10.7

1.6

14.9%

UNM

UnumProvident

15.75

UW

$1.70

$1.78

4.7%

9.3

8.8

0.6

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.

6

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

North American Equity Research New York 14 January 2004

Primer Summary This 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 product’s 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 Tools In the appendices of the report, we have created valuable resource tools covering earnings, distribution, products, and key insurance terms. 7

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

North American Equity Research New York 14 January 2004

Macro Earnings Drivers Interest 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 Sensitivity We 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.

8

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

North American Equity Research New York 14 January 2004

Interest Rate Sensitivity Approximately 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 Curve Spread 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 Income Risk 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 Sensitivity

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

Insurers 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.

9

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

North American Equity Research New York 14 January 2004

How to Make Money in the Sector Understanding 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 Names HIG, LNC, AIG, PRU, NFS, PFG, and PNX are equity market sensitive stocks.

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

10

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.

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

North American Equity Research New York 14 January 2004

• 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 Names JHF, MET, MFC, and UNM are credit-sensitive names.

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

Βuy 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 Names AFL, 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.

11

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

North American Equity Research New York 14 January 2004

Life Insurance Success Factors Companies 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 Distribution Distribution 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 Name A 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 Strategy Company investment exposure by class is discussed in the invested assets section on page 65.

12

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 Mix A 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 Efficiencies Due to the modest top-line growth for many insurance products, an insurer’s 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.

13

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North American Equity Research New York 14 January 2004

Effective Use of Capital Using 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 Scorecard Efficiency

Effective use of Capital

Prudent Investors

Broad-based distribution

Diverse business mix Brand name

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

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

14

Average

Weak

Valuation

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Distribution Highly 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 Channels Investment 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

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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.

Banks Banks 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 $49.1

$50 $38.1

($ billions)

$40

$37.1 $38.5

$31.0 $26.4

$30 $20

$18.1 $12.3 $13.5

$14.2

$17.2

$19.3 $19.7

$10 $0 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 9M02 9M03 Source: The Kehrer Report and JPMorgan calculations.

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 of 16

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North American Equity Research New York 14 January 2004

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 Channels Captive 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 Channels The 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 product’s 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 Matrix Channel

Products

Market

Sold

Penetration

Stage

High Moderate Low Low

Mature Developing Nascent Nascent

Agent Led Life, Annuities, Supplemental Investment Dealer Annuities, GICSs Bank Fixed Annuities Direct Term Life, Supplemental

Development

Source: JPMorgan.

17

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North American Equity Research New York 14 January 2004

Historical Perspective Changes 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 Protection Insurance 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 Channels Traditionally, 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 Metrics When 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 Growth The life industry’s 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 Sector 2 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.

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Figure 3: P/E vs. Growth Rate 21.0 AFL

Price / Earnings Ratio 2003

19.0 AIG

17.0

PRU

NFP

SCT

PFG

15.0

JP

NFS

SLF LNC

RGA SFG MET HIG

JHF 11.0

DFG

PL

13.0

MFC

TMK

(-1.1%, 11.5) UNM (-14.1%, 9.5)

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 industry’s 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 Declining 20.0

Period 3

18.0

Period 1

R2=0.36

Period 4

2

R =0.69

R2=0.11

16.0

14.0

12.0

Period 2

10.0

R2=0.81

8.0 1/94

1/95

1/96

1/97

1/98

1/99

Actual P/E

1/00

1/01

1/02

1/03

1/04

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

North American Equity Research New York 14 January 2004

Figure 5: Life Industry P/BV Ratio Has Averaged 1.8 Times 2.6 2.4

P/BV ex. FASB115

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

1/99

P/BV

1/00

1/01

1/02

12/03

1/03

P/BV ex. 115

Source: Company reports and JPMorgan estimates.

Price to Book Value Relative to ROE Life 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 ROE AFL

2.7

AIG MFC 2.3

Price / Book Value

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NFP

1.9 SLF 1.5

DFG PL MET

NFS

PLFE

0.3 0.5%

HIG TMK

LNCJHF RGA

PRU 1.1

0.7

SFG

PFG

JP

SCT

AMH

PNX

MNY

UNM

2.5%

4.5%

6.5%

8.5%

10.5%

12.5%

14.5%

16.5%

18.5%

Next Twelve Months Return on Equity

Source: Company reports and JPMorgan estimates.

Embedded Value While 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 insurance 21

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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 Annuities Overview In 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 Statistics Return 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 Description The 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 ½.

Economics: Equity Market Drives Profits Revenues 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 minimum 23

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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 insurer’s 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 Success The breadth and depth of the distribution network is a key driver of a company’s 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

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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 Importance 40% 35% 30% 25%

1996

20%

3Q03

15% 10% 5% 0% Direct response

Bank/credit union

NY wirehouse Regional firms

Independent NASD

Captive Agency

Source: VARDS.

Concentrated Market The level of sales and assets are both relevant measures of a company’s standing in the VA market. New sales indicate the company’s 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 of 25

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

North American Equity Research New York 14 January 2004

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

3Q02

3Q03

% Change

3Q02 Mkl. Sh.

3Q03 Mkt. Sh.

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

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

65.3% -8.8% 95.4% 67.3% 26.1% 51.7% 11.7% 0.0% 5.1% 11.1%

8.56% 11.93% 5.27% 5.36% 6.57% 3.68% 4.94% 4.48% 3.58% 3.14%

12.68% 9.75% 9.24% 8.04% 7.42% 5.00% 4.95% 4.01% 3.37% 3.13%

Top 10 Companies Top 25 Companies

16,154.9 24,710.1

21,185.4 29,376.6

31.1% 18.9%

57.50% 87.95%

Total Companies

28,095.5

31,339.9

11.5%

100.00%

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

bp Change

9M02

9M03

% Change

412 (217) 396 268 86 132 1 (46) (21) (1)

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

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

68.9% 3.0% 84.4% 61.6% 2.4% 52.4% 2.0% 0.9% -9.8% 5.7%

67.60% 93.74%

1,010 579

47,912.1 72,543.2

61,154.0 87,470.8

27.6% 20.6%

100.00%

0

82,901.3

93,109.6

12.3%

Source: VARDS and JPMorgan calculations.

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

9/30/02 Assets

9/30/03 Assets

% Change

9/30/02 Mkt. Sh.

9/30/03 Mkt. Sh.

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

225,088 59,135 48,353 34,385 29,417 34,918 32,487 29,145 22,695 22,057

260,725 76,894 58,671 39,972 40,831 38,877 38,737 35,161 36,684 27,666

15.8% 30.0% 21.3% 16.2% 38.8% 11.3% 19.2% 20.6% 61.6% 25.4%

29.74% 7.81% 6.39% 4.54% 3.89% 4.61% 4.29% 3.85% 3.00% 2.91%

28.66% 8.45% 6.45% 4.39% 4.49% 4.27% 4.26% 3.86% 4.03% 3.04%

Top 10 Companies Top 25 Companies Total Industry Assets

537,682 701,419 756,734

654,217 856,416 909,761

21.7% 22.1% 20.2%

71.05% 92.69% 100.00%

71.91% 94.14% 100.00%

Source: VARDS and JPMorgan calculations.

26

bp Change

6/30/03 Assets

Seq % Change

(109) 64 6 (15) 60 (34) (4) 1 103 13

253,580 72,184 54,946 38,869 37,931 37,854 37,563 34,359 34,262 26,700

2.8% 6.5% 6.8% 2.8% 7.6% 2.7% 3.1% 2.3% 7.1% 3.6%

86 145 0

628,247 822,137 880,091

4.1% 4.2% 3.4%

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

North American Equity Research New York 14 January 2004

Market Size: Recent Growth Held Back by Equity Market Sharp 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

Table 7: Historical Variable Annuity Gross Sales - Annual

$ in billions

$ in billions 1,600

$130

1,400

$110

1,200

1,000 $70 800 $50

'(S&P 500)

(Variable Annuity Sales)

$90

600 $30

400

$10

200

-$10

0 1991

1992

1993

1994

1995

1996

1997

Total Industry Sales

1998

1999

2000

2001

2002

2003E

S&P 500

Source: VARDS and JPMorgan.

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

Year 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 9M2003

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%

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 billions 60.0

52.8

52.1

49.1

50.0 41.4

40.0

38.7

35.3

32.8

32.7

30.0

22.5

20.0

19.4 15.5

10.0 0.0 1994

1995

1996

1997

1998

1999

2000

2001

2002

9M02

9M03

Source: VARDS and JPMorgan. 27

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

North American Equity Research New York 14 January 2004

Outlook: Stronger Sales and Earnings While 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.

28

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

North American Equity Research New York 14 January 2004

Product Capsule: Fixed Annuities Overview Fixed 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 company’s ability to generate spreads is a function of the interest rate environment (primarily the shape of the yield curve) and the company’s investment prowess. Companies set their crediting rates based on their desired spreads, which in turn drives what level of sale they generate.

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

Product Description Fixed 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 ½. 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 Curve The 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 of 29

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

North American Equity Research New York 14 January 2004

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 Key Bank 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 (7%), and direct response (1%). Figure 10: Comparison of Fixed Annuity Distribution Channels 1995-2002 2002

1995 Other 3%

Other 7%

Stockbrokers 10%

Direct Response 1%

Career Agents 27%

St ockbrokers 7%

Career Agent s 12%

Direct Response 1%

Banks 21% Independent Agents 38%

Source: LIMRA.

30

Banks 36%

Independent Agents 37%

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

North American Equity Research New York 14 January 2004

Leading Players: A Fragmented Market The market for fixed annuities is relatively fragmented, with dozens of smaller players. The top 10 fixed annuity companies account for about half of industry sales, and over 100 insurers offer fixed annuities. Major players within the fixed annuity market include AIG, AEGON, GE Financial, and ING. In our coverage universe, major fixed annuity writers include Nationwide Financial, Lincoln, and Hartford. Table 8: Leading Players in the Fixed Annuity Market $ in millions Company AIG AEGON USA Allianz Life NA Allstate Financial ING Cos. Jackson National Life Fidelity & Guarantee Life GE Financial Assurance New York Life John Hancock Industry

2002 Sales 11,189.7 6,931.1 6,243.3 5,130.6 4,787.2 4,409.4 4,026.2 3,962.0 2,933.0 2,861.6

Market Share 10.8% 6.7% 6.0% 5.0% 4.6% 4.3% 3.9% 3.8% 2.8% 2.8%

103,300.0

Source: LIMRA.

Market Size Sales of fixed annuities more than tripled over the period from 1998 to 2002 to $103.8 billion in 2002, driven by consumer demand for fixed returns as a result of the sharp equity market decline. The most recent sales from the first quarter of 2003 were $23.9 billion, 8.1% over the $22.1 billion from the first quarter of 2002. Figure 11: Total Fixed Annuity Sales from 2000 to 3Q03 $ in billions 120 103.8

100 74.3

80

65.8

60

52.7

40 20 0 2000

2001

2002

9M2003

Source: LIMRA.

Outlook •

A parallel shift in the yield curve should allow companies to increase fixed annuity sales, although spreads and sales may be hurt if the yield curve flattens. The rise in rates in the second half of 2003 and regulatory relief (lowering minimum crediting rates) removed pressure against minimum rates and allowed companies to increase their sales of fixed annuities from 31

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

North American Equity Research New York 14 January 2004

depressed levels in the first half of 2003. A parallel rise in rates would provide further room above minimum rates and further support sales. Still, spreads may come under pressure in the event of sharply higher rates accompanied by a flattening of the yield curve, which may occur sometime in 2004. If the yield curve flattens significantly, preventing companies from achieving targeted spreads, companies may pull back on sales of fixed. •

32

If equity market performance remains solid, consumer preference is likely to continue to shift to variable products, resulting in weaker sales and higher withdrawals for fixed annuities.

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

North American Equity Research New York 14 January 2004

Product Capsule: Equity-Indexed Annuities Overview While blending features of fixed and variable annuities, we believe equity-indexed annuities are likely to remain a relatively less important product. Equity indexed annuities offer fixed returns similar to a fixed annuity and participation in the equity market similar to a variable annuity, but a greater level of risk to the insurer than either of those products. We believe it is likely that difficulty in hedging this risk is likely to be a barrier to growth in the equity-indexed annuity market. While recent growth in equity-indexed annuity sales has been strong, we also do not believe consumers are ultimately likely to prefer them to fixed annuities (a simpler product) or variable annuities (a more flexible product).

Key Statistics Return on Equity: 10-12% Forecast Long-Term Earnings Growth Rate: 9-11% Typical Commission Structure: 7-9% of deposits

Product Description Equity indexed annuities guarantee a fixed return and an additional return based on the performance of an equity market index (usually the S&P 500 Index). The return credited to the policyholder based on the index (known as the participation rate) can be based on a variety of crediting methods, including a percentage of the maximum anniversary value of the index, the annual performance of the index, or the multi-year average performance. The amount credited based on the index’s performance is generally capped at about 7-8%. As with other annuities, the IRS assesses a 10% penalty, in addition to tax, if funds are withdrawn from a variable annuity before age 59 ½.

Economics: Product Design, Hedging Important Investment risk inherent in equity-indexed annuities makes careful product design and risk management important. As with fixed annuities, the insurer bears the investment risk for equity-indexed annuities, and the majority of assets backing the annuities are invested in fixed maturity securities. The guarantee linked to the equity market essentially creates short equity market exposure, which companies hedge against by investing in call options with a small amount of the capital backing the annuities. The ultimate exposure to the index to the insurer depends on the crediting method and cap. Since the short equity market exposure could easily eat through the spread earned relative to the fixed rate guarantee (generally about 150-200 basis points), hedging and controlling this exposure is a key driver of the ultimate profitability of equity-indexed annuities. Companies attempt to incorporate the costs of hedging in pricing for the product.

Distribution: Agent’s Alternative to VAs In our view, equity-indexed annuities are generally sold by companies lacking access to NASD-licensed distribution personnel. Since the product is essentially a fixed annuity, distributors do not need to be NASD-licensed to sell them, although equity-based crediting methods make the product somewhat similar to variable annuities. We believe that the equity indexed product is primarily offered by companies that are not well positioned in the variable annuity market because of their 33

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

North American Equity Research New York 14 January 2004

lack of access to NASD-licensed distribution or appropriate technology or service required to participate in that market. The product typically is sold by agents who are not licensed to sell variable annuities and mutual funds but want to sell equity-linked products.

Leading Players: A Few Key Companies A niche product, equity-indexed annuities are dominated by relatively few competitors. While about 30 companies offer equity-indexed annuities, the top five companies hold 60% share of the market, and Allianz Life alone accounted for over a third of the market. Table 9: Top Sellers of Equity-Indexed Annuities $ in millions 3Q02 Rank 1 5 3 20 2 10 7 9 16 6

3Q03 Rank Company 1 2 3 4 5 6 7 8 9 10

3Q02

3Q03

% Change

3Q02 Mkt. Shr.

3Q03 Mkt. Shr.

981.6 159.5 407.7 15.0 737.5 47.7 116.4 73.2 31.0 142.7

920.6 391.7 365.1 160.7 159.9 130.5 104.1 102.1 91.0 89.3

-6.2% 145.5% -10.5% 971.2% -78.3% 173.7% -10.6% 39.6% 193.8% -37.4%

29.53% 4.80% 12.27% 0.45% 22.18% 1.43% 3.50% 2.20% 0.93% 4.29%

29.05% 12.36% 11.52% 5.07% 5.05% 4.12% 3.28% 3.22% 2.87% 2.82%

Top 10 Companies Top 25 Companies

2,712.3 3,296.3

2,515.1 2,899.3

-7.3% -12.0%

81.59% 99.15%

Total Industry Sales

3,324.4

3,169.1

-4.7%

100.00%

Allianz/LifeUSA AmerUS Life American Equity Investment Life National Western Life Midland National Fidelity and Guaranty/St. Paul Jackson National Life ING/ReliaStar Allstate Sun Life/Clarica

bp Change

9M02

9M03

% Change

(48) 756 (74) 462 (1,714) 268 (22) 102 194 (147)

2,295.5 462.2 1,186.2 29.0 1,664.8 118.3 320.4 182.4 93.9 334.7

3,309.2 990.4 820.5 354.1 508.2 395.9 275.9 342.8 209.0 381.2

44.2% 114.3% -30.8% 1121.1% -69.5% 234.7% -13.9% 87.9% 122.6% 13.9%

79.36% 91.49%

(222) (767)

6,687.4 8,144.5

7,587.2 9,093.0

13.5% 11.6%

100.00%

0

8,244.8

10,135.3

22.9%

Source: The Advantage Group and JPMorgan calculations.

Market Size: Rapidly Growing, but A Niche Market Equity indexed annuity sales have experienced rapid growth recently, but the market remains small. Sales of equity indexed annuities nearly doubled to $11.7 billion in 2002. Despite this rapid growth recently, sales of equity-indexed annuities remain small relative to fixed or variable annuities.

34

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

North American Equity Research New York 14 January 2004

Figure 12: Annual Equity-Indexed Annuity Sales $ in millions $12,500

$11,674

$10,500 $8,500 $6,471

$6,500 $5,157

$5,372

1999

2000

$4,109

$4,500 $2,559 $2,500 $500 1997

1998

2001

2002

Source: The Advantage Group and JPMorgan estimates.

Outlook: Market Likely to Remain Small While strength in the equity market may increase interest in equity-indexed annuities, we believe challenges in product design and the greater appeal of variable annuities will likely limit the ultimate growth potential of equity-indexed annuities. •

Sales of equity-indexed annuities could benefit from interest from conservative investors who still want equity market exposure. Recent equity market strength is likely to increase interest in the product, since it offers participation in equity market gains, particularly with customers that are unconvinced regarding the direction of the equity market and wish to maintain a defensive stance.



Still, we believe the market for equity-indexed annuities is likely to remain modest. Given what we view as the greater appeal of variable annuities (due to their greater flexibility) and the difficulty in hedging the risks associated with equity-indexed products, we believe they are likely to remain a niche product.

35

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

North American Equity Research New York 14 January 2004

Product Capsule: GICs, Funding Agreements (FA) Overview GICs and funding agreements can generate solid returns, but GICs are relatively mature and funding agreements are newer with opportunistic growth prospects. Companies with skill at managing spreads can achieve ROEs in the mid-teens for GICs and funding agreements, making this an attractive market for some companies. Due to intense competition and varying demand from end users (investors in money market and stable value funds and other fixed-return investors), however, sales for these products are unlikely to grow over 10% on a normalized basis. GICs and funding agreements are capital intensive, and companies are limited in how much GIC and funding agreement business they can write. Liquidity is also a major concern for buyers of both GICs and funding agreements, given the put features offered on many of these types of products. Put features allow the contract holder to immediately (or within a few days) receive their principal, which can cause a liquidity crisis if many contract holders exercise their puts at once. The structure of GICs also poses the potential for disintermediation as large blocks of business mature. For these reasons, rating agencies generally limit the contribution of GIC/funding agreement businesses to a company's total earnings. However, ratings agencies view retail notes, which are funding agreement-backed notes issued in small denominations and sold to retail investors, as less risky since they are spread among a wider investor base. Companies selling retail notes include John Hancock and Protective Life.

Key Statistics Return on Equity: 10-12% Forecast Long-Term Earnings Growth Rate: 8-10% Typical Commission Structure: Varies

Product Description Guaranteed investment contracts (GICs) are fixed rate investments, backed by the general account offered by insurance companies that guarantee a rate of return on assets for a fixed period and payment of principal and accumulated interest at the end of the period. GICs can be seen as an institutional fixed annuity. GICs are typically used to fund defined contribution plan stable value funds and generally have terms of three to five years. Synthetic GICs are GICs backed by the separate account. GICs are generally purchased by qualified investors such as defined benefit plan sponsors. They are often used to back a stable value retirement fund options. Funding agreements (FAs) are large (generally over $100 million) investment contracts, similar to bonds, sold to non-qualified fixed income investors. Segments of the funding agreement market include European Medium Term notes (EMTNs), Global Medium Term Notes (GMTNs), and money market. Companies have also begun selling retail notes backed by funding agreements, which are sold in denominations as small as $1,000 and maturities ranging from two to 10 years and which are not as capital intensive as funding agreements. Funding agreements are purchased by institutional fixed income investors, both domestic and international. Money market funds purchase about 20% of funding agreements issued. 36

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

North American Equity Research New York 14 January 2004

Economics: Spread Management Is Key Skill at spread management is vital to generating earnings from GICs and funding agreements. Earnings for GICs and FAs are generated by maximizing the spread between the crediting rate (the rate paid to the GIC or FA holder) and the investment income on the assets backing the GIC or FA. Spreads for GICs are generally 100-200 basis points. Crediting rates are set primarily by the competitive environment, so maximizing investment yield while not taking on undue liquidity or credit risk is the key driver of profitability for these products. Solid credit ratings (AA and above on the Standard & Poor’s scale) and liquidity are vital to success in the GIC and FA markets. GICs and funding agreements represent a claim on the assets of the insurer and are not (except in the case of some synthetic GICs) bankruptcy remote. Because of the failure of several insurers selling GICs in the late 1980s (due to negative spreads, losses on below investment grade bonds and excessive rate guarantees), buyers of GICS now tend to be extremely sensitive to the ratings of the issuing insurer. Also, overexposure to products with put features caused the demise of General American, as the company was not able to satisfy the large numbers of customers exercising their puts. Managing the credit and liquidity risks associated with GICs and funding agreements is a key success factor in this market.

Distribution: Driven by Relationships Wholesale products, sales of GICs and funding agreements are dependent on relationships with institutional customers. Dedicated sales teams of salaried employees generally handle the sale of GICs, which are also sold through benefits brokers and consultants. Funding agreements are sold through investment banks and specialized salaried salespeople, although retail notes are sold to retail investors primarily through broker/dealers.

Leading Players: Ratings Matter The leading sellers of GICs and funding agreements tend to be highly rated insurers with a competence in asset/liability management. AIG is a leading player in the GIC and funding agreement market and the only AAA-rated company among the largest issuers of GICs/funding agreements. Other major writers of GICs and funding agreements include Principal Financial, John Hancock, Nationwide, and Protective Life.

Market Size: Large, Slow-Growth Both GICs and funding agreements compose fairly large markets, whether viewed by sales or assets. According the Stable Value Investment Association, sales of GICs and synthetic GICs totaled $74 billion in 2002, while sales of funding agreements were $41 billion. At year-end 2002, SVIA estimates there were over $300 billion of GIC and synthetic GIC assets and over $100 billion in funding agreement assets. Synthetic GICs form the largest and fastest growing part of the guaranteed investment contract market, while foreign issued and global notes dominate the funding agreement market.

Outlook Earnings of GICs and funding agreements should benefit in the near term from the steep interest rate environment, although in the long term, competition and modest demand are likely to limit the market’s growth. 37

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

38

North American Equity Research New York 14 January 2004



Sales of both GICs and funding agreements are likely to remain modest in the near term, driven by intense pricing competition and the low interest rate environment. Demand may also be negatively impacted by a consumer shift out of stable value funds and fixed-return options into equities.



Earnings for GICs and funding agreement are vulnerable to a flattening of the yield curve, although a parallel rise in rates could help. GIC and funding agreement earnings generally benefit from a steeper yield curve, and earnings for these products would likely suffer in the event of a yield curve flattening.



Retail note programs, a relatively new product, have substantial growth potential. While still relatively small, funding agreement-backed retail note programs represent a potential growth market for funding agreements. John Hancock and Protective Life currently offer retail notes.

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

North American Equity Research New York 14 January 2004

Product Capsule: Universal Life Overview Universal life has become an increasingly important product given the slow growth in the traditional life market and challenges with the variable life product. Companies have relied on sales of universal life to offset weak sales of variable life, which have been dented by weakness in the equity market, changes in the estate tax regime and distribution and product complexity challenges. Companies that did not traditionally offer UL have also begun to target the market. UL is likely to remain a key focus for insurers, given challenges facing the VL market and low margins for traditional life products.

Key Statistics Return on Equity: 10-12% Forecast Long-Term Earnings Growth Rate: 8-11% Typical Commission Structure: 80-90% of first-year premiums, sometimes in addition to a percentage of asset management fees.

Product Description Capital requirements for nolapse guarantees for UL will increase under Regulation AXXX. See page 99 for more details on AXXX.

Universal life is permanent life insurance that accumulates a cash value at a credited interest rate (which is generally reset periodically by the insurer). Unlike traditional whole life insurance, UL allows the policyholder the flexibility to change the death benefit and the timing and amount of premiums. In addition the cash account is not credited a fixed rate but a rate that varies with interest rates, subject to a 3-4% minimum rate. UL is also sold as second-to-die or survivorship policies, which are less expensive joint policies paying a death benefit in the event of the death of the second of two insureds. Such policies are typically used in estate planning. Universal life appeals to more conservative consumers who favor fixed returns.

Economics: Underwriting, Spreads Drive Earnings Underwriting discipline is a key driver of UL profitability. Since death benefits are the most substantial expense associated with UL policies, skillful underwriting of this mortality risk is one of the main determinants of profitability for this business. Companies that are better at assessing risk and underwriting profitable risk generally should have lower benefits expenses relative to premiums than other companies. Spread management is another driver of profitability for universal life. Spread income, generally about 150-200 basis points on general account assets associated with UL business, is another component of UL profitability. UL spreads had been under pressure due to the sharp decline in interest rates in early 2003, which pushed investment yields closer to minimum crediting rates (generally about 3-4%). Spreads would benefit from a parallel rise in interest rates, although a flattening of the yield curve could hurt spreads and earnings. UL surrenders may increase modestly as a result of the stronger equity market, although uncertainty regarding the state of the economy and the “stickiness” of UL assets should prevent a major spike in withdrawals. Given slow top-line growth potential, scale, and efficiency are also important drivers of UL earnings. Since top-line growth is unlikely to exceed 3-5% in most 39

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North American Equity Research New York 14 January 2004

cases, driving down operating costs as a percentage of premiums is important for generating earnings growth for UL.

Distribution: Primarily Traditional Channels UL is sold primarily through traditional channels, with modest penetration of alternative channels due to licensing requirements. UL is sold through captive and independent agents, investment dealers, and banks. Agent-led channels account for the bulk of UL sales, and while sales through alternative channels such as broker/deals and banks have been growing, selling through this channel is difficult due to the requirement of an insurance license.

Leading Players New York Life, ING, Jefferson Pilot, and Aegon are among the largest sellers of universal life. Among our coverage companies, AIG, Jefferson Pilot, Manulife and MetLife are among the largest sellers of universal life.

Market Size: A Key Insurance Product Universal life is among the top-selling insurance products and has outpaced variable life in recent periods. UL accounted for roughly a third of life insurance sales in 2002 (not including annuities and other life products), more than any other life product and higher than variable life for the first time since the strong equity market in the late 1990s. UL accounts for a smaller portion of insurance in force. According to the ACLI, there were 24.4 million universal life policies in force in 2000, with $1.9 trillion of insurance in force, representing about 13% of all insurance in force.

Outlook: Strong Near-Term Growth Universal life sales should continue to be strong, although spreads may be vulnerable in case of a flattening of the yield curve. Longer term growth is likely to be modest, however, due to increased competition and a recovery in the equity market.

40



Companies will likely continue to emphasize sales of UL, which has been partially compensating for sharply weaker sales of variable life in 2003. Consumer demand for some form of guarantee continues to be a major driver of UL sales. The rise in interest rates in the second half of 2003 relieved pressure on minimum crediting rates for universal life, which tend to be higher than fixed annuities (about 4% on average). Still, as with other spread products, earnings for UL would likely come under pressure in the event of a rapid rise in rates accompanied by a flattening of the yield curve.



Increased competition is likely to limit sales and earnings growth potential for this market, however. A number of companies have recently entered the UL market, as companies that had focused on variable life are shifting their focus to universal life. The increased level of competition is likely to limit growth and profitability of the product going forward.



A recovery in the economy and the equity market is likely to hurt demand for UL, as consumers shift away from fixed-return products to equity linked products such as variable life.

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

North American Equity Research New York 14 January 2004

Product Capsule: Whole Life Overview Traditional whole life accounts for a large percentage of life insurance in force, but is being eclipsed by newer types of insurance. The primary life insurance product until the introduction of universal life in the late 1970s, whole life insurance is slowly on the wane in terms of importance to the life industry. While mutual insurers still sell whole life, demutualized companies and stock companies do not emphasize the product due to its low ROE (due to expensive product features and heavy capital requirements). Still, many companies continue to sell the product and have substantial amounts of whole life on their books, which generally generate modest returns.

Key Statistics Return on Equity: 3-8% Forecast Long-Term Earnings Growth Rate: 3-4% Typical Commission Structure: 80-100% of the first-year premiums.

Product Description Whole life is permanent insurance with a level annual premium over the life of the policy and a fixed death benefit. Whole life can be used as a savings vehicle since policies accumulate a cash balance related to premiums and a fixed interest crediting rate. Whole life policies are typically participating, where the policyholder shares in the profits of the policy and are paid dividends in addition to fixed crediting rates. Since returns are fixed, the product appeals to more conservative consumers. Many policies in force today were purchased at a time when no other types of insurance were available.

Economics: Expense Saves Are Key Given modest top-line growth for whole life, expense reductions are one of the few ways to generate earnings growth for whole life. As with other insurance products, insurers earn investment income on reserves backing whole life policies and mortality charges for the cost of insurance. Sales and premium growth for whole life are generally low, resulting in modest growth in reserves and premiums in force. One of the few remaining ways for companies to grow earnings for whole life blocks is to reduce operating expenses to increase margins. Underwriting discipline is another driver of whole life profitability. Since death benefits are the most substantial expense associated with whole life policies, skillful underwriting of this mortality risk is one of the main determinants of profitability for this business. Companies that are better at assessing risk and underwriting profitable risk generally should have lower benefits expenses relative to premiums than other companies. Whole life is a capital intensive product, which also depresses returns. The high level of reserves that must be held against whole life policies depresses ROEs for the product. For this reason, public companies often segregate whole life policies to closed blocks (blocks of business that are not being added to and that run off over time) and their results reported separately.

41

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

North American Equity Research New York 14 January 2004

Distribution: Led By Agents Agent-led channels have been the dominant distribution outlet for whole life, not surprising given the large presence of mutual insurers (which often emphasize distribution through agents) in the product. Agent led channels should continue to drive sales given the channel’s focus on life products and dedicated marketing strategy.

Leading Players: Established Companies Dominate Since whole life is an older product, the whole life market is dominated by established companies that have a long operating history. Mutual insurers, including Northwestern Mutual, New York Life, and Mass Mutual, have a significant presence in this market. Among public companies, AIG, Prudential, and ING are the leading players, although public insurers typically do not sell large quantities of whole life and often carry their in-force block of policies in a closed block (a block of policies that is not added to that runs off over time). Whole life is not a highly concentrated market, as the top 10 companies make up 52% of the market.

Market Size: Large, but Growth Is Slow Whole life dominates insurance in force, but new sales have been declining over time. Measured by insurance in force, traditional whole life accounted for 22.8% of insurance in force as of 2000, the predominant type of permanent insurance (including universal and variable life) by this measure. New sales of whole life, while still substantial, have been declining steadily over time with the introduction of more innovative and flexible types of insurance. We expect premiums to experience only modest growth going forward as insurers continue to emphasize the sale of other products over whole life.

Outlook: Modest Growth Expected Traditional whole life is likely to experience modest growth in sales and earnings as companies emphasize products with higher returns such as variable and universal life.

42



Given continued modest top-line growth, expense saves should continue to be an important driver of earnings growth for whole life businesses. Since few insurers emphasize sales of whole life, preferring products with better returns such as universal and variable life, sales of whole life are likely to continue to grow modestly, at best.



Public companies with large blocks of whole life policies may seek to free up capital associated with these blocks through reinsurance transactions. Capital freed up in this way can be re-deployed in higher return businesses.

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

North American Equity Research New York 14 January 2004

Product Capsule: Term Life Overview Term life is widely available and commodity-like, and is not a major driver of earnings growth for most companies. The market for the product is highly competitive, forcing companies to price products aggressively, ultimately lowering margins and returns. To compete effectively in the term life market, companies need to focus intensely on costs, and companies that are most effective at driving down costs and increasing efficiency are most likely to succeed. Since it is a simple product, term life is more widely distributed through online and electronic channels than other insurance products.

Key Statistics: Return on Equity: 9-11% Forecast Long-Term Earnings Growth Rate: 5-7% Typical Commission Structure: The first-year commission for term life insurance is usually 50% of the first year’s premium. The second- through 12th-year commission is usually 3–5% of the annual policy premium.

Product Description Term life provides life coverage for a defined period of time with no cash accumulation features or other benefits once the term expires. The policyholder has the option to renew the coverage at the end of the term, but if coverage lapses no payment is made to the insured in the event of death. Additionally, if the customer does not die in the term covered by the policy, beneficiaries receive nothing. The premiums for term life are substantially less than those of permanent life (whole, universal, variable life) for the same face amount of coverage, although upon renewal premiums increase to reflect the beneficiary’s age and higher mortality risk. The most popular type of term life insurance is level term, which has a fixed premium throughout the term of the contract. Because of the lower premiums for a given face value (compared with permanent insurance), term life appeals to several groups: middle to lower income families and younger families, who prefer the lower prices, and sophisticated, affluent individuals who prefer to hold their investment portfolios separate from insurance may also prefer less expensive term life to investment-oriented policies.

Economics: Efficiency Essential Keeping expenses low is key to generating earnings on term life. Insurers generate premium income and investment income on reserves associated with term policies. Premiums for term life vary widely and depend on the age and health of the policyholder and the length of the term. Due to the competitive nature of the market, term is priced to generate a relatively low margin relative to other insurance products. Keeping operating expenses as low as possible and constantly seeking to increase efficiency is the only way to generate earnings growth and moderate returns from term life business. Underwriting discipline is another driver of term life profitability. Since death benefits are the most substantial expense associated with term life policies, skillful underwriting of this mortality risk is one of the main determinants of profitability for 43

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North American Equity Research New York 14 January 2004

this business. Companies that are better at assessing risk and underwriting profitable risk generally should have lower benefits expenses relative to premiums than other companies. Although less than other types of insurance, term life is becoming increasingly capital intensive, depressing returns. Regulation XXX increased the level of capital that must be held to back term life policies. While the reserves required for a term life policy are less than for a comparable whole or universal life policy, the higher level of capital required to back a term life liability reduces the return that can be earned on term life, generally limiting potential return to about 10%.

Distribution: Direct Channel Has Potential The simplicity of term life makes it one of the few insurance products successfully sold directly. Increasingly, life insurance companies are selling products directly to the public through mail, telephone, and the Internet. Only a few companies (particularly Torchmark through its Globe Direct subsidiary) have had success in selling through the direct channel. Given the thin margins for the product and its relative simplicity, however, term life is probably the best-suited insurance product for direct sales. Given the product’s relative simplicity, banks also hold some promise as a distribution channel for term life. Still, agent-led channels have been the dominant distribution outlets for term life, although agent productivity is key given the product’s narrow margins.

Market Size: Large Market with Modest Growth Potential The market for term life is relatively large, although its growth potential is relatively modest given the maturity of the product. As of 2001, 6 million term life policies were sold (43% of total individual life insurance sales) and $1 trillion of term life was in force, representing 63% of individual life insurance in force. Regulation XXX, which required companies to increase term and universal life reserves, caused companies to make large amounts of sales before raising prices to adopt the new regulation, thus generating additional growth, although this was a temporary blip. The growth of this market is expected to be in the mid single digits in the coming years.

Outlook: Solid Sales, Modest Earnings Growth Term life sales are expected to remain solid, but the product’s contribution to top-line growth and earnings is likely to remain small.

44



Demand for inexpensive death protection is likely to remain solid in light of continued uncertainty regarding the direction of the economy. This should continue to drive solid sales of term life, which has lower premiums for a given face value of coverage than for other life policies.



Competition and reserve requirements are likely to continue to result in continued modest margins for the product. Hundreds of companies offer term life, depressing returns for the product. Onerous reserve requirements will also likely continue to weigh on returns for term life (although not to the same extent as for other insurance products). Keeping expenses low and increasing efficiency will likely remain vital to generate earnings growth and adequate returns for term life.

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

North American Equity Research New York 14 January 2004

Product Capsule: Variable Life Overview Sales and earnings for variable life have decelerated sharply recently, and this trend appears likely to persist in the near term. While variable life (VL) was the growth insurance product in the 1990s, VL sales declined along with the equity market in 2001 and 2002, and continued to decline in 2003 despite the equity market rally. Changes in estate tax laws also appear to have contributed to the decline. Given continued sales declines in 2003, it appears that weakness in the VL market is also a function of other factors, (such as the complexity of the product and the distribution challenges it faces), although we think sales are beginning to bottom out.

Key Statistics Return on Equity: 11-14% Forecast Long-Term Earnings Growth Rate: 9-12% in normal equity market Typical Commission Structure: 50% of first year premiums; second- through 12thyear commission is usually 3-5% of annual premiums.

Product Description Variable life (VL) has set premiums over the life of the policy, whereas variable universal life (VUL) allows for flexible premiums and death benefits. For the purposes of this report we refer to both types of policies as VL.

Variable life (VL) is a permanent life policy where the policyholder can choose to invest the cash balance of the policy in equity and fixed income fund options. The benefits and cash values provided by the policy depend on the performance of these investments. VL is often used for retirement planning because it offers a range of investment options, as well as the ability to access the cash balance through loans. VL policies, in general, and survivorship (second-to-die) policies, in particular, are used as an estate-planning tool. VL is targeted at wealthy, sophisticated customers who both have a need for and understand the product’s many complex features. The primary consumers of variable life products have been middle-aged consumers interested in retirement savings and tax accumulation benefits. VL also appeals to consumers with large estates that are concerned with estate-planning issues and wealth transfer.

Economics: Equity Market Drives Earnings The performance of the equity market is a major driver of earnings for variable life, although less so than variable annuities. Insurers earn fees (generally about 75-100 basis points) on separate account balances associated with variable life, which are often mostly invested in equities. Growth of the assets, and hence fee income, is dependent on the performance of the equity market. However, insurers also earn cost of insurance fees based on the age and health of the insured and the face amount of the policy, which partially buffers the exposure of variable life earnings to the equity market. Equity market performance also affects VL profitability through DAC expenses. 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.

45

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

North American Equity Research New York 14 January 2004

Underwriting discipline is another driver of variable life profitability. Since death benefits are the most substantial expense associated with variable life policies, skillful underwriting of this mortality risk is one of the main determinants of profitability for this business. Companies that are better at assessing risk and underwriting profitable risk generally should have lower benefits expenses relative to premiums than other companies.

Distribution: A Key Growth Challenge VL is among the most complex life insurance products and, as a result, is difficult to sell. VL is highly customizable, as policies have flexible premiums and death benefit options, and the policyholder also often has the option to change the face amount of the policy. The product also tends to have higher face values, which results in a more complicated underwriting process. In addition, because it is often used for estate planning, the structuring of VL policies for individual customers often depends on complex tax considerations. License requirements complicate the distribution of VL. Individuals selling variable life must have both insurance and NASD licenses, which limits the number of qualified salespeople that can distribute the product. Long underwriting periods also create less incentive for brokers to sell the product. •

Independent agents account for the largest share of VL sales, gaining share from captive agents. In 2002, independent agents accounted for 41.7% of VL sales, up from 26.3% in 1995.



Investment dealers have become an increasingly important distribution channel for VL, although the product’s complexity makes it a tough sell through this channel. Sales of VL through stockbrokers accounted for 11.1% of industry sales in 2002, up from 1.5% in 1995.



The complexity of VL makes it difficult to sell through banks or through the direct channel, both of which are likely to remain relatively small channels for VL distribution. Banks and direct distribution channels accounted for only 2.6% of VL sales in 2002.

Leading Players: A Changing of the Guard? Strength in alternative distribution channels and access to the high net worth market has become increasingly important for VL sales. As competition intensifies within the VL market, companies such as Hartford, MET, and IDS are gaining share by leveraging the strength of their distribution capabilities and their access to multiple channels (particularly to the investment dealer channel). Access to the high net worth market is also a key driver of sales in the VL market. The market for VL is relatively concentrated, with the top 10 companies holding 60% share of the market, and appears to be growing more concentrated.

46

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

North American Equity Research New York 14 January 2004

Table 10: Individual Variable Life Sales $ in millions 3Q02 Rank 1 3 5 2 6 12 9 7 10 13

3Q03 Rank Company 1 2 3 4 5 6 7 8 9 10

Hartford Financial Services Pacific Life IDS Life Nationwide/Provident Mutual AXA Group Allstate Life Prudential/Skandia ING/ReliaStar Aegon/Transamerica Lincoln National

3Q02

3Q03

% Change

3Q02 Mkt. Sh.

3Q03 Mkt. Sh.

77.6 69.8 52.5 71.9 47.7 29.6 36.4 39.1 32.6 26.7

60.0 52.8 50.5 38.4 32.0 28.4 27.6 24.4 23.4 21.5

-22.7% -24.4% -3.8% -46.6% -32.9% -4.1% -24.2% -37.6% -28.2% -19.5%

8.87% 7.98% 6.00% 8.22% 5.45% 3.38% 4.16% 4.47% 3.73% 3.05%

10.43% 9.18% 8.78% 6.68% 5.57% 4.94% 4.80% 4.24% 4.07% 3.74%

bp Change

9M02

9M03

% Change

157 121 278 (153) 11 156 64 (23) 34 69

234.5 220.9 192.4 222.7 178.7 95.4 129.2 136.1 140.0 129.0

174.6 157.9 129.4 123.7 102.2 90.8 86.5 85.4 72.1 79.2

-25.5% -28.5% -32.7% -44.4% -42.8% -4.8% -33.0% -37.3% -48.5% -38.6%

Source: Tilinghast -Towers Perrin and JPMorgan calculations.

Top players in VL by assets appear to be losing share to newer players. As with variable annuities, earnings for variable life are a function of assets, not sales. Traditional players (Prudential, AXA, Kemper) maintain a majority of the assets under management in the market despite the rising sales of the newer entrants to the VL market. Asset share for all three companies appears to be declining, however, as companies generating stronger sales take share in the market. Among the key drivers of VL asset growth are persistency, fund flows (new sales less surrenders), and market performance. Table 11: Variable Life Insurance Company Assets and Asset Market Share $ in millions 09/30/2002 Total Asset Assets Mkt.Sh.

09/30/2003 Total Asset Assets Mkt.Sh.

% Chg. TOTAL Assets

Mkt.Sh. bp Change

Prudential AXA Financial Kemper Investors Life Nationwide/Provident Mutual MetLife/New England/GenAm John Hancock Hartford Financial Services Merrill Lynch Pacific Life IDS Life

12,569.0 9,186.0 6,506.0 5,108.0 3,708.0 3,993.0 3,444.0 NA 3,127.0 5,040.0

17.26% 12.61% 8.93% 7.01% 5.09% 5.48% 4.73% NA 4.29% 6.92%

14,788.0 9,982.0 6,589.0 6,480.0 4,765.0 4,593.0 4,265.0 3,906.0 3,823.0 3,494.0

16.75% 11.31% 7.46% 7.34% 5.40% 5.20% 4.83% 4.43% 4.33% 3.96%

17.7% 8.7% 1.3% 26.9% 28.5% 15.0% 23.8% NA 22.3% -30.7%

(51) (131) (147) 33 31 (28) 10 NA 4 (296)

Top 10 Companies

52,681.0

72.34%

62,685.0

71.02%

19.0%

(132)

Total Assets

72,823.0

100.00%

88,267.0

100.00%

21.2%

0

09/30/02 09/30/03 Rank Rank Company 1 2 3 4 7 6 8 NA 9 5

1 2 3 4 5 6 7 8 9 10

Source: Tilinghast -Towers Perrin and JPMorgan calculations.

Market Size: Held Back by Complexity and Tax Changes Confusion regarding estate law changes and difficulty in distribution of the product due to its complexity appear to capping the potential of the VL market. In 2002, the total industry sales for variable life were $4 billion, a decrease of 10.8% from 2001. The recovering equity market in 2003 should help bolster the variable life market going forward, both in terms of overall sales and assets under management. However, recent sales trends have been very weak, with sales of variable life down over 40% in the first half of 2003. Assets declined in 2002 relative to 2001, pressured by the weak equity market and the drop in sales. Further weakness in sales is likely to impede VL asset growth going forward. 47

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North American Equity Research New York 14 January 2004

Table 12: Historical Variable Life Sales and Assets—Annual

Historical VL Sales

Historical VL Assets

$ in millions

$ in billions

$ 8,000

$100 $ 6,975

$ 7,000 $ 6,000

$88.3

$84.2

$80

$74.8

$77.9

$75.1

$ 5,400

$70

$ 4,700 $ 4,000

$ 3,800

$ 4,000

($ billions)

$ 5,000

($ millions)

$90 $ 5,900

$ 3,250 $ 3,000 $ 1,771

$ 2,000

$60

$52.4

$50 $40

$40.5 $30.8

$30 $20

$ 1,000

$10 $0 1996

1997

1998

1999

2000

2001

2002

9M 2003

$0 1996

1997

1998

1999

2000

2001

2002

9/30/03

Source: Tilinghast -Towers Perrin and JPMorgan calculations.

Variable Life Outlook: Continued Weakness Expected Variable life sales appear to have bottomed and will likely increase in 2004 due to easy comparisons. However, the rate of sales declines appears to have slowed, perhaps marking a bottom in the market.

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VL sales are down 42% year over year in the first nine months of 2003, but sales were only down 4% sequentially in the third quarter. Despite recent weak sales, we expect 25-30% growth in assets in 2003 due to the strong performance of the equity market and the high proportion of VL assets invested in equities. In 2004, we expect 6-7% sales growth, mostly due to an easy comparison with 2003. We still think the product is challenged because of lack of mass-market appeal, complex features, and distribution challenges.



Overcoming distribution challenges represents a key growth hurdle. For expansion into the investment broker/dealer channel, more brokers must obtain an insurance license or be willing to share commissions with a life insurance professional. Although there is potential for the product to expand through the wirehouse channel, it is doubtful that the product will have the same appeal as stocks, mutual funds, or variable annuities for consumers.



Estate tax changes and alternative wealth accumulation products could potentially dampen the appeal of variable life products. If estates taxes are abolished altogether, as opposed to being reinstated in 2010 as current legislation suggests, this would have eliminate one major use of VL (particularly survivorship life).



The equity market and simplifying product design will be important growth drivers in the long term. The longer term prospects for variable life will largely rest on the strength of recovery in the equity market, and simpler product structures that offer broader appeal will be key drivers of future growth in for variable life products.

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

North American Equity Research New York 14 January 2004

Product Capsule: Group Life Overview The group life market is highly saturated and competitive, particularly in the large-case market, but growth opportunities exist in the small and mid-case markets. The large-case market is highly penetrated, and sales are most likely to come from takeaway business from other group life providers. The small and mid-case segments of the market have greater growth potential for established players in the large-case market, but many more small cases must be sold to generate the same earnings as a single large case would. As a result, we believe growth in group life sales and earnings are likely to be modest going forward.

Key Statistics Return on Equity: 10-14% Forecast Long-Term Earnings Growth Rate: 4-6% Typical Commission Structure: Commissions are generally paid on a sliding scale, with a commission of about 10% paid for the first $10,000-15,000 in premiums, declining with the size of the case to about 0.5% for cases above $1,000,000.

Product Description Group life is sold to corporations, professional societies, unions, and other organizations to provide life insurance and other disability and extended benefits to their employees or members. Group life can either be offered as a term policy (representing about 95% of all group life policies), or as traditional whole life, universal life, and variable-universal life. Group life plans can also offer additional features such as survivorship and disability benefits, and these plans can be purchased on a participating or nonparticipating basis. Corporate-owned life insurance (COLI) and bank-owned life insurance (BOLI) is insurance taken out on employees but with the corporation or bank named as beneficiary. COLI and BOLI are often used to fund post-retirement benefits. The primary buyers of group life are large companies and professional associations with more than 5,000 employees or members. This highly penetrated segment of the market accounts for the largest portion of premiums written in term of dollars. Small to mid-scale business and organizations represent a much smaller portion of group life business, but this segment is much less penetrated and represents a growth opportunity in this market.

Economics: Scale Matters Given the maturity and slow growth of the group life market, scale is necessary to drive adequate returns. Insurers earn premium income and investment income on general account reserves backing group life policies. Because of the competitive nature of the group life market, margins tend to be very thin. Only companies that have significant scale in the market that are able to spread the overhead from the business can earn decent returns from group life. Underwriting discipline is another driver of group life profitability. Since death benefits are the most substantial expense associated with group life policies, skillful underwriting of this mortality risk is one of the main determinants of profitability for this business. Companies that are better at assessing risk and underwriting profitable 49

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North American Equity Research New York 14 January 2004

risk generally should have lower benefits expenses relative to premiums than other companies.

Distribution: Relationships Are Key Corporate relationships are an important driver of group life sales. While there are multiple channels of distribution for group life products, relationships with the companies purchasing the policies are the key driver of sales. A substantial amount of group life is sold directly from the insurer to the company. As of 2000, direct distribution and independent agents were the two primary distribution channels, accounting for 20% and 16% of sales, respectively. “Other” represents primarily salaried reps. Table 13: Group Life Distribution by Channel Third Party 9%

Worksite 2%

Direct 20%

Independent Agents 24%

Career Agents 3%

Other 42%

Source: A.M. Best. Data as of 2001

Leading Players: A Concentrated Market Due to the importance of scale in group life, the market is highly concentrated. The top five group life writers account for almost 50% of the market, and the largest participants in the market have been gaining market share. MetLife is by far the largest writer of group life insurance, with over 20% share of the market. MET’s purchase of John Hancock’s group life business should further solidify its strong market position. Prudential is also among the largest companies in the group life market, with about 12% share of the market. Hartford and UnumProvident have a significant presence in the market, although UNM has been pulling back from the market recently to focus more exclusively on disability. Table 14: Top Players Dominate the Group Life Insurance Market $ in millions, as ranked by 2001 net premiums written 2000 Rank 1 2 3 4 8 7 9 5 12 13

2001 Rank Company 1 2 3 4 5 6 7 8 9 10

FY 2000

FY 2001

% Change

MetLife Prudential of Am Grp CIGNA Group Hartford Life Massachusetts Mutual Aetna Inc Group American General /AIG UnumProvident Group ING Group Fortis, Inc.

5,304.1 3,000.4 2,226.4 1,205.8 906.2 970.2 741.5 1,144.1 625.7 577.2

6,250.3 3,253.6 1,831.3 1,767.9 1,364.4 996.4 974.0 913.4 693.7 626.3

17.8% 8.4% -17.7% 46.6% 50.6% 2.7% 31.4% -20.2% 10.9% 8.5%

19.60% 11.08% 8.23% 4.45% 3.35% 3.58% 2.74% 4.23% 2.31% 2.13%

22.14% 11.53% 6.49% 6.26% 4.83% 3.53% 3.45% 3.24% 2.46% 2.22%

255 44 (174) 181 149 (5) 71 (99) 15 9

Total for 10 Companies Industry Sales

16,701.4 27,067.6

18,671.4 28,225.8

11.8% 4.3%

61.70% 100.00%

66.15% 100.00%

445 0

Source: A.M. Best and JPMorgan calculations. Note: Bolded companies are those under JPMorgan life insurance coverage. 50

2000 2001 Mkt. Shr. Mkt. Shr.

bp Change

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

North American Equity Research New York 14 January 2004

Market Size: Large, but Growing Slowly As of 2001, group life premiums totaled $28.2 billion dollars, an increase of 4.3% over 2000. The market is extremely competitive, with major players vying to for share of the heavily penetrated large-case segment, which includes companies with more than 5,000 employees. Because of this, we expect modest growth in the group life market (about 4-6%). Group life represented 42% of life insurance in force in 2001.

Group Life Outlook: Continued Modest Growth Expected The group life market is likely to continue to experience slow growth, with little growth in the saturated large-case market and tight competition in the small and midcase market. •

Group life premium growth is likely to be modest, and future profitability will depend upon achieving cost efficiencies, simplifying product structure, and creating incentives for independent agents to promote group life products. Companies with the greatest scale are likely to be most successful in this market, as they have the greatest opportunities for cost savings.



Increasingly, the most significant opportunities for growth lie in targeting small and mid size companies. Successful development of this segment will require larger numbers of policy sales to offset the lower profitability of selling to smaller consumers. This strategy may allow insurers with broader distribution capabilities to gain share in this highly competitive market.



Concerns over corporate-owned life insurance (COLI) products could hold back growth for this product. The COLI market has received considerable negative publicity and scrutiny from regulators (including the IRS), who have questioned the tax treatment of the product. The controversy over COLI is likely to continue into the near future and may negatively impact future sales.

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

North American Equity Research New York 14 January 2004

Product Capsule: Disability Insurance Overview While an attractive market on the surface, few companies have been able to generate attractive returns in the disability insurance market. Competition, recent low investment yields, and difficulty in pricing the product correctly have made it difficult for companies to grow profitably in the disability market. A difficult regulatory environment also makes it difficult for companies to achieve solid returns in the individual disability market. Weakness in the economy has caused higher incidence rates for some players, pressuring earnings. Disability incidence correlates with economic uncertainty, making the product sensitive to downturns in the economy. Earnings for some players in the disability business have come under pressure as a result of weakness in the economy, although other companies appear to have avoided this through tighter underwriting discipline. Incidence may moderate and earnings could get a boost if the economic recovery gains steam.

Key Statistics Return on Equity: 8-12% Forecast Long-Term Earnings Growth Rate: 8-12% Typical Commission Structure: 50% of first-year premium and a renewable commission of 5-15%, depending on the policy’s persistency

Product Description Disability insurance (DI) provides income to individuals suffering from a recent disability that precludes them from working. Most disability insurance is provided through employer-paid and government-sponsored programs, and a smaller amount is purchased by individuals. A group DI policy typically pays 45-60% of annual income upon the claim. DI policies are more expensive than term and traditional life policies, costing as much as 2% of annual salaries. Two major types of disability insurance are short-and long-term disability—short-term disability (STD) offers benefits for a specified period of time, usually 13, 26, or 52 weeks. Long-term disability (LTD) provides benefits up to age 65 or normal retirement age. Policies can be sold on a noncancelable basis (where policies cannot be repriced or canceled, which can lead to problems if policies were not priced correctly at time of sale) or guaranteed renewable basis (where prices can be adjusted based on loss experience). The largest segment of the disability insurance market has been in the group segment, which comprises employers and groups with more than 100 employees or members. Within the smaller individual disability market, consumers tend to be between ages 35 and 50. These consumers tend to have several dependents and financial obligations or are not covered fully under their group policies.

Economics: Underwriting Drives Profitability Underwriting disability policies well is the key driver of profitability for the product, and scale is also important. Insurers earn premium income from the policy and investment income on reserves backing the policy. Careful underwriting is extremely important for disability, since high claims can easily overwhelm premium and investment income. Disability is a newer product than life insurance and claims 52

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North American Equity Research New York 14 January 2004

are harder to forecast, making it more difficult to price the product and creating greater differentials in incidence and loss experience among market participants. The level of interest rates also impacts profitability, as the discount rate applied to reserves must be adjusted over time. Reductions in the discount rate force the insurer to increase reserves, hurting profitability. Scale is another factor impacting profitability, as companies writing a greater volume of business can lower their unit costs and achieve greater profitability.

Distribution: Primarily a Group Product Voluntary benefits are optional benefits sold at the worksite that are paid for by the employee and funded through payroll deduction.

Salaried employees specializing in group policies are the main channel selling employers group policies. Worksite marketing is another method of distribution for disability insurance. Voluntary employee payroll insurance deductions have traditionally accounted for the majority of disability insurance purchases. Individual disability is sold primarily through independent agents.

Leading Players: Highly Concentrated The top sellers of disability insurance control a substantial part of the market. UnumProvident is by far the leading disability insurer, with a 30% share of the market for total disability insurance. Other major disability insurers include MetLife (12% of the market), Hartford (11%), Stancorp (8%), and Prudential (7%). Group disability is highly concentrated, with the top five players controlling over 50% of the market. UnumProvident is the leading group disability insurer, with 24% of the group market in 2002, although UNM’s share of the market declined from 25.6% in 2001. Given the spate of negative publicity and financial difficulties the company has experienced, it is possible that UNM’s position will deteriorate further. Hartford and MetLife, two other leading providers of group disability insurance, both gained share in 2002. HIG’s share of the market increased to 11.1% in 2002 from 10.2% in 2001, while MET’s market share increased to 10.4% in 2002 from 8.8% in 2001. Table 15: Total Group Disability Market $ in millions, as ranked by 2002 sales premiums 2001 Rank

2002 Rank

1 2 3 4 5 7 10 9 16 6

1 2 3 4 5 6 7 8 9 10

Company

2001

2002

% Change

2001 Mkt. Sh.

2002 Mkt. Sh.

Bp Change

UnumProvident Hartford Financial MetLife Standard Prudential CNA Jefferson-Pilot Reliance Standard Guardian Life Cigna

448.7 176.9 152.9 113.2 107.5 81.3 53.7 60.6 27.9 87.7

416.3 191.9 179.0 117.2 111.7 103.6 84.2 76.0 63.0 53.9

-7.2% 8.5% 17.1% 3.5% 3.9% 27.4% 56.8% 25.4% 125.8% -38.5%

25.79% 10.17% 8.79% 6.51% 6.18% 4.67% 3.09% 3.48% 1.60% 5.04%

24.06% 11.09% 10.35% 6.77% 6.46% 5.99% 4.87% 4.39% 3.64% 3.12%

(172) 93 156 27 28 132 178 91 204 (192)

Top 10 Companies Total

1,310.4 1,740.0

1,396.8 1,730.0

6.6% -0.6%

75.31% 100.00%

80.74% 100.00%

543 0

Source: John Hewitt and Associates and JPMorgan calculations. Note: Bolded companies are those under JPMorgan life insurance coverage.

The market for individual disability insurance is even more concentrated than the group market. The top 10 individual disability companies control 91% of the market, 53

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North American Equity Research New York 14 January 2004

compared with 81% for group disability. UNM is also the leading provider of individual disability insurance, although the company is also losing share in this market (26.6% in 2002 vs. 30% in 2001). Table 16: Total Individual Disability Market $ in millions, as ranked by 2002 total individual disability sales premiums 2001 Rank

2002 Rank

1 2 3 7 5 6 4 10 8 11

1 2 3 4 5 6 7 8 9 10

Company

2001

2002

% Change

2001 Mkt. Sh.

2002 Mkt. Sh.

bp Change

UnumProvident Mass Mutual Northwestern Mutual Life Berkshire Life MetLife Principal Financial IDS Life Standard State Farm Union Central

78.1 35.4 34.9 10.0 18.6 16.9 18.7 5.9 9.3 5.8

78.9 38.2 33.9 31.1 22.9 19.5 18.9 11.0 7.7 7.4

1.1% 7.8% -2.8% 210.2% 23.2% 15.0% 1.4% 85.2% -16.4% 28.3%

30.03% 13.62% 13.43% 3.86% 7.15% 6.52% 7.19% 2.28% 3.56% 2.22%

26.64% 12.88% 11.46% 10.51% 7.73% 6.57% 6.39% 3.70% 2.61% 2.50%

(339) (74) (198) 665 58 6 (79) 142 (95) 28

233.6 259.9

269.6 296.2

15.4% 14.0%

89.87% 100.00%

91.00% 100.00%

113 0

Top 10 Companies Total

Source: John Hewitt and Associates and JPMorgan calculations. Note: Bolded companies are those under JPMorgan life insurance coverage

Market Size: Solid Growth Potential Few employers currently offer disability insurance, and there are significant opportunities for increasing the penetration of this market. Currently, only 15% of workers have any type of DI coverage. In 2002, total disability market sales premiums reached $2 billion dollars, a small 1.3% increase over the previous year. The flat premium of group disability in 2002 was driven by a slowdown in the short-term disability products. Sales were also affected by the weak economy, however, as companies have backed away from the STD market in favor of the higher margin LTD market (where premiums increased 3% in 2002). The individual market is also underpenetrated and offers opportunities for growth. Individual disability premiums increased 14% to $296.2 billion in 2002, helped by increased sales at the worksite. The growth was driven by strong results for the non-cancelable product, somewhat offset by a decline in guaranteed renewable premiums. Overall the individual disability market remains small, with double-digit growth (albeit off a low base).

Outlook: Near Term, Held Back by Economy Disability earnings growth should gradually improve, driven by the stronger economy and higher interest rates.

54



The recovery in the economy should lead to a slowdown in disability incidence, which should gradually drive lower loss ratios and better earnings. Earnings should also be helped by rising interest rates, which should boost investment income and reduce pressure on loss ratios caused by reductions in reserve discount rates.



Continuing penetration of the worksite market, consumer education consumers and increased scale should help to drive the growth for disability going forward. Since the market for disability insurance is relatively undeveloped, educating consumers on the benefits of the product

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

North American Equity Research New York 14 January 2004

and how it fits into their financial plan should be an important driver of sales in the future. Increased sales of voluntary benefits through the worksite, also a relatively underpenetrated market, should help drive sales growth. As the size of the market increases, companies should also begin to benefit from scale.

55

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

North American Equity Research New York 14 January 2004

Product Capsule: Long-Term Care Overview While potentially a promising product, difficulty in pricing correctly and lack of consumer awareness are two barriers to growth for LTC. With the aging of the population and increased concern about the rising cost of medical care, LTC has the potential to be a growth product for the industry. However, growth of LTC faces a number of hurdles. Given the relative immaturity of the product, it is difficult to assess whether or not insurers are pricing LTC appropriately. In addition, consumer familiarity with the product (while growing) is still relatively low, making it difficult to sell, particularly to individuals under 65.

Key Statistics: Return on Equity: 12-14% Forecast Long-Term Earnings Growth Rate: 11-12% Typical Commission Structure: 50-66% first-year premiums and an average commission of 13% of premiums on renewals.

Product Description Long-term care insurance (LTC) protects the insured against all or a portion of the expenses incurred from services needed to assist the protected in carrying out daily living activities (such as bathing, dressing, eating, etc.) when they are unable to perform these activities by themselves. LTC provides coverage for chronic physical and mental conditions, which traditional health insurance does not typically cover. Long-term care policies extend to patients with cognitive impairments (such as Alzheimer’s disease) as well. Nearly 92% of the long-term care market is individual long-term care, while the remaining 8% is group long-term care. Most purchasers of long-term care are over 65, although the market for LTC insurance for those under 65 is growing more rapidly and represents an opportunity for insurers.

Economics: Underwriting Drives Profitability Skillful underwriting of business is a key driver of LTC profitability. Insurers earn premium income from the policy and investment income on reserves backing the policy. Careful underwriting is extremely important for LTC, since high claims can easily overwhelm premium and investment income. LTC is a newer product than life insurance and claims are harder to forecast, making it more difficult to price the product and creating greater differentials in incidence and loss experience among market participants. In addition, since price flexibility is limited because price increases must be approved by state regulators, pricing the product correctly at the time of sale is all the more important. The lapse rate is a key assumption incorporated in the pricing of LTC insurance. It is common for insurers to assume that a certain percentage of policies will lapse before their health deteriorates and claims on the policy accelerate (known as “lapsesupported pricing”). As a result of lapse-supported pricing, a lower lapse rate will translate into lower profitability.

56

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

North American Equity Research New York 14 January 2004

Distribution: Searching for a Channel A challenge to growth of LTC will be to development of more effective distribution channels. LTC is a relatively immature product and has yet to develop a dominant distribution channel. Agents, independent financial planners, and benefits brokers are the primary channels that sell long-term care plans to both individuals and groups. The growth of the product has been challenged, however, by the fact that the channels with the best access to those under 65 years of age (the faster-growing portion of the market) such as broker/dealers may not be eager to sell the product due the need for an insurance license.

Leading Players: Top-Heavy Market The LTC market is highly concentrated, with the top three writers accounting for more than two-thirds of the market. The market appears to be growing more concentrated over time, making it increasingly difficult for smaller players to compete. GE Financial alone controls about 40% of the market. In our coverage universe, AFLAC, John Hancock, and UnumProvident are among the largest players in this market. Table 17: Total Long-Term Care Market $ in millions 1999 Rank 1 2 3 7 6 8 5 12 10 11

2000 Rank Company 1 2 3 4 5 6 7 8 9 10

GE Financial Assr Gr Conseco AFLAC Inc John Hancock AEGON USA Inc UnumProvident Group Citigroup Mutual of Omaha New York Life Aetna Inc Group Top 10 Companies Total Companies

1999

% 2000 Change

1999 Mkt. Shr.

2000 Mkt. Shr.

bp Change

818.1 771.0 351.0 198.4 227.3 154.0 239.7 37.6 41.3 41.3

1,653.2 820.4 358.5 293.2 273.2 194.3 135.2 67.3 50.7 44.4

102.1% 6.4% 2.1% 47.8% 20.2% 26.2% -43.6% 79.0% 22.5% 7.6%

21.11% 19.90% 9.06% 5.12% 5.87% 3.97% 6.19% 0.97% 1.07% 1.07%

39.06% 19.38% 8.47% 6.93% 6.45% 4.59% 3.19% 1.59% 1.20% 1.05%

1795 (52) (59) 181 59 62 (299) 62 13 (2)

2,879.9 3,874.8

3,890.5 4,232.5

35.1% 9.2%

74.32% 100.0%

91.92% 100.0%

1760 0

Source: A.M. Best and JPMorgan calculations. Note: Bolded companies are those under JPMorgan life insurance coverage.

Market Size: Small but Developing Market The market for LTC is small, but it is poised for future growth. In 2000 (the latest available data), the LTC market consisted of $4.3 billion in premiums. Individual LTC is currently the larger market (about 90% of the LTC market) although group LTC is growing more quickly. The primary market for long-term care is expected to double from 35 million to 70 million consumers by 2030. Increasing penetration of this market should also continue to develop over the next several years given these demographic trends, increasing consumer awareness and better methods of distributing the product develop.

Product Outlook: Educating Consumers Key The education of customers and distributors and the increased visibility of the product are critical to growth for this product. Sales of LTC should see solid growth, but from a small base. 57

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58

North American Equity Research New York 14 January 2004



The Federal Long Term Care Insurance Program, should help drive LTC growth. The program, a joint venture of MetLife and John Hancock, should raise consumer awareness of the benefits of long-term care and help familiarize consumers with the product.



Group LTC should become increasingly important. Currently, 92% of the long-term care market is for individual long-term care. Over time, the demand for group long-term care is expected to increase as companies develop group long-term care and disability and group life products.



Regulatory developments are also likely to have an impact on LTC growth going forward. The continued development of long-term care will also depend on continued federal funding of programs such as Medicare, which pay for a portion of the expenses that are associated with long-term care. Proposed legislation allowing tax deductions for individual LTC premiums could also increase the market potential for LTC.



The rising cost of LTC is one factor that may limit growth for the market. LTC is an expensive product and difficult for many middle class consumers to afford, which may limit its growth potential. The costs of longterm care are rising rapidly as a result increasing demand for limited numbers of service providers, as well as the costs associated with providing service to the elderly. Long-term care costs have been outpacing inflation by about 3% a year.

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

North American Equity Research New York 14 January 2004

Product Capsule: Supplemental Health Overview While currently a small market in the United States, supplemental health insurance has promising growth prospects. The aging of the population and rapidly rising health care costs should both support growth of the supplemental health market. The rising cost of major medical coverage should also drive growth for supplemental health products as consumers seek alternatives to traditional health insurance plans. The Medicare supplement market, however, is likely to continue to be held back by regulation. As the law currently stands, benefits offered by Med-Supp plans and deductibles are standardized by regulators. One result of this inflexibility has been a rapid increase in premiums for Med-Supp policies, which has hurt overall persistency as policyholders can no longer afford the premiums.

Key Statistics: Return on Equity: 12-13% (varies by product) Forecast Long-Term Earnings Growth Rate: 10-12% Typical Commission Structure: Cancer/Accident: 35-60% of first-year premiums, 3-5% renewals Medicare supplement: 20-23% of premiums (first year and renewals)

Product Description Supplemental health insurance typically supplements coverage provided by primary health insurance, reimbursing expenses not covered by major medical. Policies are sold on both a group and an individual basis. Types of supplemental health coverage include cancer, Medicare supplement, hospital indemnity, accident, and dental insurance. Purchasers of supplemental health products vary by coverage: •

Cancer and accident policies are aimed at consumers with major medical coverage seeking additional coverage.



Hospital indemnity products are typically aimed at lower-income or selfemployed individuals lacking major medical coverage.



Medicare supplement policies are targeted at Medicare beneficiaries (usually senior citizens), about 85% of whom purchase some form of Medicare supplement insurance.

Product Economics: Careful Underwriting Necessary Underwriting is a key driver of profitability for supplemental health insurance. Insurers earn premium income from the policy and investment income on reserves backing the policy. As with other types of health coverage, careful underwriting is extremely important for supplemental health, since high claims can easily overwhelm premium and investment income. Claims are generally harder to forecast for supplemental health than for life insurance products, making it more difficult to price the product and creating greater differentials in incidence and loss experience among market participants.

59

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

North American Equity Research New York 14 January 2004

Scale and efficiencies are also important drivers of profitability in the supplemental health market. Greater scale allows companies to lower their unit costs, increasing profitability for the product. It also gives companies greater flexibility to pay greater commissions, which in turn can help drive sales growth.

Distribution: Evolving Channels Since supplemental health is a far from a mature market, distribution of the product continues to evolve. Supplemental health insurance is typically sold through independent and captive agents, at the worksite through payroll deduction, and also over directly by phone or over the Internet.

Leading Players: Varies by Product AFLAC is the leading players in the supplemental health market, with a dominant market share in cancer insurance and strong market positions in accident and hospital indemnity markets. Other major players in the supplemental health market include Torchmark (particularly in Medicare supplement), UnumProvident, and Aon (in hospital indemnity). Conseco was formerly a major presence in the supplemental health market, although the company’s financial troubles has diminished its standing in these markets. AIG, while not currently a factor in the market, has signaled it will begin offering supplemental health products.

Market Size: Small, but Solid Growth Potential The market for supplemental health insurance is currently relatively small, although most product categories have strong growth potential. In 2000, individual dread disease (cancer) premiums grew 11.4% to $7.3 billion, while hospital indemnity premiums were flat at $1.1 billion. Individual accidental death and dismemberment premiums grew a modest 5% to $617 million. One exception is Medicare supplement, which is a relatively established product, but unlikely to grow rapidly as the market is highly penetrated.

Product Outlook Growth in the supplemental health market, which continues to be underpenetrated, should generally remain strong, while growth in the Medicare Supplement market is likely to be more modest.

60



Sales of supplemental health products are likely to remain strong as companies focus on penetrating the market. AIG recently signaled it would begin offering supplemental medical products, which could make the market incrementally more competitive. However, given the low penetration of supplemental health products, competition is likely to remain subdued as companies focus on educating consumers about the need for these products.



Heavy regulation and unaffordable, high policy premiums are likely to continue to hold back growth in the Medicare supplement market. Allowing higher deductibles would allow providers of Med-Supp policies to decrease premiums, which would increase the affordability and persistency of the policies. It is unlikely, however, that significant modifications to the current array of standardized plans will be achieved before 2004.

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

North American Equity Research New York 14 January 2004

Capital and Ratings Maintaining capital strength and flexibility is a key core competency for life insurers, but often involves a balance between stability and returns. Companies must maintain a level of capital to maintain a given financial strength rating (a measure of the insurer’s claims-paying ability) from the ratings agencies. Maintaining high ratings is important for life insurers to retain the confidence of prospective buyers and current policyholders. For this reason, ratings agencies exercise significant influence over insurers, who must consult regularly with the agencies regarding the impact various corporate actions would have on their ratings. Companies face a tradeoff, however, between financial strength and returns. Retaining a higher level of capital in excess of rating agency requirements is viewed favorably from a ratings perspective and provides a greater level of flexibility to the company, but tends to dampen returns on capital. For this reason, life insurers usually return capital above a targeted level to shareholders in the form of share buybacks or dividends.

Statutory Capital and RBC Ratios Statutory capital is a key driver of insurance company credit and financial strength ratings, which often have substantial impact on sales for certain products. Regulators, rating agencies, and insurance buyers view the level of capital held by an insurance company as a key measure of the company’s ability to meet its claims in the future. A strong rating is essential for many lines of insurance business, so companies need to maintain a sufficient level of statutory capital to satisfy ratings agencies and maintain a targeted rating. Statutory capital is often viewed by rating agencies as the more relevant measure of available capital. See page 85 for more details on statutory accounting.

There are several key differences between GAAP and statutory capital. GAAP capital for insurance companies generally reflects economic capital, or the difference between assets and liabilities on the balance sheet. Statutory capital differs from GAAP capital in that some GAAP assets are not admitted as statutory capital. Certain assets, including certain receivables and furniture and equipment net of depreciation, that are included in GAAP assets are not admitted under SAP. SAP also places restrictions on the recognition of deferred tax assets. Risk-based capital (RBC) ratios are a key metric used in evaluating the adequacy of a company’s statutory capital. The National Association of Insurance Commissioners (NAIC) has established the most widely used risk-based capital formula. Capital requirements are determined for each insurer based on the risk profile of the company’s business mix and investment portfolio. Statutory capital is then divided by required capital to product the RBC ratio, expressed as a percentage. Life insurers generally target an RBC ratio of roughly 300% to maintain an “AA” rating. As of the end of the third quarter of 2003, most companies in the sector met or exceeded their targeted range. Companies in the sector typically have financial strength ratings from the two major ratings agencies, Moody’s and Standard & Poor’s, in the Aa /AA range.

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North American Equity Research New York 14 January 2004

Table 18:Life Insurance Company Excess Capital, RBC Ratios $ in millions Company AFLAC* AIG Hartford Life Jefferson Pilot**** John Hancock* Lincoln National Manulife Financial Metropolitan Life Nationwide Phoenix Principal Life Protective Life** Prudential Insurance RGA Torchmark* UnumProvident

Excess Capital (9/30/03) 500 NA NA 500 0 0 1,600 0 0 0 500 100 3,500 150 225 0

RBC Ratio 12/31/2002 401% 209-316% 325% 310% 305% 318% 250% 313% 350% 309% 406% 262% 316% 281% 350% 248%

Updated** RBC Ratio NA NA NA 310% 315% 315% 251% 320% 305% >300% NA 285% NA NA NA 240-250%

RBC Target 400% NA 325%-350% 300% 300%-325% 300% 185%-200% 300% 250%-275% 300% 400% 250% NA 275% NA 250%

Rating Aa2 AAA Aa3 Aa2 Aa3 Aa3 Aa2 Aa2 Aa3 A3 Aa3 Aa3 A1 A1 A1 A3

Moody's Outlook Stable Stable Negative Stable Stable Stable Stable Negative Stable Stable Stable Stable Stable Stable Stable Negative

Standard & Poor’s Rating Outlook AA Stable AAA Stable AAStable AAA Stable AA Stable AAStable AA+ Stable AA Stable AAStable A Stable AA Stable AA Stable A+ Positive AAStable AA Stable ANegative

Source: Company reports and JPMorgan calculations. Moody’s and Standard & Poor’s ratings refer to insurer financial strength ratings. *AFL, TMK excess capital reflects only approximate annual free cash flow generation. **Updated RBC ratio for JHF as of 3/31/03. Updated RBC for JP, LNC, MET, MFC, NFS, PL, PNX and UNM are as of 9/30/03; MFC RBC reflects MCCSR. **** JP excess capital includes $300 million in marketable securities.

Ratings Agencies: Calling the Shots Officially, state insurance commissioners are the primary regulators of life insurance companies. Insurance companies are regulated at the state level, and state governments are responsible for granting licenses to insurers and approving products sold by insurers. Each state has an insurance commissioner responsible for these tasks. These commissioners belong to the National Association of Insurance Commissioners (NAIC), an organization that seeks to coordinate activities of the state commissioners. The NAIC seeks to unify standards from state to state through the introduction of model regulations, which are regulations drafted by the NAIC for voluntarily adoption by the state regulators. However, some states often choose not to adopt model regulations, making the regulatory framework a patchwork with regulations differing from state to state. However, evaluations by private ratings agencies such as Moody’s and Standard & Poor’s regarding capital adequacy are as important (or more so) than state regulators. Moody’s, Standard & Poor’s, Fitch, and A.M. Best make assessments of the financial strength and claims paying ability of insurance companies. While state regulators set the basic standards for insurer solvency (using Statutory Accounting Principals and risk-based capital), investors and customers often pay more attention to evaluations made by the private ratings agencies as to the financial health of these companies. Since much is riding on the evaluations made by these agencies, they have significant influence with the companies and often are the final arbiter of the level of capital held by the companies. Over the past two years, refinements to capital models and increased conservatism on the part of ratings agencies have driven life insurers to hold greater levels of capital (as measured by RBC) to maintain a given rating.

Returning Capital: Dividends and Buybacks Life insurers return capital to shareholders through share buybacks and dividends, although dividends are much more consistent than buybacks. All companies in our universe pay a regular dividend, and several companies also return capital to shareholders through share buyback programs. The average life insurance 62

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company yields 1.4% and pays out 22.6% of net income as dividends. While this is higher than for the typical broker or asset manager, payouts for life insurers are lower than those paid by banks and thrifts, which are closer to life insurers in terms of earnings growth and returns. Share buybacks tend to be more irregular than dividend payouts, although a few companies have maintained regular share buybacks. A number of companies, for instance, were forced to suspend their buyback programs as a result of capital pressures in 2002. Only a few (AFL, JP, PFG, TMK) maintained their buyback programs through the downturn.

Payout ratios for asset managers are inflated by a few companies with very high payout ratios due to their corporate structure.

The average life company pays out about 22.6% of its earnings in dividends. Payout ratios for some companies are understated if capital returned to shareholders in the form of share buybacks is included, although few companies (including AFL and TMK) buy back stock on a regular basis and including these buybacks would probably not significantly raise the average payout ratio for the industry. This payout compares with an average yield of 2.5% for banks, 2.1% for thrifts, and 1.9% for asset managers, and 1.1% for broker/dealers, and payout ratios of 39% for banks, 32.4% for thrifts, 41.2% for asset managers, and 14.7% for broker dealers. Given the maturity and modest growth prospects of the life insurance industry, we think a payout ratio closer to that of the banks (at 40%) would probably be more appropriate and would increase the appeal of life insurers with investors. Table 19: Companies with Low Payout Ratios May Raise Dividends Company AFLAC AIG Hartford Financial* Jefferson-Pilot John Hancock Lincoln National Manulife Metlife National Financial Partners Nationwide Phoenix Cos. Principal Financial Protective Life Prudential Reinsurance Group Torchmark Corp. UnumProvident** Average

Price 1/12/04 35.39 70.50 62.69 49.38 39.44 41.33 33.83 32.63 30.25 34.43 13.04 32.32 33.97 42.26 38.34 45.45 15.75

Annual Dividend 0.32 0.26 1.12 1.32 0.35 1.34 0.62 0.23 0.40 0.52 0.16 0.45 0.64 0.40 0.24 0.44 0.30

Averages for other financial services companies: Banks Thrifts Asset Managers Broker Dealers

Yield 0.90% 0.37% 1.79% 2.67% 0.89% 3.24% 1.84% 0.70% 1.32% 1.51% 1.23% 1.39% 1.88% 0.95% 0.63% 0.97% 1.90% 1.42%

LTM LTM Payout Net EPS Dividends Ratio 1.73 0.30 17.3% 2.47 0.24 9.8% 5.29 1.09 20.6% 3.08 1.32 42.9% 2.87 0.35 12.2% 2.70 1.36 50.2% 3.19 0.78 24.5% 2.79 0.23 8.2% NA NA NA 2.56 0.45 17.6% -0.51 0.16 NM 2.40 0.45 18.8% 2.55 0.63 24.7% 0.98 0.50 51.0% 3.01 0.24 8.0% 3.63 0.40 11.0% 1.63 0.37 22.9% 22.64%

2.5% 2.1% 1.9% 1.1%

39.09% 32.41% 41.20% 14.70%

Source: Company reports and JPMorgan calculations. Payout ratio is calculated as the last 12 months’ dividends paid divided by the last 12 months’ net income. Industry groups include all companies with market caps over $1 billion in each sector. LTM net EPS, dividend figures for Manulife in Canadian dollars. * HIG LTM net income excludes $1.7 billion asbestos reserve charge in 1Q03. ** UNM LTM net income excludes $295 million reserve charge in 1Q03.

See page 81 for more details on the dividend tax cut and its impact on the insurance industry

A number of life insurers raised their dividends as a result of the change in dividend tax rates. The tax rate on dividends was cut to 15% from the higher ordinary rate (as high as 38.5%), prompting a number of companies to increase their dividend payouts. AIG, Principal, and Prudential introduced the largest dividend increases, raising their dividends by 38.3%, 80%, and 25%, respectively. 63

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Table 20: Summary of Companies Increasing Dividends in 2003 Company AFLAC AIG Hartford John Hancock Lincoln National Manulife Metlife Principal Prudential Torchmark

Old Dividend $0.28 0.19 1.08 0.32 1.34 0.72 0.21 0.25 0.40 0.36

New Dividend $0.32 0.26 1.12 0.35 1.40 0.84 0.23 0.45 0.50 0.44

Increase 14.3% 38.3% 3.7% 9.4% 4.5% 16.7% 9.5% 80.0% 25.0% 22.2%

Dividend Yield 0.9% 0.4% 1.9% 0.9% 3.4% 2.0% 0.7% 1.4% 1.2% 1.0%

Source: Company reports and JPMorgan calculations. Figures represent annual dividends. *Manulife dividend in Canadian dollars.

Life Industry Invested Assets Investment income generated on invested assets is a key driver of earnings for life insurers. Life insurers invest general account funds collected as premiums and deposits for guaranteed return products in various assets classes. The investments are expected to provide returns that will support future policy claims and also provide a profit for the company. Policy claims often take years to materialize, so the impact of investment experience on overall product profitability is considerable. For this reason, the anticipated return on assets is a major factor in determining premium rates and other costs. Companies also place a percentage of assets in reserves to guard against the potentially negative impact of unexpected events. While investment income is recognized in life insurers’ operating earnings, realized gains and losses are excluded. While realized gains and losses do affect net income, investors generally exclude these when analyzing a insurer’s recurring earnings and they are not generally included in First Call earnings estimates since the conventional wisdom historically did not give companies credit for investment gains since they could be easily managed. Still, realized investment gains and losses have important capital implications and should not be ignored. Realized investment losses become more of a focus of attention in troubled markets, when companies often realize significant levels of losses.

Asset/Liability Matching Insurers generally match their investment exposures to the liability the investment is backing. Portfolios are segregated by product, and the investment portfolios of each product tend to have different characteristics. Short-duration products such as fixed annuities and GICs are generally backed by short-duration bonds (although some GICs are have longer durations), while life insurance products have longer durations and are generally backed by bonds with durations of 10 years or more. In general, insurers have greater latitude in choosing investments to back longer duration products, which do not always need to be duration matched, while short duration products must be strictly matched.

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North American Equity Research New York 14 January 2004

Table 21: Insurance Product and Investment Durations DURATION

PRODUCT

INVESTMENT

Short duration Short-duration bonds MBS

3 Years GICs Fixed annuities 5 years

Medium-term bonds Life Insurance Health insurance

8 years

Long-term bonds Disability insurance

10 years +

Reinsurance contracts

Long Duration

Investment partnerships Equities

Source: JPMorgan.

The challenge for insurers is to maximize investment yields while minimizing mismatch relative to liabilities. Insurers can generally gain yield by increasing the duration of their assets, but face interest rate risk or liquidity risk if the portfolio duration is extended far beyond the duration of liabilities. Companies can increase yield without affecting duration by taking on additional credit risk, but then lead themselves exposed to higher realized losses (which can also eat into investment yield).

Major Asset Classes Fixed income (primarily corporate debt) is the predominant asset class in the portfolios of insurers, making up 75% of the investments on average. Mortgage loans and policy loans comprise the next two most commonly held classes, making up 11% and 4% of invested assets, respectively. Insurers typically have little exposure to equities or real estate, each accounting for about1% of their investment portfolio. Many companies also have a small portion of their assets invested in hedge funds, limited partnerships, and exotic credit products such as CDOs/CBOs. Insurers’ have increased their exposure to corporate bonds and other fixed maturities at the expense of mortgage loans, which has increased the liquidity of their portfolios. Historically, life insurers’ investment portfolios were more heavily weighted in mortgage loans (22% in 1990 vs. 11% in 2001). As a result of steep losses on such loans in the early 1990s, in addition to the adoption of risk-based capital guidelines (which assess a greater capital charge from mortgage loans relative to bonds), insurers pared back their exposure to this asset class. Meanwhile, companies have increased their exposure to corporate bonds (a more liquid asset class) over time. About 75% of industry investments were invested in bonds in 2001, up from 62% in 1990.

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North American Equity Research New York 14 January 2004

Figure 13: Out of Mortgages, into Bonds: Investment Exposures Shift over Time

2001

1990

Bonds 75%

Bonds 62%

Other 2%

Preferred stock 1%

Other 3% Cash & Short term 3% Policy loans 4%

Real estate 1%

Mortgage loans 11%

Common Stock 2%

Preferred stock 1%

Cash & Short term 4%

Common Stock 3%

Policy loans 4% Real estate 2%

Mortgage loans 22%

Source: Best’s Aggregates & Averages.



Corporate debt generally makes up over half of life insurers’ fixed maturity portfolios, with an average of 65% of fixed maturity holdings invested in corporate bonds. The key risk associated with corporate debt is credit risk, which varies with the quality of the holding. Below investment grade (BIG) bonds are the lowest credit quality corporate bonds and are most at risk of default. (Note that an insurer’s aggregate BIG exposure includes below investment grade ABS, MBS, and foreign government holdings, although straight debt is generally the largest component of BIG exposure).



Asset backed (ABS)/mortgage backed securities (MBS) are another important asset class, accounting for about 19% of fixed maturities on average. Mortgage-backed securities are generally the larger exposure. While MBS are favored because they are highly liquid and not usually exposed to credit risk, their cash flows are uncertain due to their negative convexity. ABS exposure includes airline equipment trust certificates (ETCs and EETCs), which have come under pressure recently due to turmoil in the airline industry.

See page 71 for further details regarding company exposure to BIG securities.

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North American Equity Research New York 14 January 2004

Table 22: Breakdown of Fixed Maturity Investments Company AFLAC AIG Hartford Financial Jefferson-Pilot John Hancock Lincoln National Manulife Metlife Nationwide Phoenix Principal Financial Protective Life Prudential Reinsurance Group Torchmark Corp. UnumProvident

Ticker AFL AIG HIG JP JHF LNC MFC MET NFS PNX PFG PL PRU RGA TMK UNM

Corporate Bonds 74.9% NA 44.6% 76.0% 77.4% 79.9% 57.0% 49.7% 65.8% 50.3% 76.8% 52.3% 53.7% NA 76.2% 73.6%

ABS/ MBS 0.0% NA 27.8% 21.8% 16.8% 14.1% 1.2% 32.6% 29.9% 39.7% 18.9% 34.6% 13.0% NA 3.4% 15.8%

US Treasuries 0.1% NA 1.5% 1.3% 0.4% 1.5% 41.8% 9.2% 3.6% 4.2% 1.0% 0.7% 6.9% NA 0.9% 6.1%

65.2%

19.3%

5.9%

Average

Foreign Municipal Preferred Government Bond Stock 23.9% 1.1% 0.0% NA NA NA 2.2% 15.1% 0.1% 0.0% 0.0% 0.1% 3.7% 1.4% 0.0% 3.8% 0.5% 0.2% 0.0% 0.0% 0.0% 5.7% 2.0% 0.3% 0.2% 0.5% 0.0% 1.5% 4.3% 0.0% 2.0% 1.4% 0.0% 0.0% 0.2% 0.0% 25.8% 0.0% 0.0% NA NA NA 0.3% 1.5% 17.8% 4.5% 0.0% 0.0% 5.3%

2.0%

1.3%

Other 0.0% NA 8.7% 0.7% 0.4% 0.0% 0.0% 0.5% 0.0% 0.0% 0.0% 12.1% 0.7% NA 0.0% 0.0% 1.6%

Source: Company reports and JPMorgan calculations. Data as of 9/30/03. * Data for AFLAC as of 12/31/02.

While fixed maturity investments are the primary asset class for life insurers, some companies emphasize other asset classes to achieve higher yields. Principal, Nationwide, and John Hancock, for instance, have heavy exposure to mortgage loans (27.3%, 20.5%, and 17.0%, respectively), which often feature attractive yields relative to those available on corporate bonds. Most U.S. insurers have a relatively small exposure to equities (less than 1% for most companies), due both to regulatory constraints and to the fact that insurers have not wanted to develop a separate staff to invest in equities. Manulife, a Canadian insurer, has the largest investment exposure to the equities, with 7.7% invested in equities, and also has most exposure to real estate relative to the group at 5%, although the company’s pending merger with John Hancock (with only 1.6% invested in equities) is likely to reduce this percentage. Table 23: Exposure to Selected Asset Classes as Percentage of Invested Assets $ in millions Company AFLAC AIG Hartford Financial Jefferson-Pilot John Hancock Lincoln National Manulife Metlife Nationwide Phoenix Cos. Principal Financial Protective Life Prudential Reinsurance Group Torchmark Corp. UnumProvident Average

Ticker AFL AIG HIG JP JHF LNC MFC MET NFS PNX PFG PL PRU RGA TMK UNM

Fixed Income 97.0% 59.5% 93.5% 79.9% 73.8% 83.4% 59.8% 76.7% 72.1% 78.4% 65.7% 75.2% 79.3% 50.0% 93.1% 87.8%

Equities 0.2% 1.8% 0.9% 2.8% 1.6% 0.6% 7.7% 0.8% 0.3% 2.2% 0.7% 0.3% 1.0% 0.0% 0.7% 0.1%

Mortgage Loans 0.0% 2.5% 1.1% 13.2% 17.0% 9.8% 13.7% 12.2% 20.5% 2.0% 27.3% 16.2% 0.0% 5.6% 1.4% 1.4%

Real Estate 0.0% 1.2% 0.0% 0.5% 0.4% 0.6% 5.3% 2.6% 0.3% 0.0% 2.7% 0.1% 0.0% 0.0% 0.2% 0.1%

Policy Loans 0.0% 1.3% 3.4% 3.4% 2.9% 4.5% 5.7% 4.2% 2.2% 13.3% 1.4% 3.2% 2.5% 10.9% 3.4% 7.9%

76.6%

1.3%

9.0%

0.9%

4.4%

Source: Company reports and JPMorgan calculations. Note: BIG = below investment grade bonds. Data as of 9/30/03

67

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North American Equity Research New York 14 January 2004

Realized Investment Gains and Losses Life insurers’ substantial corporate bond holdings expose companies to losses from defaults. While realized investment gains and losses do not affect operating income, they do have an impact on net income and even more importantly, statutory income, and capital. Historically, many investors focused on operating earnings for life insurers, which exclude realized investment gains and losses, because these gains and losses can be volatile and companies often have discretion as to when the gains are realized, giving them the potential to manage earnings. As investment losses mounted in 2001 and 2002, however, many investors began to pay more attention to realized and unrealized investment gains and losses. Substantial levels of realized losses likely forced companies to prematurely realize gains in some cases, causing them to reinvest principal at a lower yield and disrupting their asset/liability matching. As a general rule, insurers will not get full credit from investors for income generated from investment gains, but they are likely to be penalized for substantial investment losses.

See page 61 for a more detailed discussion of capital for life insurers.

Substantial realized losses put pressure on capital and increase scrutiny from ratings agencies. The magnitude of losses in 2002 raised concerns from rating agencies, causing them to downgrade some companies or pressure them to replace capital lost through realized losses. Both Moody’s and Standard & Poor’s have maintained a cautious view of the life insurance industry since the downturn in the credit and equity markets beginning in 2001. Bankruptcies, corporate scandals, and other defaults caused realized investment losses to reach the highest level seen in years in 2002. Most companies in the sector saw substantially higher levels of realized losses in 2002, which put pressure on capital and raised scrutiny from ratings agencies. Gross pretax losses (investment losses before offsetting investment gains and taxes) were as high as $3 billion for MET and $1.4 billion for PRU. Investment losses improved substantially for most companies in 2003, however, as the credit market has rallied and defaults decelerated sharply.

Table 24: Realized Losses $ in millions Company AFLAC AIG* Hartford Financial Jefferson Pilot John Hancock Lincoln National Manulife Financial MetLife** National Financial Partners Nationwide Financial Phoenix Cos. Principal Financial Protective Life Prudential Financial RGA Torchmark UnumProvident

Gross pretax losses Losses 3Q03 2Q03 -21.0 -26.0 -213.8 -277.0 -120.0 -51.0 -28.2 -14.0 -93.8 -130.4 -55.8 -99.2 NA NA -195.0 -188.0 NA NA -25.5 -29.2 -19.5 -121.8 -33.2 -21.4 -1.8 -1.0 -70.8 -80.0 -9.1 -9.1 -3.0 -9.0 -61.2 -82.8

Gross pretax Losses 2002 -120.2 -1,223.1 -573.8 NA -876.5 -663.0 NA -2,610.0 NA -140.3 -160.4 -456.9 -85.6 -1,454.0 -46.3 -104.2 -568.7

Net Pretax Losses 3Q03 -6.0 -356.9 257.0 20.0 89.8 -2.6 NA -61.5 NA -22.5 -2.5 -10.9 28.0 -11.0 4.0 -0.8 -26.4

Net pretax losses 2Q03 2002 -7.0 -14.0 -631.5 -2,441.0 -53.0 -400.0 -19.0 -22.0 62.6 -430.8 -91.4 -272.7 NA NA -129.2 -213.8 NA NA -53.3 -88.5 -104.6 -107.6 -76.7 -354.8 -11.7 6.1 -113.0 -867.0 -9.8 -14.7 -14.4 -40.2 -88.2 -315.0

Source: Company reports and JPMorgan calculations. Note: *AIG gross pretax losses reflect impairments only, converted to pre-tax figures using 35% tax rate. ** MET after-tax losses converted to net pretax losses using a 35% tax rate.

The improvement in realized losses for life insurers mirrors a general improvement in the credit market. Defaults on high-yield issues, which shot 68

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North American Equity Research New York 14 January 2004

substantially higher in late 2001 and remained high throughout 2002, began to improve at the end of 2002 and have declined substantially since then. The rolling last 12month rate of defaults has improved substantially from early 2002, when it reached as high as 9.3%. In fact, the December 2003 last 12-month (LTM) rolling default rate was 2.9%, below the 3.73% the default rate has averaged since 1993. Figure 14: Credit Defaults: On the Mend Rolling LTM Domestic Default Rate--High Yield 10.00% 9.00% 8.00% 7.00% 6.00%

Average=3.73%

5.00% 4.00% 3.00% 2.00% 1.00% Jul-03

Jul-02

Jan-03

Jul-01

Jan-02

Jul-00

Jan-01

Jan-00

Jul-99

Jan-99

Jul-98

Jul-97

Jan-98

Jul-96

Jan-97

Jul-95

Jan-96

Jul-94

Jan-95

Jul-93

Jan-94

Jan-93

0.00%

Source: JPMorgan.

Looking Ahead: Projecting Future Investment Losses Many insurers disclose additional details regarding their unrealized loss positions, including the composition of unrealized losses by sector or asset class and the aging of the unrealized loss positions, which can provide clues as to the risk of investment losses on the portfolio.

The level of unrealized investment losses held in an insurer’s portfolio is often an indicator of future losses. Investments held in the general account portfolio are mostly marked to market, with unrealized gains and losses on investments flowing through other comprehensive income and collecting on the balance sheet as part of accumulated other comprehensive income (AOCI). If an insurer holds a position with an unrealized loss at a certain period, the loss may either be erased by subsequent recovery in the holding or the loss can be realized. Losses can be realized either by selling the security or by writing it down to its current market value. Higher levels of unrealized losses increase the likelihood of realized losses in the future, as positions with unrealized losses often must be sold to meet liquidity needs or to avoid further deterioration or as holdings must be written down as it becomes clear that the loss is other than temporary. Companies have considerable discretion as to when losses are realized, but losses cannot be postponed indefinitely if the security is permanently impaired. AIG had the highest unrealized loss on an absolute dollar basis at $2.4 billion, although AIG’s unrealized loss as a percentage of invested assets (0.5%) and shareholders’ equity (3.6%) are below the life group averages. As a percentage of equity, John Hancock and Manulife had the highest levels of unrealized losses at 6.0% and 18.7% of equity, respectively. Manulife’s unrealized loss reflects primarily unrealized losses on equity investments held in the surplus account.

69

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North American Equity Research New York 14 January 2004

Table 25: Gross Unrealized Losses $ in millions Company AFLAC AIG Hartford Financial Jefferson Pilot John Hancock Lincoln National Manulife Financial* MetLife Nationwide Financial Phoenix Cos. Principal Financial Protective Life Prudential Financial RGA Torchmark UnumProvident Average

Gross unrealized. losses 9/30/03 -1,245.0 -2,461.5 -392.0 -134.1 -487.0 -281.9 -1,283.0 -990.0 -151.1 -120.5 -178.9 -77.6 -367.0 -24.6 -50.0 -534.1

Invested Assets 42,711.0 491,096.0 75,503.0 25,343.0 73,562.6 42,423.3 55,718.0 210,951.0 42,886.4 16,600.8 56,325.9 16,552.7 118,343.0 7,791.7 8,561.0 34,618.9

Gross unrealized losses, % of: Investments Equity -2.9% -18.7% -0.5% -3.6% -0.5% -3.5% -0.5% -3.5% -0.7% -6.0% -0.7% -5.0% -2.3% -18.7% -0.5% -4.7% -0.4% -3.1% -0.7% -6.0% -0.3% -2.4% -0.5% -4.8% -0.3% -1.8% -0.3% -1.7% -0.6% -1.6% -1.5% -6.8% -0.8%

-5.7%

Gross Unrealized. losses 12/31/02 -1,000.0 -4,153.8 -538.0 -287.0 -1,469.2 -693.1 -1,303.5 -1,690.0 -311.8 -175.3 -488.6 -178.1 -629.0 -55.9 -177.2 -1,066.7

Change from 12/31/02 $ MM % -245.0 24.5% 1,692.3 -40.7% 146.0 -27.1% 152.9 -53.3% 982.2 -66.9% 411.2 -59.3% 20.5 -1.6% 700.0 -41.4% 160.7 -51.5% 54.8 -31.3% 309.7 -63.4% 100.5 -56.4% 262.0 -41.7% 31.4 -56.1% 127.2 -71.8% 532.6 -49.9% -43.0%

Source: Company reports and JPMorgan calculations. Unrealized loss figures for AFL, MFC reflect unrealized loss on entire portfolio; other companies reflect unrealized loss on fixed maturity portfolio only. Note: * Figures for Manulife translated from Canadian dollars.

Asset Classes, Industries Where Problems Can Arise Since insurers are large bearers of credit risk, below investment grade bonds are often a source of realized losses. Insurers generally assume a modest amount of credit risk in their investment portfolios, which allows them to achieve higher yields in positive environments but which also leads to realized losses when the economy becomes weak. The amount of below investment grade (BIG) bonds held in the investment portfolio is the primary indicator of how much credit risk an insurer holds. The proportion of bonds that are below investment grade can be a function of a conscious strategy of seeking out credit risk, or can result from downgrades of investment grade bond holdings. Torchmark, John Hancock, and UnumProvident are among the largest holders of BIG bonds as a percentage of assets, at 9.0%, 7.9%, and 7.1% of assets, respectively. Torchmark is not currently adding to its high-yield exposure, and most of its high-yield holdings resulted from downgrades in 2002. UNM’s exposure to BIG was previously even larger (12.7% of assets at the end of 2002), but the company sold a substantial portion of its high-yield portfolio in the first quarter of 2003. John Hancock consciously takes on an elevated level of credit risk, but has typically also generated solid portfolio returns relative to its peers. Interest rate volatility may create problems for large holders of MBS. Wild fluctuations in long-term interest rates lead to volatility in the value of MBS and can also lead to volatility in cash flows (due to swings in mortgage prepayment activity). This can make it difficult for companies to match assets and liabilities and can lead to volatility in spreads and earnings for the products backed by the MBS assets (fixed annuities, in particular). Prepayments of principal from MBS must also be reinvested at lower yields, which can put downward pressure on portfolio yields. In addition, companies that saw yields benefit from prepayments will likely see pressure on yields as prepayments slow and yields no longer benefit from higher prepayments. 70

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The largest holders of MBS include Protective Life (25.8% of assets), Hartford (18.7% of assets), and MetLife (18.9% of assets). Of these companies, Protective has the largest exposure to residential pass-through securities (generally the most exposed to variation in prepayment rates) at 10%, versus 4.1% for HIG and 7.1% for MET. Table 26: Exposures to Selected Asset Classes, Percentage of Assets $ in millions Company AFLAC AIG Hartford Financial Jefferson-Pilot John Hancock Lincoln National Manulife* Metlife Nationwide Phoenix Principal Financial Protective Life Prudential** Reinsurance Group Torchmark Corp. UnumProvident Average

Invested Assets 42,711.0 491,095.7 75,503.0 25,343.0 73,562.6 42,423.0 54,977.8 210,951.0 42,886.4 16,600.8 56,325.9 16,718.0 118,343.0 7,791.7 8,561.0 34,618.9

BIG BIG % of MBS MBS % of Bonds Investments Exposure Investments 1,284.5 3.0% 0.0 0.0% 36,046.0 7.3% NA NA 3,573.0 4.7% 14,142.0 18.7% 1,456.0 5.7% 3,641.0 14.4% 5,830.0 7.9% 9,141.5 12.4% 2,441.5 5.8% 4,992.7 11.8% 1,342.6 2.4% 410.2 0.7% 12,184.0 5.8% 39,794.0 18.9% 1,863.6 4.3% 4,860.0 11.3% 1,119.6 6.7% 3,731.0 22.5% 3,043.5 5.4% 5,565.7 9.9% 1,021.9 6.1% 4,307.2 25.8% 6,227.0 5.3% 5,021.0 4.2% 24.6 0.3% 818.0 10.5% 768.0 9.0% 162.0 1.9% 2,473.4 7.1% 4,778.0 13.8% 5.4%

11.8%

Source: Company reports and JPMorgan calculations. *Manulife figures converted from Canadian dollars. **Prudential figures reflect financial services business only.

Investment Yields: Portfolio vs. New Money Yields Low new money yields can put downward pressure on portfolio yields and thus investment income and earnings. Portfolio yields indicate yields on a company’s overall investment portfolio, whereas new money yields are investment yields available on new investments. In a sinking interest rate environment (like the current environment), new money yields should be lower than portfolio yields, since investments held in the portfolio that were made when rates were higher should carry higher yields. Over time, however, the portfolio yield should begin to approach the yields available on new money, as cash from operations, bond maturities, and MBS prepayments are made at the new (currently lower) yields. A rise in interest rates moving into 2004 would boost investment income and help relieve pressure on portfolio yields. Portfolio yields remain under downward pressure as yields available for new money remain below prevailing portfolio yields for nearly every company in the sector. New money yields are currently about 70-250 basis points lower than portfolio yields. Pressure is likely to be most intense for companies with the widest gaps between new money yields and portfolio yields, as well as fore companies whose portfolio yields have benefited the most from MBS prepays. A continued rise in interest rates would reduce this pressure. Long-term yields climbed rapidly at the very end of the second quarter and continued to rise through the third quarter but remain below the levels seen in early 2002 and historically. Ten-year yields were 4.2% in December 2003, up from 3.1% at their low in June 2003, roughly in line with the level they were at in August of 2002 but lower than the nearly 7% 71

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North American Equity Research New York 14 January 2004

yields seen in early 2000. Increasing rates in 2004 (as many market participants expect) would relieve downward pressure on investment income and portfolio yields. Table 27: Low New Money Yields Continue to Pressure Portfolio Yields Company AFLAC AIG Hartford Financial Jefferson Pilot John Hancock Lincoln National Manulife Financial MetLife Nationwide Financial National Financial Partners Phoenix Cos. Principal Financial Protective Life Prudential Financial RGA Torchmark UnumProvident Average

Yield 9/30/03: Portfolio New Money Difference 7.63% 6.29% 1.34% NA NA NA 5.60% NA NA 6.44% 4.68% 1.76% 5.54% NA NA 6.43% 4.75% 1.68% 6.36% NA NA 6.66% 4.20% 2.46% 5.85% 5%- 5.25% 0.60% - 0.85% NM NM NM 6.00% NA NA 6.30% NA NA 6.66% 5.50% 1.16% 6.22% 4.40% 1.82% 6.66% 5.88% 0.78% 7.00% 6.30% 0.70% 7.26% 5.75% - 6.00% 1.26% - 1.51% 6.44%

Portfolio Yield 06/30/2003 7.33% NA 5.80% 6.59% 5.76% 6.49% 6.84% 6.76% 5.93% NM 6.10% 6.50% 6.71% 6.35% 6.67% 7.37% 7.40%

5.30%

6.57%

Change in yield (BP) 30.0 NA -20.0 -15.0 -22.0 -6.0 -48.0 -10.0 -8.0 NM -10.0 -20.0 -5.0 -13.0 -1.0 -37.0 -14.0

Duration 9/30/03 8.7 NA 4.8 4.8 4.0 5.2 NA 5.2 4.5 NM NA NA 5.0 5.0 6.5 6.4 8.8 5.7

Source: Company reports and JPMorgan calculations. Note: Portfolio durations for HIG, NFS as of 12/31/02. Portfolio yields for AFL, PRU reflect U.S. business only. Portfolio durations for AFL, PRU, RGA reflect U.S. portfolios.

Industry Consolidation See our detailed report titled Life Insurance Consolidation: We Favor the Buyers published December 3, 2003, for more details on consolidation.

Renewed consolidation in the life insurance industry should benefit well positioned, scale players in key businesses, which are likely to be buyers. We believe consolidation in the industry is inevitable and likely to accelerate in 2004 as operating trends improve, capital flexibility increases, and ratings agency pressures lift. We expect greater capital flexibility in 2004, driven by credit market improvements, which should drive lower levels of realized investment losses, and recent equity market strength, which should result in continued improvements in VA earnings and reduced death benefit expenses. Right now, capital and valuation constraints imply that there are few eligible buyers, while we expect the forces driving consolidation to gradually pressure companies to sell non-core businesses, sell their company, or participate in a merger of equals. We prefer potential buyers, since they are likely to gain scale and efficiency through consolidation, driving stronger earnings growth and returns. The competitive environment in the life insurance industry remains crowded, which should continue to drive consolidation activity. The life insurance industry continues to suffer from overcapacity, with a large number of players selling commodity-like products through cluttered distribution channels in a highly regulated market, with modest top-line growth and an increasing need for scale and efficiency. These pressures have sparked recent life insurance deal activity, with Hartford buying CNA’s group life and disability businesses, MetLife buying TIAA-CREF’s long-term care business, Prudential buying Cigna’s retirement business, Manulife buying John Hancock, AXA buying MONY Group, RGA buying Allianz’s life reinsurance business, Safeco announcing it is selling its life insurance business, and GE announcing it would spin off its life business.

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

North American Equity Research New York 14 January 2004

Table 28: Large Number of Competitors Suggests Further Consolidation Needed Product Variable annuities Fixed annuities Variable life Individual disability Long-term care Individual life Group disability

Number of Market Share Data Competitors* of Top 10 as of** Source 72 130 49 18 26 80 39

62% 52% 60% 91% 92% 53% 80%

2001 2001 2002 2002 2002 2000 2002

LIMRA LIMRA Tillinghast John Hewitt & Associates LIMRA LIMRA John Hewitt & Associates

Source: See table. *Total companies indicates only total of companies (with consolidated subsidiaries) captured by data source, which likely understates the total in some cases. ** Data represents latest data available.

Our Take: Potential Transactions Based on our analysis, the volume of life insurance deals is likely to pick up. We see AIG and Prudential as among the most eligible buyers in the near term, given their size and capital flexibility. The deals are likely to be varied: companies selling noncore life operations, book of business sales; “mergers of equals;” and traditional company acquisitions. We continue to view Lincoln National as the most attractive whole company acquisition candidate in the life insurance industry, given its business mix and distribution capabilities and opportunities for the buyer to increase efficiency. LNC is one exception to our view that acquisition candidates are not likely to attain strong acquisition prices: we believe that the attractiveness of LNC's franchise could warrant a premium valuation. However, the company may not be willing to sell. Furthermore, given its size and business mix, only a large, diversified financial services company with substantial financial resources could be a potential buyer for the company. Safeco’s life business is for sale, and we think the business is likely to be broken up. The company’s group medical business may prove difficult to sell, as few life insurers are likely to be interested in it, so that it is more likely to be purchased by a health insurer or a mutual insurer. As a result, we think Safeco could split off this business and sell it separately. We believe Safeco’s life insurance businesses, which consist mainly of fixed annuities, structured settlements, and life insurance, could be purchased for about $400 million separated from the group medical insurance business. In our view, these are likely to be purchased by companies seeking greater scale in life insurance business or fixed annuities. CNA’s life insurance businesses could also be sold in pieces. CNA recently announced the sale of most of its group operations to Hartford for $500 million, leaving pieces of its group operations and its individual insurance operations. We think these businesses are also likely to be sold. Based on the limited information available, we calculate CNA’s individual operations (primarily life insurance and long-term care) might be worth about $570 million in a sale. Potential buyers of these businesses include companies interested increasing scale in the life insurance business or increased scale in long term care. Companies with a presence in the LTC market may also be interested in the group LTC business, which was not part of the Hartford deal. We think Citigroup’s life insurance business would appeal to many life insurers, but only a buyer with substantial financial resources could afford to buy the whole division. While management has mentioned a sale as a possibility, Citigroup has not definitively put its life insurance business, Travelers Life & Annuity (TLA) for 73

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sale. However, given its size, we think the company needs to gain more scale to compete with larger players or be sold if it is not a core focus for Citigroup. We believe the company is more likely to be a seller or spin the business off in an IPO (like GE), given its increasing focus on its core banking operations. Citi has already spun off its property casualty operations (Travelers). Unless Citi decided to break up the business, only a large, diversified financial services company would be likely be able to buy the whole business, which we think could be worth about $8 billion. With its mix of fixed and variable annuities and individual life insurance, there could be several interested parties if the business is split into pieces. European companies are likely to take a relatively cautious approach to deals in the U.S. than in the past. European companies were active acquirers of U.S. life insurance assets in the 1990s: ING made two large purchases, Equitable of Iowa in 1997 and ReliaStar in 2000; and AEGON purchased Transamerica in 1999. These purchases were made at valuations well above current industry valuations because of their significant valuation premium over U.S. companies. Today, foreign companies have limited (if any) premium over U.S. companies and that, combined with flowback issues and limited free capital, would likely prevent them from being size buyers in the near term. More recently, AXA announced the acquisition of the MONY Group, although the size ($1.5 billion) and valuation (a 27% discount to BV) for this deal were more modest than for deals executed in the 1990s. AXA’s deal is likely more representative of the types of deals European insurers would now pursue. Companies that we believe could emerge as sellers include Jefferson Pilot, Lincoln National, and Phoenix. These are companies we believe have businesses that could be attractive to an acquirer and that would be more attractive in the long term if they had greater scale. More generally, we think nearly every company in the life insurance sector could emerge as a buyer or seller, capital and valuation permitting.

Recent Deals: Modest Premiums The recovery in the equity and credit markets appears to have resulted in a revival in M&A activity. Company P/E and P/BV multiples have recovered substantially from trough levels, capital positions in the industry are beginning to improve, and operating conditions are also improving, sparking recent merger activity. The largest life insurance transaction announced in 2003 was the recent offer from Manulife Financial to buy John Hancock for $10.8 billion in stock. John Hancock has been eager to pursue a transaction for some time, and Manulife has a substantial level of excess capital and sought to make a major purchase in North America. MFC was outbid by Great West Lifeco in its proposed hostile acquisition of Canada Life earlier in 2003. The deal represents the most significant life insurance deal since AIG’s acquisition of American General in April 2001. Other recent transactions include HIG’s $500 million purchase of group life and disability businesses from CNA, PRU’s $2.1 billion purchase of Cigna’s retirement business, UNM’s sale of its Canadian operations to RBC, AXA’s $1.5 billion bid for MONY Group, and RGA’s $310 million purchase of Allianz’s U.S. life reinsurance business.

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

North American Equity Research New York 14 January 2004

Table 29: A Flurry of Deals Announced Recently $ in millions Date 12/1/03 11/20/03 11/18/03 11/17/03 9/28/03 9/22/03 9/17/03

Target Name CNA selected group businesses TIAA-CREF LTC business UnumProvident Canada operations Cigna retirement business John Hancock Financial Allianz U.S. life reinsurance business MONY Group

Acquirer Name Hartford Financial MetLife Royal Bank of Canada Prudential Manulife Financial RGA AXA Group

Deal Value $500.0 NA 500.0 2,100.0 10,871.0 310.0 1,507.8

Payment Type Cash Cash Cash Cash Stock Cash Cash

P/BV 0.7 NA NA NA 1.36 NA 0.7

P/E-- Last FY NA NA NA 9.1 12.1 NA NM

P/E Forward (est.) 10.0 NA NA 8.5 11.2 8.9 NM

Source: Company reports and JPMorgan calculations.

Valuations of recent deals appear modest relative to the recent past, however. In the late 1990s, life and health insurance deals saw average valuations of close to two times book value and P/Es above 20. While these valuations were likely inflated due to the robust performance of the equity market, valuations of recent deals have been much more constrained. While consolidation activity should generally support valuations in the sector, given industry dynamics and current trends we do not believe sellers are likely to receive the rich premiums they saw in the late 1990s. • Hartford purchased group life and disability businesses from CNA at a 30% discount to book value. • PRU acquired Cigna’s retirement business for a relatively modest valuation of 8.5 times 2004E earnings. • Manulife’s bid for John Hancock offered only a 30% premium to book value. At 12.1 times and 11.2 times our 2003 and 2004 estimates, respectively, Manulife’s bid for JHF also does not appear to be aggressive. • While P/E ratios are inflated due to the MONY Group’s depressed earnings, AXA’s bid for MONY values the stock at a 30% discount to book value. Table 30: Average Multiples of Life, Health Announced Deals Valuation: Median Price/ Earnings (x) Average Price/ Book (%)

1997

1998

1999

2000

2001

2002

17.57 1.98

31.21 1.87

22.45 1.38

20.67 1.62

22.53 1.48

19.78 1.16

Source: SNL.

Background: Historical Life Deals Despite the recent pickup in deals, activity remains far below the peak levels seen in the late 1990s. From 1997 to 2002, there were $106 billion of announced life and health insurance deals (excluding Prudential plc’s failed bid for American General in 2001) in 240 separate transactions. Activity, in terms of number of deals peaked in 1998, while value of announced deals peaked in 2001. The $12.7 billion of deals announced in 2003 easily surpasses the $2.9 billion of deals in 2002, but this is also primarily driven by a single large transaction (Manulife’s $10.8 billion bid to purchase John Hancock).

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

North American Equity Research New York 14 January 2004

Figure 15: Deal Activity Picking Up in 2003, but Still Off Peak 40,000.0

Total Deal Value ($M)

33,915.3

35,000.0 29,018.4

30,000.0

Number of Deals

25,000.0 20,000.0 15,000.0

50 40 30

16,198.7 13,050.0

12,393.2

11,320.4

60

20

10,000.0 10

2,718.0

5,000.0 0.0

0 1997

1998

1999

2000

2001

2002

2003 YTD

Source: SNL. Note: 2001 excludes Prudential Plc’s $24.6 billion unsuccessful bid for American General, which was subsequently purchased by AIG.

The largest acquirers of life insurance companies in the 1990s included diversified financial services companies (particularly AIG) and major European insurers. • AIG executed two of the largest life insurance acquisitions of the past five years, acquiring SunAmerica in August 1998 for $19.7 billion in stock, and later buying American General in 2001 for $23 billion in stock. Both acquisitions expanded AIG’s presence in various life insurance businesses and made the company a leading provider of variable annuities. • European insurers were active acquirers of U.S. life insurance assets in the 1990s. ING made two large purchases, buying Equitable of Iowa in 1997 for $2.2 billion and Reliastar in 2000 for $4.9 billion. AEGON made the largest life insurance purchase for a European insurer, buying Transamerica in 1999 for $10.9 billion. • In 2000, France-based AXA purchased the 40% of its U.S.-based subsidiary, AXA Financial, it did not already own for $9.5 billion. AXA Financial is the holding company for Equitable Life and AXA Advisors, among other companies. Table 31: Selected Large Transactions in the Life Insurance Sector $ in millions Date 12/20/02 12/18/02 8/8/01 7/30/01 5/3/01 4/3/01 1/25/01 8/30/00 5/1/00 9/20/99 2/18/99 11/23/98 8/20/98 9/12/97 7/28/97 7/8/97 2/13/97

Acquiree Name American Skandia Conseco--Assets And Operations Provident Mutual Life Insurance Lincoln National--Reinsurance business Liberty Financial--Keyport Life American General Corp. Fortis Financial Group AXA Financial Reliastar Financial Corp Guarantee Life Companies Inc Transamerica Provident Companies Inc SunAmerica Western National Corp CIGNA--Individual Life, Annuity Business Equitable Of Iowa Companies USlife Corp Average Median

Source: SNL and JPMorgan estimates. 76

Acquirer Name Prudential CFN Investment Holdings Llc Nationwide Financial Serv- A Swiss Re Sun Life Financial Inc American International Group Hartford Financial Svcs Grp AXA Group ING Group NV-CVA Jefferson-Pilot Corp AEGON UnumProvident Corp American International Group American General Corp Lincoln National Corp ING Group NV-CVA American General Corp

Deal Value $1,265.0 850.0 1,120.0 2,000.0 1,700.0 22,989.1 1,120.0 9,503.6 4,969.1 415.3 10,938.1 4,550.3 19,676.9 1,163.0 1,400.0 2,179.9 2,177.8

Payment Type Cash Cash Cash and Stock Cash Cash Stock Cash Cash and Stock Cash Cash, Stock & Debt Cash, Stock & Debt Stock Stock Cash and Stock Undisclosed Cash and Stock Stock

P/BV 0.7 NA 1.3 2.9 1.3 2.7 NA 1.5 2.4 1.4 1.7 1.3 5.7 2.1 NA 2.6 1.5

P/E-- Last FY NA NA 14.9 16.0 17.1 22.3 NA 12.3 18.2 20.7 14.3 15.0 34.3 18.0 NA 17.6 22.1

P/E Forward (est.) 8.0 NA 13.4 14.8 NA 16.0 NA NA 15.6 17.0 19.4 NA 33.0 16.9 NA NA 14.1

2.0 1.5

18.2 17.3

15.6 15.2

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

North American Equity Research New York 14 January 2004

Mutual Insurers and Demutualization While there are a larger number of stock life insurers, many mutual insurers are well capitalized and are key competitors in major life insurance businesses. According to the ACLI, there were 89 mutual insurers in the United States, in 2001, which represented 13.5% of industry assets and 12.7% of life insurance in force. Major mutual life insurers are often well capitalized and have substantial distribution capabilities, which enable them to compete with stock insurance companies. The largest mutual insurance companies have significant capital and asset bases, and seven of the 20 largest life insurers (as ranked by statutory assets) are mutual companies. Figure 16: Largest Life Insurance Companies by Statutory Surplus, 2002 $ in millions Rank 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20

Company American International Group TIAA Group MetLife New York Life Group Northwestern Mutual Group Travelers (Life company) MassMutual Financial Group Prudential Financial Equitable John Hancock Allstate Life Principal Life State Farm UnumProvident Hartford Life Jackson National Thrivent Financial Lincoln National Western and Southern IDS Life

Statutory Surplus 15,571.1 9,671.6 8,924.4 7,855.2 7,217.1 6,942.8 6,104.6 5,699.4 4,091.3 3,522.9 3,400.8 3,339.2 3,310.6 3,252.6 3,019.0 2,888.9 2,643.8 2,628.1 2,587.0 2,408.4

Statutory Assets 233,668.2 144,477.9 244,974.8 81,993.5 102,918.6 55,274.5 74,762.1 186,612.4 78,251.3 79,332.2 63,792.2 78,002.4 32,098.0 27,318.2 136,833.3 45,364.1 41,203.5 70,964.3 7,692.6 44,831.4

Premiums Written 33,622.7 9,631.9 28,238.9 10,730.3 10,071.1 3,772.0 10,296.6 16,202.8 11,302.9 8,022.5 9,175.0 5,065.9 3,227.8 6,065.9 15,336.6 6,153.1 3,365.6 8,762.1 447.5 5,612.1

A.M. Best and JPMorgan calculations. All figures represent statutory figures and reflect aggregates for life insurance subsidiaries only. Mutual companies are bolded.

Mutual insurers are oriented to maximize solvency, not returns, which allows them to be more aggressive in some markets than stock companies. The lack of pressure from public shareholders to generate high ROEs often allows mutual insurers to price their products more competitively than stock companies. This can reduce returns in markets where mutual companies have chosen to compete aggressively. Since they do not have a stock currency, it is more difficult for mutual companies to execute acquisitions. The lack of a stock currency makes it very difficult for mutual insurers to participate in industry consolidation, which is one reason many mutual companies have chosen to come public.

The Demutualization Wave The number of mutual companies is shrinking as companies decide to go public, and further demutualizations are likely. The largest mutual insurers, New York Life, Northwestern Mutual, and Massachusetts Mutual have indicated that they will continue under the mutual structure in order to maintain focus on serving policyholders. Some mutuals have resisted the temptation to fully demutualize and 77

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North American Equity Research New York 14 January 2004

have formed holding companies to more effectively compete with pure stock companies. Still, it is likely that other mutuals will convert to stock companies in the coming years. A large number of mutual insurers chose to convert to stock companies in the late 1990s and early 2000s. Companies that have demutualized include smaller companies such as the MONY Group and Stancorp and some of the largest companies in the industry, such as MetLife and Prudential Financial. The largest Canadian life insurers, including Sunlife, Manulife, and Canada Life, also underwent demutualization in the late 1990s. Most deals were priced at book value or below, although a few companies that came public before the equity market decline in 2001 sold stock at a premium to book value. Table 32: Recent Demutualizations in United States, Canada Company Mony Group StanCorp. Financial Group Clarica Life Manulife Canada Life John Hancock Sun Life of Canada Metlife Phoenix Life Insurance Principal Financial Prudential Financial

Date of Demutualization 11/16/1998 04/16/1999 07/15/1999 09/24/1999 10/28/1999 01/27/2000 03/23/2000 04/05/2000 06/20/2001 10/23/2001 12/13/2001

Average

IPO Price 23.50 23.75 C$20.50 C$18.00 C$17.50 17.00 C$12.50 14.25 17.50 18.50 27.50

BV Multiple 0.65 0.92 1.17 1.45 1.00 1.00 0.85 0.77 0.79 1.01 0.85 1.01

Source: Company reports and JPMorgan calculations.

Demutualization: Strategic Rationale and Process Greater flexibility to raise capital or make acquisitions and the ability to attract qualified employees through stock compensation have been catalysts for the recent wave of demutualizations. Many companies have felt they needed the increased capital flexibility and the ability to make acquisitions (or be acquired) in order to compete effectively in an increasingly tough competitive environment. Demutualization also can result in better capital strength, and one common result of demutualization is a higher credit rating owing to requirements on public companies for a higher degree of transparency. Demutualization can also have substantial financial appeal for key senior executives both because of the possibility of stockbased compensation. Demutualization creates increased pressure to achieve higher returns, which can lead to higher efficiency. Companies that have demutualized often have substantial opportunities for cost savings and increased efficiency, which allows the companies to boost earnings growth and returns. Cost saves can be achieved through headcount reductions, changes in product pricing, and process optimization. In a demutualization, the policyholders who own the company essentially sell their ownership interest to the public through an IPO. A mutual insurance company is designed as a cooperative of policyholders, who act as owners of the company. Policyholders elect the board of directors and vote on corporate issues, but 78

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North American Equity Research New York 14 January 2004

the equity of a mutual company is owned by the cooperative. Individuals have no right to the equity a mutual except in the case of dissolution. During a demutualization, equity payments are made to policyholders through cash or stock offering. The firm recapitalizes once all of the equity has been repaid, most often through an IPO. This process usually lasts a year and a half to two years. Conversion is another method that allows a mutual company to become public through selling policyholder’s shares of stock equal to the valuation price of the initial offering price of the stock. The stock is then listed on an exchange and becomes publicly traded. While conversion is common, most mutual companies choose to demutualize. Sponsored demutualization is another way mutual companies can become public. In a sponsored demutualization, the mutual company exchanges its equity for shares in a publicly traded life insurer instead of launching an IPO on its own, and merges with the publicly traded company. Two examples of sponsored demtualizations include Provident Mutual (purchased by Nationwide Financial) and Indianapolis Life (purchased by AmerUs). A mutual holding company structure maintains the company's ownership by policyholders, but enables it to issue stock for sale to the public. Insurers reorganize into a stock life insurer by forming a new mutual holding company. This new holding company owns, directly or through one or more stock holding companies, the mutual life insurer. The mutual holding company is able to sell stock and have access to the capital-raising marketplace and pursue affiliations with companies. The Nationwide group has more than $117 billion in assets. Nationwide Mutual Insurance is the parent company of Nationwide Financial Services with Nationwide Financial as the holding company for Nationwide's retirement savings operations and Nationwide Life Insurance Co. Other examples of mutual holding structures include Principal Financial, Pacific Life, and Minnesota Life.

Regulatory Issues Regulatory scrutiny due to the mutual fund scandal, a push to create new savings accounts, and tax cuts are among the regulatory issues affecting insurers. Insurance is a highly regulated industry, and life insurers operate within a complex regulatory framework. The industry has recently come under scrutiny from regulators due to the recent mutual fund scandal, although we think the ultimate exposure for insurers will be limited. In addition, the Bush administration’s push to create new taxadvantaged savings plans could create additional competition for variable annuities and could reduce their appeal. Also, since tax advantages are the primary appeal of many insurance products, the industry is sensitive to changes in tax rates and recent changes in the dividend and capital gains tax rates have had ramifications for many life insurance products, and have also led some life insurance companies to reevaluate their dividend policy.

Fund Timing: VA Company Exposure Appears Limited We believe variable annuity companies do not have significant exposure to the mutual fund timing scandal, although the issue is likely to hang over certain companies. Regulators have begun investigating companies involved in asset management for market timing or late trading by employees and fund holders in the funds they manage, as well as those companies in the variable annuity business in the 79

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North American Equity Research New York 14 January 2004

event that market timing or late trading occurred in the mutual fund underlying the variable annuity. Variable annuities could also come under fire for their fee levels. Market timing takes advantage of the fact that net asset values for funds (particularly international funds) sometimes lag market developments. Market timing is possible in variable annuities, but it is really being done in the mutual funds embedded in the variable annuity product and the responsibility would appear to be with the asset manager or the broker. Given that the large component of variable annuity assets is in mutual funds, the opportunity for market timing and late trading exists. Customers are allowed to switch among mutual funds without triggering a tax event. Also, the mutual funds embedded in the variable annuities are the same funds consumers can buy in the retail market. Companies with broker/dealer or asset manager subsidiaries are most likely to be exposed to this issue. While we do not think variable annuity companies are likely to bear responsibility for mutual fund timing, nearly every asset manager in the United States has received a request for information regarding market timing. MetLife, Phoenix, Lincoln, AIG, Principal Financial, John Hancock, and Prudential all own asset managers. Among life insurers, Prudential has received the most scrutiny as a result of the scandal, but the company is cooperating fully with investigators. While PRU has entered into a joint venture with Wachovia, PRU is exposed to risk if Prudential Securities is found liable for any damages on events occurred prior to the Wachovia deal. The SEC charged five former Pru Securities brokers and one branch manager with conducting market timing trades in mutual funds. The company has also received a subpoena from the U.S. District Attorney in Massachusetts requesting information regarding mutual fund timing. While Prudential has not been charged with any wrongdoing, the company has been incurring litigation expenses, in the form of lawyer and legal fees, to defend itself from any adverse developments. While it is difficult to gauge the company’s ultimate exposure to this issue, management appears to be doing everything possible to satisfy the regulators.

Renewed Savings Accounts Push Could Hurt VA Industry The Bush administration appears to be reviving efforts to introduce new taxsheltered savings accounts, which would be a negative for the VA industry. The administration introduced the idea of the accounts in 2002, but retreated amid opposition and severe pressures on the federal budget. Press reports indicate the President has renewed his push to create the savings accounts and plans to unveil a new plan to create them in January of 2004. Variable annuities retain a number of advantages over the plans, including unique product features and incentives for distributors to sell VAs. One advantage that variable annuities would retain is that variable annuities offer unlimited contributions whereas the two new plans have a $7,500 cap in 2004 and future years’ contribution maximums are tied to inflation. Annuitization, death benefits, and living benefits (such as GMIBs and GMWBs) are other advantages annuities would retain over the plans. Another mitigating factor is that high commissions may still encourage brokers to sell variable annuities, even though the new savings accounts may be more attractive to consumers. The administration’s plan would create a lifetime savings account (LSA) and a retirement savings account (RSA), both of which would potentially create more 80

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North American Equity Research New York 14 January 2004

competition for retirement savings dollars and reduce the appeal of VA products. The new plan could also introduce a savings plan similar to a 401(k), as was included in the earlier proposal. •

LSAs would allow individuals to contribute $7,500 after taxes each year, and gains on the account would not be taxed. Funds could be withdrawn at any time. RSAs would also be funded in after-tax dollars and have an annual contribution limit of $7,500, and gains could also be withdrawn tax free, although funds could only be withdrawn after retirement. While individuals would not need earnings to contribute to an LSA, RSAs could only be funded with the account holder’s earnings. Additionally, RSA funds could not be accessed before age 58.



Whereas gains on the LSA and RSA would not be taxed, gains from annuities are sheltered from taxes but withdrawals are taxed at the ordinary income tax rate.

We do not think the proposals spell the end of the variable annuity industry. If the plan is approved as is, the industry may be forced to focus on either building up new products (like long-term care which caters to an older market) or focus more on products in the payout, rather than accumulation phase, like immediate annuities. Companies in the industry could also create wrap products for these 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. Additionally, the plans are still likely to face stiff opposition, given growing budget deficits, and the plans are likely to be significantly altered as they make their way through Congress.

Dividend Tax Cut Impact Appears Minimal See page 63 for details on Life Insurers’ changes in dividends as a result of the tax law change.

The reduction in the dividend tax rate appears to be having little negative impact on the variable annuity industry. Congress approved a tax cut measure that included a reduction in the dividend tax rate to 15% from the current rate (where dividends were taxed as ordinary income, at a rate up to 38.6%). The industry continues to lobby for a similar reduction in taxes on variable annuities. The lobbying arm of the life insurance industry, the American Council of Life Insurers (ACLI), undertook an aggressive lobbying effort to have the dividend tax reduction applied to annuities, but it was unsuccessful. The industry continues to lobby for a reduction in the tax rate on income from variable annuities upon annuitization, and industry officials expect to be successful in winning a reduction sometime in 2004. Given strains on the budget, however, and the size of tax cuts already pushed through by the administration, we think these efforts face an uphill battle. Variable annuities require a long holding period (roughly 12 years) for their tax advantages to overcome higher fees compared to taxable mutual funds. Since withdrawals on variable annuities will continue to be taxed at ordinary tax rates, a reduction in the tax on dividends in mutual funds would erode the tax advantages annuities have over taxable mutual funds and cause the breakeven point, or holding period, to extend to about 15 years. This analysis assumes that variable annuity dividends get taxed at the ordinary rate and that dividends represent about 40% of mutual fund income.

81

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

North American Equity Research New York 14 January 2004

The tax cut reduces the relative appeal of variable annuities, but does not appear to have significantly impacted sales. The new tax legislation reduces the relative attractiveness of variable annuities over mutual funds because the income on annuities is taxed at ordinary income tax rates when withdrawn. However, we believe that agents and brokers will continue to aggressively market variable annuities because of the products’ other tax deferral features, death benefits, and high commissions paid to distributors. Strong growth in VA sales in the second quarter of 2003 seems to indicate the impact of the dividend tax cut on VA sales is modest, at most. A number of life insurers raised their dividends as a result of the change in dividend tax rates. The tax rate on dividends was cut to 15% from the higher ordinary rate (as high as 38.5%), prompting a number of companies to increase their dividend payouts. AIG, Principal, and Prudential introduced the largest dividend increases, raising their dividends by 38.3%, 80%, and 25%, respectively. Table 33: Summary of Companies Increasing Dividends in 2003 Company AFLAC AIG Hartford John Hancock Lincoln National Manulife Metlife Principal Prudential Torchmark

Old Dividend $0.28 0.19 1.08 0.32 1.34 0.72 0.21 0.25 0.40 0.36

New Dividend $0.32 0.26 1.12 0.35 1.40 0.84 0.23 0.45 0.50 0.44

Increase 14.3% 38.3% 3.7% 9.4% 4.5% 16.7% 9.5% 80.0% 25.0% 22.2%

Dividend Yield 0.9% 0.4% 1.8% 0.9% 3.4% 2.0% 0.7% 1.4% 1.2% 1.0%

Source: Company reports and JPMorgan estimates. Figures represent annual dividends. *Manulife dividend in Canadian dollars.

Background on the Tax Bill On May 22, 2003, republicans in the House and Senate reached agreement on H.R. 2, the “Jobs and Growth Tax Relief Reconciliation Act of 2003.” The proposed bill encompasses $350 billion in tax cuts, including an aid package for states worth $20 billion. While substantial, the tax cut package is lower than the amount the White House initially envisioned. • Among the various features of the bill is a proposal to reduce the capital gains tax rate from 20% to 15% (and from 10% to 5% for lower bracket taxpayers). • In addition, the bill proposes a reduction in the tax rate on corporate dividends from the ordinary tax rate, which can be as high as 38.6% currently, to the new rate for capital gains taxes. Thus taxpayers in the top income bracket will pay a 15% tax rate on corporate dividends while those in the lowest bracket will pay 5%. Additionally, in 2008, the dividend tax rate for those in the lowest income bracket will go to 0%. • However, the dividend tax reduction expires in 2009 due to a sunset provision. In 2009 and beyond, dividends will be taxed at the ordinary income tax rate for individuals in all tax brackets, as they are currently. It is highly likely that republicans will mount an effort to make the tax cut permanent in the future, however.

82

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North American Equity Research New York 14 January 2004

Earnings Model Mechanics Insurance company financial statements do not resemble those of manufacturing companies, and line items will often appear unfamiliar to analysts not familiar with the sector. Below, we offer a brief overview of typical income statement items for insurance businesses and a description of account value rollforwards, which have become increasingly important with the rising prominence of investment-oriented insurance products.

Business Segment Income Statements Business segment income statements provide a snapshot of earnings for a given period, although it is important to remember that many line items are estimates. Income statements for life insurance businesses reflect the mix of products managed within the business, with traditional products generating premiums income, while savings-oriented products generate fee income and investment income. Revenues generally fall into three categories, although companies often break these into several line items: FAS 60 products include traditional life insurance policies (short-duration contracts) such as term life, while FAS 97 products include savingsoriented (long-duration) products such as VL, UL, and variable annuities.



Premiums are non-investment revenues earned from traditional insurance products such as term life and many health insurance products. These are often known as FAS 60 products. Insurers sometimes disclose gross premiums, reinsurance ceded, and net premiums, with net premiums being most relevant to earnings (although gross premiums can indicate top-line growth potential). Premiums can be modeled as a percentage of average insurance in force.



Fees are driven by the level of life insurance in force and the level of separate account assets. These are generally earned on variable annuities and variable and universal life (often known as FAS 97 products). Insurers provide different levels of detail regarding these fees and the line items are called by various names, including “expense assessments,” (LNC) “variable annuity and life fees,” (JHF and HIG) and “asset fees.” Fees for these products, particularly for variable annuities, can be projected by multiplying a fee rate by the average account balance associated with the product.



Net investment income, which represents investment income earned on reserves associated with products (such as traditional life, fixed annuities, health insurance products, and universal life) held in the general account. Some insurers disclose several components of net investment income, but the final (net) figure is generally the most relevant. Net investment income can be projected multiplying the average general account balance associated with a given product by a reasonable yield. Projecting investment income in this way is most useful for products such as fixed annuities and GICs, for which companies typically disclose detailed account value information.

The level of detail regarding expenses disclosed by insurers also varies, although expenses generally fall into these categories: •

Benefits are generally the largest expense items associated with insurance products. These consist of death benefits and disability payments associated with a given product. Benefits can be projected as a percentage of premiums, which varies with the type of product and the underwriting skill of the 83

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North American Equity Research New York 14 January 2004

company. Benefits for companies not as skilled at underwriting will generally tend to be both more volatile and higher as a percentage of premiums. •

Interest credited represents interest payments made to holders of fixed-return type products such as fixed annuities, universal life, and GICs. It is usually broken out as a separate expense line, although it is sometimes consolidated in the benefits line. Interest credited can be projected as a percentage of the general account balance associated with the business segment being modeled.



Commissions, DAC, and DAC amortization are three interrelated expense items. Commissions are mostly commission payments made to agents and other salespeople for selling a product. DAC is a contra-expense consisting of commission expenses that are capitalized. These commissions later flow through the income statement through the DAC amortization line. Commissions can be projected as a percentage of deposits or new sales. DAC and DAC amortization are difficult to model, but generally are related to sales and the size of the asset base associated with a product. They also depend on the performance of assumptions underlying the product, including persistency and profitability.



Operating expenses represent overhead and general operating expenses associated with the business. They can be projected as a percentage of premiums or revenues, which should be a relatively stable relationship, although companies with opportunities for expense savings should see a decline in this ratio over time. Companies achieving greater scale in a given business should also see this ratio decline.

Table 34: Summary: Important Income Statement Line Items and Major Drivers Line item

Driver

Revenues: Premiums

Insurance in force

Expenses: Benefits / losses

Premiums

Description

Premium income from traditional life products, recognized proportionally over the life of the policy. Fees Reserve balances/ Fees charged on average account balances associated with Insurance in force variable annuities. Also, cost of insurance fees charged based on the face value of variable life and universal life policies Net investment income Reserves / invested assets Investment income earned on all products backed by general account (fixed annuities, GICs, health insurance products)

Interest credited

Reserves/invested assets

Commissions

Sales

DAC

Deposits

DAC amortization

Various

Operating costs

Premiums / revenues

Death benefits associated with life insurance products, disability income payments, and other benefit payments. Interest payments associated with general account products. Payments (to agents and other producers) associated with sales of products. Commissions, selling expenses capitalized at time of sale Capitalized selling expenses amortized over projected life of policy based on basic profitability assumptions. General operating expenses that usually track overall size of business and overhead

Source: JPMorgan.

Account Value Rollforwards Account value rollforwards are important indicators of future earnings for fixed and variable annuities and asset management businesses. Given the shift to investment-oriented products from protection products, fees earned on account balances have increased in importance. Modeling the account value rollforward for these products makes it possible to project these fees more accurately. 84

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North American Equity Research New York 14 January 2004

Growth in deposits and net cash flows are the best indications of a company’s success in selling a product. Additions to the account include deposits and investment performance (when investments appreciate). While investment performance is often larger in magnitude than deposits to the account, deposits are one variable that the company can control (through marketing and distribution efforts). Withdrawals, often an indication of how happy policyholders are with their contract, are another important variable in the growth of the account balance. The net of deposits less withdrawals, also known as cash or net flows to the account, indicate how successful the company’s efforts to grow the account are. Over time, superior growth in account balances is likely to lead to faster earnings growth for the business. Table 35: Anatomy of an Account Rollforward Item

Description

Beginning Balance

= Previous ending balance

Deposits

New sales and deposits into existing contracts

Investment Performance Performance of account assets Surrenders

Also called withdrawals

Exchanges Other

Movement to another account, often transfers between fixed and variable accounts. A positive value represents a transfer into the account from another account and vice versa Death benefits, annuitizations, other reductions in the account balance

Ending Balance

Sum of all of the above

Source: JPMorgan.

Statutory Accounting Regulators and ratings agencies use more conservative statutory accounting principals (SAP), not GAAP, to evaluate life insurers. Publicly held insurers generally prepare financial statements using both statutory accounting principals (SAP) and generally accepted accounting principals (GAAP). SAP statements are used in filings with state regulators, while GAAP financials are presented to shareholders. A primary concern of state regulators is to ensure insurers will be able to meet their policy obligations, so SAP financials tend to be focused on solvency (rather than profitability). As a result, capital and net income tend to be lower under SAP than under GAAP. Statutory net income and capital disclosed in SEC filings refer only to individual regulated insurance entities, and often do not compare to consolidated results. Earnings and capital relating to subsidiaries not included in the regulated entity, for instance, are not included in statutory earnings but do appear in consolidated results. International operations, for instance, are often not held by the statutory entity, so earnings from these operations do not appear in SAP net income.

SAP vs. GAAP Net Income Statutory net income is a more conservative measure than GAAP net income in several respects. The level of statutory net income is an important determinant of the capital flexibility of the insurer, since the amount of capital that can be sent from the regulated insurance entity to the holding company (without special regulatory approval) is generally limited to 10% of statutory capital or the previous years’ statutory income from operations excluding any capital gains. As a result, pressure on 85

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North American Equity Research New York 14 January 2004

statutory earnings is felt more acutely in times of financial distress and becomes more of a focal point for investors.

86



Commissions and selling expenses are major expenses associated with the insurance business. Under GAAP accounting, policy acquisition costs (DAC) can be capitalized and held on the balance sheet and gradually amortized over the life of the policy, so that the costs of acquiring the policy are matched to the revenue flow of the policy. Acquisition costs are expensed as incurred under SAP accounting. Companies that are experiencing strong sales are likely to show significantly lower SAP than GAAP earnings since SAP accounting demands the up front expensing of acquisition costs, while revenues from the policies accrue to the company over a number of years.



In contrast to GAAP, wholly owned subsidiaries are not consolidated but are recorded at statutory equity value. Net income or loss of the subsidiary is not reflected in income but in surplus.



Some realized gains recognized under GAAP net income are deferred under SAP net income. Under SAP, realized capital gains on bonds that have appreciated due to changes in interest rates are kept in an interest maintenance reserve (IMR) and amortized over the expected future life of the security. As a result, these gains do not immediately benefit net income. In periods of heavy credit losses, this treatment makes it more difficult for companies to offset realized losses with gains, since interest rate gains are amortized over time.

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

North American Equity Research New York 14 January 2004

Appendix I: Life Insurance and Annuity Market Players Individual Variable Life 2001 2002 %Chg.

$ in millions Sales/Premiums Assets/Reserves A Key players(sales/premiums)

Distribution (% of total) Career agents PPA/independent Broker/Dealer Financial institutions Third party Worksite Other Sources:

$ in millions

Ordinary Life 2001 %Chg.

2000

5,900

4,000

-32.2%

102,387.2 94,637.3

-7.6%

84,150

66,317

-21.2%

564,752 588,984

4.3%

Hartford Financial Pacific Life Nationwide MetLife AXA Group

7.76% 7.60% 7.09% 6.48% 6.02%

2000 52% 27% 14% 1% 0% 0% 5%

2002 45% 30% 20% 2% 0% 0% 3%

2001 48% 29% 17% 1% 0% 0% 4%

Sales data by Assets Key Players by Distribution data by .

Tillinghast Tillinghast Tillinghast VARDS

Individual Variable Annuities 2001 2002 %Chg.

AIG/Amer. General Northwestern Mutual Prudential of Amer. New York Life ING Group 1998 51% 26% 8% 1% 7% 1% 6% Premiums Key Players by Distribution data by Distribution data by

9.31% 8.34%% 6.55%ss 6.31% 4.45%%

1999 55% 3% 10% 1% 3% 1% 6%

2000

27,067.6 28,255.8 23,980

Individual Fixed Annuities 2001 2002 %Chg.

27,062

MetLife Prudential CIGNA Group Hartford Financial Mass Mutual

2000 50% 25% 11% 1% 7% 1% 7%

AM Best AM Best AM Best AM Best

Group Life 2001 %Chg.

1998 3% 14% 0% 0% 9% 2% 72%

1999 2% 13% 0% 0% 3% 1% 80%

AM Best AM Best AM Best AM Best

Total Annuities 2001 %Chg.

113,001.7

113,875.6

0.8%

74,300.0

103,300.0

39.0%

303,834.4 250,373.7

-17.6%

Assets/Reserves

886,043.1

795,816.4

-10.2%

417,000.0

484,000.0

16.1%

868,015.9 780,217.6

-10.1%

Distribution (% of total) Career agents PPA/independent Broker-Dealers Financial institutions Other Sources:

TIAA-CREF Hartford Financial AIG/Amer. General Aegon AXA Group 2000 34% 27% 24% 12% 3% Sales data Assets by Key players by Distribution data by

11.2% 9.2% 7.1% 5.8% 5.7% 2001 36% 24% 27% 11% 2%

AIG/Am. General Aegon Allianz Life N.A. Allstate ING

2002 35% 26% 26% 11% 2% VARDS VARDS VARDS VARDS

10.86% 6.73% 6.06% 4.98% 4.65%

AIG/Am. General Hartford ING Aegon Nationwide

4,232.5

9.2%

GE Financial Conseco AFLAC Inc. John Hancock Aegon

39.06% 19.38% 8.47% 6.93% 6.45%

2000 3% 24% 0% 0% 9% 2% 61%

Sales/Premiums Key players (sales)

3,874.8

12.9% 22.14% 11.53% 6.49% 6.26% 4.83%

Premiums Key players by Distribution dada by Distribution data by

2000

4.3%

Long –Term Care 1999 2000 %Chg.

7.70% 7.00% 6.29% 5.62% 5.10%

Premiums Key players by

AM Best AM Best

Total Group Disability 2001 2002 %Chg. 1,740

1,730

UnumProvident Hartford MetLife StanCorp Prudential

-0.6%

24.06% 11.09% 10.35% 6.77% 6.46%

2002 12% 38% 7% 36% 8% Sales data by Assets by Key players by

LIMRA LIMRA LIMRA

Sales data Key players by

AM Best AM Best

Sales data Key players by

JHA JHA

Note: Individual variable annuity assets refer to assets in variable annuity separate accounts plus the fixed bucket assets of variable annuities. Individual fixed annuity assets refer to total assets in individual fixed annuities. Total annuity reserves refer to statutory reserves for individual and group variable and fixed annuities and are not comparable to assets data.

87

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North American Equity Research New York 14 January 2004

Data as of: Aegon/Transamerica Aetna AFLAC Allianz Life Allmerica Financial Allstate Insurance American Enterprise American Express (IDS) AIG/American General American Skandia Annuity & Life Re AXA Group CIGNA Group Citigroup/Travelers CNA Insurance Conseco Group Fidelity Investments Fortis, Inc. GE Life Great-West Life Guardian Insurance Hartford Financial ING Group/Reliastar Jackson National Jefferson-Pilot John Hancock Lincoln National Thrivent Financial Manulife Financial Massachusetts Mutual Merrill Lynch Life MetLife, Inc. Nationwide Financial New York Life Group Northwestern Mutual Pacific Life Phoenix Principal Financial Protective Life Prudential Financial* Reinsurance Group SAFECO Corp. Security Benefit StanCorp Financial Sun Life of Canada TIAA-CREF Torchmark Corp. UnumProvident

403 (b)

401 (k)

457

Ind. Dread Disease

2002 2002 9/03 2002 2002 2002 2002 6/03 2001 2002 2002 2002 2002 2002 2000 2000 2000 1999 1999 1999 2

4

11

7 23 9

20 15 16

18 16

12 1 22

9 3 13

10 3 NA

8

5

4

15

14

14

2

6

20

20

1

6 11

8 3

14

13

1

4 17

18

6 12

5 20

7

5

2

10

14

2 4 11 21 13

22 2 7 18 11

20 2 7 22 5 21 13 23 25 8 9 17

20

12 24

8 10 16

6 8 19

17

10 21

12

23

6

11

7

15 5 4 9 20 16 3 13

15 1 9 11 12 14

2 19 5

9 7 8

1 9

8 13

16 8 10

15 7 14

18 15

22 17 9 6 4 18 12 10 21

4 3 17 22 2 23 21 11

14 6

1

17 1

15 1

8

13

10

5 10 3 22

12

24

4

11

1

24 7

17

3

6

8 8

5

10 25

12 13

13 17

7 2 14

10 2 20

6

9

24 4 9

7

15

23

19 6

19

7 21 2

5 1

2

1

15

21 20

4

13

3

25

18

22

11

16

2

3

6

16 12 8

2

5

1

4

1

9 6

5 4

9

6

10

1

23 2

6

5 12

4

4

8

3 2

8 3

10 3

13

13

1

12 2

8 15

11 15

4 15 19 6

10

8

1

25

14 10

2

1

22

11 14

4

5

20

25

7

12 18 3

3 7

16

11

19 14

7

11 23 6

Source: JPMorgan. Note: Data represents latest data available (for assets) or latest full-year data available (for sales/ premiums). *Prudential VA assets include American Skandia

88

Ind. Med. Supp.

Long Term Care

Noncancellable Ind. Disability

Guar. Renew. Ind. Disability

L Term Group. Disability

S Term Group. Disability

Life Reins. Premiums

Group Life

I Individual Var. Life Assets

Individual Var. Life Sales

Equity-Indexed Annuity Sales

Bank Variable Annuity Sales

Bank Fixed Annuity Sales

Individual Var. Annuity Assets

Individual Var. Annuity Sales

Total Annuity Premiums

Appendix II: Top 25 Players in Selected Insurance Products

2

7 9 1

5

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

North American Equity Research New York 14 January 2004

Appendix III: Product Characteristics Classification

Term Life

Whole Life

Universal Life

Variable Life

Fixed Annuities

Variable Annuities

Primary type of income earned by company

risk income

risk income

fee, spread, and risk income

fee and risk income

spread income

fee income

Typical returns

9-11%

3-8%

8-11%

11-14%

8-13%

15%+ (in a normal equity market)

Growth prospects

moderate

low

moderate to high

moderate

moderate

high

Who bears investment risk?

company

company

company

both

company

typically, customer

Surrender charges

yes

yes

yes

yes

yes

yes

Typical buyer

all ages

all ages

40 and up

40-59

55 and up

Death protection

Limited to "term" of policy

significant

significant

significant

limited - only if lifetime annuitization chosen

45-64 modest - available during accumulation phase and if lifetime annuitization chosen

Described as …

cheapest form of life coverage

na

na

buying term and investing the rest.

tax-deferred C.D.

mutual fund in insurance wrapper

Level of complexity

Low

moderate

moderate

Best features

significant life choice of fixed or insurance protection, variable payments; but payments made for significant life a limited time insurance protection.

low

moderate

significant life insurance protection with variable crediting rate

high tax deferral, satisfies significant estate planning needs, significant life insurance protection.

tax deferral, easy to understand

tax deferral, higher returns than fixed annuities, death benefits

Biggest criticism

payment only if death occurs

long payment period and low crediting rate

long duration of payment

complex

low crediting rates

high fees

Flexible deposit payments

no

no

yes

yes

yes

yes

Fixed or variable return option

fixed

fixed

variable

both

fixed

Other buyer characteristics

varies

conservative

a little more savvy than whole life buyers

highest income and sophistication level;

both sophisiticated and not incredibly more educted than sophisiticated, risk fixed annuity buyer; averse; lowest income risk tolerant; mid to of three groups upper middle income

Source: JPMorgan.

89

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North American Equity Research New York 14 January 2004

Appendix IV: Annuity Margins Table 36: Margins* for Annuity Products 1Q02

2Q02

3Q02

4Q02

1Q03

2Q03

3Q03

1999

2000

2002

Avg.

HIG

Individual Annuity

0.54% 0.55% 0.50% 0.53% 0.47% 0.53% 0.56%

0.60% 0.58% 0.52%

0.57%

JHF

Variable Annuity Fixed Annuity Variable + Fixed

0.59% 0.30% -2.41% 0.36% 0.01% 1.29% 0.75% 1.46% 1.48% 1.67% 1.55% 1.67% 1.61% 1.65% 1.04% 0.96% 0.02% 1.09% 1.07% 1.50% 1.34%

0.73% 0.39% 0.38% -0.24% 0.95% 1.90% 0.00% 0.00% 0.82% 1.01% 0.20% -0.10%

0.32% 0.71% 0.48%

LNC Total Annuity

0.73% 0.43% 0.08% 0.29% 0.56% 0.83% 0.91%

0.69% 0.77% 0.71% 0.39%

0.64%

MET Total Annuity

0.47% 0.60% 0.53% 0.57% 0.64% 0.67% 0.74%

0.74% 0.59% 0.58% 0.53%

0.61%

MFC Variable Annuity

0.34% 0.27% 0.25% 0.39% 0.27% 0.49% 0.58%

0.86% 0.26% 0.31%

0.48%

NFS Individual Annuity Institutional Annuity Individual + Institutional

0.50% 0.52% -2.85% 0.52% 0.37% 0.45% 0.42% 0.46% 0.42% 0.29% 0.51% 0.38% 0.40% 0.46% 0.48% 0.47% -1.13% 0.52% 0.38% 0.42% 0.44%

0.64% 0.63% 0.53% -0.29% 0.42% 0.47% 0.43% 0.41% 0.52% 0.55% 0.48% 0.10%

0.38% 0.43% 0.41%

PNX Total Annuity

0.20% 0.06% -1.36% -0.35% -0.36% -0.09% 0.02%

0.69% 0.09% 0.24% -0.39%

0.16%

Source: Company reports and JPMorgan estimates. *Note: Margin is defined as pretax annuity earnings divided by average annuity assets.

90

2001

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

North American Equity Research New York 14 January 2004

Appendix V: Life Company Earnings Breakdown Table 37: Earnings Breakdown by Product % of earnings AFL

AIG

HIG

JHF

JP

LNC

MFC

MET

NFS

10.0% 10.0%

11.0% 32.0% 43.0%

13.5% 1.0% 14.5%

3.4% 7.8% 11.2%

13.0% 13.0% 26.0%

1.5% 3.5% 5.0%

1.0% 3.1% 4.1%

3.0% 3.0% 6.0%

8.0%

11.1%

7.7% 11.6%

33.0%

28.3% 21.4%

13.1%

3.0% 9.0%

49.8% 5.5% 3.3%

20.9% 2.3% 18.3%

29.0% 12.0%

4.3% 5.1% 5.1%

74.8% 1.0% 4.0%

54.0% 11.0% 6.0%

61.5% 3.0%

58.6%

41.5%

41.0%

14.4%

79.8%

71.0%

64.5%

24.6%

1.6%

4.1%

Individual Variable Annuities Individual Fixed Annuities T. Individual Annuities

2.0% 6.0% 8.0%

20.8% 2.9% 23.6%

1.0% 12.0% 13.0%

403(b), 457, 401(k) GICs, funding agreements

6.0% 4.0%

1.0% 3.0%

37.0%

33.0% 1.0% 2.0%

4.4% 4.7% 4.7%

16.0% 17.0%

36.0%

13.8%

33.0%

1.0% 1.0% 2.0%

3.9%

5.0% 2.0% 7.0%

Individual Whole and UL Individual VL Group Life Insurance

9.7%

Total Life Insurance

9.7%

Retail Asset Mgmt. Institutional Asset Mgmt. Total Asset Management Long-Term Care

3.9%

1.4%

Disability Insurance

14.0%

Supplemental Medical

74.9%

60.0% 5.0% 7.0%

43.0% 4.0%

72.0%

47.0% 1.0% 1.0% 2.0%

Other Total

0.7%

10.0% 4.8%

10.0%

3.3%

1.0% 12.5% 35.0% 8.0%

PL

1.1% 5.5% 6.6%

PRU

RGA

49.9%

3.5%

1.8%

7.0%

14.0%

TMK

UNM

1.5% 0.7% 2.2%

24.6%

7.0% 2.0% 9.0%

1.2%

Reinsurance Property & Casualty

0.7%

PFG

2.0%

46.3% 31.1%

3.6%

25.0%

100.0%

8.0% 8.0%

4.0%

8.4%

3.0%

0.5%

100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0%

Source: Company reports and JPMorgan estimates. Note: Earnings breakdown based on 2003 earnings estimates. For AIG, Other includes trading, financial products, consumer finance, and ILFC. For JP, Other refers to the communications business. For Principal, Other refers to the mortgage banking business. HIG's earnings from GICs, funding agreements are based on the sales breakdown of the other investment products segment. MET's earnings from GICs, funding agreements are based on general account assets in the retirement & savings segment. NFS's 403(b), 457, 401(k) earnings comprise income from the institutional annuity business.

91

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North American Equity Research New York 14 January 2004

Appendix VI: Life Products Macro Benefits Strong Equity Market Qualified Variable Annuities Nonqualified Var. Annuities Total Variable Annuities

Group Fixed Annuities Group Variable Annuities. Total Group Annuities

X X

Total Fixed Annuities Total Variable Annuities Total Annuities

X X

Traditional Life Variable Life Total Individual Life

X X

Retail Asset Mgmt. Institutional Asset Mgmt. Total Asset Management

X X X

Source: JPMorgan.

92

Steep Yield Curve

X X X

Qualified Fixed Annuities Nonqualified F. Annuities Total Individual F. Annuities

Group Life Group disability Individual Disability Reinsurance Supplemental Medical

High Interest Rates

Strong Economy

Careful Underwriting

X X X X X X

X X X

X

X

X

X

X

X

X

X

X X

X X

X X X X X

X X X

X X X X X X X X

X X X X

X X X X X

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

North American Equity Research New York 14 January 2004

Appendix VII: Life Product Earnings Drivers SALES Earnings Drivers

Recurring Deposits

FEES Breadth of Distribution Driving Sales

ASSETS

Fund Fees Fee Sharing Withdrawals Investment Asset / Performance Charged to w/ Fund / Lapses Performance Reserve Driving Groups Managers / Asset Growth Sales Growth

Qualified Variable Annuities Nonqualified Var. Annuities

X

X X

Qualified Fixed Annuities Nonqualified Fixed Annuities

X

X X

Group Fixed Annuities. Group Variable Annuities.

X X

X X

X

X

X X

Traditional Life Variable Life Total Individual Life

X X

X X

X

X

X X

X X

X

Retail Asset Mgmt. Institutional Asset Mgmt. Total Asset Management

SPREADS

X X

X

X X

X X

Yield on Assets

Spreads

X X

X X X

Crediting Rates

RISK EXPENSES INCOME Appropriate Disciplined Adequate Underwriting Pricing Reserving

Expense Controls/ Scale X X

X X

X X

X X

X X

X X

X X

X

X

X

X

X X

X X

X

X X

X X

X X

X X

X X

X X

X X

X X

X X

X X

X X

X X

Group Life

X

X

X

X

X

X

X

X

X

Long-Term Care

X

X

X

X

X

X

X

X

X

Group disability/dental

X

X

X

X

X

X

X

X

X

Individual Disability

X

X

X

X

X

X

X

X

X

X

X

X

X

X

X

Reinsurance Supplemental Medical

X

X

X

X

X

X

X

X

X

International

X

X

X

X

X

X

X

X

X

Source: JPMorgan.

93

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

North American Equity Research New York 14 January 2004

Appendix VIII: Distribution AFL

AIG

HIG

JHF

JP

LNC

MET

MFC

NFS

PFG

PL

PRU

TMK

UNM

Individual focused agents/reps No. of exclusive agents/reps

2,335

400

2,100

11,331

55,300

33,000

186,600

21,480

20,000

200,000

142,000

43,500

Total individual focused agents/reps

55,300

37,700

186,600

23,815

20,400

202,100

153,624

43,500

Foreign Life Agents

59,500

195,000

No. of independent agents/reps

4,700

550

1,026

0

31,352

120,613

34,841

193

120,613

40,359

193

44,000

4,281

5,518

9,723

Group focused agents/reps No. of annuities/401(k) agents/reps

1,900

50

No. of group life/disability/LTC agents/reps

375.0 155

431

600.0

102 50

Total group focused agents/reps

60

237

152

237

Worksite marketing agents

6,400

Group plans/participants No. of govt. plans/participants

41K / 1.7M 3595 / 357K

8 / 102K

No. of 401(k) or 457 plans/participants

470 / 942K

25,606

975,400 1,152 / 48K

12,000 23,800/940K

1,037,598

26,416/ 2 M

Investment dealer relationships

45,327

Wirehouse relationships

5

Regional broker/dealer relationships Independent broker/dealer relationships

105,000

Active producers

240

Annuities Life Insurance Mutual Funds

94

8

5

11

54

25

139

850

1,200

854

29,755

200,000

86,000

45,000

57,221

36,000

Wholesalers devoted to investment dealer channel

Source: Company reports and JPMorgan estimates.

4 336

1,155

Reps in investment dealer channel

Products sold through investment dealers

5

40

17,000 22

Life Insurance Annuities Mutual Funds LTC

Annuities

186

75

167

Life Insurance Annuities

Annuities

Annuities

Mutual Funds

Insurance Pensions

11 4,500

118 1,227

5,686 127

19

Life & Annuities

Annuities

Life Insurance Variable Annuities

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

North American Equity Research New York 14 January 2004

Distribution (Cont'd) AFL

AIG

HIG

Top 3 inv. dealer sellers of products

No. of banks/thrift selling agreements

JHF

Edward D. Jones

564

JP

LNC

MET

MFC

PL

AG Edwards Merril Lynch

AG Edwards

UBS

Linsco Raymond Private James Ledger

AG Edwards

Morgan Credit Stanley Suisse First Boston

Prudential

Smith Barney

Royal Wachovia Alliance Securities

ProEquities

500

214

48

93 25

55

5

1 INVEST PFIC

5

INVEST

Essex

ICA

54

135

Var. Annuities

Var. Annuities

Annuities

Fixed Annuities

Fixed Annuities

Fixed Annuities

Annuities

Fixed Annuities

Fixed Annuities

Mutual Funds

Life Insurance

Var. Annuities

Var. Annuities

Pensions

Life

Mutual Funds

Edward D. Jones

TMK

UNM

Wachovia Prudential

15 10

7

AIM

Life Insurance

40

20

Essex

Wholesalers devoted to the bank channel

Raymond AG Edwards James

PRU

Merril Lynch

Names of third-party relationships

Products sold through banks/thrifts

PFG

Merril Lynch

No. of banks/thrifts actively selling No. of third-party marketers

NFS

Morgan Stanley

27 less than 25

Talbot

1

Financail Life Network Insurance 46

Annuities

19 Life & Annnuities

Variable annuities

Life

LTC Products currently sold over the Internet

Supplement Auto & home al Insurance insurance CDs

Annuties

Term Life

Annuities

Annuities

Insurance

Annuities

401(k)

Term Life

Annuities

Life Insurance

Accident

AD&D

Sickness

Consumer Loans Aggregator sites where products are sold?

21st.com, AnnuityZone ReliaQuote AnnuityZone AnnuityNet.c AnnuityZone WorldInsure. AnnuityZone Impact401k. SelectQuote. AIGdirect.co .com and InsWeb .com om .com com .com com com m

PlanSimply.c om

Source: Company reports and JPMorgan estimates. 95

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

North American Equity Research New York 14 January 2004

Appendix IX: Key Life Insurance Terms 403(b)

A qualified plan that allows teachers, hospital employees, and individuals who work for nonprofit organizations to contribute pretax dollars (up to a certain limit) in annuities.

457

A qualified plan that allows government employees to contribute pretax dollars (up to a certain limit) in annuities.

529 (College Savings)

A savings plan that allows individuals to establish accounts with after-tax dollars for a beneficiary (which can be changed over time) that can be used for education expenses. Earnings from the account are exempt from federal and, in some cases, state taxes.

1035 Exchange

A tax-free method of exchanging an existing life insurance or annuity policy for a new policy with another company provided the exchange meets the requirements of Section 1035 of the Internal Revenue Code. 1035 Exchanges allow a contract owner to exchange outdated contracts for more current and efficient contracts, while preserving the original policy’s tax basis and deferring recognition of gain for federal income tax purposes.

Adverse Mortality/ Morbidity

Unusually high mortality claims relative to normal experience, which cause an elevated benefits ratio in a given period. Adverse morbidity refers to unusually high claims associated with health insurance or medical policies.

Annuitization

The process of having an annuity paid out to the annuity holder. Annuities are typically paid out in a lump sum, 10 annual installments, 15 annual installments, or the annuity holder's lifetime.

Benefits Ratio (Loss ratio)

Policy benefits in a given period divided by premiums.

Bonus Annuity

An annuity that credits a one-time bonus (ranging from 1-6% of the initial deposit depending on the size of the initial deposit) when the product is purchased. To recoup the cost of the bonus, some companies charge an additional fee while others imbed the cost of the feature in the insurance expense. Most bonus annuity products also have a higher first-year surrender charge and/or a longer surrender period to protect the company from premature withdrawals.

COLI./BOLI

Corporate-owned / bank-owned life insurance. Insurance owned by corporations covering the lives of employees, with the corporation as beneficiaries. A tax-advantaged investment, COLI and BOLI are often used to fund post-retirement benefits for employees.

C-share

No-load variable annuity shares. Instead of a front-end or back end load, higher ongoing fees are charged.

Closed Block

A special account usually established by insurers at the time of demutualization to separate participating life insurance and annuity policies and the assets that would be used to pay dividends to these contracts.

Deferred Acquisition Costs (DAC)

Costs associated with acquiring new insurance and annuity business, primarily commissions, underwriting, and issue and agency expenses. Under U.S. GAAP, these costs are deferred and amortized over the expected life of the policy.

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North American Equity Research New York 14 January 2004

Discount Rate (individual disability)

Discount rate used to convert future expected individual disability claims to present value. The rate must be adjusted periodically based on market interest rates—lower discount rates increase the value of the liabilities, so that more reserves must be set aside. This flows through the benefits ratio and hurts earnings in the period in which the rate is lowered.

Dollar Cost Averaging

A feature typically associated with variable annuities whereby the consumer is offered a bonus crediting rate (usually 50-100 bps higher than the typical crediting rate) on the fixed portion of a variable annuity in exchange for an agreement by the customer that funds will be moved out of the fixed bucket and into the variable buckets (mutual fund options) by a specified time (usually six months or one year).

Equity Indexed Annuity

Equity indexed annuities guarantee a fixed return and an additional return based on the performance of an equity market index (usually the S&P 500 Index).

Excess Capital

Capital held by an insurance company in excess of capital required by ratings agencies to maintain a given rating.

Fee Income

Income earned on products that generate fees (like variable annuities, the asset portion of variable life, and asset management). The insurer could earn fee income on mortality and expense fees and asset management fees where the insurer does not bear the investment risk—the consumer does. The insurer shares the asset management fee on the separate account assets with the asset manager since the asset manager manages the assets but the insurer is responsible for marketing and distributing the product.

Fixed Annuity

An annuity contract where the consumer is guaranteed a fixed rate of return (reset annually) and income is tax deferred until annuitized. If the consumer withdraws money before the age of 59½, there is a tax penalty. Upon annuitization, the consumer pays tax on the deferred income at its ordinary income tax rate.

Fixed Bucket of Variable Annuities

The fixed bucket of variable annuities refers to an investment choice in a variable annuity contract whereby the insurer guarantees the account holder a specified return (usually 3% annually) on assets committed to the fixed bucket. The insurer bears the investment risk in the fixed bucket while the contract holder gets a guaranteed return.

General Account Assets

Assets that back life insurance, disability, long-term care, fixed annuity, and supplement medical products where the company bears the investment risk and generates a spread between the yield generated on these assets and crediting rates.

Guaranteed Investment Contract (GIC)

An institutional contract that guarantees a rate of return on assets for a fixed period. GICS are sometimes used to fund the fixed-income option in defined contribution plans, such as 401(k) plans.

Guaranteed Minimum Death Benefit (GMDB)

A benefit offered in association with variable annuity contracts, where the insurer guarantees to pay a specific death benefit, which may be greater than the underlying account value.

Guaranteed Minimum Income Benefit (GMIB)

A variable annuity benefit that guarantees the customer a return of 3-6% per year during the annuitization period.

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

North American Equity Research New York 14 January 2004

Guaranteed Minimum Accumulation Benefit (GMAB)

A variable annuity benefit that guarantees the customer's account value will grow at a minimum return each year or reach a certain value by the end of a specific period. The insurer makes up the difference if the account balance does not reach the guaranteed value at the end of the specified accumulation period.

Guaranteed Minimum Withdrawal Benefit (GMWB)

A optional benefit for variable annuities that guarantees return of principal to the contractholder. The policyholder can withdrawal their deposit over a period ranging from 5 to 10 years, and the benefit costs from 35 to 65 basis points.

Guaranteed Renewable Individual Disability

Policy where the insurer has the right to reprice the policy if experience deteriorates. This is a smaller segment of the individual disability market (see: Non-Cancelable Individual Disability).

Immediate Annuity

An annuity contract where payouts begin immediately or within one year.

Incidence Rate

Claims per 1,000 lives for a disability policy

L-Share Variable Annuities

L-Share variable annuities generally carry surrender charges for 3-4 years (traditional products have surrender charges for 7 years) and have a trailing commission in addition to a set commission in the first year or first 3 years.

Lapses

Termination of insurance policies at the end of the grace period because of nonpayment of premiums.

Lifetime Savings Account (LSA)

Tax-free investment accounts proposed by the Bush administration. Individuals can contribute up to $7,500 annually to the account, and earnings and capital gains in the account are not taxed upon withdrawal. There is no income limit (i.e. maximum or minimum income) to contribute to the accounts.

Long-Term Care

Insurance that pays for services (i.e., hospice care or nursing home care) when policyholders cannot perform certain activities of daily living, such as bathing and eating etc., without assistance. Long Term Care policies also pay benefits when the insured requires supervision due to a cognitive impairment such as Alzheimer's disease.

Mortality and Expense Fee

Insurance fee embedded in the cost of a variable annuity and variable life policy that pays for part of the costs of selling the product (i.e., commissions) and covers the cost if the contract holder dies and the balance in the account is lower than the initial deposit, since the basic death benefit guarantees the policyholder the greater of the initial deposit or current balance.

Non-Cancelable Individual Disability

Policies where the insurer cannot change features or raise prices once the policy is in force. The majority of individual disability policies are this type. (see also: Guranateed Reneweable Individual Disability).

Non-Qualified Plan

A plan whereby contributions are not qualified to be made on a pretax basis because the customer already has access to a tax-deferral program like a 401(k) plan.

Participating policies

Life insurance and annuity policies historically sold by mutuals that allowed policyholders to participate in the profits of the policy in the form of a dividend. When the mutuals demutualize, they typically separate these policies into what is known as the Closed Block.

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North American Equity Research New York 14 January 2004

Retirement Savings Accounts (RSA)

Tax-free retirement accounts being proposed by the Bush administration (to replace IRAs). Individuals would be able to contribute up to $7,500 RSAs. While there is no maximum income limit for the accounts, an individual must have earnings to contribute to the account.

Qualified Plan

A plan whereby contributions are qualified to be made on a pretax basis (like 403(b) and 457 plans) because the employee does not have access to a tax-deferral program like a 401(k) plan.

Regulation XXX

An ordinance that went into effect on January 1, 2000, requiring life insurance companies to increase their reserves for certain term and universal life insurance policies.

Regulation AXXX

An ordinance that went into effect on January 1, 2003, requiring life insurance companies to increase reserves associated with no-lapse guarantees for UL.

Risk-Based Capital (RBC) Ratio

The ratio of capital held by an insurer to regulatory-required capital. The capital required by regulators is a function of product mix, asset composition, and other factors.

Risk Income

Income earned on actuarial pricing like mortality risk on life insurance policies; morbidity risk on disability and long-term care policies; and losses on reinsurance business.

Separate Accounts

Assets maintained independently from general account assets and back variable annuity and variable life products. The customer, not the insurance company, bears the investment risk and, as such, the capital requirements are minimal.

Spread Income

The difference between investment income on assets backing spread-based products (like fixed annuities and GICs) and guaranteed interest credited. Spreads tend to widen in a rapidly declining interest rate environment when the yield curve is steepening because crediting rates drop faster than the overall yield on the investment portfolio.

Statutory Capital

Surplus of assets over liabilities according to statutory accounting. Differs from GAAP capital because some GAAP assets (DAC, for instance) are not admitted under statutory accounting.

Statutory Earnings

Earnings according to Statutory Accounting Principals. Stat earnings are closer to “cash” earnings since expenses (particularly DAC) may not be deferred under stat accounting.

Structured Settlement

Annuity used to provide periodic future payments stemming from the settlement of a lawsuit. Structured settlement payouts are often tax-advantaged to the claimant.

Supplemental Medical

Insurance policies that supplement one's primary health plans by providing cash benefits to policyholders for additional time or benefit coverage, costs not covered by traditional medical plans such as travel to and from treatment centers and other out of pocket expenses; and/or specific medical ailments.

Survivorship/Secondto-Die

Features usually associated with life insurance policies whereby benefits are not paid until the "survivor" or both people on the policy dies. A feature typically used when the policy is being established to help fund estate taxes.

Surrender Charges

The cost to a contract owner for early redemption of a contract.

Terminal Funding

Typically a group fixed annuity used to fund a pension liability. Terminal funding is often used to fund pension plans that are discontinued due to bankruptcies, mergers or plant closures.

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

North American Equity Research New York 14 January 2004

Third Sector

A segment of the Japanese insurance market that represents the supplemental medical market. The first sector represents the life insurance and annuity market and the second sector represents the property/casualty market.

Universal Life

A permanent life insurance policy that offers the policyholder more competitive crediting rates than a whole life policy, flexible premium payments and flexibility in adjusting the death benefit.

Value of Business Acquired (VOBA)

Present value of future profits from insurance business acquired from another company. Similar to DAC (and unlike goodwill) VOBA must be amortized through earnings over time.

Variable Annuity

An annuity contract in which the consumer has a choice of fixed rate returns where the company bears the investment risk or a number of variable rate options where the consumer bears the investment risk. In the variable rate options the consumer can choose from among a wide array of mutual fund options typically management by well-known asset managers. Income accumulates tax-free until annuitization when income is taxed at the ordinary income tax rate. Withdrawals before the age of 59 ½ are subject to tax penalties.

Variable Life

A type of permanent life insurance that provides death benefits and cash values that vary with the performance of an investment portfolio selected by the policyholder. The policy is sometimes set up in an irrevocable trust for beneficiaries to avoid estate taxes.

Whole Life

A traditional life insurance policy whereby a death benefit is paid to the beneficiary at the death of the insured. A policyholder may pay premiums for either a specified number of years (limited payout) or for life (straight life). Premium amounts are fixed and crediting rates are typically modest making this product less attractive than other life insurance products.

Withdrawal

A process whereby policyholders take their money out of an investment product (i.e., variable and fixed annuities). Withdrawals are often subject to surrender charges.

100

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North American Equity Research New York 14 January 2004

101

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North American Equity Research New York 14 January 2004

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

North American Equity Research New York 14 January 2004

Analyst Certification The research analyst who is primarily responsible for this research and whose name is listed first on the front cover certifies (or in a case where multiple analysts are primarily responsible for this research, the analyst named first in each group on the front cover or named within the document individually certifies, with respect to each security or issuer that the analyst covered in this research) that: (1) all of the views expressed in this research accurately reflect his or her personal views about any and all of the subject securities or issuers; and (2) no part of any of the research analyst's compensation was, is, or will be directly or indirectly related to the specific recommendations or views expressed by the research analyst in this research. JPMorgan Equity Research Ratings Distribution, as of December 31, 2003 JPM Global Equity Research Coverage IB clients* Financial Institutions - N. America & Latin IB clients*

Overweight

Neutral

Underweight

37%

43%

21%

27% 36%

25% 38%

22% 26%

48%

41%

29%

*Percentage of investment banking clients in each rating category. For purposes of NASD/NYSE ratings distribution disclosure rules, our Overweight rating most closely corresponds to a buy rating; our Neutral rating most closely corresponds to a hold rating; and our Underweight rating most closely corresponds to a sell rating.

Legal Disclosures •

• •



Lead or Co-manager: JPMSI and/or its affiliates acted as lead or comanager in a public offering of equity and/or debt securities for Hartford Financial Services, National Financial Partners, Principal Financial Group and Prudential Financial within the past 12 months. Director Disclosure: A senior employee or executive officer of JPMSI and/or its affiliates is a director of American International Group, MetLife and Prudential Financial. Investment Banking (past 12 months): JPMSI and/or its affiliates received in the past 12 months compensation for investment banking services from John Hancock Fincl Services, Lincoln National, MetLife, National Financial Partners, Prudential Financial and UnumProvident Corp. Investment Banking (next 3 months): JPMSI and/or its affiliates expect to receive, or intend to seek compensation for investment banking in the next three months from AFLAC, American International Group, Hartford Financial Services, Jefferson Pilot, John Hancock Fincl Services, Lincoln National, MetLife, National Financial Partners, Nationwide Financial Services, Principal Financial Group, Protective Life, Prudential Financial and UnumProvident Corp.

103

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North American Equity Research New York 14 January 2004

Copyright 2003 J.P. Morgan Chase & Co.—All rights reserved. Additional information available upon request. All research labeled North American Equity Research or Latin American Equity Research is a product of J.P. Morgan Securities Inc. (JPMSI). Legal Entities: JPMorgan is the marketing name used on global equity research issued by JPMSI and/or its affiliates worldwide. JPMSI is a member of NYSE, NASD and SIPC. The analysts who write global equity research are employees of JPMSI or its affiliated companies worldwide, including the following companies. J.P. Morgan Securities Ltd. (JPMSL), J.P. Morgan plc (JPM) and J.P. Morgan Europe Limited are authorised by the FSA. JPMSL is a member of the LSE. J.P. Morgan Equities Limited is a member of the Johannesburg Securities Exchange and is regulated by the FSB. J.P. Morgan Securities Asia Private Limited is regulated by the Monetary Authority of Singapore (MAS) and the Japan Financial Services Agency (FSA). J.P. Morgan Securities (Asia Pacific) Limited (CE number AAJ321) and J.P. Morgan Securities (Far East) Limited (CE number AAB026) are regulated by the HKMA and the SFC in Hong Kong respectively. J.P. Morgan Securities Singapore Private Limited is a member of Singapore Exchange Securities Trading Limited and is regulated by the MAS. J.P. Morgan Malaysia Sdn. Bhd. (18146-X) is licensed as an investment advisor by the Securities Commission in Malaysia. J.P. Morgan Australia Limited (ABN 52 002 888 011) and J.P. Morgan Securities Australia Limited (ABN 61 003 245 234, a Participating Organisation with the ASX) (JPMSAL) are licensed securities dealers. J.P. Morgan Securities New Zealand Limited is a member of the New Zealand Stock Exchange. J.P. Morgan Securities (Taiwan) Limited is a participant of the Taiwan Stock Exchange (company-type) and regulated by the Taiwan Securities and Futures Commission. J.P. Morgan India Private Limited is a member of the National Stock Exchange of India Limited and The Stock Exchange, Mumbai and is regulated by the Securities and Exchange Board of India. J.P. Morgan Securities (Thailand) Limited is a member of the Stock Exchange of Thailand and is regulated by the Ministry of Finance and the Securities and Exchange Commission PT. J.P. Morgan Securities Indonesia is a member of the Jakarta Stock Exchange and Surabaya Stock Exchange and is regulated by the BAPEPAM. This report is distributed in the Philippines by J.P. Morgan Securities Philippines, Inc. General: Information has been obtained from sources believed to be reliable but J.P. Morgan Chase & Co. or its affiliates and/or subsidiaries (collectively JPMorgan) do not warrant its completeness or accuracy except with respect to any disclosures relative to JPMSI and/or its affiliates and the analyst’s involvement with the issuer. Opinions and estimates constitute our judgement as of the date of this material and are subject to change without notice. Past performance is not indicative of future results. This material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. Securities, financial instruments or strategies mentioned herein may not be suitable for all investors. The opinions and recommendations herein do not take into account individual client circumstances, objectives, or needs and are not intended as recommendations of particular securities, financial instruments or strategies to particular clients. The recipient of this report must make its own independent decisions regarding any securities or financial instruments mentioned herein. JPMSI distributes in the U.S. research published by non-U.S. affiliates and accepts responsibility for its contents. Clients should contact analysts and execute transactions through a JPMorgan subsidiary or affiliate in their home jurisdiction unless governing law permits otherwise. Price Charts for Compendium reports (U.S.): Price charts are available for all companies under coverage by JPMSI for at least one year through the search function on JPMorgan's website http://mm.jpmorgan.com and accessible to JPMorgan's clients via password, or by calling MorganMarkets toll free number (1-800-477-0406). Analysts’ Compensation: The equity research analysts responsible for the preparation of this report receive compensation based upon various factors, including the quality and accuracy of research, client feedback, competitive factors, and overall firm revenues. The firm's overall revenues include revenues from, among other business units, Institutional Equities and Investment Banking. Explanation of Ratings: JPMorgan uses the following rating system: Overweight [Over the next six to twelve months, we expect this stock will outperform the average total return of the stocks in the analyst's (or the analyst's team's) coverage universe.] Neutral [Over the next six to twelve months, we expect this stock will perform in line with the average total return of the stocks in the analyst's (or the analyst's team's) coverage universe.] Underweight [Over the next six to twelve months, we expect this stock will underperform the average total return of the stocks in the analyst's (or the analyst's team's) coverage universe.] The analyst or analyst’s team’s coverage universe is the sector and/or country shown on the cover of each publication. Each analyst’s coverage list, showing full coverage universe, is available on the analyst’s page under the Research option on JPMorgan’s website http://mm.jpmorgan.com, accessible to JPMorgan’s clients via password, or in the case of hard copy research or if no access to MorganMarkets, by calling this toll free number (1-800-477-0406). Prior to September 25, 2002, our rating system was: Buy—we expect the stock to outperform the market by a minimum of 5% within an investment horizon of one year. Long-Term Buy—we believe the stock will outperform the market over the long run, but we lack the visibility of a catalyst for outperformance within a one- year investment horizon; Market Performer—the stock is expected to perform in line with the market; Market Underperformer—we expect the stock to underperform the market by a minimum of 5% within an investment horizon of one year. U.K. and European Economic Area: Issued and approved for distribution in the U.K. and the European Economic Area (“EEA”) by JPMSL, JPM and JPMEL. All research issued to private clients in the U.K. is subject to the following: the investments and strategies discussed here may not be suitable for all investors; if you have any doubts you should consult your investment advisor. The investments discussed may fluctuate in price or value. Investors may get back less than they invested. Changes in rates of exchange may have an adverse effect on the value of investments. Australia: This material is issued and distributed by JPMSAL in Australia to “wholesale clients” only. JPMSAL does not issue or distribute this material to “retail clients.” The recipient of this material must not distribute it to any third party or outside Australia without the prior written consent of JPMSAL. For the purposes of this paragraph the terms “wholesale client” and “retail client” have the meanings given to them in section 761G of the Corporations Act 2001. Korea: This report may have been edited or contributed to from time to time by affiliates of J.P. Morgan Securities (Far East) Ltd, Seoul branch. Singapore: JPMSI and/or its affiliates may have a holding in any of the securities discussed in this report; for securities where the holding is 1% or greater, the specific holding is disclosed in the Legal Disclosures section above. Revised December 12, 2003.

THIS MATERIAL IS DISTRIBUTED IN JAPAN BY J.P. MORGAN SECURITIES ASIA PTE LIMITED. THIS MATERIAL IS ISSUED AND DISTRIBUTED IN SINGAPORE BY J.P. MORGAN SECURITIES SINGAPORE PRIVATE LIMITED [MITA (P) NO. 213/05/2003]. THIS MATERIAL IS ISSUED AND DISTRIBUTED IN MALAYSIA BY J.P. MORGAN MALAYSIA SDN. BHD. (18146-X).

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