Global Credit Research Credit Opinion 16 JUN Credit Opinion: Pacific Mutual Holding Company. Pacific Mutual Holding Company

Transcription

1 Global Credit Research Credit Opinion 16 JUN 2015 Credit Opinion: Pacific Mutual Holding Company Pacific Mutual Holding Company Newport Beach, California, United States Ratings Category Moody's Rating Pacific LifeCorp Senior Unsecured Baa1 Pacific Life Insurance Company Insurance Financial Strength A1 ST Insurance Financial Strength P-1 Surplus Notes A3 (hyb) Commercial Paper P-1 Pacific Life & Annuity Company Insurance Financial Strength A1 Pacific Life Funding, LLC Senior Unsecured A1 Contacts Analyst Phone Scott Robinson/New York City Neil Strauss/New York City Robert Riegel/New York City Stefan Kahandaliyanage/New York City Key Indicators Pacific Mutual Holding Company[1][2] As Reported (U.S. Dollar Millions) Total Assets 137, , , , ,992 Total Shareholder's Equity 10,231 8,973 9,499 8,285 7,544 Net income (loss) attributable to common shareholders Total Revenue 7,073 8,106 6,874 5,862 5,588 Moody's Adjusted Ratios High Risk Assets % Shareholder's Equity 37.5% 38.5% 51.5% 46.1% 63.4% Goodwill & Intangibles % Shareholder's Equity 49.7% 50.3% 49.8% 55.5% 60.7% Shareholder's Equity % Total Assets 7.3% 6.8% 7.2% 6.8% 6.1% Return on avg. Capital (1 yr. avg ROC) 4.4% 6.3% 4.7% 6.1% 5.7% Sharpe Ratio of ROC (5 yr. avg) 651.3% 678.5% 83.1% NA NA Financial Leverage 18.0% 19.9% 17.2% 19.2% 20.5% Total Leverage 19.6% 21.7% 19.7% 21.9% 23.4% Earnings Coverage (1 yr.) 4.6x 5.1x 3.8x 6.3x 5.5x Cash Flow Coverage (1 yr.) 16.9x 13.0x 13.1x 3.4x 12.1x [1] Information based on US GAAP financial statements as of Fiscal YE December 31 [2] Certain items may have been relabeled and/or reclassified for global consistency

2 Opinion SUMMARY RATING RATIONALE Moody's A1 long-term insurance financial strength (IFS) ratings of Pacific Life Insurance Company (Pacific Life) and its subsidiary, Pacific Life & Annuity Company (PL&A), and the Baa1 senior debt rating of its parent Pacific LifeCorp, are based on the companies' strong market position in the high end life insurance market, excellent capitalization, broad product distribution and good profitability. Pacific Life's excellent business profile includes established market positions in variable and universal life as well as annuities. Pacific Life's P-1 short-term insurance financial strength rating is based on the company's excellent liquidity, careful liability management and access to alternative funding sources if necessary. The company's strengths are somewhat offset by risks arising from the variable annuity (VA) business' sensitivity to equity market fluctuations and the low interest rate environment.. Aviation Capital Group (ACG), its aircraft leasing subsidiary, has remained consistently profitable through challenging economic times, but exposes the company to potential pressures within the aircraft leasing business. The company's life reinsurance business (including retrocession), which is almost pure mortality and longevity risk, helps Pacific Life diversify its earnings sources. However, somewhat offsetting the benefits of diversification, the life reinsurance is a slow-growth business that can produce more volatile earnings than other life businesses. PL&A's A1 IFS rating is based on the commonality of the operations of this subsidiary with its parent, Pacific Life: shared name, products, management and distribution among other key factors. Credit Strengths Pacific Life's credit strengths include: - Established market positions in variable and universal life as well as annuities - Broad and balanced independent distribution - Strong capitalization (although the volatility moderates this strength) Credit Challenges Pacific Life's credit challenges include: - Guarantees on VAs that are challenging to hedge, although mitigated on new products - Strong competition in core affluent business and professional life insurance markets - Some long duration products that can be adversely impacted by prolonged low interest rates The outlook for the ratings is stable. What to Watch For - Volatility in RBC ratio from Pacific Life's VA products with guarantees - Impact of interest rates on earnings What Could Change the Rating - Up Factors that could cause Pacific Life's ratings to be upgraded include: - Reduced capital and earnings sensitivity to capital market movements - GAAP return on capital consistently > 8% - Adjusted financial leverage below 20% and earnings coverage consistently above 8x.

3 What Could Change the Rating - Down Factors that could cause Pacific Life's ratings to be lowered include: - NAIC company action level RBC ratio falls below 350% (was 676% company action level as of 12/31/14) - Adjusted financial leverage exceeds 30% - GAAP return on capital < 4% Notching Considerations The spread between Pacific LifeCorp's senior debt rating and the IFS ratings of Pacific Life is three notches, consistent with Moody's typical notching spread for simple U.S. insurance holding company structures. Pacific Life also has surplus notes outstanding with a rating of A3, which is consistent with Moody's standard practice of notching a life insurer's surplus note rating two notches below the insurance financial strength rating of the insurer issuing the surplus note. DETAILED RATING CONSIDERATIONS Moody's rates Pacific Life A1 for insurance financial strength, which is in line with the rating indicated by the Moody's insurance financial strength adjusted rating scorecard. Insurance Financial Strength Rating The key factors currently influencing the rating and outlook are: MARKET POSITION AND BRAND: A - FOCUS ON THE HIGH-END LIFE INSURANCE MARKET The A adjusted score for the company's market position, which is in line with the unadjusted scorecard result, is supported by Pacific Life's strong, focused position in the high end life insurance market serving the very affluent and business markets. With the company having a leading market share in individual life insurance (especially indexed universal life) and a strong market position in annuities, Moody's views Pacific Life's market position and brand as being very strong. Pacific Life's market position is especially strong in the universal life and variable universal life insurance segments. Also, Pacific Life is a top 20 U.S. life insurer as measured by assets and one of the largest organized as a mutual or mutual holding company. DISTRIBUTION: A - THIRD PARTY DISTRIBUTION BREADTH Pacific Life relies primarily upon a wide variety of third-parties such as independent agents, financial advisors, banks and registered representatives for its insurance product distribution. As a result, Pacific Life maintains less direct control over its distribution and could see relatively lower persistency and more volatile sales for its third-party sold products than those companies with more control over their distribution systems. However, Pacific Life also benefits from a strong market breadth in most major channels other than career agents, resulting in an A score for diversity of distribution. Pacific Life also has long standing relationships with many key distributors, and a reputation for excellent customer service that benefits the company in the market, increasing its sustainability in the independent channels. Overall, Moody's views Pacific Life's distribution as consistent with A-rated insurance companies and we have left this factor at the unadjusted scorecard result of A. PRODUCT FOCUS AND DIVERSIFICATION: A - A BALANCED PORTFOLIO IN NEW SALES Pacific Life has a very diverse set of product offerings in life and annuity markets, including fixed and variable products, as well as institutionally oriented products. Pacific Life is particularly strong in serving the high net-worth life insurance market and benefits from very strong persistency on its products. Virtually all of Pacific Life's life insurance business is of the non-participating variety. Pacific Life benefits from a good balance between fixed and variable products, a partial result of its emphasis on risk management and diversification. Moody's views Pacific Life's product focus and diversification as consistent with A-rated insurance companies and we have left this factor at the unadjusted scorecard result of A. ASSET QUALITY: A - GOOD QUALITY INVESTMENT PORTFOLIO Pacific Life's general account investment portfolio consists primarily of fixed-income securities and commercial mortgages. As of the end of 2014, Pacific Life's ratio of high risk assets as a percentage of shareholders' equity was 38%, consistent with a Aa subfactor score. These high risk assets are approximately half invested in below investment grade debt, with the remainder split among equities, alternative investments and real estate. Goodwill and other intangibles are equal to 50% of shareholders' equity at year-end 2014, consistent with a Baa score. That said, we believe deferred acquisition costs (DAC), which represents the vast majority of intangibles, to be of higher quality than goodwill, largely because of the greater likelihood that DAC will eventually be converted into tangible equity, as profits net of DAC amortization flow through income.

4 The company's commercial mortgage portfolio has greater exposure to hotels and resorts than peers (total of these two categories is 16% of the mortgages) and includes construction loans on high end apartments, making it atypical--and generally more risky relative to peers--for a life insurer. However, these portfolios have performed well to date. We have left the score on this factor to A, unchanged from the unadjusted scorecard result. CAPITAL ADEQUACY: Aa - STRONG RBC METRICS, SOME VOLATILITY Pacific Life has good capital adequacy, as measured by capital as a percentage of total assets of 7.3% as of year-end 2014, which is in line with Moody's expectation for an A-rated company. However, for U.S. firms we consider the NAIC company action level RBC ratio to be a more reliable measure of a U.S. insurer's capital adequacy. Pacific Life's NAIC RBC ratio was 676% (company action level) as of year-end Although Pacific Life has taken prudent risk management steps to protect capital in times of stress, an RBC ratio can still exhibit some volatility in response to equity market movements. The modest increase from its 673% RBC ratio in 2013 was driven primarily by solid statutory income growth, partially offset by a $200 million dividend to the holding company, as well as an increase in capital requirements for Aviation Capital Group related to an additional investment. Pacific Life has substantially expanded its equity hedging program and taken other steps in an effort to better stabilize its reported statutory capital position even when equity markets have major moves. Moody's focuses on the economic capital needed to support the VA business; however, Pacific Life's ability to stabilize its reported amount of capital and RBC ratio, even if equity markets exhibit major movements, will be a major factor in supporting the company's A1 IFS rating. We believe that Pacific Life is best positioned in the Aa range on this factor, given its high level of reported capital, partially offset by its sensitivity to equity markets. We have consequently raised this factor score to Aa from the unadjusted scorecard result of A. PROFITABILITY: A - DIVERSIFIED EARNINGS, BUT SOME VA SENSITIVITY FROM LEGACY BLOCK Moody's considers Pacific Life's level of profitability to be good. During 2014, statutory capital generation--a better measure than statutory net income of long-term earnings capacity--resulted in an increase of $800 million. Since the financial crisis in 2008/2009, the company's allocated capital has become more diversified among its different product lines, including life and retirement solution products. Going forward, we expect this increased diversification to result in decreased earnings volatility. However, we note if interest rates remain low, earnings may come under some pressure, especially if alternative investments do not continue to outperform versus expectations. Historically the company's earnings have been more volatile than we expect from an A-rated company, especially during equity market downturns. This volatility is primarily due to the Retirement Solutions ("RSD") segment's high degree of equity market sensitivity, stemming from both changes in the level of reserves required to support VA product guarantees and fluctuations in product-related fees earned. Pacific Life addressed RSD's sensitivity to equity market fluctuations through several coordinated efforts including: (1) a hedging program that actively uses derivatives to offset some of the VA block's inherent equity market sensitivity; (2) a de-risked variable annuity product; and (3) a heavier emphasis on fixed annuities and investment only variable annuities, which are not (or not as) sensitive to equity market movements. Moody's believes that RSD's earnings will continue to be sensitive to equity market movements, but far less so than in the past. Furthermore, we note that the company has successfully been emphasizing growth in other business lines, including life reinsurance, ACG, mutual funds and life insurance. Because we believe the company's earnings and regulatory capital will exhibit volatility during stressful economic periods, we have adjusted the score on this factor down to A from the unadjusted scorecard result of Aa. LIQUIDITY AND ASSET/LIABILITY MANAGEMENT (ALM): A - BLE LIABILITY PROFILE, BUT VA ADDS ALM RISK Moody's believes that Pacific Life has excellent liquidity to meet its near-term policyholder obligations based on the unadjusted scorecard metric, and this is supported by a stable liability profile (excluding VA guarantees). More than $300 million of Pacific Life's institutional products (IIP) business has runoff at this time. Moody's believes the company has ample liquidity to manage through a stressful liquidity scenario. Appropriately managing the risks assumed from a book of VAs containing embedded guarantees is a challenging task at best and is subject to difficulty in predicting policyholder behavior and market disruptions. Additionally, the company faces some challenges from the low interest rate environment. We have consequently lowered Pacific Life's rating on this factor to A from the Aa raw score due to these challenges. FINANCIAL FLEXIBILITY: A - LOW LEVERAGE AND STRONG CASH FLOW COVERAGE Pacific Life's adjusted financial leverage (18% as of year-end 2014) is consistent with Aa-rated insurers. We expect the company's financial leverage to remain relatively stable going forward, ignoring the impact of interest rates on AOCI. Cash flow coverage has been a strength, and we expect cash flow coverage to remain in the Aaa range through Earnings coverage was 4.6x as of year-end As of 31 December, 2014, the company held approximately $137 million in cash at the holdco relative to its anticipated annual interest expense of approximately $40 million (at the holdco), net of interest income received from internal surplus notes issued by Pacific Life.

5 Given the company is organized in a mutual holding company structure, we believe that raising external equity is not a realistic alternative for the company. Overall, we believe that Pacific Life is best positioned in the A range for financial flexibility given the lack of access to equity markets, and so we have adjusted the score down to A from the Aa unadjusted score. Liquidity Profile Pacific Life has a $700 million commercial paper program. These unsecured notes rank pari passu with Pacific Life's other unsubordinated indebtedness. Pacific Life had no commercial paper outstanding as of 31 December, 2014, and did not have any outstanding at any time during the fourth quarter. Pacific Life's $400 million bank revolving credit facility matures on October 17, 2019 and Pacific LifeCorp's $600 million bank revolving credit facility matures on October 17, There were no amounts outstanding as of 31 December, 2014, and the facilities contain no material adverse change clauses. Interest and debt payments at Pacific LifeCorp are serviced by cash available at Pacific LifeCorp and Pacific Life's statutory dividend capacity ($668 million available in 2015 without requiring special regulatory approval). Pacific Life paid dividends to Pacific LifeCorp of $200 million during Although Moody's gives credit for dividends and loans available from insurance subsidiaries to a holding company, we recognize that the actions of insurance regulators during a time of stress could create a delay or uncertainty in accessing such sources. The company's next debt maturity of $450 million comes due in February Rating Factors Pacific Mutual Holding Company[1][2] Financial Strength Rating Scorecard Aaa Aa A Baa Ba B Caa Score Adjusted Score Business Profile A A Market Position and Brand (15%) A A - Relative Market Share Ratio X Distribution (10%) A A - Distribution Control X - Diversity of Distribution X Product Focus and Diversification (10%) A A - Product Risk X - Life Insurance Product Diversification X Financial Profile Aa A Asset Quality (10%) A A - High Risk Assets % Shareholder's Equity 37.5% - Goodwill & Intangibles % Shareholder's Equity 49.7% Capital Adequacy (15%) A Aa - Shareholder's Equity % Total Assets 7.3% Profitability (15%) Aa A - Return on Capital (5 yr. avg) 5.4% - Sharpe Ratio of ROC (5 yr. avg) 651.3% Liquidity and Asset/Liability Management (10%) Aa A - Liquid Assets % Liquid Liabilities X Financial Flexibility (15%) Aa A - Financial Leverage 18.0% - Total Leverage 19.6% - Earnings Coverage (5 yr. avg) 5.0x - Cash Flow Coverage (5 yr. avg) 11.7x

6 Operating Environment Aaa - A Aaa - A Aggregate Profile A1 A1 [1] Information based on US GAAP financial statements as of Fiscal YE December 31 [2] The Scorecard rating is an important component of the company's published rating, reflecting the stand-alone financial strength before other considerations (discussed above) are incorporated into the analysis This publication does not announce a credit rating action. For any credit ratings referenced in this publication, please see the ratings tab on the issuer/entity page on for the most updated credit rating action information and rating history. 2015, Moody's Investors Service, Inc. and/or its licensors and affiliates (collectively, MOODY S ). All rights reserved. CREDIT RATINGS ISSUED BY MOODY'S INVESTORS SERVICE, INC. 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