Research Update: Pacific LifeCorp And Subsidiaries Ratings Affirmed After Insurance Criteria Change; The Primary Credit Analyst: Carmi Margalit, CFA, New York (1) 212-438-2281; carmi.margalit@standardandpoors.com Secondary Contact: Michael E Gross, San Francisco 415-371-5003; michael.gross@standardandpoors.com Table Of Contents Overview Rating Action Rationale Outlook Ratings Score Snapshot Related Criteria And Research Ratings List WWW.STANDARDANDPOORS.COM/RATINGSDIRECT JULY 1, 2013 1
Research Update: Pacific LifeCorp And Subsidiaries Ratings Affirmed After Insurance Criteria Change; The Outlook Is Stable Overview Following a review under our revised insurance criteria, we are affirming our ratings on and its core insurance affiliates. The ratings reflect our view of the group's very strong business risk profile and strong financial risk profiles, based on its diverse earnings and strong capitalization. The stable outlook reflects our expectation that Pacific Life will maintain its competitive position and continue to generate stable operating results. Rating Action On July 1, 2013, Standard & Poor's Rating Services affirmed its 'BBB+' counterparty credit rating on Pacific LifeCorp (PLC) and its 'A+' insurer financial strength ratings on PLC's insurance subsidiaries (collectively, Pacific Life). At the same time, we raised our short-term rating on Pacific Life Insurance Co. (PLIC) to 'A-1+' from 'A-1'. The outlook is stable. Rationale The ratings reflect our view of the Pacific Life's very strong business risk profile (BRP) and strong financial risk profile (FRP), built on the group's strong capital and earnings and very strong competitive positions in individual life insurance and annuity markets in the U.S. We derive an 'a+' BRP/FRP anchor that reflects Pacific Life's brand recognition, strong operating performance, and strong capitalization. Partially offsetting these strengths is the company's exposure to unfavorable equity market and interest rate swings. The sensitivity of its operating performance to equity markets and ongoing competition in the U.S. insurance market will continue to challenge the company's ability to maintain its top sales positions while sustaining price discipline. The ratings on PLC further reflect its structural subordination relative to its insurance subsidiaries. The short-term rating on PLIC reflects its exceptional liquidity. Our opinion that Pacific Life faces low industry and country risk stems from our view of low country and industry risks for its life insurance operations. We believe Pacific Life faces low country risk because of the stable economic WWW.STANDARDANDPOORS.COM/RATINGSDIRECT JULY 1, 2013 2
growth prospects, relatively effective and stable political institutions, sophisticated financial systems, and strong payment culture in the U.S. In our view, Pacific Life's life insurance operations are exposed to low industry risks due to moderate product risk as shown by its strong track record of maintaining asset-liability management mismatch within one year. The availability of fixed-income instruments of sufficient duration to match insurance liabilities in the capital markets greatly supports this capability. But we see sensitivity to interest rates and equity-market volatility as somewhat offsetting this and burdening long-term operating return prospects. We believe the weak global economy, persistent low interest rates, and intense competition will limit the sector's growth prospects and potential for higher operating margins. Pacific Life's competitive position is very strong. The company has been very successful in penetrating the highly competitive affluent marketplace (average policy size of more than $1 million) because of its unique and diverse distribution network and positive brand recognition within its target market. The diversity of its businesses (including life insurance, annuities, reinsurance, and aircraft leasing) strengthens its competitive position because it gives the group a wide source of earnings as well as access to various market segments it might otherwise not reach. Its reinsurance and newly acquired retrocession business gives Pacific Life additional exposure outside the U.S. and additional mortality exposure which balance, to some extent, the market exposure in its U.S. variable annuity (VA) business. We consider Pacific Life's capital and earnings to be strong, and anticipate the group will maintain this. Since the financial crisis, the company has shifted its hedging program to protect capital from sharp drops in the equity markets, and it has added additional hedges to protect capital from further reductions in interest rates. Pacific Life saw strong operating fundamentals and sales growth in 2012 in both its life insurance, VA and fixed annuity lines. The new and revised product lines are significantly less risky. Nevertheless, the company still has a sizable in-force block of older business, exposing it to volatile equity markets and dropping interest rates. Its hedging strategy, which focuses on protecting statutory capital, may at times exacerbate this problem because capital adequacy measured by statutory accounting may differ from that as measured by generally accepted accounting principles (GAAP) or the economic value of the assets and liabilities of these lines. Although these differences may contract over an extended period of time, they might still hurt the company's ability to grow and manage its business in the interim. Most of Pacific Life's earnings sensitivity is in its VA line, where the combination of lower fee-based income, increased liabilities associated with guaranteed living benefits, and increased hedging costs led to a sharp deterioration in performance mid-year 2011, but it was able to recover successfully in 2012. Pacific Life's risk position is intermediate, highlighted by the modestly elevated commercial mortgage exposure in its investment portfolio. While it has a long track record of strong investment returns, Pacific Life has a concentration of very large loans, many of which are of types we believe are WWW.STANDARDANDPOORS.COM/RATINGSDIRECT JULY 1, 2013 3
most vulnerable to elevated losses in a weak economy--most notably construction loans and high-end resorts and hotels. We also note that the company has very little exposure to employee defined-benefit obligations and has moderate investment leverage. We view Pacific Life's financial flexibility as adequate. The company has completed a number of external debt issuances over the past few years of both of surplus notes and holding-company senior debt. We view this demonstrated access to external capital as favorable, particularly with regard to its support of capitalization. But we believe Pacific Life has exhausted much of its capacity for external funding. We view Pacific Life's enterprise risk management (ERM) program as adequate. We don't expect Pacific Life to experience losses outside of the normal range from traditional risk areas. The most severe risk arises from equity-market exposure from its VA business. Because the company is a leading national VA and universal life insurance provider, ERM is much more important to its financial strength and rating structure than it is to the ratings on less-complex insurers. It's also more important given Pacific Life's risk profile. We believe Pacific Life's management and governance practices are satisfactory. We view the company's strategic planning process, management depth and breadth, and comprehensive financial standards as positive factors in its management and corporate strategy. Following the recent financial crisis, Pacific Life conducted a thorough review of all of its lines of business and implemented several strategic responses, including changes in pricing, risk management, capital management, and product mix. Although the company remains focused on its two core businesses--life insurance and annuities for high-net-worth individuals--management now has a distinctly lower risk appetite with a renewed emphasis on capital protection and a more-judicious and profit-focused approach to sales growth. Pacific Life's liquidity remains exceptional. Invested assets are well diversified in highly liquid asset classes, and the portfolio far exceeds the company's liquid liabilities. Pacific Life also has additional borrowing capacity through its lines of credit and other short-term financing programs. Our rating on PLC, Pacific Life's holding company, is three notches lower than those on the operating company, reflecting our standard three-notch differential for structural subordination to insurance operating companies. As an insurance holding company, PLC relies on distributions from its regulated insurance units to meet its obligations. We expect PLC to receive annual subsidiary dividends of about $150 million and maintain cash and liquid assets sufficient to meet roughly 2x its annual fixed-charge needs. WWW.STANDARDANDPOORS.COM/RATINGSDIRECT JULY 1, 2013 4
Outlook The stable outlook reflects our view that Pacific Life will maintain its very strong competitive position and strong capitalization, continue to grow its core earnings, and maintain adequate risk controls around its primary pressure points, namely equity market volatility and low or dropping interest rates. We could lower the ratings if adjusted EBIT falls to less than $700 million due to poor operating fundamentals or greater-than-expected equity market or interest rate instability; if fixed-charge coverage weakens to less than 4.0x; if capital adequacy weakens to moderately strong or below; or if Pacific Life's strong competitive profile deteriorates. We could raise the ratings if the company's capitalization increases to a very strong level and its operating performance grows in conjunction with a decrease in its exposure to market volatility and interest rates. Ratings Score Snapshot Financial Strength Rating A+/Stable BRP/FRP Anchor a+ Business Risk Profile Very Strong IICRA Low Risk Competitive Position Very Strong Financial Risk Profile Capital & Earnings Risk Position Financial Flexibility Strong Strong Intermediate Risk Adequate Modifiers 0 ERM and Management 0 Enterprise Risk Management Adequate Management & Governance Satisfactory Holistic Analysis 0 Liquidity Exceptional Support 0 Group Support 0 Government Support 0 WWW.STANDARDANDPOORS.COM/RATINGSDIRECT JULY 1, 2013 5
Related Criteria And Research Insurance Rating Methodology, May 7, 2013 Enterprise Risk Management, May 7, 2013 Group Rating Methodology, May 7, 2013 Methodology For Linking Short-Term And Long-Term Ratings For Corporate, Insurance, And Sovereign Issuers, May 7, 2013 Methodology: Management And Governance Credit Factors For Corporate Entities And Insurers, Nov. 13, 2012 Principles Of Credit Ratings, Feb. 16, 2011 Refined Methodology And Assumptions For Analyzing Insurer Capital Adequacy Using The Risk-Based Insurance Capital Model, June 7, 2010 Hybrid Capital Handbook: September 2008 Edition, Sept. 15, 2008 Ratings List Ratings Affirmed Pacific Life Reinsurance Company II Ltd. Pacific Life Re Ltd. Pacific Life & Annuity Co. Financial Strength Rating Local Currency A+/Stable/-- Financial Enhancement Rating Local Currency A+/--/-- Pacific Life & Annuity Co. Pacific Life Reinsurance Company II Ltd. Counterparty Credit Rating Local Currency A+/Stable/-- Pacific LifeCorp Counterparty Credit Rating Local Currency BBB+/Stable/-- Ratings Affirmed; Short-Term Ratings Upgraded To From Counterparty Credit Rating Local Currency A+/Stable/A-1+ A+/Stable/A-1 Ratings Affirmed Subordinated A- WWW.STANDARDANDPOORS.COM/RATINGSDIRECT JULY 1, 2013 6
COUNTS Trust Series 2006-4 Pacific Life Funding LLC Pacific Life Global Funding Pacific Pilot Funding Senior Secured A+ Pacific LifeCorp Senior Unsecured BBB+ Upgraded To From Commercial Paper A-1+ A-1 Complete ratings information is available to subscribers of RatingsDirect at www.globalcreditportal.com and at www.spcapitaliq.com. All ratings affected by this rating action can be found on Standard & Poor's public Web site at www.standardandpoors.com. Use the Ratings search box located in the left column. WWW.STANDARDANDPOORS.COM/RATINGSDIRECT JULY 1, 2013 7
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