A key ratings service has upgraded the ratings outlook for the U.S. life insurance and annuity sector from “negative” to “stable,” saying it believes the industry’s current capitalization is adequate and can withstand additional stress.

A.M. Best Co. said it believes that the sector can incorporate ongoing elevated impairments and modest overall economic growth at current ratings levels, according to a statement.

In 2009, the ratings service saw life/health companies experience their highest level of financial impairments since 1999.

“Since the fourth quarter of 2008, A.M. Best Co. has taken a preponderance of negative rating actions on U.S. life and annuity companies as the industry’s operating performance deteriorated and company balance sheets weathered the effects of the global financial crisis,” the service said. “Through these actions, A.M. Best has largely factored in the potential impact of macroeconomic issues such as the troubled real estate sector, high unemployment, low interest rates, muted consumer spending, European sovereign debt crisis and rising credit defaults.”

The stable outlook, it said, reflects its view that rating actions are not expected to move profoundly in one direction, with the ratio of downgrades/negative outlook changes to upgrades/positive outlook changes trending towards one in the near to medium term.

“While A.M. Best does not typically react to short-term volatility, large reductions in capital or earnings will be viewed negatively, given the recent volatility in the equity markets and other emerging risks,” the statement said.

The ratings service said it has observed “favorable trends pertaining to credit spreads, asset impairments, balance sheet and product de-risking, access to the capital markets and overall risk management.”

“To a large extent, substantial unrealized loss positions in general account investment portfolios have recovered” in the first quarter of this year, A.M. Best said. Several life insurers have successfully raised capital through debt and equity issuances to fund near-term maturities, decrease leverage, reduce reliance on short-term funding (such as commercial paper or bank debt), and/or contribute capital to their operating subsidiaries, according to the analysis.

A.M. Best reports a “substantial increase”—greater than 20%—in the industry’s absolute capital from first quarter 2009 to the first quarter of this year. Additionally, life and annuity companies have curtailed or de-emphasized sales of products that are more capital intensive such as institutional spread-based products, no-lapse universal life and fixed annuities, leading A.M. Best to conclude that demand for fixed annuities will continue to fluctuate with the economy and interest rates, while variable annuity sales will remain highly correlated with equity market performance.

While capital measures have stabilized, A.M. Best said it believes that challenges remain for the life/annuity segment. Although operating earnings have generally improved, recent results remain below pre-crisis levels. Individual life insurance sales, after experiencing the largest year-over-year decline on record, remain sluggish as application activity has essentially been flat through the first part of 2010. The ongoing trend towards offering simpler variable annuities in conjunction with higher pricing and less generous guaranteed living benefit riders has tempered new sales growth, despite strong equity market performance in 2009. Additionally, A.M. Best believes the slow U.S. economic recovery, coupled with the European sovereign debt crisis and continued weakness in U.S. housing trends and unemployment, is triggering some of the recent volatility in the equity markets—perhaps an indication that the threat of a double-dip recession may indeed be real, it said.

Fundamentals for the vast majority of life and annuity companies are currently sound, despite a cloudy macroeconomic picture and a cautious outlook recently announced by the Federal Reserve. A.M. Best maintains a  cautious view with respect to the future impact of both residential and commercial mortgage delinquencies as well as restructured loans, which may be masking the true default rate of these investments. Additionally, the persistent low interest rate environment is likely to continue to pressure spreads and reinforce current levels of reinvestment risk. And, although the current state of financial regulatory reform is likely to have a limited impact on life insurers, the lack of direction from the current administration regarding 2011 tax changes is causing uncertainty on the part of investors, producers and consumers.

Finally, notwithstanding the considerable upsurge in the industry’s capitalization on both an absolute and risk-adjusted basis, A.M. Best believes that the overall quality of capital has diminished given the volume of recent surplus note issuances, reserve financings and reinsurance transactions to provide capital relief. Going forward, A.M. Best will monitor the life industry’s strategies for deploying capital as merger and acquisition activity and share repurchase programs resume.