Tuesday, March 13, 2007

Increase in Earnings Volatility for Life Insurance Cos

  
Scotia Capital, 13 March 2007

Event

• The most recent version of "Scotia Capital Insurance Weekly Update", released last night, contains a small piece on the New Accounting Standards, effective 2007, which will result in increased earnings volatility for the Canadian lifecos. We highlight the piece in this note.

What It Means

• The inherent smoothing due to the amortization of gains and losses on assets backing capital and surplus, accounting for 3% (in the case of GWO) 4% (in the case of SLF and IAG) and 7% (in the case of MFC) of 2006 EPS, will be a thing of the past. Under the new standards, effective Q1/07, gains and losses on these assets will be taken into income when realized.

• While we don't believe that over the long run EPS estimates should change due to the new standards, we expect that quarterly income will be more volatile, especially for Manulife.

More EPS Volatility Starting Q1/07

• Get ready for an increase in the volatility of Canadian lifeco earnings in 2007, especially for Manulife.

• The most significant net income impact of the new accounting standards (specifically Section 3855 of the Canadian Institute of Chartered Accountants), which become effective in 2007, is the loss of amortization of gains and losses on assets backing capital and surplus.

• Prior to Q1/2007, realized gains and losses on bonds and mortgages backing capital and surplus were deferred and amortized into income over the remaining term of the asset, and realized and unrealized gains and losses on stocks were deferred and amortized at a rate of 5% per quarter.

• Starting with Q1/2007 gains and losses on assets backing capital and surplus will be taken into income as they are realized. That means the steady amortization of these items, which in the past accounted for about $0.04 to $0.05 in quarterly EPS for Manulife, $0.04 in quarterly EPS for Sun Life, $0.02 to $0.03 in quarterly EPS for Industrial-Alliance and $0.02 in quarterly EPS for Great-West Lifeco (see exhibit 1), will now be replaced by whatever the after-tax realized net gain (or loss) on these assets is in the quarter.

• With the most excess capital, and, as well, the company with a larger percentage of capital and surplus assets in stocks, Manulife is the most susceptible to the inherent net income volatility of the new standards.

• Over the long run EPS estimates shouldn't change due to the new standards, in our opinion. That's because we believe that over the long run the average realized net gain on the assets supporting capital and surplus is probably close to the average impact of the amortization of gains and losses we've seen on these assets in the past. It's just that now, the quarterly income is going to be more volatile.
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