Monday, April 23, 2007

Preview of Life Insurance Cos Q1 2007 Earnings

Scotia Capital, 23 April 2007


• Canadian insurers start reporting Q1/F07 results on May 1. We've released our detailed Insurance Q1/F07 Earnings Preview on April 23.

What It Means

• Get ready for EPS volatility. This will be the first quarter the companies report under the New Accounting Standards. The most significant change to impact the bottom line is that the net realized gains on assets backing surplus and capital will no longer be amortized or "smoothed" into income, but rather taken into income when they are realized. Manulife is the most susceptible to inherent income volatility of the new standards.

• For the lifecos we expect 12% EPS growth, and look for 12% EPS CAGR through 2008.

• The P&C insurance market remains rational, and above industry norm profitability is expected to continue. However, pricing is expected to continue to decline (at a slower pace than 2006 for the auto insurers, and at a slightly faster pace than 2006 for the commercial lines players) and operating earnings growth is expected to be flat to slightly down YOY. That said, some valuations, particularly KFS and IIC, are starting to look attractive.

Q1/F07 Earnings Preview

The following is an excerpt from our Insurance Q1/F07 Earnings Preview report released April 23, 2007. Canadian Lifecos - new accounting standards start Q1/F07 - watch for an increase in earnings volatility

• We expect an increase in the volatility of Canadian lifeco earnings in 2007, starting with Q1/F07, 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/F07, 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/F07, 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-$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, they’ll just be more volatile. 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 more volatile.

• The amount of realized net gains on surplus assets needed to replace the 'loss in amortization' is certainly plausible and definitely not insurmountable. We estimate that, in order to replace the annual earnings associated with amortization of net gains on surplus assets, the annual net realized gain yield on surplus assets needs to be 1.5% for Manulife, 1.3% for Sun Life, 0.7% for Great-West Lifeco, and 0.5% for Industrial-Alliance (which serve as our estimates for Q1/F07). Given that these yields are far less than the 1.5%-2.0% yields we see for the P&C insurers, we believe that over the long run EPS estimates should not change due to the new standards.

• There is a possibility, due to the buoyant equity markets in Q1/F07, that the companies could beat our estimates and consensus. With U.S. and Canadian equity markets up 11% and 10% year over year (on average) and 3% and 5% quarter over quarter (on average), well in excess of the 7% annualized rate we assume (see Exhibit 2), we could possibly see companies surpass our estimates on better-than-expected fee income from wealth management business, better-than-expected net realized gains on assets supporting surplus, and some favourable movement in reserves associated with guarantees on segregated fund/variable annuity business.

• The macro environment continues to look good for our insurers. Long-term interest rates appear to have stabilized, and with Scotia Economics forecasting both U.S. 10-year treasuries and government of Canada 10-year yields to modestly increase by the middle of 2008, we see little in the way of headwinds due to declining long-term yields. U.S. equity markets, where the Canadian lifecos have the majority of their equity market risk, appear to be co-operating, which after increasing 14% last year appear to be on track (as per our strategist) to increase 7% this year. Credit conditions continue to track at very favourable levels. Given this backdrop, along with an expected S&P/TSX increase in the mid-single digit range for the next 12 months, we recently increased our recommendation for the Canadian lifecos from market weight to overweight. Finally, we have conservatively assumed that the recent bid the C$ has caught relative to the USD and the £ will continue through 2008. Should currency markets remain at current levels through 2008 we would expect to increase our 2008 EPS estimate for GWO by 1%, decrease our 2008 EPS estimate for MFC by 1%, with no change for SLF.

• The amount of share buybacks for MFC and SLF has declined over the last 2 quarters. These companies have gone from spending 30%-40% of EPS on buybacks to half those levels over the last six months (see Exhibit 3). We believe that shoring up cash for the $720 million Genworth acquisition (expected to close in Q2/07) accounts for some of SLF's recent slowdown, and we expect the company’s buyback pace to pick up after the close, consistent with the company’s targeted $500 million annual buyback spend (or 25% of 2007E EPS). For MFC, which has no share buyback target, we’re not quite sure why there is a slowdown (building an acquisition war chest? If so, coveted properties are quite expensive - see our Excess Capital Update report of April 2, 2006). We do not expect the company to significantly increase its dividend, as its payout ratio currently sits at the midpoint of its 25%-35% targeted range. If Manulife’s share buyback pace continues at this pace we would reduce our EPS estimates by $0.02 in 2007 and $0.04 in 2008, as well as freeze projected ROE at the current 16% level.

Great-West Lifeco Inc.

1-Sector Outperform : $40 one-year target, based on 3.0x 3/31/08E BV and 14.1x 2008E EPS

• We are looking for $0.56 per share for Q1/F07, $0.01 per share below consensus. Our 2007 EPS estimate is $2.46, $0.05 ahead of consensus.
• Likely no update on Putnam financing - we have to believe the longer we wait the more likely the deal could be financed without issuing common equity.
• YOY strength of the Pound and the Euro versus the C$ could push EPS above consensus.
• Recently completed tuck-in acquisitions in the United States should start to bear fruit.

Industrial-Alliance Insurance and Financial Services Inc.

3-Sector Underperform : $38 one-year target, based on 1.7x 3/31/08E BV and 12.5x 2008E EPS

• We are looking for $0.70 per share in Q1/F07, $0.01 below consensus. We peg organic growth excluding tax gains at about 9% for the quarter. Our 2007 EPS estimate of $2.91 is $0.04 below consensus.
• The Clarington acquisition will continue to propel individual wealth management earnings as should what we believe to be traditionally strong RRSP results - but increasing leverage to Canadian equity markets may cause some concern going forward.

Manulife Financial Corporation

2-Sector Perform : $43 one-year target, based on 2.5x 3/31/08E BV and 13.9x 2008E EPS

• We are looking for $0.67 per share for Q1/F07, $0.01 per share below consensus. Our 2007 EPS estimate of $2.82 is $0.01 below consensus.
• We expect EPS growth to return to a 12% clip, after growing by 22% in Q4/F06 and 20% in 2006 due to the benefit of 54% earnings growth in U.S. Fixed Products (exceptional investment and credit results) and tax gains in Canada.
• After several quarters of deceleration in sales growth in the United States and Japan, will we get a significant lift in the top line? We remain cautious.
• So what are you going to do with your excess capital? Always a conference call question.

Sun Life Financial Inc.

1-Sector Outperform : $58 one-year target, based on 1.9x 3/31/08E BV and 13.0x 2008E EPS

• We are looking for $0.94 per share for Q1/F07, $0.02 below consensus. Our 2007 EPS estimate of $4.05 is in line with consensus.
• We look for 12% EPS growth, similar to the 13% we saw in the last two quarters.
• U.S. variable annuity - we expect top-line growth momentum to continue.
• We expect the company is taking steps to alleviate the AXXX individual insurance strain issue in the United States. A new funding arrangement appears to have started in Q1/F07.