Tuesday, April 22, 2008

Preview of Life Insurance Cos Q1 2008 Earnings

BMO Capital Markets, 22 April 2008

In light of the continued volatility in the marketplace over the last quarter and the global credit deterioration, the Canadian lifecos should report modest earnings growth in Q1/08. Q4/07 results did highlight the strength of these franchises: specifically, no exposure to short-term liquidity challenges faced by the global banking system due to the long-term nature of their funding sources and little credit exposure to troubled sectors in the North American economy such as U.S. subprime mortgages and leveraged CDOs.

The conventional wisdom on the Canadian life insurers is that the conservatism embedded in the accounting model should provide relative stability in earnings emergence over time. However, recent share price performance has not supported this conventional wisdom. Over the last year, the Canadian life and health index outperformed the Canadian bank index and the S&P 500, but underperformed the S&P/TSX Composite (Table 1). During the first quarter of 2008, the Canadian Life & Health index underperformed both the S&P/TSX composite and the Canadian bank index. Year to date, the lifecos have underperformed. Therecent underperformance may refl ect concerns on future credit deterioration among the Canadian lifecos and concerns on future acquisitions given increased acquisition opportunities in the U.S. While we cannot gauge the impact of acquisitions until a deal is announced, we believe that the Canadian lifecos, in general, have a good track record of acquisitions. With respect to asset quality, we believe that the Canadian lifecos should distinguish themselves relative to their peers in terms of asset quality.

For the industry, we are projecting an average of 4% EPS growth, based on solid in-force profit growth, higher income on capital, lower new business strain, good expense gains and continued share buybacks, primarily from MFC and SLF, partially offset by a stronger Canadian dollar, and lower investment gains and fee income. Our Q1/08 EPS estimates are based on a C$/US$ exchange rate of 1.0000 versus an average rate of 1.0053 for the quarter and the current rate of 1.0057.

In this preview, we discuss four industry-wide conditions that are important to all four insurers: credit and equity markets, low long-term interest rates, currency and buybacks. The last section of the report discusses each company independently.

Equity & Credit Markets – Some Light Turbulence

One of the major drivers in lifeco earnings over the last five years has been the strong equity markets. Earnings from lifecos are increasingly sensitive to events in the equity markets, as the percentage contribution from wealth management (versus protection) has almost doubled since 2000. The average of the S&P 500 fell 5.3% year over year, while the average S&P/TSX Composite was up 2.2% on a year-over-year basis. Accordingly, year-over-year growth in average equity market levels should be a positive for Q1/08 earnings in Canada, with lower levels of investment gains from the U.S. operations. The quarter-over quarter change in the average composites was down 9.7% for the S&P 500 and 4.5% for the S&P/TSX Composite. This hinders future fee income growth and may require some additional reserves to support segregated fund guarantees.

On the credit side, U.S. subprime (and Alt-A) mortgage exposure in the Canadian lifecos is low, averaging 0.8% of total assets versus a U.S. average of 3.7%. We expect that credit will continue to deteriorate given the writedowns that have been taken by the global investment banks and the negative outlook on the global economy. However, widening credit spreads in Canada and the U.S. should help the life insurers improve portfolio yields. For a full discussion of credit quality at the Canadian lifecos, please see the most recent Life Insurance Register dated April 3, 2008.

Long-Term Interest Rates – Long Rates Continue to Decline

Long-term interest rates, as represented by the 10-year government bond yields, have been on a downward trend over the last year. The average 10-year rate for the first quarter of the 2008 has fallen by 37 basis points year over year to 3.73% in Canada and 104 basis points to 3.64% in the U.S. Partially offsetting some of the recent weakness in long-term rates, credit spreads continue to widen. Lower long-term interest rates pose a variety of challenges to life insurers, most important of which is the impact on the discount rates used to calculate policyholder reserves and premiums charged on new products.

Interestingly, the Canadian Asset Liability Method (CALM) used to prospectively calculate policy holder reserves, as defined by the Consolidated Standards of Practice of the Canadian Institute of Actuaries, describes the best estimate risk-free ultimate reinvestment rate (URR), beyond 40 years into the future, as the average of the 60- and 120-month moving averages of long-term risk-free yields. In our case, we have proxied the long term yields with the 10-year government bond yield. While a discussion of CALM is beyond the scope of this preview, we believe that there are some noteworthy observations:

• The CALM URR does not exhibit the same volatility as the actual rate.

• Despite falling rates, the Canadian lifecos have successfully managed to grow earnings through this environment since 2002.

• While current interest rates are below the URR, investors should note that a number of adjustments are applied to this URR to derive the valuation URR used in the calculation of actuarial liabilities. These adjustments include assumptions on credit spreads (net of defaults) and additional provisions for risk of asset depreciation (C1 risk) and interest rate mismatches (C3 risk), all subject to thr lifeco’s current investment strategy and worst-case scenario. When applied, these adjustments will reduce the URR, refl ecting the conservative nature required in valuing long-tailed liabilities.

• To the extent that the valuation URR is below the current rate, a margin of safety exists that can mitigate the requirement for additional reserve increases.

Under Canadian GAAP, reserves are “fair valued” quarterly and, as a result, refl ect some impact of the decline in long-term interest rates. In addition, since pricing new policies is based on assumed investment returns, low long-term interest rates reduce potential future investment return assumptions and hence increase the cost of insurance. While it is difficult to isolate the impact of low long-term interest rates in any given quarter or year, we believe that the current rate environment creates a long term earnings growth headwind for the life insurance industry.

Stronger Currency

The Big 3 Canadian lifecos generate approximately 21–47% of total earnings in Canada and the balance is generated outside of Canada, primarily in the U.S., or in U.S. dollar-based jurisdictions. We estimate that the U.S. and U.S. dollar-based jurisdictions accounted for 27–65% of total earnings a year ago and last quarter.

At the extremes, Manulife has the most U.S. dollar exposure and Industrial Alliance has the least. We estimate the average C$/US$ exchange rate of 1.0053 in Q1/08 versus 1.1717 a year ago, 0.9803 last quarter and the current rate of 1.0057. It is important for investors to remember that the currency fluctuations are a translation issue rather than an economic issue.

Our 2008E EPS assume an average exchange rate of 1.0000 C$/US$ versus the current exchange rate of 1.0057 C$/US$. Earnings sensitivities to different F/X rates are shown in Table 4. In the past we have adjusted our exchange rate forecasts after quarterly results have been released. Of note, our EPS sensitivity
analysis to changes in exchange rates has historically projected too severe an impact on lifeco earnings.

While the fluctuations in exchange rates have a short-term translation impact on earnings, the stronger Canadian dollar provides the Canadian lifecos with a more valuable currency to make acquisitions. We expect the Big 3 Canadian lifecos to remain very active in the U.S. market. Specifically, we expect that MFC would entertain large acquisitions such as Principal Financial Group, Lincoln National or Ameriprise, among others. SLF may also consider these types of deals but may be more willing to acquire blocks of business rather than entire companies. We believe SLF’s tolerance for larger deals (i.e. above US$1–2 billion) has increased. With the acquisition of Putnam, GWO is likely to focus on this integration over the next year but would probably continue to make relatively smaller 401(k) acquisitions.

Share Buybacks

The continued deterioration of the global credit environment, coupled with the weak first-quarter results of global conglomerate General Electric, Wachovia, Merrill Lynch, Citibank and UBS, and the JP Morgan bailout of Bear Stearns, has led to a less than positive outlook for the Financial Services sector. Canadian banks have essentially stopped or dramatically slowed their buybacks during the last six months. Year to date, only Royal Bank has bought back 1.2 million shares. However, the Canadian lifecos continue to maintain balance sheets that support the return of capital to shareholders through buybacks, with MFC and SLF being the most active participants. For the first two months of 2008, SLF and IAG have repurchased 0.5 million and 0.4 million shares, respectively, and MFC is estimated to have repurchased approximately 8 million shares. The sustained buyback activity among the lifecos has led to total payout ratios (dividends + buybacks) that were significantly higher than the banks’ in 2007.

Company-Specific Comments

Sun Life – Credit Strong; Watching Earnings in Canada and U.S. Insurance

Sun Life (SLF) will report its Q1/08 earnings on Tuesday, May 6. We are projecting a modest increase of 2% in EPS to $0.98 (mean estimate is $1.01) from $0.96 in Q1/07. Our estimates are based on modest growth expectations from Canada, improved (lower) new business strain in U.S. individual insurance and a modest reduction in the weighted average shares outstanding. We believe that investors will focus on conditions in the capital markets, new business strain levels in U.S. insurance, scale efficiencies in U.S. group, total company sales levels and net flows in U.S. VA and MFS.

Q4/07 results were largely below market expectations mainly due to modest growth in Canada and reserve strengthening in its run-off reinsurance operations in the Corporate segment. The benefits of the new AXXX funding structure in the U.S. and strong earnings at MFS and Asia were unable to offset these items. Sales results were mixed in the quarter, with solid growth in life and health offset by weaker results in wealth management. The company did provide excellent disclosure on its bond portfolio and exposures to different sectors, and we maintain our view that SLF’s balance sheet remains very strong.

In Q4/07, the U.S. VA segment experienced net redemptions of US$89 million, reflecting a lapse spike on legacy annuity products, which did not incorporate any of the product features found in the company’s successful (and well-received) Income ON Demand VA. With the increased volatility in the equity markets, we expect to see moderating wealth management sales and AUM growth in the quarter, although the company’s Income ON Demand VA should still generate attractive sales growth, given the lack of competition from its U.S. peers with similar product features. We suspect that the market volatility may also hinder net flows at MFS in the quarter. Pre-tax margins at MFS should migrate back to the mid-30s from 40% in Q4/07.

Inforce profits and income on capital should be a steady contributor of earnings in the quarter and benefits from finalizing its AXXX funding structure should continue to support earnings in U.S. insurance. As well, scale efficiencies from the EGB acquisition in U.S. group should help offset the seasonality in group claims that the company experiences each first quarter.

Despite the short-term earnings headwinds created by the volatile equity markets, uncertainty on credit (in conjunction with lower interest rates) and appreciation in the Canadian dollar, we still expect to see modest growth in EPS for the quarter. Although acquisition opportunities currently remain sparse, it may take another 6–12 months of volatile equity markets and/or bad credit to rejuvenate M&A activity, particularly in the U.S. SLF remains Market Perform rated.

Manulife – Global Leader Well Positioned for Consolidation

Manulife (MFC) is scheduled to report Q1/08 earnings on Thursday, May 8 and we are projecting EPS of $0.70 (mean estimate is $0.72), up 4% from $0.67 the same quarter last year. We are projecting inforce profit growth from Canada and Asia and U.S. Protection. Equity market volatility will slow AUM growth and may create temporary earnings headwinds for wealth management businesses in the U.S. and Japan. Earnings growth in the U.S. operations may also face a tough comparison in Q1/08 versus Q1/07 due to an unsustainable level of favourable investment gains JH fixed products group from last year.

We upgraded MFC to Outperform from Market Perform, reflecting the strength of its balance sheet, strong sales performance over the last two quarters of 2007 across all product lines in all jurisdictions, an attractive global platform, and the financial and operational ability to capitalize on consolidation opportunities in an uncertain market. Q4/07 results were well above consensus estimates and our expectations. Noteworthy in the quarter was the continuation of strong investment gains, this time in the U.S. protection business. While the timing and sustainability of these gains is difficult to predict, the sales momentum and inforce profit growth potential provide a solid foundation for earnings growth going forward. MFC also remained active in its share buyback program, repurchasing 56.4 million shares during 2007 for a total of $2.2 billion.

Credit experience remains strong at MFC, and asset quality remains better than expected. However, given the continued decline in the equity and credit markets, investment spread gains have likely moderated as well as asset growth in its wealth management businesses. Sales growth may be a challenge in the quarter, but steady inforce profit growth and interest on capital should help mitigate (at least partially) the situation. Moreover, MFC should remain active in its share buyback program.

Wealth management sales in Asia may face a difficult environment given the recent equity market volatility in the Asian markets. In the U.S., VA sales competition remains high; however, we hope to see good VA sales given the very encouraging net flows over the past few quarters and strong demand for its U.S. Income Plus for Life rider. JH RPS also launched a new Guaranteed Income for Life rider on its 401(k) plans at the start of April, which should help boost RPS sales in the coming quarters. In Japan, MFC posted strong sales last quarter, but the sales outlook for Q1/08 will be impacted by the changes in Japan’s financial disclosure laws. GMWB sales in Canada have been very promising over the past several quarters; however, given the poor RRSP season, wealth management sales in Canada may have also moderated.

We continue to believe that MFC has the most attractive long term outlook for all the large Canadian financial services companies given its global reach and strong competitive positions in Asia and the U.S. Short-term earnings headwinds include the volatility in the global credit and equity markets, and low long term interest rates could be a long-term headwind to earnings.

Because of MFC’s global diversification, the rising Canadian dollar may also moderate earnings growth; however, U.S. acquisitions will become cheaper. MFC has an estimated $3 billion in excess capital plus additional leverage capacity (not to mention the ability to issue shares) to fund large acquisitions. While large acquisition targets dominate the market view on MFC, we would not be surprised to see MFC make smaller acquisitions in the 401(k) market and mutual fund segments in the U.S. MFC remains rated Outperform.

Of note, MFC does have some indirect exposure to auction rate preferred shares in nine closed-end funds with total AUM of approximately US$6 billion. These closed-end funds were sold to retail and institutional investors in the U.S. through John Hancock. The auction rate preferred share market has come under stress, and seven of these closed-end funds have exposure totalling approximately US$1.8 billion. Currently, we do not believe that MFC has any obligation, or intention, to support these closed-end funds. Nonetheless, management’s view on this issue is likely to be scrutinized during the quarter.

Great-West Life – Putnam Dominates Perceptions Despite Generating Only 6% of Earnings

Great-West Life (GWO) is expected to report its Q1/08 earnings on Thursday, May 1. We are projecting EPS growth of 5% to $0.60 (mean estimate is $0.64) from $0.57 at Q1/07. Canada and Europe are expected to report another good quarter and the U.S. should show modest growth with increases from financial services, partially offset by languishing performance at Putnam.

On April 1, GWO announced that it completed the sale of its U.S. healthcare operations to CIGNA for US$2.25 billion. While we expect that investors are likely to remain focused on Putnam’s issues and fund performance, we believe the Canadian and European results should remain strong. Growth in premiums and deposits in Canada have been very good for the company over the last 12 months and similar trends remain in Europe with last quarter’s acquisition of a block of Standard Life’s U.K. payout annuities. Aside from Putnam, GWO’s U.S. financial services operation remains acquisitive, particularly in the 401(k) space.

Equity market volatility, however, has slowed the growth in AUM at Putnam and net flows will remain an issue, and are unlikely to show any sustained improvement until the end of 2009 at the earliest. It appears that Putman mutual funds experienced $4.6 billion in net outflows in Q1/08. Despite the U.K. acquisition last quarter, European sales in Q4/07 were down, primarily driven by lower sales of savings products in the U.K. and Isle of Man due to the uncertainty created by proposed changes in taxes in the U.K. on certain products offered in the Isle of Man. We doubt that sales are likely to rebound until further clarity is provided on any tax changes by the U.K. government.

GWO’s asset portfolio remains strong. Gross impaired and net impaired assets continued to decline last quarter. Although GWO has the highest exposure to monoline wrapped bonds ($3.5 billion) in the lifeco group, over half of the exposure (58%) is in Europe and does not cover structure financed transactions but mainly traditional utilities, water and other municipal services. If the monoline wraps disappear, we estimate that this could have a financial impact of up to $25–30 million—a very manageable impact on $3.5 billion in earnings.

We continue to rate GWO Outperform, based on strong growth outlooks in Canada and Europe, valuation improvement in the U.S. business as it focuses more on financial services rather than healthcare, and attractive valuation based on relative P/E and relative yield. Although Putnam is faced with challenges, it represents less than 6% of GWO’s total earnings, and the remaining 94% of GWO’s business operations are performing well (see our report entitled Putnam Concerns Weigh on Share Price but May Be Overdone, dated April 10, for our views on the Putnam acquisition).

Industrial Alliance – Benefits of Canada Only Franchise

Industrial Alliance (IAG) is scheduled to release results on Wednesday, May 7. We are projecting a 4% increase in EPS to $0.75 (mean estimate is $0.80) from $0.72 in the same quarter last year. Our estimates are based on steady contributions from both of IAG’s main operating segments: individual insurance and individual wealth management. Although sales and AUM growth may languish, lower fee income and investment gains should be offset by inforce profit growth and income on capital.

IAG’s balance of earnings continues to improve, as wealth management is increasingly contributing to earnings since the Clarington acquisition, and we expect to see further penetration outside of Quebec.

IAG continues to improve its insurance new business strain by shifting its sales mix from level cost of insurance (COI) universal life (UL) to yearly renewable term (YRT) COI UL. Q4/07 new business strain decreased to 46% of first-year sales; below the target of 50–55%.We expect to see strain levels maintained within the company’s target range in the medium term. IAG launched its own version of an individual GMWB segregated fund in December 2007. However, given the recent volatility in the equity markets, and competition from MFC’s and SLF’s GMWB products, sales may be off to a slow start. Moreover, given the slow RRSP season, overall wealth management sales may face a tough comparison versus Q1/07.

On April 9, Canaccord announced that it would repurchase, at par, $138 million of non-bank ABCP held by its smaller investors, increasing the likelihood of the Montreal Accord being approved, with the final vote scheduled for April 25. As part of the repurchase, Canaccord would use an external market bid for the restructured notes, which we estimate to be approximately 68 cents on the dollar. IAG currently values its non-ABCP holdings at 85%. If IAG were to take an additional 15% writedown, we estimate that this would result in an after-tax EPS reduction of $0.13. To be clear, our EPS estimates do not include any writedowns beyond what IAG disclosed in Q3/07.

Despite a challenging operating environment in Q4/07, IAG continued to generate good operating EPS growth of 10%, total company premiums and deposits were up 10%, individual life sales rose 20% and quarterly VNB rose 16%. Moreover, with relatively little exposure to the U.S., we expect IAG to maintain its strong credit profile. We continue to believe that IAG has attractive growth prospects in Canada and should remain a core holding for small and mid-cap portfolios. IAG remains Outperform rated.