Tuesday, October 21, 2008

Preview of Life Insurance Cos Q3 2008 Earnings

Scotia Capital, 21 October 2008

Canadian Lifecos – It's Gonna be an Ugly quarter

• Another brutal quarter – EPS will suffer. Markets were down 9% quarter over quarter (QoQ) in the United States, 19% in Canada, 13% in the United Kingdom, and 18% in Asia. Credit spreads widened considerably. Significant writedowns/impairment charges on LEH/AIG/Wamu bond holdings will take a big bite out of EPS. The only economic headwind that turned into a modest tailwind was the Canadian dollar, which fell 4% QOQ versus the U.S. dollar and yen.

• Weakening equity markets to take a big bite out of EPS, especially Manulife’s. A 10% decline in equity markets hurts annualized EPS for Manulife (MFC) by 8%, Industrial-Alliance (IAG) by 7%, and Great-West Lifeco (GWO) by 5%. (We are restricted on Sun Life Financial due to the CI Financial/Bank of Nova Scotia transaction.) And with equity markets, weighted by geography, down (QOQ) 12% for GWO, 19% for IAG, and 12% for MFC, this could be the worst quarter we have seen. Per MFC’s recent release, we expect the decline in equity markets will hurt EPS by $0.26, of which $0.12 in EPS is related to the company’s announced $200 million pre-tax reserve hit for segregated fund/VA guarantees and $0.14 EPS is related to other equity market items like the decline in the value of equities supporting liabilities (MFC generally has a higher percent of equities supporting liabilities than its peers), the decline in fee income, and the decline in the value of surplus assets. With the S&P/TSX down 19% QOQ, IAG, which is nearly as levered as MFC to declines in equity markets, and 100% vulnerable to swings in Canadian equity markets, will suffer as well (we estimate $0.09 in EPS). GWO, with a limited 100% segregated fund guarantee book of business in Canada and very insignificant U.S. variable annuity exposure, will suffer less. We estimate the impact of GWO will be $0.06 per share, predominantly related to declining asset values in wealth management businesses, including Putnam (which is still less than 5% of GWO’s bottom line), U.S. financial services (401(k) and P/NP), and offshore Isle of Man business

• Credit woes. Credit worries, more related to the spillover effect of the sub-prime meltdown rather than the sub-prime issue itself (to which the Canadian lifecos’ exposure is immaterial), will certainly weigh on EPS in Q3/08. Not only do we anticipate considerable EPS hits from the already disclosed exposures to Lehman, AIG, and Washington Mutual bonds, we also expect increases in provisions for defaults, primarily as a result of credit downgrades. Exhibit 3 outlines our estimates.

• Credit spreads are the widest we have seen. Widening credit spread risk is minimal for our lifecos (ex Sun Life) as they have limited exposure to book value guarantees on U.S. fixed annuity business.

• Next year EPS estimates reduced. The sharp decline in equity markets of late will obviously reduce average assumed market levels next year, even if markets climb back to our strategist’s unchanged 2009 year-end targets of 14,800 for the S&P/TSX and 1,400 for the S&P 500. Thus, the increase in the average level of the Canadian and U.S. equity markets is now assumed to be 5% and 2%, respectively, down 3% from previous estimates. As such, we have reduced 2009 EPS estimates by 3% to 5%.

• No more drag from currency. In the first half of 2008, the appreciating Canadian dollar was about an 11% drag on U.S. business, or a 3%-5% drag on the bottom line (more so for MFC). We forecast no EPS drag from currency in Q3/08 (apart from perhaps a very modest negative impact for GWO due to the weakening U.K. sterling), and expect a significant tailwind from currency in Q4/08 and 2009.

• Capital is not a concern. We believe capital concerns at Manulife are largely overblown. We anticipate the company has no plans to issue common equity to raise the capital level at one of its primary segregated fund/variable annuity insurance subsidiaries (Manufacturers Life Insurance Company, or MLI), and expect the company’s excess capital to decline to closer to $1 billion from over $3 billion (primarily due to reserves). Despite the decline, S&P maintained its AAA rating – the highest rating of any lifeco. We estimate GWO’s excess capital to have declined to $0.7 billion from about $1.1 billion and IAG’s excess capital to have declined to $100 million from $144 million. We look for MFC to utilize internal measures, such as co-insurance and/or an optimization of capital through subsidiary consolidation, to boost its excess capital level if necessary.

Great-West Lifeco Inc.

1-Sector Outperform – $33 one-year target, based on 2.5x 9/30/09E BV and 12.5x 2009E EPS
• We are looking for EPS of $0.48 for Q3/08, $0.06 below consensus.
• Putnam could likely be very weak. Net sales could be negative US$5B, margins 15%.
• We expect credit “hits” to be $0.12 EPS and weak equity markets to hurt EPS by $0.06.
• More U.K. payout annuity means more yield enhancement opportunities to help drive EPS growth, especially now with wider credit spreads. But additional credit default provisions could hurt bottom line.
• Europe top line will likely continue to be weak.

Industrial-Alliance Insurance and Financial Services Inc.

2-Sector Perform – $33 one-year target, based on 1.3x 9/30/09E BV and 10.3x 2009E EPS
• We are looking for EPS of $0.63 in Q3/08, $0.09 below consensus.
• Wealth management top line could very well continue to be weak.
• We expect credit “hits” to be $0.07 EPS and weak equity markets to hurt EPS by $0.09.
• Unless another acquisition is made, we see medium to long term growth in the 9% range.

Manulife Financial Corporation

1-Sector Outperform – $39 one-year target, based on 2.3x 6/30/09E BV and 12.6x 2009E EPS
• We are looking for EPS of $0.30 for Q3/08, $0.01 below consensus.
• We expect credit “hits” to be $0.12 EPS and weak equity markets to hurt EPS by $0.06.
• Japan could continue to be strong.
• Call should have lots of talk about capital and acquisitions. We see no need for additional capital for operating insurance subsidiaries.

Sun Life Financial Inc.

• We are currently restricted on the shares of Sun Life.