Wednesday, January 07, 2009

Another Round of Favourable MCCSR Changes from OSFI for Insurance Cos

Scotia Capital, 7 January 2009

• Over the Christmas holidays OSFI announced a series of changes to capital rules, with two important changes for 2008 year-end. We estimate the changes will boost the MCCSR ratios of GWO, MFC, and SLF by up to 8-11 percentage points. IAG has already announced the changes would boost its MCCSR by 14 percentage points. The two key changes for 2008 year-end are as follows:

1. Net unrealized gains/losses on available for sale (AFS) debt securities no longer impact Available Capital. Previously, net unrealized gains were added and net unrealized losses were deducted. AFS investments primarily back a life insurer’s surplus, with the bulk of the assets, categorized as “held for trading,” backing policy liabilities. OSFI’s decision to eliminate the impact of unrealized gains and losses on AFS debt securities is in keeping with the same theme in its previous announced changes (end of October on segregated fund reserving), where it attempts to mitigate the sensitivity of the MCCSR to volatile swings in the market. As well, AFS securities are generally held to maturity, so swings in market value should not significantly impact available capital.

2. Elimination of the interest margin pricing risk component, often referred to as the C-2 component. This component, representing 1% of recurring premium paying (generally individual life insurance) policy liabilities supposedly represented the risk associated with interest margin losses associated with future investment and pricing decisions on in-force business. It overlapped significantly with the C-3 component (changes in interest rate risk) and was thus eliminated. Lifecos with proportionally high amounts of in-force individual life insurance business relative to the rest of their business (like IAG) stand to benefit the most from the elimination of the C-2 component.

• Changes add even more capital to already very well capitalized companies. We outline the impact in Exhibit 1, along with the Q4/08 estimated MCCSR ratios, estimated excess capital positions, and sensitivity of the ratios to 25% changes in equity markets. All the companies are extremely well capitalized, with MCCSR ratios above 200% at December 31, 2008 (our estimates are GWO at 234%, IAG at 203%, MFC at 243%, and SLF at 237%). In less volatile markets one might assume anything above 200% is excess capital. Using this metric, surprisingly enough, we estimate excess capital levels to be fairly close to the amounts raised in Q4/08, or, in the case of SLF, raised by means of the sale of CIX. The recent raisings do provide significant buffer, though. Should markets fall 25% from December 31, 2008 levels (i.e., the S&P 500 falls to 677 and the S&P/TSX falls to 6,740), all the lifecos will have MCCSR ratios well within their target ranges. Should markets continue to rebound, we would anticipate the increasing amount of excess capital would be put to work, likely by way of acquisitions (in the case for all the companies), as well as debt repayment (MFC would likely pay off its $2 billion loan).
Financial Post, Jonathan Ratner, 5 January 2009

Sun Life Financial Inc. lost roughly 45% of its value in 2008, taking the stock from above $50 per share early in the year to under $30. Citigroup analyst Colin Devine doesn’t think prospects will improve much for investors in 2009, cutting his price target on the life insurer from $40 to $30 and trimming his earnings estimates for 2008 through 2010.

The changes reflect the impact of the fourth quarter equity market decline on fee-based revenues tied to lower segregated and mutual fund assets under management. They are also a result of higher variable annuity reserving and hedge-related costs, as well as the impact of the weaker Canadian dollar, Mr. Devine told clients.

Since Sun Life’s variable annuity (VA) risk management practices in the U.S. have been far more disciplined that those of arch rival Manulife Financial Corp., it is not expected to need a massive increase in VA reserves due to equity market declines that would prompt an equity capital raise, the analyst said.

At the same time, Mr. Devine said Sun Life’s solid balance sheet, upgraded U.S. management team and significant cash position following the sale of its 37% stake in CI Financial Income Fund to Bank of Nova Scotia, puts it in a very good position to take advantage of weakened competitors.

“M&A represents potential valuation catalyst that could lead to upgrade in our rating,” he said, adding that targets could include Lincoln National Corp., Principal Financial Group Inc., Aegon NV, Ameriprse Financial Inc. or Hartford Financial Services Group Inc.

In terms of Sun Life’s fourth quarter results for 2008, the Citigroup analyst expects equity markets will drive down earnings per share by 40.5% to 58¢. However, this should be offset be an approximate $1.25 per share gain from the CI sale.

Mr. Devine said on a relative basis versus its peers, Sun Life’s whole continues to be less than the sum-of-the-parts. “Getting to the next level will require major gains by the underachieving U.S. operations, the market that offers the greatest potential, as we see it, to boost EPS. We believe recent management changes were an important first step, but will need to be followed by significant M&A.”
The Globe and Mail, Tara Perkins, 5 December 2008

Sitting in his Toronto office on Bloor Street, overlooking the treetops of the Rosedale ravine, Dominic D'Alessandro picked up the phone and, one by one, placed direct calls to the chief executives of each of the nation's biggest banks.

It was a Friday in late October, and the chief executive of Manulife Financial Corp. needed help. North America's biggest life insurer was recalculating its capital ratios every day, and plunging stock markets were dragging them down. Mr. D'Alessandro realized his company – the one he had personally turned into a global giant – would soon be forced to sock away billions of dollars to shore itself up. He couldn't get by without the big banks that he had so often criticized.

In the previous few days, Mr. D'Alessandro had been working another angle, trying to persuade Julie Dickson, who heads the country's banking and insurance regulator, to change the rules that were requiring Manulife to set aside massive amounts of money for every downtick in the stock market.

Mr. D'Alessandro laid out his case for her. The capital rules are too onerous, he said. They oblige Manulife to build a huge financial cushion, enough to carry it through a catastrophic event and a scenario where markets don't recover for a decade. But that cushion was straining the company's finances, he argued. It didn't make sense. If stock markets recovered, the cushion would become unnecessary.

For someone like Mr. D'Alessandro, who is known for calling the shots rather than dodging them, it was an unusual position. This is the same man who graduated from high school at age 14, ran a bank by age 41, and was the architect of a dramatic ascension that had made him a living legend in Canadian financial circles. The company's funds under management have more than tripled since 1999, when Mr. D'Alessandro took the firm public, to $385.3-billion, and it now has more than 24,000 employees serving customers in 19 countries and territories.

“Of course I would have preferred a little less adventure and a little less challenge in my final months with the company. Of course,” he says, referring to his planned retirement next spring.

“I don't think I'm alone in saying I didn't foresee an event of this severity. I love it when people say ‘why didn't your forecast it? Aren't you paid to know these things?' Well, I know a lot of things, but I didn't know that.”

The fall of 2008 is now littered with stories of how American and European financial giants were brought to their knees. Canadian politicians crowed about how safe Bay Street seemed by comparison. But for a few tense weeks in October, the dramatic turns inside Manulife showed how vulnerable Canada's most trusted institutions are to the turns of a global market.

As Mr. D'Alessandro made those calls to bank CEOs – and his company's stock plunged from near $35 at Thanksgiving to $24 around Halloween – he was pushing to make sure Manulife was not one of the victims. But he was also on a personal mission – to preserve his own legacy and reputation, with the clock ticking as his 14 years at the helm wind down to an early retirement in May. The plan wasn't just to guide his company through the credit storm, but to put it in a position of strength, to be one of the players expanding while others reeled. Otherwise he risked going out under a cloud.

The rapid collapse of Manulife's good fortunes is easily predictable with hindsight.

The company's beginnings date back to 1887, when an Act of Parliament incorporated The Manufacturers Life Insurance Company and the country's first prime minister, Sir John A. Macdonald, was elected president.

Mr. D'Alessandro took the helm 107 years later. The son of Italian immigrants, he arrived in the country at the age of three and would go on to build a career as a master of the takeover, beginning at Laurentian Bank and later at Manulife. In 2000, six years after Mr. D'Alessandro took over, the firm became the first Canadian life insurer to earn more than $1-billion in one year.

But it wasn't until the $15-billion merger with U.S. life insurer John Hancock Financial Services Inc. in 2004 that Mr. D'Alessandro really succeeded in muscling Manulife onto the global map. That deal made it the fifth-largest life insurer in the world, and raised expectations that Mr. D'Alessandro would deliver a financial performance to take on the biggest and the best.

“At the start of this year, they were one of the, if not the, strongest life insurers globally,” says Peter Routledge, vice-president and senior credit officer at Moody's Investors Service.

Mr. D'Alessandro's aggressiveness is at odds with the stereotype of the staid insurance man, but it successfully took the company from the era of traditional conservative insurance into the modern arena. In May he will hand over the corner office to his successor, chief investment officer Don Guloien, a man 10 years his junior who has spent the past 28 years at Manulife and at one point was head of mergers and acquisitions.

A lot of Manulife's specific problems today were compounded by a decision that Mr. D'Alessandro and his colleagues made in 2004 to remove the hedging on the equity positions it held in its variable annuity business. For several years, that decision boosted Manulife's profits. Then it backfired.

Variable annuities (also known as segregated funds in Canada) have been around since the 1980s, but caught on fire in recent years. They can be thought of as something akin to a personal private pension plan for an individual. A customer gives money to Manulife, and the insurer invests it, often in mutual funds or indexes with a small proportion in bonds. Manulife promises the customer payments down the road, generally after retirement, and guarantees benefits in return for a fee.

One key aspect of the variable annuities and segregated funds business is they give the company significant exposure to stock markets. When the insurer's stock portfolio sinks, so do its capital ratios, which are determined by a complex set of rules that dictate the amount of money the firm must have on hand to reasonably ensure it will be able to make the payouts that customers might claim down the line.

Here's how they work, courtesy of a company sales brochure designed for its brokers. Bob, age 65, has $500,000 in retirement savings and needs to take income immediately. He invests $500,000 with Manulife, and establishes an annual guaranteed income of $25,000. Lets say the value of his $500,000 market portfolio drops to zero in 16 years. Bob still receives $25,000 from Manulife for the rest of his life. If markets perform well, his annual payments could one day be nearly double that amount.

Variable annuity investors can make money when markets rise, but also have some protection when they drop, depending on the guarantee they've bought. Financial advisers often pitch the products to people between the ages of 50 and 70.

Michael Morrow, a certified financial planner in Thunder Bay, Ont., started recommending Manulife's IncomePlus products at the beginning of this year. “What made it attractive for customers was I could tell them that if they started to take an income out the year they turned 65, they were guaranteed that income for the rest of their life, and that was the worst-case scenario,” he says. “What you're doing is you're buying a life jacket or you're buying a seatbelt.”

Bill and Marianne McDougall, retired teachers in New Liskeard, Ont., are among customers who saw the appeal. The biggest selling point “was the fact that in a downturn we still had that guaranteed income,” Mr. McDougall says.

Variable annuities have been all the more appealing to companies such as Manulife because life insurance sales have by and large been stagnant for decades. Life insurance reached its peak after the Second World War, when soldiers returned home with a strong sense of their own mortality and worried about providing for their families. But in the 1970s, more women went to work, divorce rates rose and that sense of mortality diminished, causing a slowdown in sales.

Between 2002 and 2007, life insurance sales grew 3 per cent a year in Canada and 6 per cent in the U.S., according to RBC Dominion Securities analyst André-Philippe Hardy. During that same period, the Canadian and American variable annuity markets grew 13 to 14 per cent annually.

For its part, Manulife boasts that it “turned retirement thinking on its head” in Canada in October of 2006 with the launch of the country's first guaranteed minimum withdrawal benefit product, GIF Select featuring IncomePlus. The insurer launched a massive advertising campaign and in Mr. D'Alessandro's 2007 letter to shareholders, he lauded the company's “flourishing” and expanding business.

Manulife's U.S. variable annuity sales topped $10.8-billion (U.S.) that year, up 18 per cent. The company was one of the top 10 players in the U.S., and the No. 1 player in Canada.

But back in 2004, Manulife's executives stopped paying for reinsurance against the stocks backing its annuities and opted to take the risk of a market drop itself instead. Manulife was an insurer, it should be insuring itself, they thought.

It is a move that UBS Securities analysts now label “imprudent,” but for years Manulife's executives stuck to the decision. In early 2007, they started to get a bit nervous when the business was growing by leaps and bounds. Manulife was stealing market share in the U.S., and had introduced products in Japan and Canada. Its exposure to stock markets was ballooning as a result.

Manulife decided, belatedly, to develop its own program internally, and slowly started rolling it out in November of 2007, three months after the credit crunch first erupted. It continued to move slowly, and as the financial crisis rippled through the markets it became more expensive to put the hedges in place.

Nearly one year on, the program covers about $3-billion of Manulife's U.S. variable annuity account value. The company believes the program protects it from more than 80 per cent of the losses that substantial market declines could cause in the hedged part of its portfolio, and it plans to hedge its new business from now on. But the damage has been done.

The key measure of an insurer's financial cushion that OSFI keeps an eye on is called the minimum continuing capital and surplus requirements (or MCCSR) ratio. It's a complicated test of whether the insurer's assets are sufficient to cover its liabilities. It measures the minimum capital and surplus the company needs, adjusted for how risky its business and investments are. Insurers must keep the ratio above 150 per cent, and Manulife tries to keep its ratio between 180 and 200 per cent.

In the first three months of the year, it dipped 23 percentage points, prompting Manulife's executives to decrease share buybacks and take other action to boost capital, bringing the ratio back up to 200 per cent. But the implosion of Lehman Brothers in September and subsequent near-collapse of AIG, once the world's biggest insurer, sent markets into an extended spiral that would whack Manulife once again.

On Sept. 16, the U.S. government announced a bailout of AIG, which planned to sell off pieces of itself to pay the government back. Manulife's executives wasted no time jumping on potential opportunities to grow their company. For Mr. D'Alessandro, this was the chance to pull off one final blockbuster deal before he retired. For Mr. Guloien, it was a chance to push the company he will soon run firmly to the front of the pack. On Sept. 22, Mr. Guloien was meeting with investment bankers in Toronto to talk about putting together a bid for some prized pieces of AIG. But stock markets continued to move at speeds that took investors breath away, and the crisis was turning financial institutions around the globe into punching bags.

By the end of September, the value of the funds that Manulife had invested in equities and bonds for segregated fund and variable annuity customers stood at $72.74-billion. That was $12.85-billion short of the amount the company had guaranteed to pay out down the road. (Most of the payments Manulife has promised customers come due between seven and 30 years from now.) In no time, potential acquisitions were on the backburner. Manulife's top team had more pressing issues to deal with.

There were rumours that Manulife might issue a large amount of stock in order to raise capital, diluting its current shareholders. Mr. D'Alessandro decided to hold a conference call with analysts on Oct. 14 to put those fears to rest. “When you see your stock drop by 25 per cent in two days, it sort of focuses your mind that maybe you ought to pay attention to reassuring, and making your investors understand your position,” he told them. “We think that Manulife was sideswiped by the meltdown in the markets in a way that grossly exaggerates any impact that they're going to have on us.”

The company had no intention of issuing equity to raise capital, he said. If it came to it, Manulife would think about issuing preferred shares or debentures to boost capital levels. Within days, Mr. D'Alessandro was lobbying Ms. Dickson to revise regulatory guidelines on capital and she was persuaded by his argument. On Oct. 28, OSFI announced that it was changing the rules to give insurers a break on the amount of capital they had to set aside for payments that were more than five years away. The changes brought Manulife's capital ratio closer to 200 per cent, but executives decided they needed more of a buffer in case markets continued to tumble. That weekend, the company negotiated the final details of a $3-billion loan from the country's six largest banks.

Those two measures collectively brought the insurer's capital ratio up to about 225 per cent, but only temporarily. They did not take the heat off of Mr. D'Alessandro and his colleagues.

In the first week of November, Prime Minister Stephen Harper requested a meeting with a handful of top executives from the country's financial institutions in order to gather their thoughts ahead of a meeting of G20 leaders in Washington the following week. But on the Thursday afternoon, when some of his peers were giving the Prime Minister their thoughts, Mr. D'Alessandro was instead taking a grilling from analysts. Manulife had just revealed that its third-quarter profit had fallen in half from a year ago, to $510-million, because the steep drop in stock markets shaved $574-million from its bottom line.

Citibank analyst Colin Devine laid into executives on a conference call that afternoon, questioning Manulife's risk management systems. Over the years, Manulife chief financial officer Peter Rubenovitch had told analysts many times that he would be comfortable dealing with a 10- to 15-per-cent drop in markets, and that's why the company didn't have a hedging program. But this drop was steeper than that.

“Why was some sort of pro-active action not being taken in October while all of this was going on, because what would you have done if OSFI effectively hadn't moved the goalpost for you?” Mr. Devine demanded. “Because it seems [to me] you might have had to raise $5-billion of equity.”

Mr. D'Alessandro stepped up. “You're entitled to your view, Colin, that it was a breakdown,” he said. “In one week we had a massive reorganization of the financial sector. Maybe you guys saw it at Citibank, but we didn't see it.”

In the weeks to follow, Manulife's capital ratio softened yet again, landing somewhere around 200 per cent. “The world has completely changed,” Genuity Capital Markets analyst Mario Mendonca said. Over the course of October and November, stock indexes dropped a further 21 per cent in Canada, 23 per cent in the U.S. and 24 per cent in Japan.

Analysts pressed the firm to raise equity and suggested that issuing $3-billion worth of shares would give the insurer enough capital to meet challenges as well as jump on opportunities in 2009, if the company hadn't lost its reputation as an attractive suitor. With the pressure rising, Mr. D'Alessandro finally softened to the idea of issuing equity. On Nov. 26, the company began canvassing the market. This past Monday night, executives decided to proceed with a plan to issue at least $2.125-billion of common equity. At the same time, Manulife paid back $1-billion of its bank loan that it no longer needed.

Manulife is now looking at a $1.5-billion loss for the final three months of the year, the first time it has dipped into the red since going public in 1999. Mr. D'Alessandro acknowledges that his decision to issue equity is an about-face. But circumstances have changed dramatically since October, when he said the insurer would do no such thing. “It was what I believed when I said it, and had the market been more receptive to our solution, it might have prevailed,” he said in an interview this week.

Shareholders were increasingly encouraging him to put the problem behind the company, he said, something he had hoped to accomplish with the bank loan. “So we bit the bullet.”

While Manulife's capital ratio was still within its target prior to the equity issuance, the company's old targets aren't good enough for the market any more. “We were still comfortable, but it didn't give us any latitude,” said Mr. D'Alessandro, who believes that OSFI's capital rules are still too strict, even after the changes.

“I don't think that Dominic would have wanted to go out like this,” said Shane Jones, managing director of Canadian equities at Scotia Cassels. “It's tarnished his reputation.” But he quickly adds that, in fairness, “the decline in the market took us all by surprise.”

“I felt pretty good that this stuff had been dealt with, but then the markets kept going down and down and down,” Mr. D'Alessandro says. “I don't see it as a failing on my part. What could I have done?”

Moody's Mr. Routledge says the equity raise doesn't make any material improvement to Manulife's financial flexibility in the near term, or compensate for lower earnings going forward. “It helps, it just wasn't enough,” he said. Nearly all of the new equity will be eaten up by the fourth-quarter loss and dividend payments. Over the course of the year, “they went from being excellent to just great,” he said.

Joseph Iannicelli, chief executive of the Standard Life Assurance Company of Canada, believes this is a short-term blow for Manulife. Of his rival Mr. D'Alessandro, he says “the timing is unfortunate because it is at the tail end of his career with Manulife.”

Manulife expects to have $5-billion in reserves for its variable annuity guarantees at the end of this year, up from $526-million at the beginning. If markets recover, which they presumably will, it will be able to release its reserves back into earnings, and put some of its headaches behind it.

Mr. D'Alessandro still deserves a tremendous amount of respect for what he has accomplished in his career, Mr. Iannicelli said. “He took a Canadian company global, and kind of put the Canadian insurance industry on the map,” he said. “The acquisition strategy has been brilliant. Each deal was either more complicated or more bold or bigger.”

Pieces of AIG are still up for grabs, and a number of U.S. life insurers are now ripe for takeover because their stocks have taken a pounding. The opportunities are tremendous. Mr. D'Alessandro has not lost his appetite to swallow one last target. The question is will he be able to now?