Wednesday, January 14, 2009

BMO to Acquire AIG's Canadian Life Insurance Business

  
TD Securities, 14 January 2009

Event

BMO announced an all-cash deal to acquire AIG’s Canadian Life Insurance business.

Impact

Neutral. While not likely at the top of BMO's current strategic priorities, the bank moved on an opportunity presented by AIG to grow the bank's presence in insurance. Insurance is a potential growth area for the industry and to us, it makes sense for BMO to be there. The transaction should add some manufacturing and distribution expertise to BMO's efforts to develop its insurance offering. However, managing risk and return over very long dated assets is critical in this space and bears watching as the bank enters the arena. A relatively small transaction, we have made no changes to our outlook.

Details

Adds range of business lines. The bank has not disclosed details around the book of business that will come with the transaction (regulatory filings indicate AIG Life Insurance Company of Canada has assets on the order of C$2.4 billion as of Q3/08), but the platform offers a range of life products (Term, Whole, Universal), critical illness coverage and segregated funds. Filings also indicate the entity was comfortably reserved with MCCSR at 205%.

Bank developing its insurance presence. BMO has previously focused largely on the familiar turf of credit insurance and acted solely as a sales channel through its wealth and private banking businesses for a wider range of insurance products. With this transaction the bank is now in the business of managing assets and will be increasingly focused on product development and manufacturing.

Managing risk and returns is critical. The life, annuity and illness businesses requires considerable expertise and due diligence to effectively manage the risk and return profile of what are often extremely long dated assets. BMO has some in-house personnel and this transaction should bring with it additional experience and expertise. We expect the bank to move in manageable steps (as it has with this transaction), however, to us it will be critical to monitor developments in the business line over the coming years.

No changes to our outlook. In the context of the bank this is a relatively small transaction and we have not made any changes to our outlook, although the bank expects the deal to be accretive to cash EPS in year 1 (not quantified).

Transaction Details

All cash deal. The deal is valued at C$375 million or approximately 1.06x book. The deal is expected to close by June 1, 2009.

Accretion. The deal is expected to be accretive to earnings in year 1, although no guidance was provided. Insurance accounts for approximately 2% of BMO’s total core revenue base in fiscal 2008, or about C$50 million per quarter. By our estimates, we could see insurance generate less than C$25 million in net income per year. As per Office of the Superintendent of Financial Institutions (OFSI) regulatory financial statements, AIG Life Insurance Company of Canada generated approximately C$55 million in net income over the past four reported quarters ending Q3/08. The earnings impact from the acquisition will unlikely be material to BMO’s overall net income.

Capital. BMO has indicated the Tier 1 capital impact from the transaction will be less than 15bps. Based on our estimates, BMO’s Tier 1 capital before the deal (pro-forma capital raises post Q4/08 reported Tier 1 of 9.77%) is approximately 10.5%.

Outlook

We have made no changes to our estimates or Target Price.

Justification of Target Price

Our Target Price reflects a discount to our estimate of equity fair value 12 months forward (based on our views regarding sustainable ROE, growth and cost of equity), implying a P/BV of 1.25x.

Key Risks to Target Price

1) Additional losses or write-downs from key risk exposures 2) significant competition in the Chicagoland market and 3) adverse changes in the credit markets, interest rates, economic growth or the competitive landscape.

Investment Conclusion

The bank moved on an opportunity presented by AIG to grow the bank's presence in insurance which is a potential growth area for the industry and in our view, it makes sense for BMO to be there. The deal is a relatively small transaction and we have made no changes to our outlook.
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Financial Post, Jonathan Ratner, 13 January 2009

Calling Bank of Montreal’s $375-million cash purchase of AIG’s Canadian insurance business “a bit of a steal,” Dundee Securities analyst John Aiken highlighted the fact that management’s calculated price to book was under 1.1 times. That compares to an average price to book multiple of 1.3x for Canada’s four publicly traded insurers.

More importantly given the current environment, however, is the fact that the acquisition of AIG Life of Canada will only have a modest impact on BMO’s capital ratios, Mr. Aiken told clients. The bank’s management anticipates a less than 15 point decline in its Tier 1 ratio.
On a pro forma basis including recent capital issues and changes in risk-weighted assets, the analyst said BMO’s Tier 1 capital is above 10.2%, “still above the market’s apparently mandated 10% minimum threshold.”

“We view the acquisition favourably as it will benefit BMO by diversifying its revenues, gaining access to additional customers and add to earnings,” Mr. Aiken said. “However, this is not a transformational acquisition but does put the bank in good stead if the Canadian Bankers Association can lift the restriction of branch sales of insurance at some future point.”

Nor does it change the analyst’s position on BMO, which he said has been leading the charge in credit deterioration among the Big 6 banks so far in the current downtrun. So while this deal may help explain why BMO issued common equity in December, Mr. Aiken said it still does not justify the bank issuing shares below book value. He continues to rate BMO at “neutral” with a $28 price target.

Desjardins Securities analyst Michael Goldberg notes that bank investments in insurance subsidiaries are not consolidated under Basel II rules. However, those rules will change in 2011 when 50% of an investment would be deducted from Tier 1 capital, which he said would produce a further 10 basis point reduction.

“BMO’s intent is to become a one-stop shop for its clients, allowing it to expand its insurance and wealth management offerings,” Mr. Goldberg said in a research note.

He views the acquisition as immaterial to near-term earnings but positive for optics. “For BMO, optics are relatively more important as its uncertain outlook is reflected in the stock’s 8.5% yield,” the analyst said. Nonetheless, he thinks the near-term impact will be positive, as optics should outweigh the small near-term fundamental impact. Mr. Goldberg rates BMO at “hold” with a $44.50 price target.

He also believes that markdowns and the losses incurred aside, earnings in the Canadian banks are prolific. “The question remains: how large are the holes that are to be filled.”

RBC Capital Markets analyst Andre-Philippe Hardy noted that AIG’s life insurance business is small with earnings of $48-million in 2009 and a loss of $17-million in the last 12 months. This compared to BMO’s annual earnings of more than $2-billion.

“AIG’s range of individual life and annuity products allows BMO to broaden its range of insurance products, which has primarily been credit life and disability insurance, but the small scale will not have a large impact on the growth outlook,” he told clients.

Since Canadian banks cannot sell life insurance in their branches nor share databases with their life insurance subsidiaries, revenue synergies will be limited, Mr. Hardy said. However, BMO intends to offer insurance products as an extention of existing wealth management offering and can sell through its brokerage channel, he added.

RBC maintained its “underperform” rating on BMO. It views the bank’s stronger capital position positively but believes the banks has more exposure to “potentially problematic off-balance sheet assets” and to U.S. lending.
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