Wednesday, January 14, 2009

Preview of Life Insurance Cos Q4 2008 Earnings

  
RBC Capital Markets, 14 January 2009

Q4/08 results to be weak in our view

We expect the four lifecos to report YoY declines in earnings per share, driven by difficult conditions in equity and credit markets.

• Our EPS estimates for Manulife are in line with consensus, while they are well below for the other three companies.

• Directionally, the short-term pressure on earnings is greatest on Manulife, in our view, driven by greater exposure to equities. Great-West faces the least near-term pressure in our view.

• Sun Life has the most exposure to deteriorating credit while Great-West and Industrial Alliance have the least, in our view.

• We think the street will lower 2009 earnings estimates following the release of Q4/08 results.

Recent regulatory capital changes are positive

The Office of the Superintendent of Financial Institutions Canada (OSFI) announced proposed revisions to guidelines on capital adequacy late in the quarter.

• OSFI revised the methodology for calculating available capital whereby it will no longer require lifecos to reflect unrealized gains and losses on available for sale (AFS) debt securities in available capital - a positive for all four lifecos, but probably most so for Manulife and Sun Life.

• Segregated fund changes include the previously announced rule changes from October (see our report dated November 7, 2008 entitled "Primer on segregated funds/variable annuities" for more information), as well as allowing greater credit for effective hedges of segregated fund guarantee risk. We think the latter is most positive for Sun Life and the former is most positive for Manulife.

Lifeco stocks are a levered play on equity markets

We believe that the lifecos' shares offer attractive value relative to their long term earnings power, and what should be a better year in 2009 but the catalysts near term are not obvious, especially since we believe that street estimates for Q4/08 profitability are way too high.

We prefer the life insurance sector to the bank space

While we might be early with our call, we expect equity markets to rebound before the economy does and the lifecos have more exposure to equity markets while the banks have more exposure to the real economy. Furthermore, three of the four lifecos have strengthened their capital bases via either equity issues or the sale of a large stake in a publicly-traded company (in the case of Sun Life), which, combined with recent regulatory capital changes, increase the companies' cushions against declines in equity markets.

Company-specific highlights

Great-West Life (February 12)

• We expect Q4/08E operating EPS of $0.44, below consensus estimates of $0.52. Our EPS estimate represents a decline of 26% versus Q4/07 and 9% sequentially, as the company’s earnings continue to suffer from weak credit and equity markets.
• Our estimated Q4/08 hit from equity markets is $180 million ($0.20 per share).
• We expect experience gains and changes in assumptions to be negatively impacted by reserve strengthening for segregated funds, equities that back policy liabilities as well as those that back surplus capital.
• We do not expect credit-related costs to be as large in Q4/08 as they were in Q3/08, as the collapse of a number of previously highly-rated U.S. financial institutions had a negative impact on GWO’s earnings ($95.5 million or $0.11 per share). In Q4/08, while we expect lower pressure on earnings from impairments, we expect continued reserve strengthening as the ratio of downgrades to upgrades of high yield bonds continued to climb in Q4/08. (Exhibit 7)
• We expect Putnam to report assets under management of approximately US$106 billion as at the end of Q4/08, down 43% YoY and 22% sequentially. We forecast a pre-tax margin of 3.0% in Q4/08, well down from 25.5% in Q4/07 but an improvement from the negative 5.2% margin reported in Q3/08.
• Management reviews goodwill yearly (in Q4/08). We believe that some of the $3.5 billion in goodwill and intangibles related to Putnam could be at risk of being marked down as AUM have dropped from US$192 billion in February 2007 when the acquisition was announced to US$106 billion at the end of December.
• We expect U.S. operations, which includes Putnam and financial services, to generate $26 million of earnings in Q4/08 compared to $141 million in Q4/07. The primary differences versus Q4/07 are the negative impacts from credit and equity market weakness and the sale of the healthcare division (which closed on April 1, 2008).
• We expect the mid-Q1/08 $13 billion acquisition of Standard Life’s payout annuity block of business to positively impact Q4/08 earnings for the European division, but will likely largely offset by weakness in global credit and equity markets.
• We expect currency translation to positively impact Q4/08E earnings by approximately 5% versus Q4/07, as reduced earnings in the U.S. somewhat temper the positive effect of a 19% average increase YoY in the U.S. dollar versus the Canadian dollar.

Manulife (February 12)

• We expect Q4/08E core EPS of ($0.99), in line with consensus estimates. Our EPS estimate is well below the $0.75 reported in Q4/07 and $0.33 reported in Q3/08.
• On December 2nd, management provided guidance based on November 30, 2008 equity market levels. The Q4/08 expected loss, announced at the same time as the equity issue, was $1.5 billion, or approximately $0.98 per share.
• The loss would be primarily driven by reserve strengthening for segregated fund/variable annuity guarantees (which we estimate was a $1.8 billion after-tax hit). Equities that back policy holder liabilities as well as surplus capital would also have accounted for a portion of the loss (we estimate a $500-700 million after-tax impact).
• Global equity markets ended the quarter up only marginally from levels on November 30, 2008.
• We do not expect credit-related costs to be as large in Q4/08 as they were in Q3/08, as the collapse of a number of previously highly-rated U.S. financial institutions had a negative impact on MFC’s earnings ($253 million or $0.17 per share). In Q4/08, while we expect lower pressure on earnings from impairments, we expect continued reserve strengthening.
• We expect year-over-year growth in the Value of New Business (VNB) to be muted, hindered by weak expected wealth management product sales given the state of equity markets globally, and by our expectation that insurance sales (outside the U.S.) will also begin to slow following five consecutive quarters of double-digit year over year increases in sales. Insurance sales in Japan should continue to show solid YoY growth due to product introductions and expanded distribution.
• We expect currency fluctuations to positively impact earnings by approximately 7% this quarter versus Q4/07, as strength in the U.S. dollar versus the Canadian dollar and Japanese Yen versus the U.S. dollar (beneficial for MFC) are somewhat offset by weak expected results out of non-Canadian divisions. Manulife’s U.S., Hong Kong, Japanese and reinsurance operations typically account for almost 70% of earnings.

Sun Life (February 12)

• We expect Q4/08E core EPS of ($0.20), well-below consensus estimates of $0.33. Our EPS estimate represents a decline of 120% versus Q4/07, but an improvement from the $0.71 loss in the prior quarter. We believe consensus estimates do not fully reflect the negative impact from equity market weakness during the quarter.
• Our estimated Q4/08 hit from equity markets is $672 million ($1.20 per share). Management has disclosed that each 10% decline in equity markets would reduce net income by $200-250 million ($0.36-$0.45 per share).
• We do not expect credit-related costs to be as large in Q4/08 as they were in Q3/08, as the collapse of a number of previously highly-rated U.S. financial institutions had a negative impact on SLF’s earnings ($636 million or $1.13 per share). In Q4/08, while we expect lower pressure on earnings from impairments, we expect continued reserve strengthening. Management stated in a late November investor day that the company’s bond portfolio had not experienced significant defaults in Q4/08 at that point.
• We expect year-over-year growth in the Value of New Business (VNB) to be muted, hindered by weak expected wealth management product sales given the state of equity markets globally, and by our expectation that insurance sales will be challenged by the weakness in global economies.
• We expect MFS to report 50% lower YoY net income in Q4/08, primarily due to weak equity markets. Operating margins are likely to continue to decline to 21%, from 32% in Q4/07 and 24% in Q3/08.
• We expect currency translation to only minimally positively impact Q4/08E earnings versus Q4/07, as reduced earnings in the U.S. largely temper the positive effect of a 19% average increase YoY in the U.S. dollar versus the Canadian dollar. In a more normal year, we estimate that a 10% decline in the Canadian dollar versus all other currencies would positively impact Sun Life’s earnings by 5%.
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