Saturday, March 07, 2009

Manulife Judged Hedging to be Costly & Unnecessary

Financial Post, Eoin Callan,7 March 2009

On a chilly evening early in 2004, Dominic D'Allessandro was treated to warm applause from his peers during an exclusive event at the historic Carlu in Toronto, where he accepted the award for Canada's Most Respected CEO of the Year.

The head of the country's largest insurer regaled the black-tie audience with the secrets of Manulife Financial Corp.'s charmed existence as a solid-yet-fast-growing public company.

But what the CEO refrained from sharing with his audience was that management were so convinced of their own prowess they had just decided to gamble the company's fortunes on a one-way bet on financial markets.

With stocks on a roll and the company on a winning streak, Manulife had begun pushing the envelope of risk-taking in the insurance industry, putting such competitors as Sun Life Financial Inc. under pressure to keep up.

The fateful decision that would contribute to a dramatic destruction of the company's value began with an offer to customers of guaranteed minimum payouts each year if they put their money in special new funds created by Manulife that it would in turn invest in stocks.

This type of quasi-retirement fund was becoming popular in the industry as a way to cash in on ageing Baby Boomers and enhance income from more staid life-insurance offerings.

But Manulife decided to go one step further, finding a clever way to increase returns that would leave rivals scratching their heads.

It dispensed with the industry practice of hedging bets to help cover guaranteed payouts in the event markets crashed, judging this to be too costly and unnecessary.

To even the closest observers, this increase in risk-taking that began in 2004 and continued into 2007 was almost imperceptible, even as it helped shape the competitive landscape for products such as segregated funds.

"If you really step away from it, you realize the risk that was added over time. But it didn't feel like it when it was happening on a day-today basis. It was gradual," said Jukka Lipponen, an analyst with Keefe, Bruyette & Woods, an investment bank that specializes in the financial sector.

Yet people inside the industry point to a deliberate strategy by Manulife to gain an edge on rivals by avoiding the costs of hedging.

"We felt that retaining the risk would give us a little more volatility and a little more return," Peter Rubenovitch, Manulife's chief financial officer, said during an industry conference this week.

He said the "2004-2007 period is where we differentiated ourselves, in hindsight unfavourably, by assuming more risk than most of our competitors."

That extra little bit of volatility Manulife banked on has turned into a relentless downward spiral as markets have tanked.

Manulife's shares dropped about 20% this week, contributing to a staggering 75% drop in the company's value from a year ago amid a broad decline in stocks.

People close to the company defend the decision to skip the step of hedging bets, acknowledging that while it is unfortunate in retrospect, it is preferable to be exposed to markets that may bounce back than to have loaded up on subprime mortgages.

They also are unrepentant about not factoring into their planning the type of crash that has occurred, adding that no one person was solely responsible for the strategy.

While an overconfident streak at the top may have played a role, the board of directors were briefed on the key decisions. "They were well aware. The board was totally familiar, " said a person close to top management.

People close to the company also point out that while Manulife is more heavily exposed to falling equity markets because it did not hedge its bets, it was not alone in rushing to offer overly generous guaranteed minimum withdrawal funds to clients.

Having raced to keep up with Manulife, Sun is now also reeling. Sun's shares fell 20% this week, and are down more than 65% in the last year.

"Clearly, companies miscalculated," Mr. Lipponen said. "Competition drove the product features to a point they were simply too rich. They were priced for equity markets that would not have this kind of a dramatic drop."

The once rock-solid, even boring insurance companies are now bound inextricably to the performance of financial markets.

Kin Lo, a professor at the Sauder School of Business, said Canada's top insurance companies had strayed from responsible business practices.

"Insurance is about protecting people from risk and what we have seen is the insurance industry going out and seeking risk," he said.

"It is in the nature of insurance that these companies should be fairly conservative in how they go about their business.

"What we saw in the last few years is insurers getting away from conservatism," he said.

Both of Canada's top insurers are now on the watch-list of credit-rating agencies. Sun was downgraded yesterday by Standard & Poors, while Manulife was moved d own a notch earlier by Moody's.

However, neither has strayed as far beyond the pale as American International Group Inc., the collapsed insurer in the United States.

AIG was brought down by a relatively small unit in London that sold protection on complex credit instruments to sophisticated financial clients that it did not hedge and which led to a call on its capital it could not meet.

The breakup of AIG's global empire is adding to the uncertainty for Manulife and Sun because it is creating tempting takeover targets even for severely weakened insurers.

Compounding the uncertainty is pending upheaval at the top of both Sun and Manulife, which are each led by two elder statesmen in the final days of their careers.

Mr. D'Alessandro has announced his intention to retire in May but has remained at the helm as the company has nose-dived.

"It is a terrible shame. He has given his heart and soul to the company. I have enormous respect for him. He has built a true northern tiger, a global company headquartered here in Canada," said Dick Haskayne, a former member of the board of Manulife.

"It is terribly disappointing what has happened to the stock price. The whole market has brought everybody down," he said.

Sun is headed by Donald Stewart, a veteran of the industry who is expected to step aside for a recently hired heir apparent waiting in the wings in the company's small, under-performing U. S. operation.

Despite their diminished state, both chief executives are making desperate bids to do one last international takeover that could help restore their legacies and mark their final acts with a flourish rather than a near-death experience: Manulife in Asia and Sun in the United States.

"Don always wanted to do the big deal in the U. S., but could never pull it off," said an industry veteran of the Sun chief executive.

But it is looking increasingly likely that even if both executives succeed in making long-shot acquisitions, it would not have much impact on the rot underway. It could also make matters worse in the short term.

To understand why the insurers' share prices kept falling this week, it helps to have an understanding of the company's investment portfolios.

U. S. regulatory filings show a Manulife subsidiary, for example, holds at least US$200-million in long-term bonds in Citigroup, US$500-million in exposures to Bank of America and US$260-mill-lion in Wells Fargo securities.

So, it weighed on the stock this week when concerns about the capital reserves of U. S. banks prompted Moody's to downgrade the ratings of long-term bonds in Bank of America and Wells Fargo, and Citigroup's share price dropped below US$1.

Also hanging over Manulife and Sun is growing pessimism about the U. S. commercial-property market, which had held up better than the housing sector but saw an even bigger fall in prices last year than the hard-hit residential market.

"Canadian life insurers are still relatively more exposed to the property markets than their peers in other countries," said Peter Routledge, of Moody's.

Shares in Manulife and Sun also came under pressure after AIG this week wrote off 25% of the value of its portfolio of complex structured products linked to the commercial-property market, called commercial-mortgage backed securities.

A similar writedown by Canada's insurers would cost them dearly. In addition to direct investments in property developments, Manulife also holds $5.7-billion in commercial-mortgage backed securities, while Sun has a $2.6-billion portfolio dominated by the instruments.

Manulife also has niggling tax issues that were the subject of private discussions on Capitol Hill this week, according to people familiar with the discussions.

Both Democrats and Republicans participated in the meetings, which discussed Manulife's participation in an alleged tax shelter in which the insurer assumed the tax benefits of a rural industry electricity co-operative in Indiana.

The company has acknowledged it may have to surrender some tax benefits to U. S. authorities. In the first quarter it set aside extra funds for "possible disallowance of the tax treatment," adding that the full amount the company would have to cough up could climb to $643-million though this was "not expected to occur".

But lawmakers have also discussed applying an extra penalty to Manulife after they became incensed over the company's attempts to claim cash from the tax shelter early through legal action against the Indiana co-operative.

"We are talking about serious punitive measures against the Manulifes of the world," said one person briefed on the week's dialogue, adding a 200% excise tax on any funds recovered from these alleged tax shelters was being considered.

The tax exposure is a relatively minor matter for the insurer compared with the scale of the upheavals in world markets, but it underscores the steady stream of setbacks for Canadian insurers.

"Asset impairments and losses in the investment portfolios of life insurers are expected to increase materially over the next few quarters," Mr. Routledge said.

This would continue to put pressure on the capital that insurers must hold in reserve to cover guarantees to customers, he said

"In 2009, the overriding credit issue for the Canadian life insurers will be managing dramatically higher demands on their capital--as reserves for variable annuity guarantees rise -- as well as higher capital requirements," Mr. Routledge said.

The country's top insurance regulator has already come to the aid of insurers with one round of moves that loosened capital reserve requirements. But it is unclear it is prepared to do so again.

"We aren't planning any imminent material changes to [capital requirements]," said an official at the Office of Superintendent of Financial Institutions. "However, it is possible that economic and market conditions or business developments, for example, new products or changes in risk, may necessitate the review of certain rules before the usual three-year cycle," the official said. "It's everyone's ultimate goal to have a safe and sound financial system."

Two senior insurance executives said they anticipated Ottawa might permit insurance companies to sell illiquid assets to the federal government to give them more financial flexibility.

Yet insurers have already tested the limits between Bay Street and Ottawa about how to achieve a sound financial system while still allowing them to reward shareholders with aggressive expansion.

Manulife even went so far as to approach Ottawa with a plan to change the law restricting foreign ownership of financial institutions so it could make an offer for the Asian assets of AIG. The plan included handing a stake in the Toronto-based insurer to the U. S. and Chinese governments.

Ottawa decided to take a pass on the plan, according to people familiar with the matter, leaving the $15-billion company to raid $10-billion to $20-billion if its bid succeeds.

Sun Life has also hit hurdles as it pursues target companies that have applied for bailouts from the U. S. government. As it tries to avoid taking on massive new risks or getting caught up in a part nationalization, it could wind up with only a tiny slice of a U. S. insurance company. While this might not faze shareholders, it could throw a spanner in the works of its informal executive succession plan, which was built around the idea that it will appoint a veteran of the U. S. industry in the wake of a big U. S. acquisition.

While the Conservative government places a premium on helping Canadian insurers compete internationally and is prepared to provide limited support, it is also mindful of the sensitivities of voters.

Brenda Sansregret said customers who stop into her insurance brokerage in North Battleford, Sask., have one question on their minds: Is my insurance company safe?

"No matter what they do -- farmers, average working families, businesses owners -- they are all asking," said her colleague Deanna Mclay.

The answer brokers are giving their clients is that at least 85% of their policies are protected through an industry self-insurance scheme called Assuris.

"We are here to protect Canadian policyholders in the event that their life-insurance company should fail," said Gordon Dunning, the head of Assuris.

But the scheme -- backed by a $100-million liquidity fund and member commitments of up to $4.5-billion -- offers no protection to shareholders in insurance companies, which do not enjoy the same explicit backing from the central bank as deposit-taking banks.

So what can shareholders expect? Like many financial analysts, Darko Mihelic expects Canadian insurers to weather the storm. The CIBC analyst views the stocks as oversold because of irrational fear that is coursing through markets and driving investor behaviour.

He even sees a strong possibility of a major rally in insurance stocks, though this may not prove sustainable until the credit crisis has peaked.

"I stick by that view. But I still lose sleep at night," he said.