Monday, April 20, 2009

Preview of Insurance Cos Q1 2009 Earnings

  
Scotia Capital, 20 April 2009

Canadian Lifecos - Another Tough Quarter but Capital Positions Remain Strong - Focus Turns to Credit

• Declining equity markets make for another tough quarter. Obviously, Manulife is the most sensitive, and with equity markets, on a Manulife weighted average basis, down 9% quarter over quarter (QoQ), its EPS should suffer to the tune of $0.88, as outlined in Exhibit 1. Despite its hedging efforts, Sun Life’s EPS should be hit by $0.45 EPS, consistent with its guidance, and could suffer more pain depending on any extraordinary hedging breakage costs. Due to Industrial-Alliance’s unusual Q4/08 practice of reserving more than what was needed under mark-to-market accounting in what was a throwaway quarter, the company has softened the blow of declining equity markets in Q1/09 (we estimate by as much as $0.15 in EPS), making the EPS hit from a 3% decline in the S&P/TSX just $0.07, as per guidance. Finally, for Great-West Lifeco, the least sensitive Canadian lifeco by far to equity markets due to its lack of U.S. variable annuity exposure and its decision to write Canadian segregated fund business with minimal guarantees, guidance suggests a $0.10 hit to EPS from a GWO weighted 6% decline in equity markets.

• We’ve significantly cut our 2009 and 2010 EPS estimates for Sun Life, largely due to credit concerns. We took $1.00 and $1.20, respectively, off our 2009 and 2010 EPS estimates for Sun Life, in part to reflect continued concerns with respect to credit (Sun Life makes us the most nervous in this regard) and in part to reflect continued profitability issues with respect to its sub-scale U.S. operations. GWO and MFC 2009 EPS estimates were each trimmed by $0.20 to reflect a more uncertain credit environment, with 2010 EPS estimates reduced by $0.20 (MFC) and $0.08 (GWO). With no sensitivity to U.S. credit, estimates for IAG were left unchanged. Our estimates assume markets end 2009 at 925 (S&P 500) and 10,000 (S&P/TSX) with a further 8% appreciation in 2010.

• We see healthy Q1/09 capital ratios. We peg MCCSR ratios at 232% for GWO, 202% for IAG, 218% for MFC, and 228% for SLF, as outlined in Exhibit 2, all well above regulatory minimums (120%), regulatory watch-list levels (150%), and comfortably above target ranges (175% or 180% to 200%). IAG can withstand a 17% drop in equity markets from current levels (i.e. S&P/TSX of 7100) before its MCCSR ratio hits 175%, and a 35% drop (i.e., S&P/TSX of 5450) before it hits 150% levels. We estimate MFC (on a do nothing basis) can withstand a 20% drop in equity markets from current levels (i.e., S&P 500 of 625) before its ratio hits 180%, and a 35% drop in equity markets (i.e., S&P 500 of 515) before it hits regulatory watch-list 150% levels.

• An increasing focus on credit. In our opinion, equity markets often move first and credit issues generally lag. While equity market volatility will continue to be an issue, we see 2009 unfolding with an increasing focus on credit. We believe the commercial real estate sector will continue to face strain as the macro economic downturn worsens. Moody’s now forecasts peak-to-trough commercial real estate price declines of 30%-plus, and while it did not speculate on commercial real estate loan delinquency trends, at over 5% currently, there’s clearly more downside (1991 peaks were 12%). It also indicated that commercial mortgage-backed securities (CMBS) delinquency rates are approaching 1% for more recent vintages, and delinquency rates should continue to head higher as economic fundamentals deteriorate (historical average is 0.6%), with CMBX spreads widening dramatically over the past 12 months.

• Sun Life most likely to suffer as credit continues to weigh. SLF’s track record in this regard speaks for itself. A total of $1.20 EPS in credit hits in the past two quarters (excluding LEH/Wamu and AIG) versus $0.04 for GWO, $0.21 for IAG, and $0.14 for MFC. As well, gross unrealized losses on fixed income securities trading below 80% of acquisition cost for more than six months represent 3.1% of fixed income assets for SLF, significantly higher than 1.8% for GWO, 0.8% for MFC and 0.4% for IAG.

• Relatively low CMBS exposure and generally of good quality – but NAIC filings show SLF’s CMBS portfolio is trading 57% of amortized cost, significantly below peers. CMBS relative exposures for the Canadian lifecos are significantly less than those of the U.S. lifecos, at 24%, 22%, and 12% of BV (ex AOCI) for GWO, MFC, and SLF, respectively, versus 43% on average for U.S. lifecos. As well, 90% and 85% of MFC’s CMBS investments are in relatively safer AAA tranches and pre-2005 vintages (75% and 86%, respectively, in the case of Sun Life) versus just 76% and 62% on average for U.S. lifecos. NAIC filings disclose the MV of the CMBS portfolio, and, assuming the unlikely case that CMBSs are written down to MV (liquidity constraints have blown out spreads on what are traditionally long-term holdings), we can estimate the after-tax EPS hit. Sun Life’s CMBS portfolio, with a market value at just 57% of amortized cost per the NAIC statements, is the most questionable (GWO is 95%, MFC is 85% and the average for the U.S. lifeco group is 78%). Furthermore, a full impairment down to MV would result in a $1.04 EPS hit for SLF versus $0.10 for GWO, $0.39 for MFC, and a very high $1.70-$2.00, on average, for the U.S. lifeco group.

• Relatively low U.S. commercial mortgage and real estate exposure and significantly less than U.S. lifecos. Total after-tax exposure as a percent of BV (ex AOCI) is just 7% for GWO, 24% for MFC, and 18% for SLF, well below the 79% for MET and PRU and the 45% average for the U.S. lifeco group. As well, defaults and losses on the lifecos’ commercial mortgage portfolios should perform better than CMBS conduits (especially those of the post-2005 vintage) because the loans are less leveraged (generally around 60% loan-to-value), were made on higher-quality property, and with higher-quality borrowers.

• U.K. financials hybrid exposure – a 50% write-down, although not expected, would hurt GWO by $0.74 EPS, SLF by $0.49, and MFC by $0.11. We suspect some hits will be taken in 2009, but given the long-term nature of these securities, we suspect the hits will be confined to only the riskiest preferreds, largely those in Tier 1. This would put GWO’s potential EPS hit in the $0.20-$0.30 range.

Great-West Lifeco Inc.
1-Sector Outperform – $27 one-year target, based on 1.8x 3/31/10E BVPS and 10.5x 2010E EPS
• We are looking for EPS of $0.45 for Q1/09, $0.01 below consensus.
• Another weak quarter for Putnam. We expect net sales of negative US$3-US$4 billion.
• We expect the decline in equity markets to hurt EPS by $0.10 and credit hits to be $0.03 EPS – while U.K. financial hybrid exposure weighs, we do not expect any significant hit in Q1/09 and expect a modest charge ($0.20) in 2009.

Industrial-Alliance Insurance and Financial Services Inc.
2-Sector Perform – $28 one-year target, based on 1.2x 3/31/10E BVPS and 8.5x 2010E EPS
• We are looking for EPS of $0.60 in Q1/09, $0.02 above consensus.
• A cleaner quarter than the rest of the group, with the decline in equity markets hurting EPS by $0.07 and credit hits hurting EPS by just $0.03. IAG is most likely to come out of the quarter with an increase in EPS estimates.
• Top line could very well continue to be weak. The negative top-line momentum in individual insurance sales will likely continue, building on a 14% YOY drop in Q4/08, a 16% YOY drop in sales in Q3/08 (22% organically), and a 1% YOY drop in Q2/08 (8% organically).

Manulife Financial Corporation
1-Sector Outperform – $30 one-year target, based on 1.6x 3/31/10E BVPS and 10.8x 2010E EPS
• We are looking for EPS loss of $0.40 for Q1/09, $0.05 below consensus.
• We expect the decline in equity markets to hurt EPS by $0.88 (per guidance), and credit hits of $0.08 in EPS, but increasing yields since Dec 31/08 could provide a modest boost.
• Conference call should have lots of talk about capital and acquisitions – likely no deal in immediate term.

Sun Life Financial Inc.
2-Sector Perform – $33 one-year target, based on 1.2x 3/31/10E BVPS and 9x 2010E EPS
• We are looking for EPS loss of $0.20 for Q1/09, $0.59 below consensus.
• We estimate the decline in equity markets to hurt EPS by $0.45.
• Credit makes us nervous with SLF. SLF’s recent track record has been one of more credit hits than its peers, as does its CMBS portfolio ($2B and trading at just 57% of amortized cost), and its fixed income security portfolio (3.1% of which is more than 20% below amortized cost for more than 6 months), and its $500 million (MV) U.K. bank hybrid portfolio.
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RBC Capital Markets, 3 April 2009

Q1/09 results to be weak, but better than Q4/08, in our view

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

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

• Directionally, the short-term pressure on earnings is greatest on Manulife, in our view, driven by a much greater exposure to equities.

• Sun Life has the most exposure to deteriorating credit while Industrial Alliance has the least, in our view.

• We are lowering our Q1/09 EPS estimates for three of the lifecos. Our estimate for Manulife is up significantly as we had updated our numbers for the company near the market trough during the quarter.

Lifecos continue to be levered plays on equity markets

The most important factor for lifeco shares is equity market direction as, in the short term, the health of their capital positions is most impacted by movements in equity markets. This is particularly true for Manulife. Also key to the lifeco shares is the direction of credit spreads, which we view as a broad indicator of credit quality, although we believe that Canadian lifecos have less credit risk than both U.S. lifecos and Canadian banks.

Our favourite lifeco shares are Sun Life's

We think valuation (0.86x book value) is too low even though the company's performance in credit has been weaker than peers. Sun Life has a stronger capital position than peers and lower exposure to equities than Manulife. The company has exposure to a recovery in equities in 2009 as well as the higher U.S. dollar. The management changes in the U.S. division as well as the potential for acquisitions of assets from distressed sellers gives us hope that performance in the U.S. division, as well as the firm's competitive position, might improve. We rate Sun Life's shares Outperform.

ING Canada's shares are also attractive

We like the shares of ING Canada as the company has less exposure to credit and equity market challenges than banks/lifecos, in our view, and as a result the company is less likely to post weak earnings results. The company is well-capitalized, with $425 million in excess capital and no debt. We believe the probability of an acquisition this year has risen, and that it could be a positive catalyst for shares of ING Canada. In our view, ING Canada deserves a P/B multiple at the upper end of the industry, as it has a superior track record of ROE and underwriting outperformance, conservative reserving practices, a risk profile that is lower than that of the average U.S. P&C insurer and very little balance sheet leverage.

Company-specific highlights

Industrial Alliance (May 6)

• We expect Q1/09E core EPS of $0.56, in-line with consensus estimates of $0.58. Our EPS estimate represents a decline of 29% versus Q1/08 but is up significantly from the $1.47 per share loss in Q4/08.

• Our estimated Q1/09 hit from equity markets is $5 million ($0.06 per share), given the 3% drop in the S&P/TSX Composite Index since the end of Q4/08.

• Relative to its peers, Industrial Alliance should benefit from its more conservative credit exposure (62.5% of its bond portfolio is invested in government or government-related issuers and only 6.7% of bonds are BBB-rated, versus 22.1% for the Big 3).

• We expect EPS growth to face a relatively easy margin comparison on new individual insurance sales (at 56% of new sales in Q1/08, strain was slightly above management’s mid-term guidance of between 50% and 55%).

• We expect year over year comparisons in the company’s P&C insurance business to benefit from what we perceive to have been a relatively uneventful quarter in terms of harsh winter weather, particularly versus the difficult conditions faced in Q1/08. Q1 is typically the worst quarter for P&C insurance profitability.

• We reduced our full year 2009 EPS estimate by an additional $0.04 to reflect the negative impact of the company’s $100 million subordinated debenture issuance, which closed on March 27.

Great-West Life (TBD)

• We expect Q1/09E operating EPS of $0.37, below consensus estimates of $0.45. Our EPS estimate represents a decline of 38% versus Q1/08 and 37% sequentially, as the company’s earnings should be negatively impacted by weak credit and equity markets.

• Our estimated Q1/09 hit from equity markets is $190 million ($0.20 per share).

• The company disclosed that a 10% drop in equity markets would result in a $245 million increase in actuarial liabilities (assumes a 10% decline in the value of T.H. Lee – which we have excluded in our estimate). Our estimated impact from equity markets assumes a 9% blended decline in Q1/09 (Great-West has exposure to more than one country’s equity markets).

• Our estimated Q1/09 hit from credit markets is $115 million ($0.12 per share).

• We expect credit-related costs to be larger in Q1/09 than they were in Q4/08. We expect continued reserve strengthening as the ratio of downgrades to upgrades of bonds continued to climb in Q1/09. (Exhibit 7)

• We expect Putnam to report assets under management of US$99 billion as at the end of Q1/09, down 41% YoY and 6% sequentially. We forecast a pre-tax margin of negative 5.0% in Q1/09, well down from 14.2% in Q1/08 but an improvement from the negative 20.7% margin reported in Q4/08.

• We expect U.S. operations, which includes Putnam and financial services, to generate an $8 million loss in Q1/09 compared to $108 million in Q1/08. The primary differences versus Q1/08 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 Q1/09 earnings for the European division, but will likely largely offset by weakness in global credit and equity markets.

• Despite the positive effect of a 19% average increase YoY in the U.S. dollar versus the Canadian dollar, we do not expect currency translation to be material to Q1/09E earnings versus Q1/08, given weakness in the U.S. division. In a more normal year, we estimate that a 10% decline in the Canadian dollar versus all other currencies would positively impact Great-West’s earnings by 5%.

Manulife (May 7)

• We expect Q1/09E core EPS of ($0.18), slightly below consensus estimates of ($0.10). Our EPS estimate is well below the $0.57 reported in Q1/08 but an improvement from the $1.24 loss per share reported in Q4/08.

• Our estimated Q1/09 hit from equity markets is $1.4 billion ($0.86 per share).

• The company disclosed that a 10% drop in equity markets would result in a $1.6 billion decrease in earnings; our estimated impact from markets assumes a 9% decline in Q1/09, based on the company’s exposure to different equity markets worldwide.

• Our estimated Q1/09 hit from credit markets is $140 million ($0.09 per share).

• We expect credit-related costs to be above the $128 million reported in Q4/08 and expect continued reserve strengthening as the ratio of downgrades to upgrades of bonds continued to climb in Q1/09. (Exhibit 7).

• We expect sales growth to decline year over year, due to volatile equity markets and overall economic uncertainty.

• Recent price increases in certain product lines (i.e. U.S. retail LTC) and the revamping of the company’s U.S. variable annuity product line (less generous guarantees and higher pricing) will also hinder sales growth, in our view.

• Product introductions and the success of the still relatively new MGA channel in Japan should continue to bolster insurance sales in Asia/Japan, although we expect the pace to slow from the triple-digit growth of recent quarters.

• 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.

• We expect currency fluctuations to only modestly impact earnings this quarter versus Q1/08, as strength in the U.S. dollar versus the Canadian dollar and Japanese Yen versus the U.S. dollar (beneficial for MFC) are largely 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 (May 7)

• We expect Q1/09E core EPS of ($0.09), well-below consensus estimates of $0.21. Our EPS estimate represents a decline of 110% versus Q1/08, but an improvement from the $1.25 loss in the prior quarter. We believe consensus estimates do not fully reflect the negative impact from credit and equity market weakness during the quarter.

• Our estimated Q1/09 hit from equity markets is $285 million ($0.51 per share).

• Management has disclosed that each 10% decline in equity markets would reduce net income by $275-350 million ($0.49- $0.63 per share). Our estimated impact from markets assumes a 9% blended decline in Q1/09.

• Our estimated Q1/09 hit from credit markets (including credit spreads) is $272 million ($0.49 per share).

• Approximately $200 million of our estimated $272 million impact is related to writedowns and downgrades; we estimate that downgrades increased by 20% versus Q4/08.

• The remaining negative impact from credit relates to spread widening (primarily affecting the U.S. fixed annuity business). We expect the negative earnings impact to result from the widening of spreads on asset-backed securities, as CMBS spreads ended the quarter largely unchanged, despite widening significantly during the three months.

• 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 almost 60% lower YoY net income in Q1/09, primarily due to the impact of weak equity markets on AUM. Operating margins are likely to stabilize at 18% (they were 17% in Q4/08) but are well down from the 32% level in Q4/07.

• We expect currency translation to only minimally positively impact Q1/09E earnings versus Q1/08, 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%.

Power Financial (May 12)

• We expect Power Financial to report Q1/09E EPS of $0.46, in line with consensus estimates. Our EPS estimate represents a decline of 31% versus Q1/08 and 22% sequentially.

• We expect Great-West to report Q1/09E EPS of $0.37, down 38% versus Q1/08. Great-West accounts for 70% of Power Financial’s Q1/09 estimated EPS.

• We expect IGM Financial to report Q1/09E EPS of $0.52, down 35% versus Q1/08. IGM Financial accounts for 22% of Power Financial’s Q1/09 estimated EPS.

• Pargesa and Other income are expected to report earnings of $26 million in Q1/09, above the $4 million recorded in Q1/08.

• Power Financial’s shares do not typically trade based on earnings as investors usually focus on net asset value.

Power Corporation (May 13)

• We expect Power Corporation to report Q1/09E EPS of $0.47, in line with consensus estimates. Our EPS estimate represents a decline of 27% versus Q1/08 and 12% sequentially. We expect lower earnings YoY at Power Financial to more than offset higher contributions from investment funds.

• Similar to Power Financial, Power Corporation’s shares do not typically trade based on earnings as investors usually focus on net asset value.

ING Canada (May 13)

• We expect Q1/09E operating EPS of $0.48, in line with consensus estimates. Our operating EPS estimate represents a decline of 14% versus Q1/08 and 23% sequentially. Note, consensus EPS is a blend of operating and GAAP EPS.

• The primary reason for our lower year over year EPS estimate is our expectation for lower interest and dividend income – the company’s investment portfolio (excluding cash) decreased from $7.2 billion to $6.1 billion in the past year.

• We believe a more benign winter for many regions of the country will positively impact year over year comparisons for Canadian P&C businesses. The company’s Q1/08 results were also negatively impacted by a $10 million increase in provisions for its Alberta auto business.

• We expect a 3.1% increase in earned premiums in Q1/09 versus Q1/08 primarily due to an increase in the number of insured risks and insured amounts in personal property and rate increases in personal auto.

• ING Canada began raising Ontario auto rates several quarters before its peers, however, based on the most recent available data, the industry’s rate increases have begun to close the rate gap (the entire industry raised rates by an average of 5.6% in 2008). Although being an early mover has hurt premium growth for ING Canada in recent quarters, we expect underwriting profitability and ROE to benefit longer term.

• Book value growth will once again likely be slowed by continued weakness in equity markets (although ING Canada’s exposure to common equities has decreased from 25% of invested assets to 12%).

• We estimate a net realized investment loss of $20 million (pre-tax) in Q1/09, given the combination of a 3% drop in the S&P/TSX Index and the company’s $134 million unrealized loss position on common equities as at Q4/08.
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