18 October 2006

Preview of Insurance Co Q3 2006 Earnings

Scotia Capital, 18 October 2006


• Canadian insurers start reporting on October 26.

We continue to recommend market weight – Cautious given economic backdrop, but warming up to valuation.

• As we approach the Q3/06 earnings season, we are much more comfortable with the Canadian lifeco group’s valuation, which, after a modest and somewhat overdue “correction,” over the last six months, is now in line with historical averages. Other financials have certainly fared better than the Canadian lifecos over the last six months. The Canadian banks are up 3% in the last six months and up 7% in the last three months, and U.S. lifecos are up 13% in the last six months and 8% in the last three months. On the other hand, the Canadian lifecos are down 2% in the last six months and up 2% in the last three months. What’s caused this? In our opinion, the negative impact of declining interest rates, which tends to penalize the lifecos versus the banks (and also the Canadian lifecos versus the U.S. lifecos, where the accounting model is less punitive to market swings in interest rates), is one reason. The other is a much needed correction in lifeco valuations, fuelled in part by a few “sloppy” quarters, marked with slight misses and below-average earnings quality. The correction has brought the valuation for the group relative to U.S. lifecos back closer to historical averages, with the premium (forward P/E) versus the U.S. lifecos declining to 7% from 15%, now closer to its three-year mean of 5%. The premium versus the Canadian banks, at 4% (forward P/E), has also come in over the last six months, from an 8% premium six months ago, and now is nearly in line with its 2% four-year average. While we believe a premium above historical levels is justified in a rising interest rate environment, given that long-term rates appear to want to continue to fall rather than rise, we see little catalyst in the lifeco group that would force the multiple to significantly increase versus the banks going forward. However, given the significant excess capital positions, reasonable valuations (12.9x forward P/E, in line with long-term average) after a necessary correction, and steady long-term growth prospects (11% through 2007), we continue to recommend market weight for the group. Should long-term rates start to reverse their decline, and/or, valuations fall further, we would upgrade to overweight.

Fundamentals remain steady – a continuation in the decline in long-term interest rates is the only modest headwind.

• Fundamentals remain steady for the group, with ROEs modestly climbing, excess capital positions growing, and targeted dividend payout ratios rising. Excellent risk-management techniques, in our opinion, help mitigate the risks to any potential unfavourable macro environments. As it stands now, we are comfortable with the risk profiles for the group. The continued decline in long-term interest rates is the only headwind.

Canadian P&C insurers – Market remains rational – Auto continues to pace ahead of industry norm, commercial becoming increasingly competitive.

• The profitability of Canadian auto insurance continues to pace well ahead of industry norms due to the sustained effectiveness of automobile reforms and continued low frequency levels. We get the impression from management at ING Canada that this trend will continue throughout 2006. The U.S. non-standard auto market (a significant portion of Kingsway’s business) remains very competitive and perhaps somewhat irrational, as niche players have gained market share. It remains to be seen whether the impact of what is expected to be more expensive reinsurance (in light of last year’s hurricanes) will introduce an element of rationality to the market, an obvious positive for Kingsway. However, the longer we keep waiting for the “expected” increase in reinsurance rates to drive out what some call “irrational” players, the more likely this scenario will not play out. As such, we believe there is a good chance the U.S. non-standard market will remain irrational for some time. While the 2005 hurricanes removed US$58 billion from the balance sheets of insurers/reinsurers worldwide (one-half of the impact was on U.S. domestic companies and one-half was on those outside of the United States, predominantly European- and Bermudian-domiciled companies), the perceived “hardening” of markets was a reality only for U.S. coastal coverages. Consequently, our Canadian P&C companies will likely see little impact, and we believe rates will continue to be flat to perhaps modestly down. While the Canadian commercial market will continue to be increasingly competitive, we believe it will remain rational.

Great-West Lifeco Inc.
1-Sector Outperform – $33 one-year target, based on 2.9x 9/30/07E BV and 13.1x 2007E EPS
• We are looking for $0.53 per share for Q3/06, $0.01 per share below consensus. Our 2007 EPS estimate is $2.40, $0.02 ahead of consensus.
• Strong EPS growth (14%) expected in 2007 when negative impact of hedge roll-off is mitigated.
• Any update on the potential acquisitions discussed at the September 28, 2006, Investor Day? We counted five potential deals CEO Raymond McFeetors said the company is looking into, most of which are in the U.S. We expect an update.
• European segment (24% of bottom line), up 26% in 2005 and 28% in 1H/06 (ex-foreign exchange), should continue to show double-digit growth – with further support in 2007 from the recently announced acquisition.

Industrial-Alliance Insurance and Financial Services Inc.
3-Sector Underperform – $35 one-year target, based on 1.7x 9/30/07E BV and 11.7x 2007E EPS
• We are looking for $0.65 per share in Q3/06, $0.02 per share below consensus. Our 2007 EPS estimate of $2.86 is $0.07 below consensus. Q1/06 and Q2/06 were "misses" and Q3 could be the same.
• Low long-term rates and the associated new business strain continue to weigh on the company’s individual insurance segment.
• The Clarington acquisition will continue to propel individual wealth management earnings,but uncertain Canadian equity markets may cause some concern going forward.

Manulife Financial Corporation
2-Sector Perform – $38 one-year target, based on 2.4x 9/30/07E BV and 13.8x 2007E EPS
• We are looking for $0.60 per share for Q3/06, $0.02 per share below consensus. Our 2007 EPS estimate of $2.73 is $0.06 below consensus.
• Japan VA sales will likely be weak.
• We expect the exceptional U.S. variable annuity sales growth will start to slow and return to more “normalized” levels.
• A strong likelihood of a dividend increase in the quarter, possibly 15%.

Sun Life Financial Inc.
2-Sector Perform – $50 one-year target, based on 1.8x 9/30/07E BV and 12.8x 2007E EPS
• We are looking for $0.90 per share for Q3/06, $0.02 per share above consensus. Our 2007 EPS estimate of $3.90 is in line with consensus.
• “So what’s it gonna be boy? Yes or no?”. MFS speculation discussions will certainly dominate the conference call. Given the speculation has been prevalent for two months now, in keeping with the Meat Loaf reference, we expect the company's response will have a "let me sleep on it" tone.
• U.S. variable annuity – continues to be a “show-me” story. We expect market share gains for the company to be minimal.

Fairfax Financial Holdings Limited
2-Sector Perform – US$150 one-year target, based on 1.0x 6/30/07E BV
• We expect another steady quarter ($2.50 EPS, excluding an estimated $22 hit due to the commutation of the Swiss Re cover), not as good as the exceptional Q1/06 ($9.10 EPS) or Q2/06 ($12.14 EPS), but one with good fundamentals in ongoing insurance operations and close to break-even in runoff operations.
• Runoff segment remains under the radar screen.
• Likelihood of beating estimates is high given little catastrophe activity.

ING Canada Inc.
2-Sector Perform – $62 one-year target, based on 2.2x 9/30/07E BV
• We are looking for $1.12 per share for Q3/06, $0.02 per share below consensus. Our 2007 EPS estimate of $4.41 is $0.07 above consensus.
• A good chance the company could exceed our estimate and consensus with another excellent quarter of underwriting profitability – we forecast a combined ratio of 89%, not as good as the exceptionally strong 83% in Q2/06, but we remind investors that Q2 and Q3 are typically strong quarters.

Kingsway Financial Services Inc.
2-Sector Perform – $29 one-year target, based on 1.4x 9/30/07E BV
• We are looking for $0.77 per share for Q3/06; we believe this is in line with consensus.
• We look for a steady quarter in line with consensus, with no significant prior-period reserve development and a combined ratio in the 97% range.
• Any catalyst for growth in the United States? Likely not in the near term.

Northbridge Financial Corporation
2-Sector Perform – $37 one-year target, based on 1.5x 9/30/07E BV
• We are looking for $0.86 per share for Q3/06, $0.04 per share above consensus. Our 2007E EPS estimate of $3.32 is $0.04 above consensus.
• Given the low level of catastrophes, we look for an exceptionally strong quarter, with a good chance that earnings could significantly exceed consensus.

RBC Capital Markets, 18 October 2006

• Expecting Manulife and IAG to Lead EPS Growth. Our 15%+ YoY EPS growth estimates for MFC and IAG are above-consensus and reflect acquisition-related momentum. Our 4% YoY EPS growth estimate for SLF factors continued U.S. sales strain, while for GWO we see more earnings pressure from the U.S. Healthcare division.

• Manulife To Up Dividend. We model an 11% (2¢) hike to 20¢ per quarter for MFC (the last increase was 17% in Q4/05). GWO, SLF and IAG each increased dividends in Q2/06, so we expect no move from them in Q3/06.

• Watch MFC Lead in U.S. Life Sales, GWO in Canada. Hancock is now generating near-market-leading sales of US$200MM-250MM/quarter. SLF U.S. sales are also expected high at ~US$70MM but unsustainable based on uneconomic pricing – sales should normalize when pricing is set back to market levels. In Canada, GWO carries the strongest individual sales momentum across key products, while Manulife and Sun look flat coming out of last quarter.

• Fee Growth May Slow. In our view, SLF’s U.S. fund manager (MFS) and U.S. Annuity businesses could be hit hard by redemptions this quarter, given the trying markets and the “for sale” sign on the subsidiary. Indeed, volatility in equity markets and a drop in bond yields could dampen asset management fee growth across the group, and we believe fund sales are also being adversely impacted. However, Manulife’s U.S. wealth flows should be stronger with the GMWB and new-revamped U.S. mutual funds.

• F/X Costs Abated. The CAD/USD averaged the same level as in the prior quarter, and while off 7% YoY, was less onerous than the 11% YoY hit endured last quarter. The British Pound Sterling (CAD/GPB) declined 4% YoY, still only 1/3 the free-fall of each of the two previous quarters. Manulife and GWO benefit most, IAG least.

• Spotlight on Deals. We look for progress on Sun’s potential sale or vend-in of U.S. fund manager, MFS. Of a possible $5 lift in value from a well executed vend-in, we believe SLF at $45 has $2-3 already priced in for a deal. Also, we think Sun and GWO would be among the players interested in acquiring Unum Provident. Both would have solid U.S. Group Insurance overlaps. Both are acquisitively-minded. Last, the Unum valuation at 1.05x book value is interesting. Unum would increase Sun’s U.S. Group sales by ~2.5x, expanding product breadth and improving cost competitiveness. Ironically, SLF would also re-acquire a former UK group business, an SLF division it had sold to Unum in 2003. We do not see as tight a fit in the U.S. business lines for GWO; however, the European business overlap is exciting, vaulting GWO into a dominant leadership position.

Markets - While Volatile in Quarter, Equity Markets Were Essentially Unchanged on Average

North American equity market averages ended flat in the quarter, and were still up on a YoY basis. The TSX average was 12% higher YoY (compare to up 23% last quarter) and the S&P500 average was up 5% YoY (versus up 8% last quarter).

Average bond yields were down in the quarter, considered harmful to universal life and fixed annuity spreads (i.e. product crediting rates). However, we have yet to prove an earnings correlation with low bond yields, as might be expected intuitively. The offset seems to be the ever-increasing benefit to insurers of rising equity markets and related asset management fees when the bond yields are rallying.

In the quarter USD weakness relative to the CAD was more subdued than in prior sessions – essentially flat in the quarter and down 7% YoY. In prior periods, we have endured as much as 11% YoY hits. Since quarter-end, the CAD has weakened further to around 1.138, now creating a potentially easier Q4 as well. Manulife is the biggest beneficiary, and by a factor of ~50% versus Sun and GWO, to strength in the USD (relative to the CAD reporting currency).

Canadian Lifecos “Held In” this Quarter. Canadian lifecos have on average tracked the S&P/TSX closely in 2006, playing catch-up in Q3/06 versus last quarter’s relative underperformance.

Projected Q3/06 Sales Results

Canadian Individual Insurance – Expecting GWO to Lead Sales Growth up 14% YoY (2-3x the Industry Avg.)

Expecting Strongest Growth from Great-West. We expect GWO to be the top sales grower in Q3/06; our estimate indicates up 14% YoY. GWO’s Canada Life product suite is selling very well through independent distributors. Our channel checks tell us Canada Life product pricing and service levels are increasingly competitive. GWO also has the highest leverage to participating insurance, the highest growth insurance category in Canada last quarter, and typically a better-selling product during volatile markets. We expect the others to roughly track or be slightly above industry average growth rates.

Industry-wide sales of all individual insurance products in Canada (including term, whole, UL, T-100, long-term care, disability, and critical illness) show a 10-year CAGR of 4.3%, roughly in line with the recent few quarters. We project a likewise modest 4% lift in Q3/06 for the industry overall.

U.S. Individual Insurance Sales Projections

Watch for Continued Strength from Manulife-John Hancock. We project individual insurance sales of US$200 million for MFC, up 17% YoY as distribution benefits of the integration and the product revamp continue.

Canadian Individual Wealth Management Sales Projections

We expect moderating YoY growth in domestic wealth sales. We expect sales to be bracketed this quarter by continued large, acquisition-driven growth at IAG (up 70%+) and by a 20% sales decline at Manulife in the sales vacuum ahead of their newest product launch on the Guaranteed Minimum Withdrawal Benefit Annuity (distributors often hold pending investments in anticipation of new product launches). Total annuity sales have shown nearly 20% YoY growth now for the past four years.

U.S. Individual Wealth Management – All Manulife

Manulife and Sun Life are the only two meaningful players in U.S. individual wealth management, and the stories have been quite different. Manulife’s already-considerable sales of variable annuities was boosted some 40% or more with the addition of the John Hancock channels. MFC’s newly-revamped mutual fund offering has also met with strong momentum. Conversely, Sun has struggled to stem redemptions in both its mutual fund and annuity complexes.


GWO: Our $32.00 target reflects our 14.5x target forward P/E multiple and our 4-quarters forward EPS estimate of $2.20. The target multiple is in-line with our sector view to reflect GWO’s reliable earnings, dividend and ROE track record, but factors some earnings challenges around the onerous foreign exchange translation and renewed U.S. Healthcare woes. Our $32 price target also indicates a prospective price -to-book ratio of 2.5, most reasonable for a 20% ROE earner.

MFC. Our $43 price target reflects a 16x forward P/E now at $2.71 for MFC, above our Canadian lifeco target average of 14.5x. to reflect excellent operating performance, strong capitalization and a leading global market position, with particularly strong growth prospects in the U.S. and Asia. For 2006, we estimate $2.50 cash EPS (3¢ above consensus) and for 2007, our $2.89 estimate is 8¢ above consensus. In both cases, we have more aggressive operating margin expectations, reflecting continued excellent execution, positive interest rate EPS torque, and favourable share buyback activity. Risk centres on foreign exchange translation, as nearly two-thirds of earnings are USD-based and unhedged. Also, Manulife could be susceptible to a downturn in claims experience or an unusually bad credit market.

SLF: Our $49 price target is set at 14x our 12-month-forward EPS estimate of $3.50 (now Q306-Q207). Our Sun Life target P/E is set a half multiple below our 14.5x sector target P/E. We believe the discount is warranted based on Sun’s growth challenges in domestic insurance and U.S. annuities. We also believe Sun’s financial performance is more reliant on favourable interest rates and equity markets, than for the peer group.

IAG: Our $40.00 target is set at 14x our 12-month-forward EPS estimate. Our target P/E is at one-half multiple point below our Canadian lifeco average of 14.5x to balance IAG’s solid franchise and positive sales trends with its concentrated geographic and product scope and lower share liquidity. The Above Average risk qualifier reflects similar risk attributes, specifically size & scale relative to the Big 3.

Price Target Impediments

GWO: Potential impediments to our price target include deterioration in equity and credit markets, unusual claim losses, and inability to turn around the U.S. group health lines. Mitigating the health care risk is potential for sale if management determines that the operation lacks sufficient return potential. Further USD weakness would pose a downside risk to our EPS estimates.

MFC: Impediments to our target price include: (i) adverse reserve or integration developments in Hancock; (ii) potential EPS estimation risk associated with increasing cost of the post-Hancock share repurchase program; (iii) adverse claims or lapse experience particularly as relates to universal life products where MFC has been known to lead pricing, and/or; (iv) unfavourable eco-political developments in emerging markets where MFC operates.

SLF: Impediments to achievement of our target price include: (i) another round of extra-low interest rates; (ii) an equity market correction; (iii) poor execution on the U.S. Annuities sales turnaround and/or domestic independent retail insurance platform rebuild. IAG: Potential impediments include sustained equity and credit market deterioration, excessive claim losses and margin erosion due to intensifying competition.