15 November 2006

Recap of Insurance Cos Q3 2006 Earnings

Scotia Capital, 15 November 2006

Life Insurance Companies

• Buoyant U.S. equity markets contribute to stronger-than-expected quarter. On average, the 11% YOY EPS growth in Q3/06 was 2% better than our 9% expectation, in part due to strong equity markets in the U.S. and in part due to better-than-expected claims experience. After “misses” in Q1/06 and Q2/06, largely due to the weight of a rapidly appreciating CAD versus USD in Q1/06, and weak U.S. equity markets in Q2/06, the “beat” in Q3/06 was much needed.

• Strong U.S. markets, a weakening CAD versus the USD, and stable long-term rates – all suggest there is a good chance the lifeco group could continue to exceed estimates. Assuming the U.S. dollar continues to appreciate, U.S. equity markets (up 8% since June 30, 2006) continue to be strong, and long-term interest rates, especially in the U.S., remain in the 4.50% range, we expect the Canadian lifecos could exceed our expected average EPS growth estimates of 13% in 2007 and 11% in 2008.

• Earnings are becoming increasingly sensitive to equity markets – additional volatility is a slight negative in our opinion. Not only is nearly half the earnings of the lifecos related to wealth management businesses, and hence susceptible to changes in equity markets, reserves for guarantees on segregated fund and variable annuity business, which are effectively “marked to market” at each quarter-end, add an additional element of equity market volatility. We estimate that each 10% move in equity markets is worth about 9% of EPS for Industrial-Alliance, 6% for Sun Life and Manulife, and 5% for Great-West Lifeco. Finally, we expect that, in the new accounting regime, beginning Q1/07, when assets supporting company surplus are “marked to market”, and realized gains and losses on assets supporting surplus are immediately recognized into income, earnings will be even more susceptible to changes in equity markets, with Manulife the most volatile.

• Up 6% in the last two weeks primarily fund flow-related – we believe the Canadian lifeco valuations are currently somewhat stretched. The October 31, 2006, proposal to tax income trusts has been the primary catalyst in the group’s recent 6% run, along with the banks’ similar 6% run over the same time period, flat Canadian and U.S. markets and flat U.S. lifecos and U.S. banks. As the beneficiary of income trust funds flow, the Canadian lifeco forward P/E multiple increased nearly 5%, to 13.6x, significantly higher than the 12.5x average (since the beginning of 2002). Furthermore, versus the U.S. lifecos, which reported a similarly stronger-than-expected Q3/06, the Canadian lifecos jumped to a 12% premium (from 7% two weeks ago), well above the 5% mean. Finally, versus the Canadian banks, Canadian lifecos are trading at a 4% premium, in line with their 2% average. We would expect the banks, with significantly higher dividend yields, to be a more logical beneficiary of funds flow out of income trusts. As well, a declining long-term interest rate scenario, similar to what we’re seeing, is generally more punitive to the lifecos.

• U.S. top-line growth slows to a more “normal” level – we expect the trend to continue. While traditionally the slowest quarter for sales, Q3/06 top-line growth was weaker than we expected, with U.S. individual insurance sales flat YOY organically (after increasing into the high teens in the first half of 2006), variable annuity sales up just 10% (after increasing over 20% in the first half of 2006), and U.S. pension premiums and deposits up just 9%, after increasing nearly 20% in the first half of 2006. The fourth quarter will be the tell-tale quarter, but we expect top-line growth to continue to rein in toward more long-term mid-single digit growth for individual insurance and high single to low double digit growth for variable annuity business.

• Mature Canadian market has a stronger-than-expected quarter in individual insurance sales, primarily due to a resurgence of Manulife. After losing market share in the first half of 2006, Manulife, with 13% growth in sales in Q3/06, likely picked up share at the expense of Industrial-Alliance, which was forced to increase premiums (perhaps later than others) due in part to declining long-term Canadian interest rates. That said we do not look to the Canadian market as a catalyst for growth. It is too mature, in our opinion, with declining penetration rates. Furthermore, despite being an oligopoly, the market does not behave like one, in our opinion.

P & C

• Canadian personal auto continues to be very favourable. ING Canada’s combined ratio in Q3/06, at 85%, showed no change from the exceptionally strong Q2/06 (at 84%) and little change from the significantly reserve release aided 80% in 2005 and 83% in 2004. Just how long this trend continues is the question. History seems to suggest that in this cyclical market, where government has a say in rate regulation, exceptionally strong underwriting results cannot last forever. That said, the trend in the direction of premium rates is starting to turn from negative to positive, and markets remain rational. We remind investors that ING Canada’s “miss” in Q3/06 was primarily due to poor results in personal property, and not in the all-important personal auto, as storm-related claims were higher than normal.

• U.S. non-standard auto shows signs of improvement. The U.S. non-standard, an important part of the Kingsway story, showed signs of improvement in Q3/06, with Kingsway’s U.S. non-standard top line flat once again organically (an improvement from the 10% decline in 2005), and competitors such as Infinity, Direct General, and Bristol West showing 6% topline growth in the quarter, after experiencing declines in the first half of 2006.

• Canadian commercial remains competitive but rational. Excluding Northbridge’s U.S. business, the combined ratio was 86%, in line with 2005, and premiums were down 4%, suggesting that despite the soft landing, the market remains rational.

• Still not an attractive entry point for cyclical P&C market. Overall P&C insurers had an excellent Q3/06, helped by low catastrophe losses and favourable reserve development. Record profit levels continue to boost capital levels, and, going forward, we expect softening prices in the U.S. in particular to put increasing pressure on profitability. Valuations for the U.S. P&C insurers are in line with historical averages, and, more importantly, still slightly above the average levels experienced in a soft market. Unless we see valuations decline 5%-7%, we advocate a below market weight for the P&C group.