21 December 2006

BMO CM on Life Insurance Cos

BMO Capital Markets, 20 December 2006

Consolidation Paying Dividends - Three Years After Consolidation: Market Shares Concentrated & Higher Operating Margins

Executive Summary:

Harvesting Earnings from Canada

The Canadian life insurers are by and large global companies. Nevertheless, earnings from Canada represent 25-100% of each company’s profits and for all, except Manulife, Canada is the biggest geographic contributor (Table 1). At the high end, Industrial Alliance generates substantially all of its earnings in Canada, followed by Sun Life at 48%, Great-West at 47%, and Manulife at 25%. System-wide, Canada contributes 38% of total earnings from the four publicly traded life insurers, which is down from 41% in 2004.

While there are numerous businesses within the Canadian operations, three areas comprise the bulk of earnings and revenue. These areas include individual life, group benefits, and group and individual wealth management. Given the diversity of the businesses, we will review each separately.

Since 2000, the Canadian life insurance industry underwent significant changes including de-mutualization and consolidation. Currently, the top three operators - Great-West Life, Manulife, and Sun Life - dominate the domestic market with aggregate market shares ranging from 62% to 71% of every major segment of the Canadian life market.

Two years ago, we released a report titled 'Post Consolidation - Harvest Time in Canada' that detailed the consolidation in the Canadian marketplace and that this consolidation would enable the Canadian lifecos to harvest earnings from their Canadian operations. Fortunately, the industry has reported very good margin improvements over the last couple of years and appears to be using excess earnings generated in Canada to fund growth.

Higher margins can be driven by better pricing or lower costs. Since markets for life insurance products are opaque, it is difficult to determine if pricing has improved, or deteriorated. However, anecdotal evidence suggests that pricing remains competitive. As such, we believe that most of the gains in the operating margins have come from the benefits of consolidation: increased scale and lower unit costs. Moreover, since pricing trends can be unpredictable because of competition, lower unit costs represent more sustainable improvements in margins. ROEs in Canada remain attractive in the mid to high teens, on average.

Consolidation is by no means the only reason for higher margins over the last couple of years. Rising equity markets and a benign credit environment have contributed to the good margins, offset somewhat by the low level of long term interest rates. While acknowledging the importance of the good equity and credit markets on current operating margins, we do believe that consolidation has led to higher 'trough' margins and higher 'peak' margins over a cycle.

We estimate that the four publicly traded lifecos will generate roughly $3 billion in earnings in Canada in 2006 and rise 10% annually for the next two years. In addition, we conservatively estimated that $300 million of these earnings will be reinvested in the domestic businesses in 2006 and rise by 10% per year over the next two years (Table 2). As a result, the domestic operations are expected to generate 'excess' earnings (earnings available to use outside of Canada, increase the dividend, or buyback stock) of $2.8 billion in 2006, rising to $3.4 billion in 2008 for a cumulative total of $9.2 billion in excess earnings over the 2006-2008 time frame. To put this in perspective, just the Canadian operations alone should be able to double the current estimated level of 'excess earnings' among the four publicly traded Canadian lifecos over the next 24 months.

In effect, Canadian insurers should be able to continue to expand internationally, comfortable in the knowledge that profitability on the home front is secure. In particular, Manulife’s ability to use excess earnings generated in Canada and reinvest in Asia is attractive for long-term shareholders.

The Big Picture:
Demographic Trends Remain Supportive

Over the last 45 years, general fund assets grew at a compound annual rate of 8%, 9% if segregated fund assets are included, and at a rate of 6% over the last five years (see table inside front cover of this report). We believe that general fund growth should range from 3-5% over the next few years, which is close to nominal GDP growth. Inclusion of segregated fund assets could add an additional 2-3% in annual growth rate. We believe that growth in general and segregated funds represent a 'floor' of earnings growth expected in Canada. Including some operating leverage, the combined 5-8% growth in segregated and general fund AUM should translate into roughly 10% earnings growth.

Conceptually, there are four phases in the financial life cycle of Canadians pertaining to insurance: protection, wealth creation, retirement and wealth transfer (a nice way of discussing death).

In the early stages of an individual’s life cycle, expenses generally exceed income and the primary attraction of insurance is to protect dependents in the event of premature death. As individuals age, the focus shifts to wealth creation, where numerous other financial intermediaries compete for financial assets. The third stage focuses on the need to fund retirement from accumulated assets, and lastly consumers need to distribute their estates in a tax efficient manner.

Life insurers are substantial participants in all stages of the lifecycle, offering protection products in the early years (term and whole life), accumulation products in the middle years (segregated funds, mutual funds and universal life), retirement products in later years (payout annuities and RRIFs), and ensuring efficient wealth transfer through death benefits on life insurance or segregated fund products.

The main attraction of insurance over the last 30 years has been to provide protection to the baby boomers, the single largest demographic group. As this demographic group aged, insurers have had to compete with banks and other financial intermediaries in the wealth management space. Accordingly, the dominant selling proposition of insurance has changed as this large demographic group aged.

The main selling proposition today focuses on the real possibility that aging boomers outlive their savings. Moreover, low interest rates do not provide the relatively high risk free rate of return that many boomers had become accustomed to prior to 2000. Insurers are particularly well positioned to serve this need through annuities and new features of segregated funds. In addition, the tax advantage benefits of life insurance are ideally suited for wealth transfer.

In reality, the stages are far less clear than we have detailed and, in fact, many insurance products have crossover appeal. Furthermore, there are two enduring characteristics of insurance that should sustain growth: tax efficiency and protection. Protection from market volatility and outliving your savings in retirement, and the tax efficient nature of death benefits as well as wealth accumulation within an individual life policy or a tax deferred capital accumulation plan. Overall, we believe that historical data plus unfolding demographics trends support industry growth projections of 5-8% in total AUM.

The most basic measure of market share would analyze the percentage of AUM - general and segregated AUM only - at the big 3 insurers. In 2000, these big three insurers had a 41% market share (Table 3). Over the course of the next four years, this market share rose to 63% due to consolidation. Results in Table 3 are supported by market share statistics presented on the front cover of this report, where the big three insurers in aggregate control 62-71% of the industry’s premium-driven business (individual insurance, group insurance, and annuities) and 65-70% of the industry’s asset-driven businesses (segregated funds and DC Plans). These formidable market shares act as a barrier to entry and represent a significant long term competitive advantage.

Individual Life - Mature with Modest Growth Prospects

Canadians currently have $1.5 trillion of individual life insurance in force (i.e., face value) and there are 13 million individual life policies in the country. The face value of all individual in-force life insurance grew at a compound annual rate of 7% over the last five years, which is at the low end of its historical growth rate. Premiums grew at a compound annual rate of just under 3% over the same time period. Premium growth rates have declined over the last 30 years as the aging population focused more on wealth creation and retirement planning than protection (see discussion in previous section).

While growth in individual life premiums has not been spectacular over the last five years, there are a number of positive trends that could help offset the slower premium growth. First, approximately 78% of all individual life premium income comes from renewals, which provides the business with some immunity to economic cycles. New policies sold in any one year represent roughly 10-12% of total premium income, a figure that is more sensitive to the economy and equity markets.

Second, the in-force block of business should continue to support steady stream of earnings, particularly as mortality continues to improve and cost efficiencies are realized due to consolidation and technology.

Third, benefits paid on life insurance contracts are not taxable and as such remain an attractive form of estate planning. It is estimated that approximately $1.2 trillion in wealth will be transferred to the baby boomers from their parents over the next 20 years. Despite these positive trends, the relatively low level of interest rates has increased pricing for traditional permanent insurance and demographics support the thesis that the core individual life business will remain a slow growth business.

New individual life sales have remained relatively flat over the last five years. Despite negligible growth in terms of new industry sales, the mix of business has changed significantly over the last decade. In the early 1990s, over 70% of the new policies sold were term or whole life policies. However, Universal Life has become the most popular form of individual life, accounting for over 50% of industry sales in 2005 and year to date in 2006.

The popularity of Universal Life tends to mirror the equity markets. Universal Life, or UL, was developed to deal with he trend among consumers to 'buy Term and invest the difference.' UL policies are comprised of a basic term insurance policy with a side fund, where premium payments above the basic cost of insurance are invested. Unlike whole policies, where the insurer takes the investment risk, UL sees the policyholder take some risk as individuals are allowed to invest in equity funds or other investment vehicles. Longer term, this product can function both as a protection vehicle and as an investment vehicle. This product has sold particularly well in the broker dealer channels.

More volatile equity markets in 2001-2003 reduced demand for UL and increased demand for whole life and term insurance. Despite improvements in the equity markets over the last couple of years, the market share of new sales in UL versus non-UL individual life insurance has remained relatively stable.

Over the last 15 years, there has been a steady decline in the number of new policies sold. The decline in new policies sold reflects the aging demographics referred to above. Despite fewer new policies, higher face value policies more than offset the impact of fewer new policies and led to modest gains in new annualized premiums. Higher face value policies can no longer fully compensate for the decline in the number of policies as new annualized premium growth has stagnated. While it appears the number of new policies sold has 'troughed,' the outlook for new business growth in individual life looks modest, 1-2%. Combined with in-force premiums, individual life could grow at 2%+ over the next few years.

Market share in individual life can be measured in a number of ways but the best measure(s) includes the market shares of in-force premiums and market share of new annualized premiums. In terms of in-force premiums, industry concentration among the top three competitors grew from 31% in 1998 to 63% in 2003 and 66% in 2005. This is very important since growth in individual life is expected to remain modest; the big three insurers are expected to generate approximately two-thirds of in-force industry profits given that they control large existing blocks of business. Unlike other financial products such as banking or mutual funds, individual insurance policies can be very sticky.

It is also interesting to note the product mix of the in-force business. In the first half of 2006, UL accounted for only 19% of the policies in force, but 33% of in-force premiums. This reflects the fact that UL policies tend to be larger and targeted to a higher income bracket. Whole life accounted for 49% of all in-force policies and 49% of all in-force premiums, while term insurance accounted for 32% of in-force policies and 18% of in-force premiums.

The concentration of new sales for the top three competitors has been less pronounced than of in-force premiums. In 2000, the top three operators accounted for 43% of new annualized premiums and rose to 55% of new annualized premiums in 2005. Similar trends exist during the first half of 2006 where weaker sales from Manulife have been offset by strong individual life sales at Great-West.

New sales concentration has been less pronounced than in-force concentration for two reasons: changes in distribution and meaningful foreign competition. The percentage of new sales accounted for by 'owned' distribution channels has declined from roughly 70% 15 years ago to under one-third today. Concurrent with the consolidation of 'owned' distribution is the emergence of national accounts, or broker dealers, as a major distribution channel for certain products, particularly UL. According to Investment Executive, roughly 70% of retail stock brokers in Canada now have an insurance license.

There are a large number, over 40, of insurers that remain active in Canada. Many of these competitors are subsidiaries of large global operators, including Standard Life, Aegon, and AIG. This should keep a certain level of competitiveness in the sales process.

Individual Life Industry Outlook

As indicated above, we project the core individual life business to grow at a modest pace of 2%+ per annum. However, if growth were to exceed these projections, sales of Living Benefit products, like critical illness (CI) and perhaps long term care (LTC), are likely to be the driving force.

CI provides policyholders with some additional financial protection in the event of illness. For example, if a policyholder is diagnosed with one of a number of diseases outlined in the insurance contract, the policyholder is paid the benefit amount and can use that money to pay for medical care. If the policyholder does not become ill and survives the length of the contract, he or she will retrieve 75-100% of premiums paid over the life of the contract. Whereas traditional life insurance provides financial protection for mortality and disability provides for supplemental income and/or assistance with health care costs, CI is specifically targeted to insure against unexpected health care costs associated with a list of different diseases.

Overall, we would expect the number of new policies sold to demonstrate very marginal growth as new Living Benefit policies offset lower sales of individual life policies. In addition, we would expect premiums per policy to rise modestly assuming that equity markets rise in a relatively predictable pattern. We believe that the individual in-force blocks at Great-West, Sun Life and Manulife provide these three companies with a significant competitive advantage in terms of scale, costs, and pricing. Accordingly, the big three should maintain, and possibly grow, their existing market shares.

Comparing and contrasting reported individual life margins among the Canadian life insurers is, to say the least, challenging given the different levels of disclosure and corporate structures. Results from Sun Life’s individual life business are commingled with results from individual wealth management and its earnings from CI. Margins at Great-West’s life segment are significantly higher than industry averages as its par block of policies absorbs its share (and the heaviest burden) of costs. Despite these obstacles, observing trends in pre-tax and after-tax margins should be useful in gauging the beneficial/detrimental impact of consolidation.

On a rolling 12-month basis, individual life operating margins for this group have risen sharply since Q1/05. The four quarters ending Q1/05 was chosen as the starting date given that most of the industry consolidation was completed by early 2004 and disclosure from the four publicly traded life companies has remained relatively consistent since that time. Industry pre-tax margins rose from 12% to the 15-16% range. Net income margins rose from 8.5% to 12%.

There are a number of factors that contributed to higher margins including favourable equity markets and a benign credit environment offset somewhat by the dampening effect of low long term interest rates. In a more adverse economic environment, the recently achieved operating margins could come under some pressure; however, we believe that consolidation has permanently increased operating margins (i.e. higher trough margins in difficult times and higher peak margins in robust environments).

The major drawback from the results is that Sun Life does not separate individual life from its individual wealth management results. To address this comparability issue, we added together the individual life and individual wealth mangement financial results for GWO, IAG and MFC. A similar trend in pre-tax and after-tax margins can be observed in this analysis as well. The major pitfall in combining these two different units together is that individual life is a premium-driven business while individual wealth management is an asset-driven business.

Group Benefits - Consolidated with Good Growth Outlook
The Economics of the Group Business

The economics of group life and health are different than in individual insurance. This contrast is most evident in two broad numbers: premiums and reserves. In Canada, total reserves for group businesses are approximately $20 billion on $16 billion in industry premiums. However, individual life has roughly $60 billion in reserves in Canada on $12 billion in annual premiums. Lower reserve requirements mean less capital intensiveness relative to individual life and as such ROEs in group business tend to be higher; however, earnings can be more volatile.

Reserve requirements are relatively low because of the structure of group plans with limited guarantee periods (i.e., one year) and the ability to reprice after guarantee periods. However, group plans can vary dramatically depending on the situation and there are a number of mechanisms for risk sharing between the plan sponsor and the insurer. In addition, insurers do not incur significant commission expenses to sell group plans and the effect of branding is minimal- both different from individual insurance.

Even with the ability to reprice frequently, there is still risk in offering certain products, particularly long-term disability (LTD). Once a LTD claim starts, it will often run for a long period and termination of a relationship with a plan sponsor will not alleviate the responsibility the insurance company has to pay the benefits. Roughly one-third of those disabled at the end of six months will be disabled at the end of five years.

From an investor’s perspective though, the risk on these products is tangible. Since the profitability of the product can be established every year, there is less likelihood of long hidden problems which can dramatically affect previously booked profits. Unfortunately, this does mean more short-term volatility in earnings.

Against a backdrop of annual repricing, little branding, minimal investment income and large individual customers, it is not surprising that low costs- achieved through technology or scale- are key competitive advantages. In addition to more rational pricing of group policies since de-mutualization, consolidation has been a dominant theme in group insurance as competitors built scale. In 1999, the top three operators accounted for 41% of industry premiums, including ASO. The top three players controlled 47% of the group life premiums, 40% of group health, and 40% of ASO fees.

In 2003, the top three operators accounted for 64% of total industry premiums, including ASO. The top three players controlled 79% of the group life premiums, 63% of group health, and 62% of ASO fees.

In 2005, the top three operators accounted for 62% of total industry premiums, including ASO. The top three players controlled 79% of the group life premiums, 64% of group health, and 57% of ASO fees. It is interesting to note how market shares have not moved materially over the last couple of years and preliminary 2006 data suggest that this trend continued.

Group Benefit Margin Trends and Industry Outlook

An analysis of margin trends in the group benefits industry is complicated by the fact that Manulife does not disclose results from Canadian group benefits, rather disclosure focuses on combined results from group benefits and group pensions. Despite the inconsistency in disclosure across the companies (just like individual life insurance discussion above) we still believe that it is useful to look at the trend in margins.

In many respects, group profitability has benefited the most from de-mutualization and consolidation. Prior to de-mutualization, group operations were often run as loss leaders. In the run-up to de-mutualization and post de-mutualization, profits in group rose at significant rates mainly driven by re-pricing strategies. As the industry entered the consolidation phase, margin improvements driven by re-pricing had mostly run its course. Since consolidation, the industry has experienced further margin improvement from 10.5% to 12.0% on a pre-tax basis and from 8.0% to 8.6% on an after-tax basis. Consistent with our margin analysis for individual life, our starting date was the four quarters ending Q1/05, which coincides with the last wave of consolidation that ended in early 2004, and ends with year-to-date results.

Including Manulife and combining group benefits and group wealth management at the other players generates a similar trend in margins as observed in group benefits. The major pitfall in combining these two group businesses is that one is primarily driven by premiums, group benefits, and the other is mainly an asset driven business, group wealth management (also known as group pensions).

The growth outlook for group benefits looks good in our view given expectations of continued growth in employment of 2-3% over a cycle combined with increased focus by employees on benefit plans offered by employers. An ageing workforce is likely to work longer into life and potentially demand incrementally more benefits. ROEs should remain attractive in the mid to high teens and new competition is likely to be limited to some existing players like IAG and Empire Life. The major trend in group is investment in technology to deliver solutions and services in a more electronic format. Anecdotal evidence suggests that Sun Life sets the technology standards within the industry. If margins do come under some pressure, we suspect that this pressure will result from either a less favourable economic environment and/or spending on technology to be competitive with the industry leader.

Individual and Group Wealth Management: Growth Segment

The third area in which insurers generally compete in Canada is the wealth management and retirement savings market. We highlight that this area involves both individual and group markets. The group and individual wealth management segments are analyzed together because we believe the consumer views both types of products as integrated elements of savings and retirement plans. Furthermore, the asset liability management requirements are quite similar.

As opposed to the other segments of the insurance businesses where premiums are key, the focus in this segment is on asset accumulation. Part of this distinction is the difficulty in determining what can be defined as a premium (discussed in greater detail later) but more importantly, this is because the business is either spread-based or driven by fees (both assessed against the asset base). The dominant products in this category are annuities and segregated funds. Annuities, which are spread-based products, tend to be fixed and are obligations of the insurance company (i.e., on-balance sheet obligations). Segregated funds, which are fee-based products, are off-balance sheet obligations (i.e., where the holder of a segregated fund takes an investment risk) and as a result are less capital intensive.

Profitability & Outlook for the Wealth Management Businesses

We estimate that the savings businesses in 2006 will generate $1.1 billion in earnings versus $1.1 billion in individual insurance and $0.8 billion in group. ROEs in the savings businesses are among the highest in the insurance business at 15%+. The above average ROE reflect the fact that an increasing proportion of assets are 'off balance sheet' business, segregated funds, versus 'on balance sheet' or general fund products like annuities.

While the ROEs are higher than individual insurance, earnings are more volatile given sensitivity to equity markets. Earnings from seg funds are sensitive to equity markets in two ways. First, higher (or lower) markets increase (or decrease), fee income as fees are assessed on the level of assets under management. Second, since seg funds have some guarantees, such as guaranteeing the return of 75-100% of premium, there are minimum reserve requirements to back these guarantees. The amount of capital is sensitive to the level of equity markets. In rising markets, reserves required to back seg fund guarantees can decline, but the reverse is also true.

Margin trends in the wealth management segment are less obvious than in the previous two segments discussed in this report. In individual wealth management, profits relative to revenue (premium and fee income) appear to have improved modestly over the last couple of years. Readers should recall that this analysis excludes Sun Life, which does not separate individual wealth management results from its individual insurance segment.

However, since individual wealth management is an asset-driven business, it may be more appropriate to analyze margin trends relative to average assets under management. On this basis, margins have been flat to down over the last two years. The difference in margin trends between earnings relative to revenue and earnings relative to AUM is noteworthy and is mainly driven by results at Great-West and is similar to some trends that have appeared in the mutual fund business. These trends may also reflect the low level of interest rates as individual annuities are unlikely to generate the level of earnings per dollar of assets as in the past. The interest rates argument breaks down in further analysis. GWO, which has experienced the most compression, has the least exposure to annuities relative to segregated funds. Similar to the margin trends in individual wealth management, group wealth experienced rising margins relative to revenue (premiums & fees) and decline margins relative to assets under management.

As indicated previously, growth in wealth management, group and individual, should be driven by segregated funds and capital accumulation plans. Combined these two segments are projected to grow AUM by 5-10% annually, which should generate earnings growth of 7-15% per annum with attractive ROEs. With respect to margins, we would be surprised to see a significant rise in the margins and are obviously dependent on events in the equity markets.

Accounting for Annuities and Segregated Funds

The method of accounting for annuities creates confusion for investors (as if investors needed more confusion at looking at the financial statements of insurers). This is because the actuarial liabilities held to support fixed products are large and changes in the amount of new annuities written (or a reduction in the amount of annuities on the books) dramatically affects several different lines in the income statement.

Annuities are purchased either by a single deposit or a series of payments, with the single premium being much more common. Life insurance companies account for the full deposit as premium income (different from the way a bank handles a GIC). Once this occurs, the company sets up a liability, within actuarial liabilities, for future policy benefits to be paid to the annuitant. The change in actuarial liability is expensed to the income statement as a provision for future benefits. The net effect is zero on earnings but does inflate revenue and costs.

Interest earned from the investment of these deposits is recorded as investment income of the life company. If the annuity is in the accumulation phase, the interest serves to increase the actuarial liabilities and therefore results in a provision expense. On the other hand, in the payout phase, the insurance company pays out the benefits, which are expensed immediately. If the annuity is surrendered, the cash is disbursed and paid out to the individual as a benefit expense on the income statement while the actuarial liability is reduced, effectively a negative cost.

Conclusion and Recommendations

Significant change has occurred in the Canadian life industry over the last three years and we believe that most of this change is benefiting shareholders. In general, margins are rising and the Canadian operations are a source of funds to invest in the Canadian lifecos already significant international platforms. Industry market shares remain concentrated albeit down slightly from the highs reached in 2003. Our analysis of market shares in 2003 calculated the pro forma market shares of all the combined entities: GWO/Canada Life and Manulife/Maritime Life.

These entities have been run on a combined basis since late 2003 early 2004 and as such, some natural attrition in market shares was inevitable. Overall, the Canadian market place should grow at 5-8% over the next few years and provide reasonably reliable earnings growth of approximately 10%. All three of the big insurers are extremely well-positioned in Canada but Sun Life and Great-West Life have the added benefit of stronger market positions in group wealth management.

Great-West and Sun Life remain Outperform rated. Our Great- West recommendation rests with a higher conviction that Europe represents an attractive and sustainable growth opportunity, earnings in Canada may be higher than expected given better-than-expected business growth over the last 12 months, the U.S. Financial Services operations continue to perform well (the Met Life and U.S. Bank 401(k) acquisitions should help earnings growth in 2007), and the U.S. healthcare segment is diminishing in relevance for GWO. In 2003, GWO generated 24% of earnings from the U.S. healthcare and is expected to generate 11% of earnings in 2006 from US healthcare. GWO is actively looking at continued expansion in the U.S. and transaction sizes may increase through 2007.

The Sun Life recommendation reflects the company’s attractive valuation, improving ROE, and expectations of some improvements in margins and earnings from MFS and U.S. annuities. Sales results should improve in U.S. life and group businesses over the next 12 months due to some new distribution arrangements announced in 2006.

Manulife is Market Perform rated. Manulife remains an exceptional franchise with the greatest long-term growth potential in our view given its Asian platform and competitive position in the U.S. Manulife should remain a core holding in any equity portfolio and we expect strong dividend growth. The shares have performed extremely well since the acquisition of John Hancock. The declining Canadian dollar and strong equity markets should help drive earnings over the next few quarters somewhat offset by continued low interest rates and a flat yield curve. The company did report unsustainably strong results from its U.S. spread-based businesses in 2006 and comparisons with 2006 results in 2007 may be challenging.

We recently lowered our recommendation on IAG to Market Perform from Outperform due to strong share price appreciation over the last 12-15 months. IAG indicated that it intends to raise its dividend payout ratio to the high 20s over the next 18 months, which translates into a 30% growth rate in the dividend over the next 18 months. This report has mainly focused on the big 3 insurers; however, investors should note that despite their incumbent position, IAG has consistently grown faster than the overall market. This trend continued in 2006. We continue to believe that the pricing umbrella provided by the big 3 in Canada offers some interesting growth prospects for IAG to grow, particularly in wealth management and group. While the shares are Market Perform rated, small to mid-cap managers should consider this a core position in their portfolios.