20 July 2009

Preview of Insurance Cos Q2 2009 Earnings

Scotia Capital, 20 July 2009

Canadian Lifecos – A Noisy Quarter Expected – Focus Remains on Credit – Capital Positions Very Strong

• Lots of moving parts this quarter. A sharp increase in equity markets quarter over quarter (QOQ) combined with continued uncertainty in credit conditions could lead to a noisy Q2/09 for the lifecos. Manulife has suggested that all of the gains from the rebound in equity markets, gains that arise predominantly from the mark-to-marketing mechanics of segregated fund/variable annuity reserving, may not all fall to the bottom line; variable annuity reserves need to be boosted for lower corporate bond rates and increasing persistency, and long-term care reserves need to be boosted for lower interest rates and a few swaps that went offside. While we don’t know what others will do, there could very well be similar reserve adjustments, although not to the same extent as the $1.00 in EPS we expect in the case of MFC. We’re also expecting some “guidance” if any as to what “underlying” EPS is for the quarter. We put underlying EPS in Q1/09 at $0.52 for GWO, $0.57 for IAG, $0.52 for MFC, and $0.72 for SLF. Exhibit 1 outlines the development of our Q2/09 estimates.

• We’ve modestly cut our 2009 and 2010 estimates – largely due to currency. For 2010 we took $0.09 in EPS off each of GWO and SLF and $0.17 off MFC, as we revised our FX assumptions to address what looks to be an increasing Canadian dollar versus foreign currencies. Scotia Economics now forecasts the Canadian dollar will average US$0.86 in 2009 and US$0.96 in 2010, £0.55 in 2009 and £0.56 in 2010, and ¥84 in 2009 and ¥87 in 2009. MFC is the most sensitive to changes in currencies. These revised forecasts also led to a $0.04 EPS reduction in 2H/09 for GWO, a $0.07 reduction for MFC, and a $0.06 reduction for SLF.

• A more measured view on long-term interest rates results in a reduction in EPS for IAG (by far the most sensitive), with little impact on others, apart from MFC interest rate reserve strengthening in Q2/09. After increasing steadily since the start of the year, new money rates have fallen since mid-June, with a 25 bp decline in long-term provincial bond yields (a good proxy, especially Quebec bonds, for IAG’s initial reinvestment rate for reserving or IRR), and a 40 bp decline in Moody’s AA corporate bond yields. For IAG, each 10 bp decline in the IRR results in a $0.30 EPS hit. We’ve decreased our 2009 and 2010 EPS estimates by $0.21 and $0.30, respectively, to reflect a more measured view of long-term interest rates. As MFC has suggested, a drop in corporate interest rates used to discount seg fund/VA liabilities, largely in the U.S., will result in a reserve hit in Q2/09. We suspect that given the recent volatility we’ve seen in these rates, MFC will significantly pad its assumption, and look for a total EPS hit in Q2/09 for interest rates that could be as high as $0.50. While we don’t forecast any reserve hits for interest rates for SLF, there certainly is a chance, and each 10 bp drop in new money rates across the yield curve results in a $0.05 EPS hit for SLF. GWO is the least affected by swings in interest rates, with a 10 bp decline hurting EPS by only $0.01.

• We suspect the lifecos will continue to increase reserves for asset default throughout 2009 as credit conditions remain uncertain. We forecast increases in assumption for credit default, largely given rating agency downgrades, as well as increases in reserves for lapse assumptions (we suspect policyholders will hold onto “lapse-supported policies” longer than expected, to the detriment of lifeco earnings) will translate into EPS hits in the second half of 2009. We estimate these “hits” will be just $0.03 for GWO and $0.01 for IAG, given their limited exposure to both U.S. commercial real estate (CRE) and U.S. commercial mortgages, as well as their modest segregated fund exposure. With relatively higher exposure to U.S. CRE and U.S. commercial mortgages, we expect these hits for MFC and SLF to be slightly higher (although exposures are still significantly below those of the U.S. lifecos) and expect these EPS hits in the second half of 2009 to be $0.17 for MFC and $0.15 for SLF. We must admit that we have a degree of cautiousness around SLF’s estimate, given its less-than-stellar history in terms of credit hits.

• Sun Life most likely to suffer as credit continues to weigh. SLF’s track record in this regard speaks for itself, with a total of $1.64 EPS in credit hits in the past three quarters (excluding LEH/Wamu and AIG) versus $0.21 for GWO, $0.22 for IAG, and $0.43 for MFC. As well, gross unrealized losses on fixed income securities trading below 80% of acquisition cost for more than six months represent 4.9% of fixed income assets for SLF, 5.7% for GWO, 1.5% for MFC, and 1.3% for IAG.

• We see healthy Q2/09 capital ratios. We peg MCCSR ratios at 213% for GWO, 230% for IAG, 255% for MFC, and 230% for SLF, all well above regulatory minimums (120%), regulatory watch-list levels (150%), and comfortably above target ranges (175% or 180% to 200%), although we do expect target ranges to be reset to levels above 200%. IAG can withstand a 32% drop in equity markets from current levels (i.e., S&P/TSX of 7,100) before its MCCSR ratio hits 175%, and a 45% drop (i.e., S&P/TSX of 5,450) before it hits 150% levels. We estimate MFC (on a “do nothing” basis, and without utilizing the $1.0 billion currently sitting at the holdco) can withstand a 30% drop in equity markets from current levels (i.e., to an S&P 500 level of 640) before its ratio hits 185%, and a 40% drop in equity markets (i.e., to an S&P 500 level of 525) before it hits regulatory watch-list 150% levels.

Great-West Lifeco Inc.

1-Sector Outperform – $27 one-year target, based on 1.9x 6/30/10E BVPS and 11.0x 2010E EPS

• We’re looking for EPS of $0.49 for Q2/09, $0.01 above consensus.

• Credit hits could be around $0.07 EPS, some related to U.K. hybrids and some related to other general provisions.

• Cautious on Putnam. We look for net sales of around negative $2 billion. Margins are expected to remain very weak as they have in the past.

Industrial-Alliance Insurance and Financial Services Inc.

2-Sector Perform – $31 one-year target, based on 1.4x 6/30/10E BVPS and 9.5x 2010E EPS

• We’re looking for EPS of $0.62 in Q2/09, $0.02 below consensus.

• "Canada only" likely leads to very modest credit hits - we expect just $0.02 in EPS.

• Keeping a cautious eye on long-term corporate interest rates – particularly Quebec long-term provincials where yields have declined 30 bp in the last seven weeks – IAG is by far the most sensitive.

• Sales will likely remain weak.

Manulife Financial Corporation

1-Sector Outperform – $30 one-year target, based on 1.7x 6/30/10E BVPS and 11.0x 2010E EPS

• We are looking for EPS of $0.45 for Q2/09, $0.25 below consensus.

• A lot of moving parts. We are expecting a noisy quarter, with $1.38 EPS due to the QOQ appreciation in the market (17% weighted average for MFC) offset by $1.22 EPS in reserve hits.

• Focus will be on “core” or underlying EPS. We look for some assistance from management in this regard. We believe core EPS could be in the $0.53 range.

• Update on capital plan - dividend cut unlikely, but remains an option (albeit at the bottom of the pecking order).

• MCCSR we expect to be 255%, well above its 180%-200% target

Sun Life Financial Inc.

2-Sector Perform – $33 one-year target, based on 1.3x 6/30/10E BVPS and 10.0x 2010E EPS

• We are looking for EPS of $0.95, $0.09 above consensus.

• Significant gains from rebound in equity markets should add an additional $0.55-$0.60 to EPS.

• Company track record makes us a little nervous with respect to credit - expect $0.32 in credits, significantly lower than prior run rate.
Bloomberg, Sean B. Pasternak and Doug Alexander, 21 July 2009

Canadian banks, facing the biggest profit decline in seven years, are expanding their insurance businesses, using the Internet and stand-alone outlets to get around restrictions dating from at least 1923 on insurance sales in bank branches.

Royal Bank of Canada, Bank of Montreal and other lenders are increasing sales online and making acquisitions to skirt the rules and take a bigger slice of the country’s C$115 billion ($104 billion) insurance market.

“Banks are definitely trying to prod areas where there’s not a strict distinction between what a bricks-and-mortar branch is,” said John Aiken, an analyst at Dundee Securities Corp. in Toronto.

With insurance revenue rising by 53 percent last quarter at Royal Bank alone, the business is helping counter the biggest profit decline since 2002 for Canadian lenders. Profit before one-time items at Canada’s six main banks will fall an average of 9.5 percent for the year that ends Oct. 31 on higher loan losses, according to Aiken.

Royal Bank, the country’s largest lender, opened 43 insurance offices adjacent to their bank branches over the last four years to bypass the restrictions, and plans to open more. Bank of Montreal, the No. 4 bank, bought the Canadian life insurance arm of American International Group Inc. in April for C$329.5 million. The purchase may increase the bank’s earnings within a year.

Bank of Nova Scotia, Toronto-Dominion Bank, Canadian Imperial Bank of Commerce and Canadian Western Bank have followed suit, getting around government restrictions by offering life, health and property insurance on their Web sites.

Canada is “the only civilized country in the world that doesn’t allow our banks to sell insurance” through branches, said Larry Pollock, chief executive officer of Canadian Western Bank in Edmonton, Alberta.

The banks’ expansion into insurance is leading to a showdown with the country’s insurance brokers, who say the lenders are violating rules set up by the federal government in 1991. The guidelines state that banks can only promote insurance “outside of a branch.” They previously had been restricted from selling most types of insurance since at least 1923, according to the Department of Finance.

The banks’ insurance outlets should be “separate and distinct” from their branches, and not next door, says Dan Danyluk, CEO of the Insurance Brokers Association of Canada, which represents 33,000 brokers. Bank clients may feel “tied” to an institution that can package insurance together with mortgages and other bank products, he said.

“It’s not about the competitive disadvantage to insurance brokers,” Danyluk said. “The fundamental principle is that consumers are in a very vulnerable position when they’re seeking credit. If banks control that money, consumers aren’t in a strong position.”

Danyluk said that adjacent branches, along with Internet advertising and insurance pamphlets on display in branches, violate the spirit of the Bank Act.

Canada’s financial services regulator gave the banks a boost last month when it clarified that a bank Web site “is not a bank branch.”

“This was exactly what we were waiting for,” said Pollock, 62, who added that Canada’s eighth-biggest bank plans to ramp up its online insurance promotions.

Manulife Financial Corp., the country’s largest insurer, has lost little share to the country’s banks, said Paul Rooney, senior executive vice president for Canada.

Manulife supports the ban on insurance sales in branches because it ensures that clients have more options than just the bank’s own insurance products. The Toronto-based insurer uses a network of 10,000 brokers to sell its policies.

“If you have in-branch selling of insurance, I think it would be difficult for you to see a TD product being sold in a Bank of Montreal branch,” Rooney said in a telephone interview. Independent brokers “are so critically important in ensuring that the consumer gets the right product from the right company at the right price.”

Even with the ban, insurance sales at the banks are growing.

Insurance accounted for 19 percent of Royal Bank’s revenue in the first half of 2009, up from 15 percent a year ago. Premiums and deposits increased 38 percent in the second quarter to C$1.24 billion, helped by higher revenue from annuities and other products.

Royal Bank “cannot provide the value that we believe we bring to the marketplace in the current Bank Act until we do it on the Internet, over the phone and somewhere near the branch,” said Neil Skelding, the bank’s head of insurance.

Bank of Montreal says its purchase of the AIG unit, announced in January, makes it the largest bank-owned seller of life insurance in the country behind Royal Bank, based on direct premiums written. The Toronto-based bank plans to sell insurance through its existing network of brokers and the Internet.

Bank of Montreal had C$222 million in insurance income in fiscal 2008, a 37 percent increase since 2005. The figure excludes the AIG acquisition.

“This is really about accelerating our strategy,” Gordon Henderson, senior vice president of insurance, said in a telephone interview. “We have viewed insurance as a strategic priority for the enterprise for a number of years.”