Source: The Canadian Press

Manulife Financial Corp. is ramping up efforts to cut its exposure to volatile equity markets, even though it will forgo profits when times are good, because it believes shareholders are more concerned about the risk of huge losses in a downturn.

Manulife (TSX:MFC) announced Wednesday it made “significant progress” on its strategy to hedge against equity and interest rate risks during the fourth quarter, when higher stock markets and interest rates made it cost-effective to accelerate the program.

“We’re not so worried about giving up upside. We’re more concerned about downside and that’s why it’s worthwhile putting those hedges in place,” said a Manulife spokesman, who asked not to be identified.

The company has come under fire from shareholders to turn around its finances since the recession pummelled stock markets, eroding the value of Manulife’s investments and resulting in losses of more than $3.3 billion in the last two quarters.

Those losses were primarily due to a combination of lower equity markets and historically low interest rates that resulted in big non-cash charges against the company’s reserve requirements.

Although Manulife acknowledged that its new hedging strategy and its decision to divest million of dollars of stocks means losing out on improving markets, the company’s primary focus is alleviating shareholder concern about downside risk.

“We’ve heard from both credit holders and equity holders that the downside was not palatable and these efforts are to reduce their concerns and reduce the risk profile significantly of the firm,” the spokesman said.

It now plans to have 60% of its earnings sensitivity to equity market movements hedged by the end of 2012 and about 75% by the end of 2014.

Barclays Capital analyst John Aiken said Manulife’s exposure to equity markets weighed on its stock valuation through most of 2010, but questioned the timing of the measures that could limit some of the potential benefits from rising equities and higher government yields.

Aiken estimated that Manulife’s new strategy to offset exposure risks means a 10% lift in equities would result in a $300 million drag on earnings and a similar loss through its interest rate hedging.

“We fear that some investors may not be pleased, as they had been looking for MFC to participate in the strengthening markets to a similar degree as how it had been dragged down,” Aiken wrote in a note.

“That said, MFC still remains very sensitive to changes in equities and interest rates but it is making significant progress and will eventually force investors to look at the prospects of its core operations.”

Among the measures taken between Oct. 31 and the end of 2010, Manulife shorted about $5 billion worth of equity futures contracts, beefed up its dynamic variable annuity hedging program by about $800 million and sold off $200 million worth of equities that had been used to back insurance liabilities.

Through its futures shorting investment, Manulife will make money if a specific reference index declines _ about $500 million for a 10% drop, the Manulife spokesman said.

The company has estimated that the $5 billion in hedging will cost Manulife about $300 million on an annualized basis.

Manulife is also dealing with the impact of persistently low interest rates by lengthening the duration of its fixed income investments in its liability segments by investing cash and by trading out of shorter bonds into longer bonds.

At the end of the third quarter it had pegged the effect of a 1% drop in rates at a $2.2 billion drop in net income. But it plans to reduce its exposure to interest rates by about 25% by the end of 2012 and by 50% by the end of 2014.

Shareholders will be able to glean some of the short-term impact of the hedging strategy on profitability when Manulife releases its fourth-quarter results in mid-February.

Ohad Lederer, an analyst at Veritas Investment Research, said he believes the company will return to profitability in the fourth quarter, despite the cost of some of the hedging moves.

He added that Manulife is still very sensitive to equity markets and interest rates after it spent years adding many different policies and products that exposed them to market variables more than some of their insurance peers.

“That worked fine in those years on the way up, it worked horribly on the way down and through the gut wrenching volatility of the crisis,” he said.

“Of course, (the hedging strategy) is going to protect them in the downturn, it’s going to mitigate how much profit they would make on the upside.”

Manulife shares were up 3% or 51 cents to close at $17.78 Wednesday on the Toronto Stock Exchange.

The company operates around the world providing insurance and wealth management services as well as pension products, annuities, mutual funds and property and casualty reinsurance.

In the United States, Manulife operates through John Hancock Financial Services, Inc., a major American life insurance company headquartered in Boston the Canadian company bought in 2004.