Despite persistent downside risks, the outlook for the Canadian life insurers is stable, Moody’s Investors Service says in a new report on the sector.

The rating agency says that the downside risks posed by the euro area banking crisis, and the persistence of low interest rates, remain significant. “The likelihood of a downside scenario consisting of a protracted period of low interest rates triggered by the euro area debt crisis or macro-economic deterioration is growing,” says David Beattie, a Moody’s vice president and senior analyst.

Moreover, Moody’s baseline economic scenario for Canada calls for a sluggish and uneven recovery. And, despite hedging efforts and moves to de-risk, the firm notes that the insurers capital positions and earnings are still sensitive to volatile equity markets. “The Canadian insurers have some residual exposure to legacy books of underpriced or difficult-to-hedge segregated funds, and to universal life policies that will continue to be sensitive to the markets,” adds Beattie.

However, notwithstanding these issues, Moody’s expects earnings to improve for Canadian life insurers. “The expectations of a modest improvement in economic fundamentals, a stable industry structure, and favourable demographics all support the stable outlook,” Beattie says. “We foresee a return to more predictable earnings growth because of improving economic trends and because the dominant life insurers benefit from the advantages of pricing power, economies of scale, and scope.”

Moody’s says that the investment portfolios of the Canadian insurers are generally high-quality, with mostly investment-grade bonds, and they are also diversified by industry and geography. It also notes that they have fared better than their U.S. peers, despite concentrations in asset-backed securities and European banks and sovereigns.

In terms of interest rates, Moody’s expects rates in North America to start rising gradually later this year, which it says will “provide some relief from spread compression and the earnings pressure from spread-based businesses over time.”