DBRS Ltd. has downgraded its ratings on Manulife Financial Corp. (TSX:MFC) after the firm delivered weak quarterly results last week, and faces reduced financial flexibility.

The rating agency said Tuesday that it has reduced its long-term debt and preferred share ratings on Manulife and its affiliates, including the issuer rating of its major operating subsidiary, The Manufacturers Life Insurance Co. to AA (low) from AA. It also downgraded the non-guaranteed long-term rating of Manulife Bank of Canada to A (high) from AA (low) and the guaranteed long-term rating to AA (low) from AA.

“With earnings volatility expected to continue at elevated levels, notwithstanding the best efforts of management to contain market exposures, DBRS recognizes that the company’s heightened risk profile and the associated adverse impact on regulatory capital and financial flexibility can no longer support the pre-existing ratings and have resulted in the negative rating action,” DBRS explains.

DBRS says Manulife’s exposure to equity markets is contributing to the earnings volatility. Much of that exposure is related to guarantees provided on variable annuity and segregated fund products that were sold aggressively in the years leading to the peak of the market in 2008.

“While the company has introduced a dynamic hedging program to opportunistically lower these equity market exposures, following years in which such hedges were not deemed economically efficient nor necessary, close to 50% of the company’s exposure remains unhedged and will be a source of continuing earnings risk as the corresponding positions are hedged,” DBRS says.

Additionally, DBRS says that the $1.5 billion adverse impact of lower long-term interest rates on reserves in the second quarter highlighted Manulife’s “exposure to long-tailed fixed-rate policy liabilities through its large long-term care and secondary guaranties associated with Universal Life product liabilities in the U.S. market.”

It notes that the company has indicated that during the third quarter, it is expecting to complete its annual actuarial review of the morbidity assumptions embedded in the reserves held against its LTC liabilities, and that it expects to incur a charge of between $700 million and $800 million related to this change in assumptions.

DBRS also believes that the company may have to raise additional capital. “While the company has taken necessary steps to build up its regulatory capital to deal with the risk of earnings volatility as it attempts to lower its exposures through product redesign, re-pricing and active hedging strategies, the degree of the drop in the minimum continuing capital and surplus requirements — from 250% at the end of March 2010 to 221% at the end of June 2010 — suggests that another negative quarter will force the company to raise additional capital,” it says.

In the meantime, DBRS says that the company’s financial flexibility “has become increasingly constrained, as the most readily available sources of capital have already been tapped”; and two major common equity issues, a dividend cut, a corporate re-organization, and debt and preferred share financings, have increased its financial leverage ratios to the point where DBRS was “no longer comfortable” with the company’s ratings.

IE