Confusion surrounds some solid lifecos

There are significant differences in using these diverging sets of rules — and there are pluses and minuses to each approach. The major difference between the two systems is the way product liabilities — the return on assets needed to pay benefits over the life of the products the insurers have underwritten — are handled.

In Canada, these are recalculated every quarter or year, depending on the company, based on current interest rates for the return on reinvestment of cash flows up to 20 years out (known as the initial reinvestment return, or IRR) and on a moving average of rates for returns on longer-term cash flows (known as the ultimate reinvestment return, or URR). In contrast, in the U.S., product liabilities are calculated when products are sold, based on interest rates at the time, and are never changed unless a company is running a cash-flow deficit.

You could argue that the U.S. rules can underestimate risk. For instance, if interest rates stay low, as they have in Japan for the past 20 years, many U.S. lifecos could find themselves in deep trouble, while their Canadian counterparts will be fully prepared.

But you also could argue that the Canadian rules paint an unnecessarily bleak picture because the assumption is that interest rates will stay at current levels. If they move up in the next few years, as is expected, then the lifecos will find themselves with greater returns than they currently are forced to plan for — resulting in strong earnings gains as liabilities are recalculated downward. But that’s of no help now.

Michael Goldberg, a financial services analyst with Desjardins Securities Inc. in Toronto, has “buy” ratings on most Canadian lifecos, as do many analysts. But, Goldberg warns, “You shouldn’t invest in lifecos without taking a view on [interest] rates. If you think rates have bottomed, then it’s a good time to buy lifecos. If you think rates will stay low, the banks are a better bet” — unless you are investing for the medium or longer term and are prepared for little appreciation in share prices in the next few years. (Goldberg does not expect share prices to move upward significantly before 2013.)

The impact of interest rates on lifecos is felt through both the IRR and the URR. As mentioned above, the IRR is based on current interest rates continuing up to 20 years out. The benchmark used by lifecos varies depending on the composition of their fixed-income portfolios, but they all move pretty much in tandem; when portfolio value falls, the increase in the lifeco’s liabilities reflects the full drop.

The URR is used to calculate the reinvestment of cash flows for 20 years or more — and many insurance products run for 30 years, 40 years or even longer, depending, for example, at what age the policyholder is when purchasing a universal life insurance policy or an annuity.

The Canadian Institute of Actuaries has set a maximum URR based on 90% of five- and 10-year moving average yield for the benchmark long bonds, and assumes that interest rates will stay at current levels. The benchmark’s yield was at 2.83% as of Sept. 30, more than one percentage point below the 3.9% maximum URR allowed for 2011. If low interest rates persist, Goldberg estimates that the maximum will be down to 3.5% by Sept. 30, 2013.

The other thing to keep in mind is that with the change to international financial reporting standards as of fiscal years starting in 2011, changes in the value of financial assets on a company’s balance sheet have to reflect current prices — and any change from three months earlier has to be reflected on the income statement. With stock markets so volatile, this can mean substantial gains or losses from quarter to quarter.

Lifecos typically assume 7%-8% annual capital appreciation in their equities portfolios, says Goldberg. When stock markets underperform deeply, as they did in the quarter ended Sept. 30, life-cos have to reflect this situation on their income statements, resulting in a direct hit on earnings.

Here’s a closer look at both Manulife and Toronto-based Sun Life Financial Inc.:

> Manulife Financial Corp.

Goldberg; Robin Cornwell, president of Catalyst Equity Research Inc.; and analysts with TD Securities Inc. and RBC Capital Markets, a division of RBC Dominion Securities Inc., (all firms are based in Toronto) have “buy” or “outperform” ratings on Manulife’s shares. However, all these analysts, except for TD’s, also have lowered their 12-month target price to $15-$18 as a result of Manulife’s Q3 2011 results.

Manulife’s 1.8 billion outstanding shares closed at $11.33 on Nov. 18.

Manulife has a target of $4 billion in net income in 2015, which will be challenging if low interest rates persist because Manulife, among Canadian lifecos, is the most exposed to movements in interest rates and equities. However, this also means the bounce-back in Manulife’s earnings should be among the greatest in the sector when rates start to rise.

Manulife is working on reducing its sensitivity to interest rates and stock markets. Through instruments such as interest rate swaps, it has halved the net impact on earnings of a drop in long interest rates of 10 basis points to $300 million as of Q3 2011 from $600 million in the second quarter. However, the company has had less success on the equities side, with its net exposure to declines in stock prices increasing significantly from Q2.

Manulife has warned that an impairment to goodwill of $650 million is likely in the fourth quarter ending Dec. 31, which would depress book value and, as TD’s analysts have put it, “lead to another unwanted messy quarter.”

Net income was $300 million on revenue of 41.3 billion for the nine months ended Sept. 30 vs a loss of $3.4 million on revenue of $34.2 billion for the corresponding period the year prior.

> Sun Life Financial Inc.

Corn-well, Goldberg and the TD analysts have “buy” ratings on Sun Life’s stock, with target prices ranging from $28-$30. However, Goldberg has “low conviction” on his “buy” rating because Sun Life doesn’t provide much detail about its interest rate and equities market sensitivities. RBC’s analysts have a “hold” rating on the stock and a target price of $24.

Sun Life’s 583 million outstanding shares closed at $20.06 on Nov. 18.

TD’s analysts feel the stock has been oversold and that Sun Life is better positioned than Manulife to weather a “prolonged low interest rate environment.” However, RBC’s analysts are concerned about “heightened earnings and capital volatility.” Goldberg says Sun Life is the most likely of the Canadian lifecos to take charges related to the European credit crisis, although he’s not expecting this.

Net income was $312 million on revenue of $7 billion for the nine months ended Sept. 30 vs $902 million on revenue of $10.3 billion for the corresponding period a year earlier.  IE

Investment Executive will examine Winnipeg-based Great-West Lifeco Inc. and Quebec City-based Industrial Alliance Insurance and Financial Services Inc. in the January 2012 issue.