Reversal of fortunes for two lifecos?

Meanwhile, analysts with RBC Capital Markets, a division of RBC Dominion Securities Inc. in Toronto, say IA is in the best position to increase its dividend, although they don’t think this is likely until the second half of 2012.

Canadian accounting rules require that product liabilities be recalculated at least once a year; this is unlike the U.S. rules, under which they are calculated when the product is sold and never changed unless the company is running a cash-flow deficit. Liabilities for up to 20 years in the future are calculated based on current interest rates; liabilities further out are based on a moving average of rates.

Further depressing Canadian lifecos’ earnings is the impact of the current volatile equities markets on their assets backing equities-indexed insurance products, as the change in the fair market value of these securities is included in the lifecos’ income statements.

And with interest rates continuing to stay low, analysts have been dropping their earnings estimates and their share-price targets for these lifecos. In the case of GWL, Cornwell has a “buy” on the stock; but Michael Goldberg, an analyst with Desjardins Securities Inc. in Toronto, and analysts with RBC and TD Securities Inc., also based in Toronto, have “hold” ratings on GWL stock.

The analysts at all these firms rate IA’s stock a “hold.”

Nevertheless, these lifecos are solid, medium- or longer-term investments. Because they pay good dividends, there’s no reason for your clients not to continue holding their shares. Even purchasing them now might not be a bad move. And once interest rates start rising, lifecos will look very good as their earnings bounce back in response to lower future product liabilities; in turn, their share prices are likely to rise quickly.

A closer look at GWL and IA:

> Great-West Lifeco Inc. “We maintain our position that GWL represents a solid, low-risk, global growth opportunity with a strategy focused on the wealth-management sector,” says Cornwell in explaining his “buy” recommendation for GWL’s stock. He expects the stock to trade at a 5% premium over its peers because of “its stronger credit position, steady earnings performance, higher yield and higher return on equity.”

GWL’s steadier earnings come from the fact that it’s less sensitive to interest rates and equities markets than the other two big lifecos, Manulife Financial Corp. and Sun Life Financial Inc., both of which are based in Toronto. However, there is a gorilla in the room — in the form of GWL’s exposure to Europe, which is greater than that of the other Canadian lifecos except for Sun Life.

For the RBC analysts, this seems to be a saw-off. They expect GWL’s stock to continue to trade at a premium; but while they think Europe is a “manageable risk” for GWL, they also think the firm’s exposure to the continent’s troubles “is likely to be a focus for investors and is likely to keep the stock subdued while macro concerns about Europe remain high.”

The exposure to Europe can be viewed in a number of ways. Cornwell notes that eurozone sovereign bonds comprise just 1.7% of GWL’s invested assets. But the TD analysts point out that GWL’s total exposure to Europe is about 38% of the firm’s total invested assets: although most of GWL’s investments in this region are mostly in Britain, given that nation’s proximity to continental Europe, this is noteworthy because of the possibility of contagion if things spin out of control in the eurozone.

The TD analysts also are concerned about the challenges with Boston-based Putnam Investments LLC, a GWL subsidiary. Putnam was dogged by mutual fund scandals in 2003-06 and has continued to struggle since GWL bought it in 2007. Putnam finally posted net fund sales in each of the first two quarters of 2011 but was back in net redemptions in the third quarter.

In contrast, the U.S. wealth-management arms of Manulife and Sun Life remain in net sales positions. Boston-based MFS Investment Management, Sun Life’s subsidiary, also was caught up in the 2003 mutual fund scandals but has been clean since.

Although Cornwell is the only analyst with a “buy” rating on GWL’s stock, his 12-month price target is at the low end, at $24 — the same as the TD analysts’ target and below both Goldberg’s $25 and the RBC analysts’ $26. GWL’s 962 million outstanding shares closed at $19.91 on Dec. 2, 2011.

Net income was $1.5 billion on revenue of $21.9 billion in the nine months ended Sept. 30, 2011, vs $1.2 billion on revenue of $24.9 billion in the corresponding period a year earlier.

> Industrial Alliance Insurance And Financial Services Inc. Much like GWL, IA had been producing steadier earnings than Manulife and Sun Life.

However, IA’s third-quarter results suggest higher sensitivity than most analysts had expected — and Cornwell, for one, thinks this may continue. TD’s analysts still believe in the company’s ability to smooth its earnings in a low interest rate environment, but warn that a prolonged period of low interest rates could deplete the firm’s “excess cushions” that are used to do this.

The TD analysts like IA management’s focus on growing its retail wealth-management and creditor insurance segments, which is aimed at diversifying revenue and lowering interest rate sensitivities. However, the analysts point out, it will take years for that strategy to bear fruit.

IA’s stock currently trades at about nine times 2012 earnings a share, the highest among Canadian lifecos after GWL. The RBC analysts think this premium is deserved for four reasons:

1. The possibility of a dividend increase in the next year.

2. The expectations that upcoming changes to capital requirements for insurance companies will have less impact on IA than on its peers.

3. Expectations of a more stable ROE than for Manulife and Sun Life.

4. A high Canadian dollar is positive for the company while dampening the earnings of the other lifecos, all of which have big U.S. operations.

Goldberg has a 12-month target price for the stock of $37.50; analysts at RBC and TD are at $35; and Cornwell’s target is $34. IA’s 90 million outstanding shares closed at $25.87 on Dec. 2, 2011.

Net income was $204 million on revenue of $5.7 billion for the nine months ended Sept. 30, 2011, vs net income of $198 million on revenue of $5.3 billion in the corresponding period a year earlier. IE