The iconic Toronto headquarters of the former Canada Life insurance companyDaniel Ehrenworth
This article is part of Report on Business Magazine's annual top 1000 rankings. See the full website here.
Life insurance used to be the quintessential safe and boring business in Canada. No more. "It's a terrible industry to be invested in right now," says Peter Routledge, financial services analyst at National Bank Financial in Toronto.
During the 2008-09 financial crisis, share prices of the Big Three that dominate the market—Great-West Lifeco Inc., Manulife Financial Corp. and Sun Life Financial Inc.— plunged by more than half, and the strain on their capital reserves alarmed regulators in Ottawa. Now, more than three years later, Manulife and Sun Life shares are still mired near their post-crash lows, and those of Great-West, the healthiest of the three, aren't doing much better. CEOs and regulators have made sweeping efforts to correct pre-crisis excesses and inject more old-style conservatism into the business. But an economic morass consisting of historically low interest rates, North America's aging population and tougher new accounting rules is wreaking havoc with insurers' results and making it almost impossible for them to earn a decent profit on their traditional basic products.
Indeed, volatility is the new norm in their reported earnings. Dramatic evidence can be found in our annual Top 1000 ranking. Last year, Manulife dove from No. 18 to No. 997 because it posted a $391-million loss in 2010, compared with a $1.4-billion profit the previous year. The company is still shaking off the hangover from its blistering expansion under Dominic D'Alessandro, who was CEO from 1994 to 2009. This year, Manulife has climbed back up to No. 140, based on its modest profit of $129 million; in the first quarter of 2012, however, it posted a $1.2 billion profit. One of the biggest losers is Sun Life, which plunged from No. 16 to No. 985 thanks to a $200-million loss in 2011. Yet it turned around and earned a $686-million profit in the first quarter of 2012.
Great-West, at No. 15 in this year's ranking with a $2.1-billion profit in 2011, has been the only consistent performer. "Did you hear my numbers?" CEO Allen Loney asks me twice during an interview. "$7.4 billion in earnings over the last four years." Great-West certainly deserves kudos. Yet Loney acknowledges that the prospects for the industry as a whole are weighing down his company's share price, too. Thanks to the transition in reporting rules, "You're going to find that reported income wanders all over the place," he says. "It's going to confuse investors."
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Low interest rates are life insurers' biggest headache. Both of their traditional basic products—life insurance and annuities—have long time horizons. A life insurance policy pays out a lump sum when you die. In the meantime, you may pay premiums for 20 or 30 years. An annuity pays out a regular stream of income as long as you live, usually starting when you retire. Back in the 1960s, when long-term rates were near more historic norms of, say, 5% or 6%, all this was a straightforward business: Sell a policy or annuity, then use payments from customers to buy and hold long-term government bonds and high-grade corporate ones to cover the obligations.
But long-term Canadian and U.S. government bond yields have sunk to below 3% since the financial crisis. Life insurers are still required to use those yields as a benchmark to calculate what they need to set aside to pay benefits far into the future. To take a very simplified example, say a company knows it will have to pay out $100,000 on a policy 20 years from now. If interest rates are 6%, it only needs to have $31,180 set aside today. If rates are at 3%, however, it needs to have $55,368 set aside. Worse, the current low rates are a problem for old policies as well as new ones. "Every year gets worse, because they get a new batch of premiums from their in-force policies and they have to reinvest those premiums," says National Bank's Routledge. "And today they're reinvesting them in assets that don't yield very much."
On top of all that, there is this little actuarial problem: North Americans are living too long. That's not bad for straight life insurance, but it has added dramatically to the cost of annuities, extended health benefits and other payments that insurers provide to still-breathing customers. "Let's say you have 10 old high-school buddies who retire at age 65. Chances are that the first will die at age 70 and the last at 100," says Sun Life CEO Dean Connor. "But if everybody has to save for 35 years of retirement, that's too much."
Regulators have turned up the heat. The 2008 crisis was triggered largely by the collapse of the world's biggest life insurer, American International Group, Inc. Both that debacle and the meltdown in the Japanese industry in the 1990s exposed the fundamental vulnerability of life insurers to big market swings: If stock markets and real estate markets plunge, the value of assets on insurers' balance sheets eventually does too. But their long-term liabilities remain. If interest rates and bond yields sink to nearly zero, as they did in Japan, insurers' net income gradually evaporates.
Canada's top regulator, the Office of the Superintendent of Financial Institutions (OSFI), is headed by Julie Dickson. One key measure that OSFI looks at to ensure that life insurers can meet their commitments to policyholders is the MCCSR ratio (minimum continuing capital and surplus requirements), which compares a company's available capital to the capital required by regulators. The bare minimum MCCSR is 120%, but OSFI doesn't like to see it dip below 200%. As markets collapsed in 2008, Manulife's ratio sank below that threshold, setting off alarm bells in Ottawa.
That put Manulife's D'Alessandro on the hottest seat in Canadian business. He was due to retire the following May, after 15 years in which he transformed the company into a financial services supermarket to rival the Big Six banks in Canada, not to mention earning it a ranking as the fifth-largest life insurer in the world. The key step in that feat was buying Boston-based John Hancock for $15 billion in 2004. As stock markets plunged in October, 2008, however, D'Alessandro at first tried to convince Dickson that Manulife couldn't be making huge adjustments to capital based on wild daily stock market swings. When that argument didn't give him the latitude he sought, he went through the embarrassment of hitting up the Big Six banks for an emergency loan of $3 billion.
That was only a temporary fix. In December, Manulife hurriedly issued $2.3 billion worth of new common shares, severely diluting existing shareholders' stakes. The following August, three months after D'Alessandro stepped down, his successor, Donald Guloien, outraged shareholders by slashing the company's dividend by half, and then issuing another $2.5 billion worth of shares in November.
Since the crisis, OSFI has been putting insurers through stress tests—computer simulations of effects should there be other severe moves in the markets. There's been some grumbling. Last year, companies were asked to test a 100-basis-point decline in interest rates. "People thought that was implausible, and not a good use of time," says Dickson. But by the time the companies submitted their results, rates had sunk by more than 100 basis points. "Outlier scenarios do happen, and you have to think about what the impact on your company is going to be," she says.
Yet the Big Three also seem to be trying to outdo each other at demonstrating how safe and prudent they are. Each now provides a blizzard of disclosure to shareholders on how they're protecting themselves from downside risks.
Judging from Manulife's and Sun Life's share prices, many investors remain unimpressed, if not bewildered. And new accounting rules aren't helping to clarify things. Since the 2008 crisis, the London-based International Accounting Standards Board has been leading a push to get its International Financial Reporting Standards (IFRS) adopted worldwide. IFRS took effect in Canada in 2011. The rules are close to Canada's old generally accepted accounting principles (GAAP). The problem is the gulf between Canadian rules and American ones.
IFRS requires insurers to account for changes in interest rates and the market value of their investments more quickly than they would under U.S. GAAP. Manulife has large U.S. operations, and it reports separate results under the two regimes. For the third quarter of 2011, the differences were absurd: Under U.S. GAAP, Manulife earned a $2.2-billion profit; under IFRS, it lost $1.3 billion. In a conference call with analysts, Guloien was clearly frustrated. In response to a question, he noted that some competing U.S. companies were increasing dividends and buying back stock to boost shareholder value, but IFRS still required him to bolster his capital. "It is what it is. We don't have roller skates," he said.
Dickson is unapologetic. IFRS, after all, adopted the Canadian approach. "I think investors looking at all companies except U.S. companies are getting a more consistent picture, and one that is more accurate," she says. There could be a silver lining, too: Canadian insurers might get a quicker earnings pop if interest rates and equity markets recover.
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Many of the problems within individual companies are their own, particularly for Manulife and Sun Life. They expanded rapidly in the United States in the 1990s and early 2000s. In addition to writing lots of traditional life insurance policies, the firms pushed newer products such as variable-rate annuities, which in some cases tied payouts to market returns but also promised buyers a minimum guaranteed income. The guarantees are now a burden. Last December, when Connor succeeded Donald Stewart as Sun Life CEO, he announced that the company would no longer sell individual policies and variable-rate annuities in the U.S.
In Canada, one product that has given Manulife a lot of grief is segregated funds. They are an investment similar to mutual funds, but are only offered by life insurers. They typically guarantee investors 75% or 100% of their money back at maturity, or in the event of death. Many "seg" funds also have a reset option allowing investors to lock in gains if markets go up. During the rising but often volatile stock markets of the 1990s and early 2000s, those promises were very attractive to risk-averse investors. From the insurers' point of view, the guarantees didn't look like much of a burden—in those days, it was hard to find a Canadian equity fund that had lost money over 10 years.
In the early 2000s, D'Alessandro convinced Manulife's board and executives that it was no longer necessary to take out costly hedges to backstop the guarantees in its variable-rate annuities and segregated funds. Then stock markets around the world crashed by 50% in 2008-09, and Manulife's capital levels sank. As of today, Manulife and Sun Life are still setting aside large amounts to bolster their reserves, and often taking quarterly hits of several hundred million dollars to account for revised actuarial assumptions.
So is there any upside for life insurers? Are their shares now a bargain? And even if the sector is a minefield, how is it that Great-West still posts such steady earnings?
First, don't be tempted by fat-looking dividend yields on the life insurers' shares. Their stock prices have been beaten up so badly that, as of early June, even Manulife's halved annual dividend was about 4.9% relative to its recent share price of less than $11 (down from a pre-crash peak of $44 in late 2007). "You take a lot of risk for that dividend yield," says National Bank Financial's Routledge. The only thing that would give the entire sector a dramatic lift is a sudden gust of inflation and higher interest rates.
That said, the Big Three still have some formidable competitive strengths. One is sheer size: The three are among the 15 largest life insurers in the world. Since each has about $500 billion in total assets under management, they're also huge asset managers, big enough to compete in that arena with the five biggest banks. Life insurers are also a major Canadian export success—about half of their premium revenues now come from abroad.
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Of the old four pillars of Canada's financial system—banks, trust companies, investment dealers and insurers—the insurers are the only ones besides the banks that survived financial services deregulation in the 1980s. The banks gobbled up the major investment dealers and trust companies. But Ottawa kept several major barriers between banks and life insurers, such as rules that prevent banks from selling most forms of insurance from their branches, and likewise annuities that pay out an income until death.
Starting in 1999, insurers were also allowed to demutualize—to switch from ownership by policyholders to ownership by shareholders. That gave them access to equity markets, and the Big Three bulked up and swallowed rivals. As a result, they are similar in size, but their operations differ. Great-West has been the biggest success recently because, in many ways, it was the stodgiest—the least willing to try new products and brash investment strategies. "We've been a very disciplined company for a long time," says CEO Loney. "For example, we don't invest in below-investment-grade corporate bonds." In the early 2000s, Loney says, Great-West paid "quite a price" for that conservatism—it lost market share to Manulife and Sun. Since 2008, however, that caution has limited the damage to Great-West's traditional insurance and annuity offerings. "Great-West didn't write many products with complex guarantees," says Routledge. "They were happy to sell you a variable annuity, but they wouldn't make you a ridiculous promise."
Great-West was also more diversified in Canada than the other two, continuing, among other things, to operate London Life and Canada Life as distinct divisions. All told, the group has about a 50% market share in some lines of business. And Great-West is part of a strong conglomerate—it's 72%-controlled by the Desmarais family's Power Financial Corp. Great-West's biggest overseas holdings are in Europe, which is a difficult market these days. Yet Great-West earned a $643-million profit there last year. The U.S. is also a troubled market, but Great-West's largest acquisition there was fortuitous. In 2007, it bought not another insurer, as Manulife did, but Boston-based Putnam Investments—an asset- and fund-management company.
None of the Big Three can simply abandon or sell off all their traditional businesses. So what is their game plan? One element is simply increasing prices, which they've done. Another is to steer clients to participating policies. While those products allow policyholders to share in more of the upside from investments, they also expose them to more risk. All three companies are also trying to rely more on wealth management, which provides reliable fee income. Last year, Sun Life raised its stake in fund manager McLean Budden to 100% from 68%, and folded it into its MFS Investment Management unit.
For Manulife and Sun Life, there's also Asia. If North America is an economic and demographic nightmare, Asia is a dream—a young, growing and increasingly wealthy population, and the source of a third of Manulife's total 2011 operating profit of $2.8 billion. Asia only accounts for about 5% of Sun Life's business, but that number is growing fast. As Connor said in his speech at his company's annual meeting, "Sales [in the first quarter of 2012] were up 27% across the region to $219 million of premium, over four times our sales in Canada."
Unfortunately, back in Canada, investors are more focused on insurers' problems of the past, and the fallout that will still be very much a part of their future.