Conservatism is paying off

US insurers struggling through the worst economy in decades need
look only to their northern neighbours, where a strong Canadian
dollar and a low level of credit risk combine to produce a much
healthier picture, to realise what might have been.

A new report from Standard & Poor’s Ratings Services’ (S&P)
concludes that the outlook on the Canadian life insurance sector
remains stable – quite an achievement given global economic
conditions.

“Despite the challenging global macroeconomic conditions, we are
expecting the Canadian life insurance sector to move through these
turbulent times without any major negative earnings news given the
relatively favourable outlook for Canada’s economy and the
industry’s solid financial shape,” noted S&P.

While the Canadian life insurance industry in general has
generated strong and consistent operating earnings over the past
five years, there has been a rising level of noise around earnings
due to a number of macro-economic factors: the headwinds created by
the strong Canadian dollar, dislocation in the capital markets that
has led to the re-pricing of credit risk and liquidity, the recent
churning down of the global equity markets, and the advent of
fair-value accounting.

S&P explained that the Canadian industry has been helped by the
relatively stable and rational domestic pricing environment,
conservative investment portfolios, tight asset-liability
management practices, very strong-to-exceptionally strong capital
adequacy positions maintained by most industry participants, robust
risk management cultures, and the relatively stable home-market
environment.

Unlike the US, where the debate these days surrounds the depth of
the recession no one will call a recession, the Canadian economy is
expected to narrowly escape falling into recession. While the
strong Canadian dollar and record oil prices have made a number of
sectors – such as manufacturing – less competitive, net gains in
other parts of the economy appear to have largely offset these
unfavourable developments.

With the strong Canadian dollar causing demand for Canadian exports
to weaken, businesses outside of Canada’s resource sector have
begun to scale back their capital spending plans. As a result,
employment growth is slowing and housing demand is softening as
reflected in a slower pace of residential construction.

However, S&P’s research found that Canada’s resource sector
employment and income growth is still being propped up by increased
demand for energy and commodities so consumer confidence has
remained resilient. The economy will also benefit from previous
monetary policy easing from the reserve bank, the Bank of Canada’s
totalling 150 basis points. After stalling in the first half of
2008, Canadian GDP growth is expected to pick up heading into
2009.

The strong Canadian dollar has resulted in a decline in
consolidated earnings for life companies with international
operations, but this has not caused any impairment in these
underlying businesses, S&P stressed.

“The impact of currency swings on the balance sheet has been muted
as the liabilities are generally match funded with assets in the
respective currency,” said S&P. “To date, the impact of foreign
exchange translation has not resulted in any outlook or rating
changes within the Canadian life insurance sector, but it continues
to pressure companies’ earnings growth and interest and fixed
charge coverage ratios, as these income streams are not normally
hedged.”

For those reasons, and thanks to a healthy measure of good Canadian
fiscal conservatism, Canadian life insurance companies have, for
the most part, been able to sidestep the credit turmoil that was
spawned by the deterioration seen within the US subprime mortgage
sector.

“Based on our industry survey, these companies had a much lower
exposure to subprime investments than their US peers,” noted
S&P.

“In general, any positions held were relatively well seasoned and
highly rated. Based on our stress test, we don’t expect the
Canadian companies to experience anything more than a nominal
loss.”

As it relates to their investment portfolios in general, most
Canadian life insurers continue to maintain their conservative
investment practices. A number of industry participants had reduced
risk levels in their investment portfolios before the latest credit
market disruption as they did not believe the spreads for lower
grade credits were adequate to compensate for the true risk of
these investments.

S&P expects the Canadian life industry will remain resilient
given the improvements that continue to be realised with
technology, expense efficiencies, enterprise risk management, and
product innovation in response to shifting needs in the
ever-changing protection and retirement markets.

Overall, the growth of protection products in Canada has been
modest, but savings and retirement products have better growth
potential due to aging demographics and given assets under
management generally accumulate with the effects of compounding
returns.

Slow but steady

Not that the Canadian life market is setting the world on fire: the
growth in direct in-force premiums for individual insurance in
Canada has been hovering in the mid-single digits during the past
few years, and sales growth has also been in this same range. The
growth in individual segregated funds (similar to variable
annuities in the US) and group segregated funds (similar to 401K’s
in the US) by the industry has been fuelled by the continuation of
positive net sales, the forward momentum created by rising Canadian
equity markets, demand for retirement products by the baby boomers,
and the creation of new life products.

In total life insurance premium income between 2002 and 2007
achieved a CAGR of 8.6 percent increasing from C$32.5 billion
($31.1 billion) to C$49 billion, according to reinsurer Swiss Re.
Health insurance premiums added about a further C$24 billion in
2007.

No discussion of Canada can ignore the impact of consolidation, as
the top three life insurance companies – ManuLife Financial, Sun
Life and Great-West Life Assurance Company – continue to control
two-thirds of the market in almost every major product line.

Their dominant domestic franchises have created an effective
earnings engine that is now used to fund further expansion within
their domestic and international operations, and the strong
Canadian dollar and relatively high stock valuation affords these
companies with more purchasing power within the international
arena.

This has played out in recent years with Sun Life Financial Inc.’s
acquisition of Genworth Financial in the US, and Great-West Life
Assurance Co.’s (Great-West Lifeco) acquisitions and indemnity
reinsurance transactions in the UK payout annuities space. Its US
sister company, Great-West Life & Annuity Insurance Co. has
made a series of acquisitions to reinforce its US 401K
business.

Manulife Financial Corp., the parent of The Manufacturers Life
Insurance Co., has been quiet on the acquisition front of late, but
its powerful distribution channels continue to generate a
substantial amount of new business in all of the major markets that
it operates in, and its balance sheet remains in excellent
shape.

“Despite this business concentration, competition for customers
remains intense as companies continue to look at ways to expand and
strengthen their distribution channels and widen the breadth and
depth of their product mix,” S&P noted in its report.

“As the major market participants are all stock companies, our view
is that the dominant players will continue to exercise prudent
pricing discipline and will have the added advantage of capital,
scale, and technology to further drive down their costs, and in
many cases maintain their superior multi-channel distribution
network, product innovation, and effective ERM [enterprise risk
management].”

A recipe for growth

The big three life insurers gained their heft in recent years
through consolidation with their largest competitors. Sun Life
acquired Clarica Life in 2002, while Great-West Lifeco bought
Canada Life in 2003.

Manulife merged with US-based John Hancock in 2004; through the
merger, it also acquired Maritime Life, a Hancock subsidiary and
the fifth- or sixth-largest Canadian insurer at the time. Earlier,
Great-West had acquired London Life.

But for rapid growth, Canada’s big three have turned to expanding
international operations. For example, Manulife now operates in 19
countries and in 2007 derived C$702 million in new annualised life
premium income from its Canadian life business, $1.12 billion from
its US arm and C$431 million from its Asian operations.

Similarly, ManuLife’s wealth management operations reflected a
similar pattern in 2007, with the bulk of new business derived from
US operations which notched up sales of C$27.05 billion. Canadian
wealth management operations delivered C$10.34 in new sales and
Asian operations C$6.77 billion. Overall, according to Manulife,
about 70 percent of its total revenue is denominated in US
dollars.

To a large degree free from the serious problems plaguing US
insurers, Canadian insurers’ profits have held up well this year.
Indeed, results from the three big Canadian insurers in the second
quarter of 2008 testify to their resilience to tough market
conditions, although investment income has suffered and the strong
Canadian dollar has done some damage to foreign earnings.

In profit terms the most impressive results were those of
Great-West Lifeco which increased net earnings attributable to
shareholders to C$1.213 billion, up 123 percent compared with the
second quarter of 2007.

Excluding non-recurring after tax gains of C$649 million in the
insurers’ US operations net earnings still reflected a 4 percent
increase to C$564 million while adjusted for currency fluctuations
net earnings were up 8 percent.

Net earnings from Canadian operations increased 7 percent to C$275
million and contributed 48.8 percent of total earnings excluding
non-recurring gains. US operations contributed 18.1 percent and
European operations 33.1 percent.

Great-West Lifeco’s premium income reflected a solid 12.8 percent
gain in the second quarter to C$4.52 billion. However the most
significant change was in its proprietary mutual fund operations
where inflows increased from C$203 million in the second quarter of
2007 to C$10.05 billion. This increase was primarily attributable
to the acquisition of US asset management company Putnam
Investments from broker Marsh & McLennan Companies in early
2007 in a deal worth $3.9 billion.

Manulife also delivered solid second quarter 2008 results,
increasing premium income 11.2 percent compared with the second of
2007 to C$5.37 billion. Adjusted for currency movements, premium
income was up 18 percent.

Currency movements also took their toll on ManuLife’s net profit
which dipped 9 percent to just over C$1 billion. Adjusted for
currency movements, which reduced earnings by C$41 million, second
quarter earnings were down 4.8 percent.

From a premium income perspective Sun Life was ahead of the pack,
lifting premium income to C$4.08 billion, up 24.1 percent compared
with the second quarter of 2007. However, Sun Life’s net earnings
were as the company put it “disappointing,” falling 12 percent to
C$519 million. Adjusted for currency movements earnings fell 9.1
percent.

Most of the damage to Sun Life’s second quarter earnings related to
weak performance of its US operations where earnings fell 47
percent to C$73 million. Canadian operations lifted earnings 5.7
percent to C$296 million.

However, despite some second quarter earnings setbacks Canadian
insurers have fared far better than many of their US counterparts
which have reported substantial earnings declines and in some
instances such AIG massive subprime-related losses.