At first glance, the Canadian life insurance industry looks like a disaster area. Manulife recently shocked the Street by posting a mind-boggling $2.4 billion second-quarter loss. As I write, the S&P/TSX Insurance Index is down a staggering 18% since the beginning of the year. Sun Life's individual life insurance sales have slumped 40% year-over-year and the company is set to write off $1.7 billion of goodwill in 2011. More stringent reporting requirements are in the works and they are bound to increase earnings volatility. What is there to like?
Well, quite a lot actually. All is not lost. As a matter of fact, the sector is in better shape than it seems. The major players are now split into two camps. On one hand, we have the stable but unexciting producers like Great-West Life and Industrial Alliance grinding out profits and trading close to their 52-week highs. No imminent danger there. On the other hand, we have two damaged high flyers, Manulife and Sun, both battered and bruised but certainly not broken. Indeed, these "fallen angels" are actually showing signs of life (pun intended).
The reason for this sharp division is quite simple. To a large extent, the leading companies are in two different businesses. Sun Life and Manulife have changed dramatically since demutualization 10 years ago. Immediately after going public, they focused on short-term performance, expansion, and cornering market share. Growth was the name of the game and their product mix reflected this. Both companies aggressively marketed variable annuities, fixed index annuities, and no-lapse life policies, all with benefits hinging on stock market performance or future interest rates.
In the midst of rising stock prices and a stable bond market, nobody appreciated the danger these products poised. However, when the crash came and rates plummeted there was a price to pay. The aggressive investment portfolios were written down. The real problem, though, was (and is) on the liabilities side where actuaries are still scrambling to increase reserves and provide for sharply reduced expectations. These huge adjustments inflicted large, unexpected losses.
Meanwhile, second division players Great-West and Industrial Alliance maintained a more traditional product mix which dampened earnings growth during the boom years but built a strong business platform. Most of their liabilities are conventional and not directly contingent on the fluctuating markets. It paid off during the financial crisis. Their stocks weathered the storm relatively well.
I mention all of this because, unlike other companies, when a life insurer makes a sale it is the beginning of the process, not the end. An insurance policy remains on the balance sheet. The reserves have to be maintained. So going forward Sun and Manulife will continue to struggle with the risks that were written, especially as it is very difficult to reinsure variable annuities and no-lapse coverage. The flip side is that both companies could quickly reverse many of the market-related charges if stock prices improve and interest rates, now close to rock bottom, start to rise. The other two insurers should enjoy more predictable experience. The important thing, therefore, is to regard Canadian life insurance as two industries, at least for the moment.
Turning to the companies themselves, Great-West Life Co. (TSX: GWO) has, as I mentioned, remained disciplined and continues to emphasize traditional life products. As a result, it is the least sensitive lifeco as far as swings in the equity and bond markets are concerned. According to BMO Nesbitt Burns, a 10% drop in stocks would inflict an 8c charge against GWO's earnings compared to 35c for Sun and 74c for Manulife.
The company is expected to earn about $2 a share this year and $2.30 in 2011. Trading at $25.17 and paying a safe $1.23 dividend, the stock yields 4.9% and is suitable for investors seeking income and some growth. However, I do not see a lot of upside potential at present because the industry is out of favour.
Industrial Alliance (TSX: IAG) is a similar situation. Its product mix is extremely conservative and earnings are highly predictable. As a result, there are no unpleasant surprises but inevitably the stock remains fully priced. Earnings in the $3 range are expected this year and about $3.25 in 2011. Because of its stability, IAG has outperformed the group during the last year or so but will probably mark time for a while.
Sun Life Financial (TSX, NYSE: SLF), on the other hand, is in a state of flux. Sun was accident-prone even before the downturn and its hedging program proved insufficient when the crash came. The company posted a 10c per share loss in 2008, something almost unheard of in the life insurance industry, and recovery has been slow. Management is still trying to tidy up its U.S. operations and is no longer selling variable annuities, which inevitably hurts sales growth. Changing the in-force business mix will take time, however, and there is still significant market exposure. As a result the dividend is a bit of a question mark.
The company could make as much as $2.40 a share this year and about $3 in 2011. That seems reassuring but my feeling is that we need to see a more conventional sales mix and a lot more solid progress before Sun Life starts looking attractive. The stock at C$27.75, US$26.65 remains vulnerable, especially if the U.S. business needs a substantial capital injection.
Finally, Manulife Financial (TSX, NYSE: MFC) is a financial giant that has been written off by many analysts. The bad news keeps coming. A loss of $2.4 billion in the second quarter included $3.2 billion of interest and equity charges but even if you strip out the non-cash items, operating earnings of 35c a share were well below the 40c analysts were expecting. Standard & Poor's has just downgraded the company's debt from A Plus to A. Some forecasters, concerned about the low interest rates, are now predicting a further loss in the third quarter. I could go on.
The intriguing thing, however, is that the stock is now priced at C$13.48, US$12.99, far below its C$15.79 book value. In more normal times, MFC trades at two times book or more. Keep in mind too that this is Canada's largest life insurance company and it is built to withstand a great deal of damage. In fact, even now its capital ratio of 221% is well in excess of the regulatory 150%. Moreover, MFC is in transition. The market is giving no credit for the reformation now underway. Products are being re-priced and in some cases discontinued as Manulife reverts to being a more conventional life insurer. Market hedge levels, previously at about 50%, are being increased to 70% by the end of 2012 and this will reduce risk and earnings volatility.
My feeling, therefore, is that while the company is in poor shape the shares are washed out and increasingly attractive for patient, long-term investors seeking capital gains. In addition, I think that interest rates will trend upwards in 2011 while the stock markets will move sideways to higher over the next 12 months. That should bolster MFC's earnings. Of course, the stock could dip even lower but this looks like a good entry level. Manulife shares currently pay an annualized dividend of 52c for a yield of 3.9%.
Action now: Manulife is a Buy at C$13.48, US$12.99 with an initial target of $18. I will stay close to the stock because of the uncertainties and keep you updated.