Tom Slee writes:
It was obvious from day one that the financial collapse was primarily a banking crisis. Nearly all of the major players were in serious trouble. Less apparent was the fact that insurance companies had also been extremely hard hit. Their shares plummeted almost 50% as the downturn spread, impairing assets and straining actuarial reserves. They have never really recovered. As a matter of fact, some of the stimulus packages actually hampered this sector.
The insurers have had to struggle. So it's a relief to finally see some green shoots. Fourth-quarter 2012 results were respectable, even encouraging. We could see some sustained earnings growth.
This is good news for a couple of important reasons. First, although it's not common knowledge, the insurance industry is a significant contributor to the Canadian economy. With over $570 billion worth of assets at work in this country and a workforce of approximately 140,000 people, these companies are a prominent force. It's important that the sector prospers if we are going to have a healthy recovery. Second, insurance stocks represent a major component of the S&P/TSX Composite Index. If their performance improves we will have a more balanced market. Investors crammed into the mining and energy sectors are going to have a wider choice. So let's look at how the insurance industry stands right now.
At first glance it's a bleak scene, an almost perfect storm. The companies are struggling with low interest rates, harsh new accounting rules, much tighter regulations, and shrinking demand for some of their core products. At the same time, people are living longer, thus dramatically increasing the costs related to annuities and extended health benefits. There are troubles on every front but it's the record low interest rates that are causing the most concern. They are a serious problem.
This is an industry that depends to a very large extent on earning a spread between yields on its assets and the rates used to calculate actuarial reserves and set competitive premiums. That spread has narrowed, in fact pinched is a better word, since 2007 because of artificially low interest rates and there is no real relief in sight. A recent survey by management consultants Towers Watson showed that 45% of North American insurance companies rated prolonged low interest rates the greatest threat to their business. Each time Federal Reserve Board Chairman Ben Bernanke injects more cheap money into the system, insurers have another hill to climb.
On the plus side, though, the companies are successfully grappling with the challenges. They are selling directly to the public and reducing their reliance on expensive brokers. New products are being introduced, many aimed at an aging population. For example, there are increasing sales of policies to third parties. For instance, there are policies that allow an elderly person to insure his or her life and arrange for the eventual proceeds to compensate a caregiver for services rendered during the final years. Also, there is increasing demand for disability and income replacement coverage.
The industry's real thrust, however, is into the Asian markets where spending on traditional insurance products is growing at 11% a year, five times faster than in Europe and North America. According to respected consultants McKinsey & Company, the Asian insurance market will grow by nearly US$1 trillion in the next five years and Canadian insurers have been quick to respond. Manulife is already staking a major claim and racked up US$1.4 billion worth of sales in the region last year. Sun Life has also been making inroads and recently purchased a Malaysian insurance venture for $293 million. Sun is now present in seven Asian markets.
More immediately, the industry is busy putting its North American business in order. This is where the companies are generating the current earnings improvement. There was an increase in the number of policies sold in 2012 over 2011 and domestic price hikes are sticking. Capital positions are improving and there is a better product mix. Nevertheless, the future is in the Far East, China in particular. Even Great-West's recent high profile acquisition of Irish Life, a good deal for both parties, is not significant on a global basis. The companies will have to look to the Pacific Rim for significant growth.
On balance, therefore, I am encouraged. We are not completely out of the woods but I think the insurance industry is now due for an investment upgrade. Several of the stocks look very attractive. Here is a look at the individual companies.
After several false starts Manulife Financial (TSX:MFC) (NYSE:MFC) is starting to gain some momentum. The company reported fourth-quarter earnings of $0.56 a share, well ahead of the $0.32 consensus forecast. Investment gains of $368 million were better than expected and year-over-year insurance sales jumped 49% while wealth sales were up 31%. Stripping away extraordinary items, core operating profit amounted to $508 million or $0.28 a share, in line with the numbers analysts were anticipating.
The fact that there were no unpleasant surprises is reassuring and the company's capital position continues to improve. What I like most about the results, however, is that the management's hedging program reduced market sensitivities by 19%. It was direct exposure to the stock market through segregated funds that created a lot of Manulife's problems.
Looking ahead, expensive top-line growth is going to restrain earnings but we should see a profit of about $1.30 a share in 2013 compared to $0.90 last year. An improvement to the $1.55 range is expected in 2014. Most important, these figures should be solid as the company continues to reduce its sensitivity to foreign exchange, interest rates, and stock market fluctuations.
Investors have noted the improvements and the stock is now trading at C$14.96, US$14.72. That is up 21% in Canadian dollar terms from our recommendation at $12.34 in February of last year. The shares, paying a $0.52 dividend and yielding 3.5%, are no longer oversold. I think that they represent good value and still have upside potential.
Action now: Manulife remains a Buy with an increased target of $17. I have set a $10 revisit level.
Industrial Alliance (TSX:IAG) also turned in a good fourth quarter. Canada's fourth-largest life insurer earned $0.81 a share, a lot better than the $0.71 Bay Street was expecting. Cost cutting reduced the strain from new business - the insurance industry is unique in that new policies are immediately charged with the high first-year commissions and set-up charges. Costs are not smoothed over the life of the policy. So this creates an oddity -the better your sales, the worse your profit. Industrial Alliance is attempting to reduce this problem.
Improved investment results are another key factor in offsetting charges for lapses and unfavourable group health and life experience.
The company intends to keep reducing the cost of new policies, accelerate top line growth, and improve its product mix. As a result, I think this often overlooked stock, trading at $37.36 and yielding 2.6% on an annual dividend of $0.98, represents good value.
Industrial Alliance, with a market capital of $2.5 billion and assets of $83 billion, has been on our Recommended List before and I am reinstating it as a Buy in light of the industry's improved outlook. We should see earnings of about $3.35 a share in 2013 with an increase to $3.70 or more next year.
The shares also trade in the U.S. over-the-counter Grey Market but volume is very light (average daily volume of 7,111) and the stock may go for days with no trading. The latest price, from March 13, was US$35.56.
Action now: Industrial Alliance becomes a Buy with a target of $42. I will revisit the stock if it dips to $32.
Great-West LifeCo (TSX:GWO) remains a defensive income investment. Priced at C$27.23, US$26.67, it pays a handsome $1.23 dividend to yield 4.5%. The acquisition of Irish Life augments GWO's position in the Irish market but will add only $0.05 a share to this year's bottom line.
Conservatively managed, Great-West weathered the financial crisis relatively well but has a small Asian presence and will probably remain focused on its traditional European and North American markets. We should see earnings of about $2.35 a share in 2013 and $2.50 next year. Analysts are not expecting a dividend increase any time soon and the stock is likely to move sideways for a while.
This stock is not on our Recommended List and we do not advise buying at present.
Sun Life Financial
Sun Life (TSX:SLF)(NYSE:SLF) is still having serious difficulties. Fourth-quarter operating profit of $0.62 a share was less than the consensus forecast. Moreover, there are still a lot of questions about the company's U.S. annuity business. Analysts have been marking down their earnings projections.
On the plus side, the 5.2% yield is attractive and I would not read too much into Sun's downgrade by Dominion Bond Rating Service (DBRS) to an A (high) from AA (low). This resulted from an industry review and brings SLF into line with Manulife.
This is not an IWB recommendation and on balance, because of the question marks, I am inclined to avoid the stock for now.
Turning to the property and casualty business (P&C), Intact Financial (TSX:IFC) continues to impress. The fourth-quarter 2012 profit of $1.42 a share was well ahead of the $1.33 analysts were anticipating. The company is now on track to make about $6.50 a share in 2013 with a 10% increase to the $7.20 range next year.
Perhaps most encouraging is the fact that foreign companies are vacating the Canadian P&C market. At one time, we were dominated by U.S. and European carriers but now it's becoming a mainly domestic industry due to our tight regulations and onerous capital requirements. Intact is well equipped to take advantage of this opportunity.
The stock has been under some pressure recently because of several high profile court decisions concerning auto injuries and accident benefits. However, the judgments have limited long-term impact on insurers and Intact has made the necessary reserve adjustments.
With close to $600 million of excess capital, the company is still hunting for acquisitions in this fragmented industry. A 10% dividend increase to $1.76 has just been announced, bringing the yield to 2.8%.
I recommended Intact in February 2012 at C$59.60 and it is the insurance company representative on our Primary Core list. The shares closed on Thursday at C$62.25. The last trade on the U.S. Pink Sheets was on March 8 at US$62.80.
Action now: Intact Financial remains a Buy with an increased target of $75. I will revisit the stock if it falls to $60.