Rating agencies put several of Industrial Alliance, Insurance and Financial Services’ ratings under watch with a negative outlook. Recent preferred share issues and interest rate vulnerability are to blame.Standard and Poor’s placed Industrial Alliance under watch with a negative outlook for its financial strength (A+) and issuer credit (A+) ratings. DBRS placed the insurer’s subordinated debentures (A) and preferred shares (Pfd-2, high) under review with negative implications.
The agencies point out that the company increased its financial leverage beyond their guidelines, via two recent preferred share issues. A $150 million offering was completed on June 1, and a $100 million issue was announced on June 19. DBRS has set a 1- to 2-month review period to decide whether it will lower the insurer’s development outlook.
Industrial Alliance’s credit ratings are also under review. Standard and Poor’s says it might lower them in the next 18 to 24 months. To reduce the risk of downgrading, the firm must rein in its debt/asset ratio to below 35%. The insurer must also keep its debt service ratio at five times income or higher.
DBRS underlines that the insurer’s first preferred share issue boosted its debt ratio to 36.6% “The higher leverage ratio basically confirms my impression that they have lost some of their financial flexibility, as they have taken more financial leverage,” David Hughes, senior vice-president, Canadian Financial Institutions at DBRS, told The Insurance and Investment Journal in an interview.
The six million preferred shares, issued at $25 each, bear a dividend rate of 4.3% for five years. “There’s an obligation attached to preferred shares in the form of dividends. It means a fixed charge on [the debt] coverage ratio,” Mr. Hughes adds.
Signals weakness
Such issues spook agencies because they signal weaknesses, Mr. Hughes explains. Even if Industrial Alliance claims that it is more conservative than the market thought, this is doing little to allay suspicions that the insurer is raising capital aggressively because of a shortfall.
All the same, Mr. Hughes thinks the stock market is relieved that the offering involved preferred shares. A common share issue would have diluted earnings-per-share, he says. “If they have addressed their capital concerns by issuing preferred shares rather than issuing common shares, surely the stock market will appreciate that. The stock price should be up,” Mr. Hughes continues.
Industrial Alliance CEO Yvon Charest agrees. Interviewed by The Insurance and Investment Journal, he says that “shareholders should be happy because the stock is trading well. Today it rose to $25.15,” he confirmed on June 21, just days after the issue (at press time on Aug. 7, the closing price was $23.29).
The agencies also find that the insurer has above average interest-rate risk. This is because its permanent life insurance portfolio guarantees high interest rates. The treatment of liabilities at fair value imposed by the new IFRS and increasingly strict capital rules issued by the Office of the Superintendent of Financial Institutions (OSFI) are compounding the problem.
The portfolio is concentrated in Canada, Mr. Hughes points out. “Industrial Alliance is very focused in Canada with long duration products embedded with interest rate guarantees, and it means that they have a lot of reserves on account for interest rate exposure. It’s not that the other insurers don’t have similar exposure, but it is [counterbalanced] with bigger operations in other markets [in the world],”he explains.
Lastly, the agencies singled out Industrial Alliance’s low regulatory capital ratio. At 186%, the Minimum Continuing Capital and Surplus Requirements (MCCSR) fall short of the industry average.
Mr. Charest is taking the credit agencies’ concerns to heart. He thinks he can meet their targets within 18 months. Mr. Charest intends to proceed deliberately, without compromising the insurer’s conservatism.
Industrial Alliance is not far from the agencies’ target, he adds. “Standard & Poor’s seemed to hesitate for some time before making a decision, because the word marginally appears three times in its release. We were really at the limits of the target.”
Industrial Alliance increased its capital by $700 million in the last 12 months, Mr. Charest says. The latest issues tipped the bucket for the agencies. “We could have waited before launching this issue, but we preferred to add capital to protect our long-term commitments to our clients,” he explains.
The insurer also transferred capital to its reserves, a prudent measure seemingly ignored by the OSFI. “If we had left money in capital rather than transferring it to the reserves, our MCCSR on March 31 would have been 16 basis points higher than that disclosed (186%),” he says.
The insurer plans to take a $120 million charge before the end of 2012 to offset the interest rate effect. This charge also rankled rating agencies. “We could have waited until next year to take the charge, but we wanted to take advantage of low interest rates,” Mr. Charest explains.
Industrial Alliance is putting money aside to offset the charge, and has accumulated $70 million in “after-tax value” by tweaking its investment activities. Mr. Charest is confident that he can finance this expense by the end of the year.
The accumulated amount does not appear officially in the company’s balance sheet. It will be used at year-end to reinforce actuarial reserves or capital. After recalculating the insurer‘s MCCSR, Mr. Charest is certain that the OSFI will consider this amount.
Price hikes
In another bid to counter interest rate effects, Industrial Alliance increased the price of all of its permanent individual life insurance products on July 3. The rating agencies link the insurer’s interest rate exposure to these products.
Level cost universal life climbed by 3% to 10%, depending on the age and product. The price of whole life insurance was up 1% to 10 %, under similar conditions. For both products, the 0 to 59 age bracket is most affected, while insured age 60 will see the lowest rises. Health and critical illness products have also gotten pricier.
