Canadian Life and Health insurance companies are a stable group of companies, but they face a fair number of regulatory and accounting headwinds that have the larger players repricing many products, while pulling others off the shelf altogether.

These pressures, coupled with stock market and interest rate volatility, are making it particularly unattractive for companies to offer products with any sort of long term guarantees – Guaranteed Minimum Withdrawal Benefits are one of the notable features being reconsidered and withdrawn from the market, but even long-term individual insurance is being reconsidered.

The problem for insurers is three-fold (at least): The simultaneous drop in both equity markets and interest rates makes it difficult for insurers to invest in such a way that will cover their longer-term liabilities. Compared to older insurance company business that focused primarily on mortality risk, this relatively new risk exposure has caused insurer credit ratings to drift lower over the past ten years as well.

Further, when markets drop, or when risk increases in some other way, companies are compelled to raise and save additional capital to meet OSFI (the Office of the Superintendent of Financial Institutions) reserve capital requirements. The amount insurers must save or vest to cover their liabilities is determined using a risk-based formula. Companies with business outside of Canada must have reserves to cover these liabilities as well.

Although analysts say the companies are well capitalized, they do add that such requirements make it difficult for companies to compete in certain markets – most notably, in the United States. Already, Sun Life Financial and Manulife Financial have both decided to exit certain business lines in the U.S., in part because of the higher capital requirements. Going forward, it’s anticipated that OSFI could make their capital requirements even more stringent for some products, or change their definition of reserve capital altogether.

Finally, the accounting measures Canadian insurers must use, don’t allow companies to smooth their liabilities over time – the mark to market, or fair value method being used, requires that liabilities are carried forward each quarter, and appear on the company’s balance sheets using current market prices, thus passing all of that market and price volatility directly through into the company’s earnings.

“You can have a quarter where interest rates fell 50 basis points on the last day, (which means) it was a horrible quarter. Then they go up 50 basis points, so that’s a fantastic quarter,” says Tom MacKinnon, managing director at BMO Capital Markets. “Earnings under Canadian (accounting standards) can be pretty volatile.”

The problem further compounds the reserve requirement issue, as well: “Company capital requirements are based on their financial statements,” says Donald Chu, director, financial institutions ratings at Standard & Poor’s. “If their financial statements show a loss that falls below their capital ratios, they’re forced to react. When the markets are going down the tubes, they’re forced to raise capital at the worst possible time, which is not exactly what you want to see a company do.”

On the surface, it can be easy to blame the new International Financial Accounting Standards for this trouble. Phase I of the standard, implemented in January 2011, requires that companies clarify and specify whether their liabilities are insurance, investment or service contracts.

According to A.M. Best Company analysts, accounting for most of a company’s insurance liabilities, however, continues to be done using the same Canadian Asset Liability Method (CALM) as before. “A.M. Best believes the volatility in 2011’s results was driven more by existing mark-to-market insurance accounting, rather than the implementation of Phase I of IFRS-C,” they write.

Similarly, Mario Mendonca, research analyst and managing director at Canaccord Genuity says the changes resulting from the conversion to IFRS accounting standards were not material. “It (IFRS) only captures the assets, it does not affect the liabilities. The liabilities are still accounted for using Canadian accounting standards.”

The second phase of IFRS implementation, however, definitely has companies concerned. Currently, phase II policies separate or disconnect the insurance liabilities with the assets that pay for the company’s obligations. A.M. Best says Canadian insurers are contesting the policies, arguing the “requirements would create a significant asset and liability mismatch that could have significant unintended negative consequences for their business models. This disconnect could affect customers, shareholders and capital markets, and cause insurers to discontinue certain product lines, especially longer term products.”

For the time being, however, volatility being passed through to a company’s earnings is one consequence of the accounting methods being used. Volatility, or sensitivity to it, can also be blamed, in part, to the sector’s increased willingness over the years to accept the risks that come with the introduction of products lines that require additional market exposure.

Mr. Mendonca observes that, before the financial crisis, insurance company earnings were more normal and based on fundamentals or what the company accomplished during the quarter. Today, he says “earnings are pretty much at the mercy of what happens with equity markets and interest rates.”

Standard & Poor’s analysts say the industry’s increased willingness to accept risk – a drift away from the mutual company’s staid and conservative ways, into less predictable product lines and a relatively new focus on shareholder interests – has tilted the sector’s business model towards a shorter-term revenue and profit horizon.


Although North American life insurers are still one of the company’s highest-rated sectors, this, they say, has lead to an incremental deterioration of the industry’s credit ratings. Since the late 1990s, the company has issued 159 ratings downgrades, compared to just 46 upgrades. Their average financial strength rating today for companies in the sector is ‘A+’, compared to the ‘AA’ average insurers enjoyed back in 2000.

“Our 12-month sector outlook, which reflects our expectation for the prospective balance of ratings upgrades and downgrades, has varied between stable and negative with some regularity during the past decade, but has never been positive,” say analysts and authors of the report, More Than Meets The Eye: What Is Behind The Long-Term Credit Erosion In The North American Life Insurance Sector? “The trend in rating actions suggests that the sector’s credit profile has little, if any, ability to ‘bounce back’.”

To manage the fact that many guaranteed policies are “in the money,” now that markets have caused invested asset values to fall below locked in high water marks, many companies are hedging their equity market risk by investing in futures contracts to offset losses.

Sun Life and Manulife have also both started getting out of the variable annuity business in the U.S., and both are making efforts to either dial back new business generation, or completely exit the different retail, long-term life insurance business lines there. “The problem, of course,” says Mr. Mendonca, “is that each time you try to reduce volatility by getting out of a product or hedging more, you’ve hurt your earnings power.”

In addition to the hedging costs – S&P analysts say a marked increase in these costs, including the cost to purchase options, is another market volatility byproduct – removing the interest rate and equity market risks reduces the company’s ability to profit when things do turn around. “The big challenge insurance companies have had is how do you reduce your earnings sensitivity without hurting your earnings power,” says Mendonca. “It has not been possible to do that.”

In addition to corporate cost cutting, analysts also say they expect to see companies to continue removing special product features and guarantees, reducing benefits, and repricing a lot of their products in the future.

Ongoing challenges

Removing a lot of the features and benefits that clients have come to appreciate and expect, however, does eventually impact future sales.

Longevity risk is another riddle insurance companies have yet to fully crack: At one end of the product spectrum, mortality risk, the cost when a client dies, is a relatively straightforward line item that companies can account for. Longevity risk, on the other hand, is comparatively unknown.

Michael Goldberg, vice president, director and financial services analyst at Desjardins Securities, points out that longevity risk products (long term care products, for example) are probably one of the biggest business opportunities available to insurance companies today, particularly given current demographics. “The question is how do you design a product that can do without containing too much in the way of long-term guarantees, but at the same time provide a good value proposition?” he asks. “In death insurance, there’s typically a fixed benefit, whereas in longevity risk, especially if it’s variable, you don’t know what the benefit is going to cost. One example is a simple life annuity. With interest rates as low as they are right now, it’s a terrible value proposition.”

The same is true of long-term care products, says Mr. Mendonca: “Long term care for an aging population was supposed to be a great product, but with interest rates this low, it’s very hard to make long term care work.”

The unknown liability element also makes it difficult for companies to match balance sheet assets and liabilities which, again because of the fair value accounting treatment, can lead to very large financial statement gains and losses and further earnings volatility.

For a while, Mr. Chu says some companies allowed the mismatch in the hope that rates would rise. In doing so, however, under the fair-value construct, that mismatch, the company’s negative, unfunded position, is multiplied over the potential duration of the contract – 40+ years in some cases – and recognized immediately in the current quarter.

“Canadian accounting forces you to look at the loss each and every year, and bring it forward to the current quarter. If you were going to lose $1 million a year for the next 30 years (based on today’s asset pricing), you’ve got to present that value, then take it in the profit and loss statement immediately,” he says. “It incents insurance companies not to take that sort of risk.”

Opportunities and the future

Despite all of this, the future is not entirely bleak. They might not be investment universe darlings, but Canadian insurers enjoy an enviably strong position domestically, with size, scale and a stable earnings base.

Mr. Goldberg says although the market is mature, demographics are also working in their favour domestically. “Governments which might ordinarily provide some of these benefits are less and less able to,” he says. “People are going to have to be increasingly more self-reliant and the only place they can get these products otherwise is through insurance companies.”

Although acquisitions are likely out of the question given current capital constraints, many companies are also growing their business outside of Canada, notably in Asia – China, Indonesia and the Philippines in particular – where companies like Sun Life and Manulife are enjoying good sales and earnings momentum. In underdeveloped regions, the companies sell rudimentary products using “armies of sales people,” then move toward pension type products and other forms of distribution as the market develops.

Another trend emerging is the move by insurance companies away from long term guarantee products, into the wealth management business which typically generates more fee income.

In addition to the bump companies will undoubtedly get, hedged or not, if markets do pick up in the future, their stock prices don’t appear to have much further to fall either. Plus, Mr. Mendonca says their beaten down prices have very little to do with underlying fundamentals: “From a stock-picking perspective, it’s hard to imagine they can get much cheaper,” he says. “I can now make an argument that their stock prices essentially reflect all of the bad news.”