Life insurers’ profitability is expected to take a hit well into next year. Market volatility and low interest rates are the prime culprits. So far, two of the top five lifecos in Canada have reported declining profits in 2008.

Credit rating agencies Standard & Poor’s and A.M. Best predict 18 months of sliding profits for Canadian life insurers. The first quarter 2008 results are in line with these forecasts.

Stock market volatility and low interest rates have eroded insurers’ returns on investments, the two agencies observe. This volatility has also hampered sales of savings and investment products, they add. Even robust life insurance sales could not make up for the shortfall.

Companies such as Manulife Financial and Desjardins Financial Security saw net income decline in the first quarter of the year. Sales were also down for three of the top five (see Table First quarter 2008 results of the five largest insurers in Canada).

The same factors that are hollowing out insurers’ profits will also drag the industry overall, the agencies say. “While it is true that the Canadian market has outperformed the American market, it will now have to face more serious challenges. Canada is not completely isolated from the U.S. but things are not cataclysmic,” says Stephen Irwin, vice-president at A.M. Best.

Manulife saw its net income drop by 12.8% between the first quarters of 2007 and 2008, to reach $861 million. The insurer attributes this slide to a major downturn in global stock markets, the worst in 21 quarters, it says in its report on first quarter results for 2008.

Of the top five Desjardins Financial Security (DSF) posted the sharpest drop in Q1 net income. It sustained a 27.1% decrease between the first quarters of 2007 and 2008, to reach $36.3 million. Turbulent financial markets and the devaluation of commercial paper hit the insurer’s earnings hard. “Excluding the impact of this deterioration, net income in the first quarter of 2008 would have been identical to the Company’s results for the first three months of 2007,” the insurer’s first quarter results explain.

This is quite a comedown for these three insurers, whose net earnings had grown between 2006 and 2007. Earnings were also up between Q1 2006 and the same period in 2007. DFS had even bested its big three rivals, as net earnings ballooned by 43.2% between 2006 and 2007, and soared by 63.5% between the first quarters of 2006 and 2007.

In the first quarter, net earnings for Great-West Lifeco (including Great-West Life, Canada Life, London Life and all other operations) were $654 million, up by 27%. Industrial Alliance reported net income of $64 million, up 6.7%.

Risk of insolvency

The financial solvency of some insurers may be put to the test. In the May 2008 issue of The Insurance Journal, Assuris president and CEO Gordon Dunning warned that insurers’ risk of insolvency had risen to its highest level since the early 1990s.

Mr. Dunning identifies three factors of concern: reduction in credit availability related to the U.S. sub-prime crisis, lingering market volatility and depressed interest rates.

He stops short of sounding the alarm, though, and points out that not all insurers will be affected.

Rating agencies that analyze the largest insurers are confident that they will remain solvent. Financial rating director at Standard & Poor’s, Donald Chu, shares this view.

“There are 100 players in Canada and only 10 of the biggest ones control 80% the market. Their significant size allows them to make significant economies of scale. Insolvency is definitely not an issue for them.

It is the smallest players that are exposed to the highest risk, the two agencies predict. Could any of them become insolvent? “We believe so. Their margins could be squeezed out more so than those of their larger counterparts. Because of their size, they cannot make the economies of scale that larger companies can. They don’t have the same resources or the same risk management know-how,” Foster Cheng, analyst at Standard & Poor’s, explains.

Interestingly, the agencies are not worried about the impact of the non-bank asset backed commercial paper crisis (ABCP) on insurers’ solvency. “The sub-prime crisis is an American phenomenon and mainly affected the U.S. life insurance industry, although Canadian banks also took a hit,” says Richard McMillan, life insurance analyst at A.M. Best.

Being conservative investors, few Canadian insurers had ventured into ABCP.

“They had very little exposure to the American market. Even Canada’s biggest insurers: Sun Life, Great West and Manulife, who were exposed to the U.S. through their American subsidiaries, weren’t impacted,” Mr. McMillan points out.

Up to now, of the five leaders, only Industrial Alliance and DFS have publicly announced that they have taken steps to write down their investments in ABCP. Their solvency, however, was not significantly affected.

The two other factors – market volatility and low interest rates – should not pose a major threat to the larger insurers’ solvency, the agencies assert. A.M. Best and Standard & Poor’s have issued encouraging outlooks for 2008 and 2009. “If we would have felt that they were becoming insolvent, we would have reflected it in our credit ratings. But that was not the case. Most insurers we rate were given a ‘stable’ outlook,” William Pargeans, an analyst with A.M. Best explains.

For its part, Standard & Poor’s gave the Canadian industry as a whole a ‘stable outlook.’

Solid industry returns, robust capitalization and proven risk management methods largely explain the good ratings. Data from the Office of the Superintendent of Financial Institutions (OSFI) confirm their observations.

OSFI calculated the average solvency ratio for the industry at 218% on December 31. It requires a minimum ratio of 120%.

The ratings of RBC Insurance and Transamerica Life Canada were the only ones that the two agencies lowered. They emphasize that the downgrading was not triggered by the current economic situation.

RBC Insurance’s rating was dragged down by RBC Financial Group. The division’s American banking activities are currently experiencing a soft market,

Mr. Chu of S&P points out.

Mr. Chu attributes the downgrading of Transamerica to the net loss of more than $300 million sustained in 2007 (see page 20). The insurer’s A- rating of Transamerica was lowered to BBB. Outlooks for both insurers remain stable, he adds.