Monday, November 20, 2006

Life Insurance Cos Excess Capital Position

Scotia Capital, 20 November 2006

What It Means

• In terms of excess capital as a percentage of BV, we estimate MFC has the most (at 14% of BV), followed by SLF at 11%, IAG at 7% and GWO at 6%.

• In Q3/06 we estimate excess capital positions grew the fastest for GWO and IAG, where buybacks have been limited. GWO's business is the least capital intensive, IAG's is the most.

• We forecast GWO's excess capital position to grow the fastest through 2008 year-end (from currently 6% of BV to 18%, excluding any acquisitions), followed by IAG (from 7% to 14% of BV), then SLF (from 11% to 12%) with a modest decrease in excess capital as a percentage of BV for MFC (from 14% to 12%). MFC and SLF we expect will continue to use between 35% and 50% of EPS to buy-back stock.

• We expect GWO to be most active in deploying its rapidly growing excess capital position, largely through continued "tuck-in" acquisitions in Europe and/or the United States.

Less capital intensive business - means more and more excess capital

• Business is now less capital intensive – which means excess capital positions continue to grow. While traditionally a capital intensive business, the foray into more wealth management type businesses, combined with the off-loading of investment risk (and its associated capital) by way of newer market-based return (i.e., variable and some universal life) type products, has resulted in a situation where less and less capital is needed to support the business. Hence, excess capital positions continue to grow, leaving more and more room to make acquisitions, increase dividends, and buy back stock.

• GWO's business is the least capital intensive of the group, IAG's is the most. In Exhibit 1 we outline our estimates of the components of earnings of the four Canadian lifecos, with buybacks reflecting recent levels.

• GWO's excess capital expected to grow the fastest. Exhibit 2 details the current and projected excess capital positions.

We make the following observations about each company:

• Great-West Lifeco – rapidly rebuild excess capital and continue to make “tuck-in” acquisitions in Europe and/or the United States. We expect the company to maintain its payout ratio in the 40% range, and with little in the way of buyback (other than for management stock options) and a book of business that is somewhat less capital intensive than the other lifecos, we look for the company to rapidly build excess capital, to levels of over $2 billion by the end of 2008. We believe the company will use the excess capital to continue to make “tuck-in” acquisitions, similar to the three it has made over the past year (two U.K. payout annuity blocks and the U.S. 401(k) block, which we believe will add $0.04-$0.06 to EPS in 2007). Great-West Lifeco’s diversified earnings base, strong market position in several niche businesses outside Canada, and good integration track record, all speak well of its ability to continue to make these “tuck-in” type acquisitions. In our opinion, these types of acquisitions are the most effective use of excess capital, and are much more accretive than share buybacks.

• Industrial-Alliance – rebuild excess capital and look to the United States for acquisitions. Industrial-Alliance saw its excess capital position significantly decline due to the Clarington acquisition, and given that its business is more capital intensive than the other Canadian lifecos, we believe the company will likely keep its payout ratio in the 25% to 30% range (the company notes it will approach 28% of trailing EPS in the next 18 months). Given that, and virtually nothing in the way of buybacks, we project the company will grow its excess capital position back to pre-Clarington acquisition levels by the end of 2008. While the company continues to look for acquisition opportunities in the United States, we remain sceptical for several reasons. One, the company has virtually no experience in the U.S. market. Two, we are somewhat doubtful the company will be able to find anything attractive enough at a price less than $500 million, a level that would be accretive without significantly diluting its stock.

• Manulife – begin to chip away at excess capital position now through increased buyback levels and gradually increased payout ratio – why wait until excess capital hits $5 billion? Manulife has significantly stepped up its buyback level in 2006, reflecting a decision, in our opinion, to stop the growth of its large excess capital position, and to do so in an accretive way. Earnings on excess capital generally don’t hit the company hurdle rate (16% in Manulife’s case), so why continue to let it grow? The buyback level in the first nine months of 2006 was more than we expected, and if the company continues at this pace (about 50% of EPS going to buybacks) we believe there should be an additional $0.04 EPS in our 2007 estimate (not in our estimates as of now). We also believe the increased level of buyback activity suggests that, given acquisitions are currently on the expensive side in our opinion; the company is possibly more content to sit on the sidelines for now and wait until a more opportunistic time presents itself. Furthermore, with a stock price at a 15% premium (on a forward P/E multiple basis) to U.S. players, Manulife already has a powerful acquisition currency, and likely little in the way of flow-back risk, as was proven in the John Hancock acquisition. In addition to an increase in buyback levels, we expect a modest increase in the payout ratio, approaching the upper-end of the company’s 25%-35% targeted range.

• Sun Life – still look for acquisitions to improve scale in the United States, with slight increase in buyback and payout ratio. We expect Sun Life, with a slight uptick in its payout ratio and buyback level in 2006, will likely look to modestly increase its excess capital level going forward, as it continues to look for deals in the $1 billion range. The problem is, in our opinion, good deals of this size just aren’t out there in the businesses in which Sun Life needs to build scale (namely U.S. variable annuity, and U.S. individual and group insurance). As such, we believe there is a chance the company could make a “big splash” largely equity acquisition in the United States and with a forward P/E multiple in line with U.S. players, the company has little in the way of an exceptionally strong currency. Thus the dilemma for Sun Life will continue – if you can’t grow organically to get into the top 10 in the United States do you need to make a big acquisition, and if so, how are you going to finance it? Nevertheless, good buyback and dividend support should continue to be a positive for the stock. and we get the impression that right now, in this environment, that is exactly what shareholders want from Sun Life.