DBRS Confirms Ratings on Manulife and Affiliates

DBRS has today confirmed its ratings on Manulife Financial Corporation (Manulife or the Company) and its affiliates at the current levels. The trend remains Stable. The Company’s current ratings are supported by its strong and diversified business franchise anchored in its Canadian insurance and wealth management businesses, the John Hancock brand and excellent distribution capabilities in the U.S. market, and in its presence in the fast-growing Asian market. Adjusted for market-related earnings volatility and non-cash items such as the Q3 2010 $1 billion charge against goodwill in the Company’s U.S. operations, the Company is reporting core earnings of between $650 million and $750 million per quarter or an approximate return on equity (ROE) of 12%, albeit down from the over $1 billion per quarter pace (ROE of 15%) reported prior to the 2008 financial crisis which included the benefit of favourable equity markets and higher interest rates. The Company’s rating is constrained by its total debt ratio including preferred shares which has increased to over 30%, above the level that DBRS associates with strong financial flexibility.

The financial crisis and the corresponding drop in equity markets and interest rates in 2008 and 2009 exposed the market and interest rate risk assumed by the Company through variable annuity guarantees and long duration liabilities such as no-lapse guarantee universal life and long-term care insurance policies. The Company’s management team has been actively focused on an active program of risk mitigation through hedging, product redesign and repricing, and refocused product sales. Through this risk mitigation process and by increasing sales and earnings diversification away from formerly “hot” products, the Company’s strategy is to achieve a better balance of risk exposures while focusing on more profitable and capital efficient products with a stronger component of fee-based revenues. In the meantime, the current ratings reflect the Company’s recent earnings volatility and the ongoing transition to lower risk growth platforms which may or may not be successful.

Certain products such as variable annuities, long-term care, and no-lapse guarantee universal life insurance products had been responsible for a disproportionate share of both the Company’s sales and its increased risk exposures. All of these products are currently being de-emphasized following recent redesign and pricing decisions in favour of less risky and less capital intensive products such as mutual funds, retirement savings plans and new current assumption universal life products with participating features. An enhanced risk management framework and reduced risk tolerance have given rise to increased hedging activity for both new business and the existing portfolio with the intention of offsetting 75% of the earnings impact of equity market movements by the end of 2014. As at March 31, 2011, hedges offset 59% to 65% of underlying earnings sensitivity to equity market exposure which was ahead of the Company’s 2012 interim target. Exposure to interest rate movements is similarly being reduced through term extension trades and forward starting interest rate swaps. Product redesign is focused on reducing embedded risk exposures by having the customer assume more risk. Price increases, while reducing new sales volumes, are expected to contribute to higher margins and more efficient allocation of capital.

While DBRS positively regards the Company’s progress in reducing market-related risks, it recognizes that Manulife is necessarily undergoing a shift in its growth model and possibly in its corporate culture that will reduce the focus on rapid sales growth of guaranteed products, especially in the U.S. market. In de-risking its product portfolio and reducing its market exposures, the Company will likely experience reduced sales growth in the U.S. market, while Asia is expected to have more potential for new sales growth. The Company’s expectation is that, notwithstanding the challenges of repositioning itself and its products, it will return to a $1 billion per quarter earnings pace or a 13% ROE by 2015. While DBRS is prepared to acknowledge that, barring a major economic crisis, the Company has probably hit its nadir, it does not believe that the lost profitability associated with the U.S. operation will recover in such short order, especially since the former earnings levels benefitted from favourable equity markets and a more favourable interest rate environment.

Through the turmoil of the past few years, Manulife has taken advantage of its financial flexibility and financial strength rating to access the capital markets in order to maintain its regulatory capital ratios at a high level, offsetting weak earnings and higher capital requirements associated with equity market guarantees and low interest rates. The Company has an attractive excess capital position relative to the Office of the Superintendent of Financial Institutions (OSFI) minimum of 150% and in excess of its own target (The MCCSR for the Company’s primary operating subsidiary, The Manufacturers Life Insurance Company, was 249% at year-end 2010 compared to 240% at year-end 2009, 243% versus 221% at the respective end of Q1) although, given Manulife’s higher relative market exposure to the equity markets and the current uncertain economic environment, DBRS regards the higher regulatory capital ratios as prudent, until the Company’s risk reduction targets are more fully achieved.

Underpinning the Company’s financial strength, in addition to good earnings capacity and acceptable capitalization, is a very high quality investment portfolio which is not a source of concern to DBRS.

Note:
All figures are in Canadian dollars unless otherwise noted.

The applicable methodology is Rating Companies in the Canadian Life Insurance Industry, which can be found on our website under Methodologies.