DBRS Comments on Industrial Alliance Equity Issue

DBRS regards favourably the decision by Industrial Alliance Insurance and Financial Services Inc. (IAG or the Company; Subordinated Debentures rated “A”, Claims Paying Ability rated IC-2, and Non-Cumulative Preferred Shares rated Pfd-2 (high)) to privately place six million common shares worth close to $200 million with the Caisse de dépôt et placement du Québec. Pro forma the new issue, the new shares will represent 6.7% of the Company’s 90 million in outstanding common shares. The Company’s solvency ratio will increase by 14 percentage points as of June 30, 2011, to 208%. Ostensibly, the raising of capital at this time was a reaction to the recent weakness in the global economy as suggested by soft equity markets and continued downward pressure on interest rates. Both market developments could result in a required increase in actuarial reserves, which could erode earnings in the short run. To issue new capital in the current uncertain economic and market environment is therefore regarded as prudent.

IAG has been increasing its exposure to equity markets by virtue of segregated fund guarantees, increased equity assets held opposite long-tailed liabilities, and through the impact on management fee income in both the segregated fund operations and in the IA Clarington mutual fund operation. The Company is also exposed to falling interest rates. While IAG, like most life insurance companies, is dynamically hedging some of these market exposures, it is increasingly exposed to financial market volatility, which justifies the decision to increase its regulatory capital relative to the peer group.

IAG had been at the low end of the range for regulatory capital among the DBRS universe of rated Canadian life insurance companies, at the equivalent of a 194% Minimum Continuing Capital and Surplus Requirements (MCCSR) ratio as of June 30, 2011, which was nevertheless within the Company’s target range of 175% to 200%. The lower ratio relative to its peers has traditionally reflected more conservative reserving for both interest rate and equity market risk exposures. An increase at this time is consistent with a gradual increase in market exposures. Although IAG’s pro forma regulatory capital ratio of 208% is now ahead of that of Great-West Lifeco Inc. at 200% and remains well behind Manulife at 241% and Sun Life at 231%, DBRS believes that the relative rank of the major Canadian life insurance companies according to the current regulatory capital ratios is reflective of their relative equity market exposures.

DBRS’s view of IAG’s announced merger with Industrial Alliance Pacific Insurance and Financial Services Inc. (IA Pacific) is also favourable. IA Pacific had accounted for approximately 16.5% of the Company’s consolidated assets, including segregated funds, but close to 30% of its net income including its profitable credit life insurance operation. As the two regulated entities have been increasingly integrated, the additional cost and inefficiency of maintaining two regulated and separately capitalized operating companies has become apparent. The merger will create a single regulated entity regulated by the Province of Québec’s Autorité des marchés financiers.

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.