DBRS Comments on Sun Life Strategic Announcement

DBRS has today commented on the decision announced today by Sun Life Financial Inc. (SLF or the Company) to stop selling variable annuity and individual life insurance products in the U.S. market. DBRS views the decision favourably. There are no rating changes as a result of this action.

Over the past several years, volatility has highlighted SLF’s economic exposure to the capital markets from guarantees written on variable annuities and embedded interest rate guarantees associated with life insurance products. However, the Company’s ability to mitigate these market fluctuations is limited by the disadvantageous accounting and regulatory capital treatment faced by Canadian life insurance companies, especially with regard to these long-tailed products. Since U.S.-based competitors have not faced the same disadvantage, the ability of Canadian companies to compete on a level playing field in these increasingly commoditized product lines has deteriorated. Despite recent efforts to de-risk, re-price and hedge these products, the cost to the Company in terms of capital allocation charges and earnings volatility, combined with cost and product disadvantages, has been deemed by the management team under new Sun Life CEO Dean Connor to be unsustainable. As of December 30, 2011, sales of these products will therefore cease.

While the Company has been attempting to reduce its new sales of capital-intensive insurance products in the U.S. market for a few years, it was the decision to stop writing new variable annuities that forced it to terminate all new individual life insurance sales. Since the Company had combined its wholesaling teams for annuities and life insurance products in 2009, the Company perceived that it would not have sufficient scale to justify retaining the wholesaling sales capabilities.

The decision to stop selling these long-tailed capital-intensive products will reduce the Company’s risk exposures and earnings volatility over time while providing a better platform for higher return on invested capital. The terminated products represent more than half of the Company’s broader exposure to interest rates and equity markets. We expect the Company to continue to manage these closed blocks of business in ways similar to how it has continued to manage its run-off book of life insurance business in the United Kingdom. The Company’s U.S. operations have struggled for a number of years to achieve critical scale and brand recognition. Market volatility and the asymmetric accounting and capital treatment between U.S. and Canadian competitors made more transparent the Company’s inherently weak competitive position in more commoditized U.S. life insurance product markets.

There will be a one-time pre-tax transition cost associated with the discontinuation of these products of up to $100 million associated with the reduction of 800 jobs to be recorded in Q4 2011 and into 2012. However, the Company will see a reduction in new business strain of $10 million to $15 million per quarter, after tax, on a total U.S. normalized earnings of just over $100 million per quarter and an expected $350 million for the consolidated Company. Goodwill associated with these two business lines of $97 million is also expected to be written down in Q4.

The Company will now focus its U.S. efforts on the group benefits business, where it is one of the ten largest market participants and which allows the Company to leverage its imposing Canadian group benefits expertise. In addition, the Company will continue to target growth opportunities in Asian markets where economic and demographic trends are favourable as well as in its “capital-lite” asset management businesses.

While reduced exposure to the U.S. variable annuity and individual life markets makes good sense from a capital and earnings perspective, DBRS recognizes that the Canadian life insurance industry continues to move away from its core and unique expertise in life underwriting in favour of more commoditized and more competitive wealth management products that require less regulatory capital.

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