DBRS Confirms Ratings on Empire Life

DBRS has today confirmed its ratings of The Empire Life Insurance Company (Empire or the Company), including its Claims Paying Rating of IC-2, its Issuer Rating of “A”, and its Subordinated Debt rating of A (low). All ratings have a Stable trend. The assigned ratings are below those of Empire’s rated peers, reflecting its smaller scale and less product diversification. The Company enjoys only modest levels of profitability but has yet to suffer a major loss despite the recent difficult market conditions. The Company’s individual life insurance line represents over 60% of its policy liabilities and therefore exposes the Company to earnings volatility associated with these long-duration liabilities due to changes in actuarial assumptions around mortality and investment returns. Empire purposefully retains a higher proportion of its mortality risk, which accrues to income as mortality rates inevitably improve. In the meantime, however, new business strain remains elevated.

Mitigating the risk of the individual insurance segment are the more stable business segments of wealth management and employee benefits. By virtue of conservative product design, the wealth management segment has not been affected by the adverse reserve development associated with segregated fund guarantees, especially with respect to the Guaranteed Minimum Withdrawal Benefit (GMWB) product. The employee benefit segment has a short duration book, with the ability to re-price on annual policy renewals to address underwriting deficiencies. Earnings on capital and surplus continue to contribute positively. Expenses per assets under management (AUM) are higher than the peer group average, which reflects both the Company’s absence of scale and chosen product mix, but are targeted for improvement through a number of strategic initiatives expected to reduce costs through outsourcing and more efficient allocation of resources.

A five-year average return on equity (ROE) of just 6% and the associated volatility of earnings in the individual life insurance segment would normally not result in an “A” rating for a life insurance company under the DBRS rating methodology, especially given the Company’s lack of geographical diversification. However, mitigating this profitability concern is the Company’s unique market niche focused on developing close relationships with distribution partners that are more naturally available to a smaller competitor; effective risk management processes and procedures that demonstrably contained the Company’s exposure to the financial and market crisis of the past few years; very strong regulatory capital and accompanying financial position; and supportive strong upstream ownership.

The Company continues to manage down its overall equity exposure to be consistent with the equity exposure levels of industry peers, by shifting some equity exposures out of the surplus account into the long-duration liability accounts. This redeployment is expected to reduce some of the volatility associated with interest rates. The Company’s asset mix is otherwise more conservative than that of its industry, with lower exposure to mortgages and real estate and a higher proportion of high-grade bonds, the corporate portion of which has been raised as attractive spread enhancement opportunities have prevailed in the wake of the financial crisis and the Company entered the private placement debt market with additional credit management resources. The Company’s segregated fund product had been designed to limit equity guarantee exposures even as a relatively high 72% of segregated fund assets are in equities.

Financial leverage, as measured by assets relative to shareholders’ equity and debt as a percentage of capitalization, is more conservative than that of the peer group. Similarly, the Company’s regulatory capital ratio is conservative, at 210%, at March 31, 2012. Some of this conservatism is to be expected, given the Company’s relatively narrow product lines and general lack of diversification. However, with a relatively low level of normalized profits, the existing interest charges are covered only adequately at 3.4 times, which limits the Company’s financial flexibility at the current rating level.

The Company’s controlling shareholder, E-L Financial Corporation Limited (E-L), is controlled by the Jackman family, members of which have overseen the business of the Company for over 50 years through three generations of ownership and oversight. With a long-term perspective on the Company’s potential to create value, E-L has traditionally been prepared to accept the trade-off between the short-term adverse impact of higher new business strain and the more favourable impact in the long term arising from the secular improvement in mortality experience. The owners have demonstrated a commitment to the Company’s continuance through capital injections and an accommodative dividend policy, which has allowed Empire to organically grow its regulatory capital.

Notes:
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.

These ratings are endorsed by DBRS Ratings Limited for use in the European Union.