DBRS Confirms Industrial Alliance; Trend Now Negative

DBRS has today confirmed the ratings on Industrial Alliance Insurance and Financial Services Inc. (IAG or the Company) and its affiliate, Industrial Alliance Capital Trust, but has assigned a Negative trend. The trend on the Company’s Claims Paying Ability rating remains Stable. The debt and preferred shares ratings have been removed from Under Review with Negative Implications, where they were placed on June 15, 2012. The Negative trend reflects the Company’s reduced financial flexibility as it has continued to shore up its regulatory capital ratios through the issuance of additional preferred shares, taking its total debt-to-capitalization ratio to 37.8% which is above the ratio expected by DBRS for an “A”-rated company in the Canadian life insurance industry. While this ratio is somewhat overstated, given the Company’s generally conservative actuarial reserve assumptions and the absence of any meaningful goodwill and intangibles, the Company’s fixed-charge coverage ratio has nevertheless also fallen below the 5.0 times lower limit, which delineates a lower rating category in the DBRS rating methodology.

The resolution of the Company’s Negative rating trend hinges to some degree on a return to a more sustainable interest rate environment which would take away some of the overhanging downward pressure on earnings. While DBRS acknowledges the significant steps that Company management is currently taking to mitigate the impact of lower interest rates on earnings and regulatory capital, it must also acknowledge that there are limits to the degree to which the Company can continue to offset adverse interest rate movements in the longer term. The Company is effectively in the process of transforming itself to better cope with an adverse market environment at an uncertain time in the global economy. Should earnings start to be negatively affected over the next 12 months by low interest rates or by deterioration in top-line growth following recent strategic decisions, DBRS would likely convert its Negative trend into a downgrade. The trend will revert to Stable if a planned reduction in new business strain, among other initiatives, is reflected in a sustained improvement in profitability, which would be signaled by a return to a fixed-charge coverage ratio in excess of 5.0 times and a reduction in the total debt ratio.

Mitigating the recently reduced financial flexibility and lower coverage ratios has been IAG’s relatively strong and stable earnings performance, despite its disproportionately large exposures to long-term interest rate guarantees which are embedded in its individual life insurance and wealth management products. In the past, the Company had used gains from mortality improvement to offset the adverse earnings impact of lower interest rates. Given the longer-than-expected period of low interest rates, however, the Company’s management team is now being forced to take more dramatic offsetting actions through repricing, redesign and withdrawal of products and business lines that would otherwise aggravate the Company’s earnings exposure to low interest rates through continued high new business strain and increased required regulatory capital. To limit market risk, the Company is also enhancing asset liability management through term extensions, rebalanced asset portfolios and intersegment notes.

Some of the Company’s recent strategic decisions, such as that to no longer write segregated funds with the Guaranteed Minimum Withdrawal Benefit (GMWB) feature and the decision to propose products that share more of the inherent market risk with policyholders, could change IAG’s competitive position. However, such decisions also suggest that the Company’s risk management approach yields the kind of difficult decisions that could sustain long-term profitability, albeit at the cost of a slower-growing revenue line and strained relationships with distribution channels. In this, the Company is no different than many in the Canadian life insurance industry who are transitioning through a difficult market environment that had not been priced into its products.

The recent $250 million issue of preferred shares lifted the Company’s Solvency Ratio from 189% at the end of 2011 to 200% at the end of June, which is at the high end of the Company’s target range. The subsequent sale of the Company’s U.S. annuity business has added eight points to its Solvency Ratio. DBRS regards a ratio in excess of 200% as conservative, given IAG’s risk profile. DBRS is also mindful that the regulatory capital ratio is inherently conservative as it assigns a disproportionate weight to traditional individual insurance risks such as policyholder behaviour to which the Company is relatively more exposed. The Company’s continued positive earnings and relatively low dividend payout ratio continues to support the organic growth of common equity, even as preferred shares have been added to complement regulatory capital requirements.

Through its captive agency in Québec and strong relationships with managing general agents (MGA) in the rest of Canada, the Company has good market penetration and has demonstrated good relative sales success. Despite its relatively small size, the Company’s franchise value continues to be supported by a mix of individual insurance and wealth management products (both segregated funds and capital-lite mutual funds), with smaller contributions from group benefits and retirement savings plans. IAG remains disproportionately exposed to the Canadian market and to universal life insurance specifically, which represented about 50% of its individual life insurance sales in 2011. Universal life is in turn more highly exposed to interest rate risks. An alternative insurance policy offering that shares more of the associated risks with the policyholder would address some of this concern. Within the group segment, the Company has a number of faster-growing product niches such as creditor insurance and an extended warranty business. The Company’s U.S. insurance business also continues to benefit from additional scale and the expansion of its distribution relationships with a focused product/market niche and limited interest rate risk. Investment policies are conservative in order to minimize the Company’s capital charge and credit market exposures.

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.