DBRS Places Sun Life Ratings Under Review-Negative

DBRS has today placed its ratings of the debt and preferred share instruments of Sun Life Financial Inc. (Sun Life or the Company) and its affiliates Under Review with Negative Implications. The Claims Paying Ability rating of IC-1 assigned to The Sun Life Assurance Company of Canada has been confirmed. The rating action reflects the Company’s recent weak profitability and earnings volatility associated with exogenous market factors over the past several years. While these exposures are not unique to Sun Life, DBRS regards the current ratings, following a review of the industry, as being out of alignment with the Company’s recent earnings track record and those of its peers. The action also reflects uncertainty associated with the Company’s strategic transition as it attempts to restore profitability and earnings stability by pursuing more profitable products with fewer embedded risks and lower capital requirements. Sun Life faces a number of challenges in this regard, including associated execution challenges and the continuing weak economic and interest rate environment aggravated by evolving regulatory and accounting regimes.

The strength of the Company’s Canadian franchise, a growing appetite for its products and services, a reasonable level of diversification in attractive market niches in the United States and Asia, and conservative risk management are nevertheless not sufficient for Sun Life to maintain its current ratings in the absence of a recovery in core earnings and reduced earnings volatility to levels that are at least consistent with its 2015 earnings target of $2 billion (with a return on equity of between 12% and 14%). The resolution of the Under Review with Negative Implications status therefore hinges largely on an imminent return to reasonable profitability which would cover the Company’s fixed charges by at least 5.0 times. However, DBRS regards as ambitious the revenue growth assumptions underlying the achievement of such earnings.

Sun Life continues to enjoy a strong earnings platform in Canada, where it is ranked first in a number of major product categories including group benefits and group retirement savings products. The Canadian operations have achieved meaningful scale and leadership positions in all of their chosen markets, representing close to one half of the Company’s normalized net income. The Asian operations continue to grow, thanks to the emerging middle class market, and represent a good source of future earnings growth. The strategic decision to exit the U.S. individual life and variable annuity lines of business was prudent, given a Canadian company’s competitive disadvantage with respect to accounting and expected regulatory frameworks for these products. Sun Life is shifting its U.S. growth focus in favour of products requiring lower capital and more predictable earnings such as mutual funds, and group benefits, including voluntary benefits where the Company is targeting a top five ranking. Nevertheless, the Company’s decision to exit two major product lines cuts into its franchise value as it adopts a niche strategy in the world’s largest insurance market. However, the wealth management franchise at MFS Investment Management continues to be a steady contributor to earnings as it successfully grows its assets under management through strong investment performance.

The Company’s financial performance in recent years suggests that its enterprise risk management platform, while regarded as superior, has mitigated but not eliminated earnings volatility tied to recent market conditions. In addition, hedging costs have put downward pressure on earnings. The requirement for additional regulatory capital at its operating subsidiaries in the wake of the financial crisis and the transition to International Financial Reporting Standards (IFRS) increased the Company’s consolidated financial leverage to 31% at June 30, 2012, from just over 21% five years ago. Without earnings to support the associated debt service costs, the five-year average fixed-charge coverage ratio has dropped to below 2.0 times from 8.0 times for the period prior to the financial crisis. The core fixed-charge coverage ratio, excluding volatile market-related factors, has similarly fallen to below 5.0 times from over 8.0 times, which is below the level expected for a company with the current ratings.

Though Sun Life’s earnings have been volatile in recent years, it is important to recognize that its cash flow has generally not been adversely affected. The Canadian accounting treatment of policy reserves due to changing market conditions has been responsible for much of the associated earnings volatility, in addition to credit loss provisions, and goodwill impairment charges. The nature of life insurance accounting, reserving and regulation make this a very conservative industry, with little to no liquidity risk. Regulatory capital ratios at 210% for the Canadian operating subsidiary at June 30, 2012, and 412% for the U.S. operating subsidiary at December 31, 2011, are conservative, especially given extensive market hedges in place for which the Company gets no credit against regulatory capital. In addition, at June 30, 2012, the Company held an $800 million cash position at the holding company.

DBRS intends to resolve the Under Review status within the next few months, following its annual review with the Company’s management team.

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.