Banks offer life & health, property & casualty, travel medical, and credit protection insurance through branches, online, and proprietary and third-party sales, as regulations prescribe.

However, the insurance divisions of some of the major banks were hit by various setbacks last year, including the widespread Alberta flooding last summer that caused an estimated $1.7 billion in insured damage. As a result of severe weather-related events, TD, for instance, recognized an earnings hit of $170 million in its fiscal Q3 2013. That was on top of a $48 million after-tax charge in the same quarter to reflect the impact of the Alberta floods on the value of TD’s loan portfolio.

The bigger insurance-related charge for TD, however, came from legislative changes in 2010 for auto insurance in Ontario. TD is still struggling to adapt to the new regulations, which were aimed at reducing insurance costs by limiting the accident benefits paid to claimants for minor injuries. As a result, third-party liabilities have increased and claimants are suing for higher settlements. Additionally, recent court rulings have favoured claimants more often. Claims costs are becoming more expensive as litigation and fraud increases, and banks with insurance in urban areas, such as TD, have become more exposed.

TD recognized a total hit of $395 million for auto claims in Q3 2013, and the bank could recognize more charges in future. If not for the combined charges of $565 million ($418 million after-tax), TD’s insurance business would have grown 14% in fiscal 2013, and would have again represented 9% of bank-wide earnings, as it did in 2012. Instead, earnings fell to 3% of profits in 2013.

Additional issues

Another legislative impact on the bank-owned insurance industry was felt by RBC, which took a hit to its fiscal fourth quarter earnings due to changes to the tax treatment of certain life insurance policies.

In October, the federal government tabled Bill C-4 (the 2013 Federal Budget). For accounting purposes, first reading in the House of Commons is usually the trigger for acknowledging “substantially enacted legislation,” which then prompts the recognition of any impacts on financial statements (such as expected losses). The bill received royal assent in December.

RBC recognized an after-tax charge of $118 million to net income in its fiscal fourth quarter related to the proposed budget legislation. As a result, earnings from the bank’s insurance segment declined 16% in fiscal 2013. The charge also reduced return on equity in the segment from 49.9% to 41.6% for fiscal 2013 (the average ROE across the bank’s other businesses was 18.6%).

The budget aimed to close many tax loopholes, including those related to individual insurance strategies. For instance, leveraged life insurance was promoted by several providers, but some advisors questioned their too-good-to-be-true tax advantages.

The premise was to borrow funds to invest in a UL policy, and the policy would act as the collateral for the loan. This allowed investments to grow inside the UL policy tax-free, but also permitted the individual to take tax deductions for borrowing money for investment purposes. The two halves of the investment were sold together, but treated separately in the hands of the taxpayer, thus allowing for the doubled-up tax savings. For instance, 10/8s encouraged people to borrow money at 10% and purchase a policy that paid 8% (the spread was guaranteed). Because the after-tax cost of borrowing was closer to 5.5%, the borrower would receive a set return.

The government also targeted leveraged insurance annuities (LIAs), a strategy that involved the use of borrowed funds to purchase life insurance and a life annuity, both issued on an individual and assigned to the lender. In this arrangement, the insurance policy covers the individual for his lifetime, with the amount of the death benefit equal to the amount put into the annuity.

The government noted, “Investors in leveraged insured annuities are provided with multiple tax benefits that are not available in relation to comparable investment products,” and moved to shut down the loophole.

The budget closed the loopholes, and outlined that there would be no tax consequences for people with 10/8s, provided they wound down the arrangements before 2014. The budget also warned that if people choose alternative strategies to replace leveraged insurance and circumvent the rules, then backdated penalties could apply.

RBC notes the majority of the affected policies were issued by third-party brokers who were working with the bank to find alternatives for clients. The impact was that the expected profit on the alternative options is lower than under the leveraged arrangements. While subject to mark-to-market accounting revisions, the $118 million after-tax earnings impact will not change for RBC, and can be viewed as more of a one-time impact, as opposed to TD’s situation, in which the bank continues to struggle with the increasing legislative fallout.

Without the charges, RBC’s insurance segment would have held steady in 2013. Instead, earnings fell to 7% of overall profit, from 9% in 2012.

Growth prospects in 2014

Even though insurance profits declined at some of the major banks last year, they aim to continue growing these divisions through both organic means and opportunistic acquisitions. The longer-term prospects are just too promising for the banks, given that insurance offers the highest return on equity of any of their business lines.

On top of other benefits, such as earnings diversification, the attraction for the banks is to grow profits through greater integration of insurance into their wealth management divisions and the wealth management strategies they can deliver to clients. While the death of 10/8s and similar strategies represent a setback in this regard, they will soon be just a bump in the rearview mirror as the banks push ahead with their growth strategies in 2014. 

Al and Mark Rosen run Accountability Research Corp., providing independent equity research to investment advisors across Canada. Dr. Al Rosen is FCA, FCMA, FCPA, CFE, CIP and Mark Rosen, is MBA, CFA, CFE.

Originally published in Advisor's Edge Report

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