2 ways to analyze life insurers

Over the last few weeks, we’ve looked at why analyzing REITs and pipelines from multiple perspectives is a good idea. Now, we’ll hear about life insurance companies.

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We asked Colum McKinley, vice-president, Canadian equities at CIBC Asset Management, and Jeffrey Waldman, head of global fixed income at CIBC Asset Management, to explain how they analyze Toronto-based Manulife Financial. McKinley owns its stock and Waldman owns its bond.

Read: Manulife Securities ramps up hiring as banks restructure

Equity metrics for financial companies

“When we look at a business in the financial services industry, we pay a great deal of attention to the balance sheet and the capital positions of those businesses,” says McKinley. “Capital positions represent the ability for that franchise to navigate through an adverse event in the markets,” such as the 2008 financial crisis.

An event like that crisis “affects the long-term earnings power of the company,” he says.

Specific to lifecos, “one of the challenges is they are affected by long-term assumptions on things like mortality and other actuarial factors. So we have to continually assess and understand how those assumptions are changing, and how they will flow through the financial statements of the company.”

McKinley also looks at whether the firm’s reserves are sufficient against “liabilities that tend to be long-term payouts. When you think about a life insurance product, you buy it today for a payout that could be required ten, fifteen, twenty years from now.”

Read: 6 forces that will impact life insurers

As a result, McKinley updates his models to incorporate trend changes. “Inputs to those models include regular discussion with the management team [to] understand how they’re thinking about […] how they’re evolving. [We] also [get] input from across the industry, where we’re looking at understanding trends in things like medical costs and how that could affect the outcome that is embedded in [a company like] Manulife’s assumptions.”

Read: Keep pace with tax changes for insurance

Fixed-income metrics for financial companies

Waldman also looks at balance sheet strength: “the life insurance business makes long-term promises to their customers.” Waldman focuses on regulatory capital, which is mandated by the Office of the Superintendent of Financial Institutions (OSFI).

“We compare the levels of regulatory capital across the industry, and we track changes in regulatory capital over time,” he explains. “We also look at the quality of the asset portfolio, because that’s the first line of defense that a company has behind the obligations that it makes to its customers and stakeholders. Asset portfolio performance can lead to some extreme volatility in the earnings of the company.”

Read: Should clients cash out an insurance policy?

He likes how Manulife has structured its holdings.

“Manulife makes sense as an investment both from a capital perspective and an asset quality perspective,” he says. “Back in 2009, during the depths of the financial crisis, the CEO of Manulife, Don Guloien, set out to build what he called ‘a fortress level of capital.’ And the reason for that was to help the company withstand adverse economic conditions. […] As bond holders, it’s reassuring to see that the CEO of the company is also focused on capital adequacy.”

The proof is in the pudding: “In the most recent reporting period, Manulife had 233% of the minimum capital stipulated by OSFI,” says Waldman. “That compares quite favorably not only to its peers, but to the historic level that Manulife has had in its capital position.”

Read: Reasons to invest in life insurers

As for Manulife’s assets, “78% of the bonds in its portfolio are rated A or higher. So the quality of the portfolio is quite high.” Nonetheless, he’s monitoring Manulife’s exposure to the energy sector, especially because they’re more exposed than their Canadian peers.

“But it’s still just 4% of assets, and we believe that that’s manageable for the company.”

Read: Best ways to analyze energy companies

Why talk to another manager

McKinley says a fixed-income perspective can help him predict equity returns. “When we work with our fixed-income team on a company like Manulife, we’re interested in two feedback loops that they can provide for us,” he says.

First, he focuses on the specifics of Manulife’s balance sheet: its debt levels, its ability to access capital markets, how quickly it can access financing, and other traditional metrics of debt servicing capability.

Then, “the second part we’re interested in is Manulife holds significant equity and bond investments as part of their reserves,” McKinley says. “Regular conversation with our fixed-income team helps us […] frame return expectations.”

Read: Great expectations: How to estimate future stock and bond returns

Specifically, he’s interested in interest rate expectations and how that can affect the earnings of these companies, “because that will have a significant effect on the profitability and the cash flows of a company like Manulife.”

Waldman asks his equity colleagues for “metrics for profitability, growth profile, and a dividend payout ratio. […] We want to know if equity investors expect management to make acquisitions or sell assets to attempt to increase shareholder returns; often these decisions are to the detriment of bondholders.”

Read: Consider distressed bonds for returns

Melissa Shin

Melissa is the editorial director of Advisor.ca and leads Newcom Media Inc.’s group of financial publications. She has been with the team since 2011 and been recognized by PMAC and CFA Society Toronto for her reporting. Reach her at mshin@newcom.ca. You may also call or text 416-847-8038 to provide a confidential tip.