Manulife’s billion dollar splashdown

When the Canadian life insurers reported their third quarter results, billions of dollars in red ink flowed. Investors and executives alike were blaming the accounting rules. Frankly, we had to smile.

A key focus of our research for advisors is to quantify the impact of inconsistent accounting rules on the value of companies. And there is nothing like a billion dollar reminder to spark interest in ongoing financial reporting risks.

While Manulife posted a Q3 loss of $1.3 billion, it was more of a headline maker than a serious issue unto itself. The effect was driven by negative equity market and interest rate impacts of $1.8 billion. Under U.S. accounting rules, Manulife would have posted a profit of $2.2 billion, representing a swing of $4.5 billion during the quarter as a result of accounting differences. Adding up all the differences in recent quarters, the cumulative impact is that Manulife’s shareholders’ equity under U.S. rules would be $15.8 billion higher than it is under Canadian standards.

Accounting differences between Canadian and U.S. insurers have existed for years, so that’s nothing new. However, the recent volatility in equity market performance and interest rates has brought the issue more into the limelight.

In speaking to some advisors, it seems that they have misconstrued the situation to mean that Canadian accounting rules are more stringent than U.S. standards, somehow part and parcel of a better financial regulatory system in general. Unfortunately, nothing could be further from the truth.

Former Canadian generally accepted accounting principles, and now IFRS, place significant emphasis on getting the balance sheet “right” every quarter. The natural effect of changing the balance sheet is a direct impact on net income. So, significant changes in liabilities every quarter translates to volatility in profits. From a valuation standpoint, the market hates large swings in income. Sell-side analysts in particular tend to punish companies whose profits are unpredictable.

In Canada and internationally, however, the accountants who set the rules do not give priority to the desires of the capital markets (the largest group of financial statement users). Instead, they are focused more on an idealistic approach with no specific financial statement user in mind. The goal of getting the balance sheet “right” every quarter seems like an interesting idea, but it is completely unworkable in practice, and could never be used by the capital markets in order to value companies.

Understanding why the accounting approach is misguided becomes easier with a deeper look into Manulife’s recent results. The main factors driving the loss were the terrible performance of the equity markets in Q3, and recent monetary moves that had an impact on long-term interest rates. Extreme equity market volatility also plays a factor.

Before going further, it is worth mentioning that Manulife has had a hedging program in place since 2010 to try to mitigate the impact of the Canadian accounting rules on its results. Indeed, the company was able to hedge away roughly 70% of the adverse impact of the market and rate changes in Q3. Combined direct and indirect impacts could have been $4.8 billion, if not for $3.3 billion in after-tax gains delivered by dynamic and macro hedging efforts.

Manulife splits the losses that it is unable to hedge into two categories. Direct impact losses were $889 million and indirect losses were $900 million, the latter of which are related to the company’s dynamically hedged variable annuity liabilities. The distinction is important, because the company excludes only the direct losses when reporting its adjusted earnings.

Manulife tries to break down the $889 million in direct charges further, attributing $333 million to the impact of lower interest rate levels. However, the influence of lower rates cannot be so easily surmised because they are intertwined with the impact of volatile equity markets. In fact, when it comes to discussing its dynamically hedged variable annuity liabilities, Manulife simply notes that “due to their correlations, the equity market and interest rate components cannot be separately identified with precision.”

Unfortunately, this complicates the matter of explaining how the assumptions required by the accounting rules have such an artificial impact on the company’s results. It will have to suffice to say that under Canadian accounting rules, current rates are used to value the liabilities held by the insurers, and everything is pulled forward and valued using the current rate, with the difference recognized immediately in income. Under U.S. accounting rules, the companies smooth out the impact over many years.

The requirement under the Canadian rules that the underlying interest rate assumption will not change (or will hold steady for a very long period) has an onerous effect on not only reported earnings but also on the balance sheet. And, as mentioned before, the clear focus of accounting rules in Canada, and what they are supposed to get “right,” is the balance sheet. But ask any analyst who follows the life insurers whether they would value the companies based on their current balance sheets, and the answer would be no. Most analysts ignore the volatile numbers, and take issue with the Canadian accounting rules, seeing them as too burdensome, and on the order of a worst case scenario analysis.

The natural result is that the insurers try to adjust their earnings to smooth out the volatility that is created by the accounting rules, in an attempt to provide the market with a basis for valuation. Essentially, the companies end up recreating what the Canadian accounting rules have specifically tried to eliminate, a normalized earnings figure that won’t leave investors twisting in the wind trying to digest 50-page quarterly reports.

There are fans of the Canadian rules, including the regulators (OFSI) which love to play it safe to the point of overplaying it. And others believe that the alternative U.S. rules provide opportunities for companies to hide the impact of market changes over long periods of time. However, that is not an issue addressed well by the Canadian alternative, which relies on management assumptions just the same, and is equally malleable in the hands of willing executives.

This does not leave advisors in a great place now or moving forward. Changes are coming under IFRS, but they will likely be slow and disappointing when they do arrive. Without specific provisions in IFRS for life companies at the moment, the insurers tend to fall back on guidance from the Canadian Institute of Actuaries.

Given the misguided nature of the accounting regime in Canada, especially when it comes to the impact on lifecos, it is easy to advise investors to dismiss the recent losses posted by Manulife, Sunlife, and Industrial Alliance. They are simply the product of myopic rules that never anticipated this type of market environment, and tend to produce results akin to a stress test rather than what might be used for valuation purposes.

Despite the hollow impact, we are still smiling about Manulife’s billion dollar splashdown. Advisors won’t soon forget the $4.5 billion gap that existed in the same company under two different sets of accounting rules. So while your attention may have been drawn by the Canadian insurers’ losses, you might leave off wondering what other accounting discrepancies are floating around out there.

For instance, it was not long ago that executives at Newmont Mining were upset that Canadian producers like Barrick were allowed to report lower cash costs per ounce because they used IFRS instead of U.S. GAAP.

To wit, the tables can turn easily, and as some have observed already, you might not see Manulife’s executives as incensed in the future if they start to reap the gains of reversing some of the company’s Q3 losses as equity markets and interest rates start to recover.

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