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Deflation 'worst possible world' for life insurers

If deflation ever breaks out, the investment to dump the fastest might come as a surprise: the shares of life insurers.

Compared to most industries, life insurance companies have an unusually large vulnerability to periods of falling prices, when they suffer a kind of mathematical vengeance from actuarial hell.

Life insurers make promises to pay people for insurance or annuities many decades hence based on today's assumptions about the likely amount of compounded future returns from investments. By depressing long-term investment returns, deflation plays havoc with this process. In Japan, the only advanced country that has experienced deflation in the modern era, the life insurance industry has taken it on the chin.

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Deflation is "the worst possible world for a life insurance company," says David Hughes, who follows the industry for Toronto-based credit rater DBRS Ltd.

If the deflation is bad enough, insurers "can go out of business by virtue of the fact that you just can't make enough money on your investments to support what you credited to your policy holders," he says.

"It does present some risk for the industry," says Colin Stewart, portfolio manager and co-founder of money manager JC Clark Ltd.

Mr. Hughes said Japan is "a perfect model for how a financial services industry can implode under a deflationary scenario."

In Japan, at least eight insurers have gone bust since 1996. One of the most recent was Yamoto Life Insurance Co., a 98-year-old firm that collapsed two years ago. A tally in Japan Economic Monthly in 2005 found that only half of the members of the Life Insurance Association of Japan in 1996 were still in operation. The rest had either merged or gone out of business.

Deflation hit life insurers hard as interest rates on 10-year Japanese government bonds plunged from levels of more than 8 per cent in the early 1990s to between 1 per cent and 2 per cent over the past decade. The paltry rates made it hard for insurers to earn robust investment returns from their bond portfolios to cover promised payouts to policy holders. Meanwhile, insurers' stock investments fell in value, making matters worse. The Tokyo market is still down about 75 per cent from its peak 20 years ago, a dangerous financial outcome when many insurers base their assumptions on stocks gaining around 8 per cent a year over the long haul.

Amid debate about whether the Japanese experience is likely to be replicated, the U.S. has shown some signs that it, too, might be on the cusp of deflation. The U.S. consumer price index has risen a minuscule 0.6 per cent over the past year, when volatile food and energy items are excluded. Canada's CPI is rising with slightly more gusto, at about 2 per cent.

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Canadian life insurers have substantial capital bases to withstand adversity, so they don't have many worries about the extreme fate of some of their fallen Japanese cousins. But they and their shareholders are likely to suffer if deflation breaks out.

An example of the industry's sensitivity to deflationary conditions is available at Manulife Financial Corp. , Canada's largest insurer by market capitalization and a firm that has substantial exposure to the United States through its John Hancock Financial Services subsidiary.

Manulife was sent reeling by the 2008 financial panic and its aftermath and became the only major Canadian financial institution to cut its dividend. The company estimates a one percentage point drop in rates cuts its net income by about $2.2-billion, while a 10-per-cent drop in stock prices cuts it by $1.3-billion.

"They are definitely exposed to a deflationary environment because you presume that the stock market then takes a leg down and interest rates take a leg down," says Peter Routledge, an analyst at National Bank Financial Inc., who has a "sector perform" rating on the company.

Mr. Routledge says the odds favour the Fed in warding off U.S. deflation. But he worries that if interest rates or stocks head south, or if Manulife takes a hit on some of its policies, the company may have to undertake actions such as selling more shares, which dilutes existing investors' stakes.

In a statement, Manulife said it has no plans to raise more equity, and that it has already factored the current low-rate environment into its long-term assumptions. It said it is also taking steps to reduce its sensitivity to both interest rates and equity markets and has a capital ratio "well above" regulatory targets.

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Nonetheless, Manulife has attracted the attention of short sellers, or those who try to profit when a company's share price falls. According to recent exchange figures, about 38 million Manulife shares have been sold short, worth about $640-million. That is about three times the dollar value of the short position against Great-West Lifeco Inc. , even though the two insurers have similar capitalizations. Manulife says it doesn't comment on market positions.

Currently, deflation isn't seen as a high probability event. Mr. Hughes called it a "tail risk," or an outcome considered statistically remote, so the impact isn't considered in setting credit ratings for life insurers or other companies. But if it does happen, it will be a problem. "It wouldn't be pretty for a lot of companies," he said.

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About the Author
Investment Reporter

Martin Mittelstaedt has had a varied reporting career at the Globe and Mail, covering politics, the environment and business. He opened up the Globe's New York bureau for the Report on Business, and has also been on the banking and capital markets beats. He's written extensively on investing themes. More

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