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The plunges in both interest rates and stock markets this week have taken a sizable chunk out of Manulife Financial Corp.'s capital, sparking calls for the insurer to sell its Canadian bank or even spin off its entire U.S. operations.

The financial crisis of 2008 showed how much falling stock markets can damage Manulife, but it has become evident that its true Achilles' heel is falling interest rates. While "Operation Twist," the program the U.S. Federal Reserve embarked on this week to bring down long-term interest rates, is not the fatal arrow, its impact is certain to sting.

And the lower interest rates go, the greater the impact further decreases will have. While Manulife's capital levels are more than sufficient right now, some analysts are calling on the company to take more actions in case rates and markets fall further.

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Manulife CEO Don Guloien recently said that only in an "absolutely unthinkable scenario" would Manulife's capital levels be inadequate. "Equity markets could go to zero and if that was the only thing that happened, we wouldn't have a problem paying all our claims, all our debt and still have a surplus left over for the shareholders," he said at a conference last week.

But some analysts remain skeptical. "I don't know if the market's calling his bluff … but I thought it probably wasn't the best choice of remarks," said Citigroup Inc. analyst Colin Devine.

After the 2008 market freefall forced it to go hat-in-hand (twice) to investors for billions in new equity to shore up its capital levels, Manulife embarked on a program to hedge its stock market exposure. As a result, more than 60 per cent of that troublesome exposure is now protected.

Manulife also began ramping up the hedges on its interest rate exposure, but not with the same vigour. The massive decline in rates this quarter, which runs from July to September, will make a big dent in the capital levels Manulife sought to bolster in recent years. (In addition to raising equity, the company slashed its dividend in half to preserve capital.)

At the end of June, the key measure of Manulife's capital levels, called the Minimum Continuing Capital and Surplus Requirements Ratio, stood at 241 per cent. That's up from a low of 193 per cent in the third quarter of 2008, and 221 per cent at the end of 2007, before the crisis.

That's comfortably above the regulatory minimum of 150 per cent, and Manulife's own internal target, which is believed to be closer to 200 per cent.

Stock markets in Toronto and New York are down by more than 11 per cent in the past three months. Manulife estimates that a 10-per-cent drop in stock markets would take $590-million off its profits and 5 percentage points off its MCCSR ratio. (In comparison, before its hedging program kicked into high gear at the end of 2008, a 10-per-cent decline was estimated to cost $1.6-billion).

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More importantly, Manulife estimates that a 100-basis-points (one percentage point) drop in interest rates would wipe $1.2-billion off its profits and 19 basis points off its MCCSR ratio.

While this environment is taking a toll on all life insurers, Manulife is one of the most sensitive to interest rates in North America, Mr. Devine said.

Many moving parts affect Manulife's capital levels, and there are various ways it can prop up the levels, including selling bonds. This quarter, for instance, it sold a unit related to re-insurance to Pacific Life Insurance Co., adding six percentage points to its capital levels. But there is no doubt that Manulife's MCCSR at the end of this month will be significantly below last quarter's, likely closer to 215 or 220 per cent, most analyst say.

"We are clearly getting into a danger zone," said Mario Mendonca, an analyst at Canaccord Genuity. "At 200 per cent, I'm sure people would be getting pretty anxious about Manulife."

If low rates and equity markets persist in the months ahead, the company could find itself shoring up its balance sheet again. Although this time around, that's not likely to be by issuing common equity.

For one thing, it could have trouble finding buyers, said Mr. Mendonca. The company issued equity at $19 per share in late 2009, and its stock is now trading below $12 – below its book value.

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A wiser course might be to issue debt and preferred shares, said National Bank analyst Peter Routledge. But that could weigh on the insurer's credit rating.

Mr. Devine thinks more-drastic measures are needed. He'd like to see Manulife spin off John Hancock Financial Services Inc., its U.S. business. "John Hancock is just going to tie up a lot of their capital, and produce a very low return, literally for decades to come," he said. "This is not a problem that gets fixed in quarters or years, it will run decades because that's the duration of their liabilities."

To illustrate Manulife's headaches, Mr. Devine, who is based in New York, points to the variable annuity that he himself purchased from John Hancock years ago. (Variable annuities, which are essentially pension plans for individual investors, are the main reason for Manulife's troublesome stock market exposure.) "My guarantee on that will compound 7 per cent this year," said Mr. Devine. "As a percentage of its account value, that's 11.2 per cent. The market's down 10 per cent."

Beyond its hedging programs, Manulife has been reducing risk by increasing prices and decreasing sales of riskier products, such as variable annuities. But while it has slashed the amount of variable annuities it sells in the U.S. by more than 75 per cent, it still must contend with products it sold at the height of the market.

Aside from parting ways with Hancock, another option for raising capital might be to sell Manulife Bank, Mr. Devine added.

If rates rebound (and, to a lesser degree, markets), many of Manulife's problems could be erased, and the company would release some of its pent-up reserves back into profits. The company's executives stress that Canadian accounting rules force insurers here to report more pain sooner as interest rates fall, whereas under U.S. rules, much of the impact is delayed.

Mr. Guloien recently told analysts that he remains committed to his goal of bringing the company's profits up to $4-billion by 2015. It made nearly that much in 2006, Mr. Devine noted.

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