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Manulife takes steps to avoid further pain

Manulife head office in Toronto

Manulife the country's most battered financial institution, is poised to report its highest quarterly profit of all time. And the source of the bounty is the same thing that drove the insurer into crisis in the first place: the financial markets.

Rising stock prices and higher interest rates are giving some much-needed relief to Manulife's balance sheet, restoring some of the fortune that plunging markets took away. As a result, analysts say the insurer, which lost more than $3.3-billion in the previous two quarters combined, could earn $2-billion for the three months that ended Dec. 31.

Investors are catching on, driving up Manulife's shares 37 per cent in the past three months - by far the largest gain of any major Canadian financial services company.

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If the recovery is lasting, it would provide the company's chief executive officer, Don Guloien, with a chance to say "I told you so." He has been telling Bay Street for months that much of the pain inflicted on Manulife during the past two years would be healed by rebounding markets, which enable Manulife to release some of the money it has set aside as reserves back into its profits.

But most investors appear to care more about Manulife's ability to avoid further pain. They are focusing on the degree to which the company can shrink its troublesome exposures, not the amount of money it earns in the short term, said Canaccord Genuity analyst Mario Mendonca.

Said National Bank Financial analyst Peter Routledge: "The market has stated pretty clearly that, 'If we own Manulife stock, we don't want to own a leveraged bet on interest rates or equity markets.' "

As a result, Manulife decided to put more muscle this quarter into its efforts to hedge its exposure, even though doing so will reduce some of the gains it would have received from rising markets. While hedges limit losses when markets drop, they also limit gains when markets go up.

"It's a tradeoff, hedging activity," Mr. Guloien said in an interview. "You give away a little bit of upside in order to protect yourself on the downside. We have taken advantage of rising equity markets and rising interest rates to hedge at the appropriate time. If we had hedged, say, in the summer, the cost would have been quite more significant."

Still, Barclays Capital analyst John Aiken said: "We fear that some investors may not be pleased, as they had been looking for Manulife to participate in the strengthening markets to a similar degree as how it had been dragged down."

Mr. Guloien declined to comment on the company's upcoming profit announcement. "I'm looking forward to the day when people will focus on the core earnings potential of the company and will be less focused on the capital markets sensitivity," he said.

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On Wednesday, Manulife announced that it shorted $5-billion worth of equity futures contracts and sold $200-million of public equities between Oct. 1 and Dec. 31 to cut its exposure to stock markets. It also invested in longer duration bonds to limit its interest rate risk.

"They're giving up upside in order to reduce sensitivity. And the sensitivity they're reducing is their earnings sensitivity, which is a number derived from their actuarial models. So it is the actuarial tail wagging the economic dog," Mr. Routledge said.

As a result of the additional hedging, analysts estimate that a 10-per-cent drop in stock markets would cost the company somewhere in the neighbourhood of $800-million to $1-billion, down from $1.3-billion at the end of the prior quarter. Manulife's goal is to hedge 60 per cent of its stock market exposure by the end of 2012.

The steep dive in stock markets in late 2008, and the persistent low interest rate environment, forced Manulife to set aside billions of dollars in capital and reserves. Regulators required it to sock that money away to protect policy holders, but the company is able to release some of the money back into earnings when conditions reverse.

Manulife's best quarter thus far was the second quarter of 2009, in which it earned $1.77-billion. The company is scheduled to report its fourth-quarter results on Feb. 10.

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