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Ottawa's financial regulator is conducting a new round of stress tests on the country's major life insurers to ensure they can withstand a major pandemic or another stock market crash.

The Office of the Superintendent of Financial Institutions is now poring through the results, according to sources familiar with the matter. If it determines that the balance sheets of companies such as Manulife Financial Corp. and Sun Life Financial Inc. would be seriously harmed by such public health or financial shocks, it could demand that those institutions hold more capital.

The stress tests are one of a series of challenges that life insurers are confronting. Sluggish stock markets and low interest rates are taking a heavy toll on the sector, and the body that sets accounting standards is debating tough new rules. Second-quarter financial results are also expected to be ugly.

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OSFI has asked 20 life insurers to run through three scenarios and assess the impact on their operations. Under one scenario, insurers are asked to run mathematical models of what would happen if a pandemic wiped out many thousands of people. Canada's regulator routinely makes financial institutions run stress tests. But industry sources say OSFI has been unusually prescriptive about how this set of tests is to be done. OSFI does not publicly release information about the specific tests it requires or their outcome.

Indeed, although the financial crisis might be a thing of the past and the banking sector has travelled far down the road to recovery, the life insurance sector remains stuck.

The economy is rebounding, but sluggish stock markets and low rates are taking a serious toll on the industry.


Any optimism that arose in the first quarter for the insurance sector is likely to be erased during the upcoming reporting season.

The ongoing impact of the crisis has driven the stock market's valuation of life insurers below that of banks and it has stayed that way for a prolonged period of time, Desjardins Securities analyst Michael Goldberg pointed out in a note to clients. Manulife Financial Corp, and Sun Life Financial Corp., which have historically had price-to-book ratios above two, now have multiples around one, he noted. The falling ratio, which compares a company's value on the stock market to its book value, suggests investor confidence has waned.

The insurers' second quarter wrapped up last week, and analysts are slashing earnings estimates and signalling their reluctance about forecasting what the next few quarters might bring.

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They expect that all life insurers will be affected by the markets, but none more than Manulife, which has the largest exposure to equities and interest rates. It could take a hit of more than $1-billion to profit in the second quarter because of declining stock markets, with the S&P/TSX index down around 6 per cent, the S&P 500 index down about 11 per cent, and Japan's Topix down 13 per cent.

"Low interest rates and volatile equity markets are essentially the opposite of an optimal operating environment, since they affect not only the in-force block, but also the outlook for sales and customer behaviour," Canadian Imperial Bank of Commerce analyst Robert Sedran pointed out in a note to clients.

In addition, insurers are contending with yet-to-be-released new rules from the International Accounting Standards Board (IASB). The International Financial Reporting Standards will affect companies around the world but they could be extremely onerous for Canadian life insurers, which have an unusually high proportion of long-term liabilities.

While the new rules won't take effect until 2013 at the earliest, a draft is due shortly and the rules could have a real impact on many of the insurers' key businesses, potentially making many popular product lines unsustainable. Canada's Finance Minister and financial regulator have written to the IASB urging it to keep the potential impact on insurers here in mind.

It has now received the results and if a life insurer were to fail a stress test, the regulator could force it to increase the amount of capital that it holds.

At the end of the first quarter, the key measure of Manulife's capital levels (called the Minimum Continuing Capital and Surplus Requirements, or MCCSR ratio) stood at 250 per cent. OSFI requires all life insurers to have a bare minimum level of 150 per cent, though individual companies might be told to keep theirs higher.

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