Manulife delivered another stinging surprise to investors, posting a $2.4-billion second-quarter loss after being sideswiped yet again by falling stock markets and interest rates.
The loss was the company's biggest ever, surpassing the $1.9-billion it lost in the fourth quarter of 2008 during the financial crisis and market crash, and the ramifications were swift. Investors penalized the insurer by pulling its stock price down to levels not seen since the market lows of early 2009, while credit rating agency Standard & Poor's, which last year stripped Manulife of its coveted triple-A status, cut its rating again, this time to double-A.
Manulife chief executive officer Don Guloien promised a "dramatic" shift in Manulife's strategy to move away from products that increase its exposure to market fluctuations. But many investors viewed the loss as the latest blow from a company that has already unleashed a number of negative surprises, from chopping its dividend in half a year ago to tapping the market for billions of dollars in fresh common equity.
"It was unexpected," said Shane Jones, managing director and head of equities at Scotia Asset Management LP, which owns Manulife stock. "I think management has lost a tremendous amount of credibility."
Analysts had been forecasting a second-quarter loss, but not one of this magnitude. Barclays Capital analyst John Aiken sent a note to clients titled "How Could it be Worse than We Thought?" Analysts expected Manulife to lose about 62 cents a share, while its loss came in at $1.36.
In explaining its decision to downgrade Manulife's ratings, S&P said the company exhibits a higher-than-average appetite for strategic risk, noting that the insurer still has a significant amount of stock market exposure that is not hedged against potential market downturns.
"They should have hedged, that's the problem," said Stephen Jarislowsky of Jarislowsky Fraser Ltd., which is one of Manulife's largest shareholders.
Mr. Guloien called the results "extremely disappointing," but stressed that much of the pain will be reversed if interest rates and stock markets rise. Canadian accounting rules require life insurers to use very conservative assumptions; that is forcing Manulife to set aside money now to pay future claims in case interest rates and equity markets don't pick up and its investments don't make the necessary returns to build up funds for policy holders in the future.
"I think as investors come to analyze the results, they will realize that they're largely mark-to-market [accounting] having to do with interest rates and equity markets that could easily reverse in the future," Mr. Guloien said in an interview. He noted that under U.S. accounting principles, Manulife would have booked a small profit in the quarter, meaning the differences between Canadian and U.S. accounting rules resulted in a variance of about $2.5-billion.
"It does highlight the volatility that it is management's job to eliminate for investors," he added. "Our approach is to eliminate it over time, because we think that approach makes the most sense for investors, but it is painful."
John Kinsey, a portfolio manager at Caldwell Securities, said he was not happy with Manulife's showing, but sympathized with the CEO's argument about the impact of the accounting rules.
"If we have a good equity market and if interest rates are higher and perchance the Fed tightens a bit down the road, then they can reverse these things," he said. "I don't like it, but I guess that's what we're stuck with." A number of Manulife's underlying businesses performed well during the quarter, he added. A number of Manulife's underlying businesses performed well during the quarter, such as its Asian life insurance sales, he added.
Stock market declines caused Manulife to take a $1.7-billion charge during the quarter, which ended in June. The S&P 500 dropped 11.9 per cent during the three month period while the S&P/TSX composite index lost 6.2 per cent.
Falling interest rates, meanwhile, cut the insurer's earnings by $1.5-billion.
The volatility caused Manulife to change its sales strategy. The company has allowed sales of its troublesome variable annuity products to drop by 49 per cent from a year ago, to $1.6-billion this quarter, as it revamps its product mix to focus on those that don't add to its equity and interest rate exposures.
"We're slowing down some of our biggest businesses," Mr. Guloien said, calling the changes a "dramatic reformation." It will see Manulife put more emphasis on its Asian business and on fee-based products such as mutual funds.
Meanwhile, the insurer is hedging the new exposure it picks up through variable annuity sales, but it was unable to hedge more of its existing exposure during this quarter because of the weak stock markets and interest rates, said chief financial officer Michael Bell.
The key measure of Manulife's capital levels, called the Minimum Continuing Capital and Surplus Requirements, or MCCSR ratio, fell to 221 per cent this quarter from 250 per cent at the end of the prior quarter. That remains well above the bare minimum level of 150 per cent that Canadian regulators require.
Mr. Guloien said he could sell businesses as a contingency plan if stock markets were to decline severely, although he's not expecting that. "There are no plans to raise equity or reduce the dividend," he said.
On Bay Street, Manulife's struggles have begun to stoke speculation that it could at some point become a merger candidate. In the past two years, the company has been on a dramatic roller-coaster ride, one that has seen it go from being a potential acquirer of American International Group's very large Asian business to a company that's the subject of merger rumours.
"You're going to start to hear talk of cross-pillar mergers [between banks and insurers]coming back again," Mr. Jones said. "Five or six people today have asked me 'do you think this is going to be a target for a merger?' "